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Interview with market participants: BTP yields continue to drive Euro-BTP volume

Release date: 01 Nov 2018 | Eurex Exchange

Interview with market participants: BTP yields continue to drive Euro-BTP volume

Eurex launched its options on the Euro-BTP Futures (OBTP) in October 2017. This option segment has shown dramatic growth, buoyed by the uncertainty across Italy’s political landscape. On 25 October, 2018, a new volume record of 73,927 contracts traded. When we compare this ‘newcomer’ volume to the average daily volume of the established options on the Euro-Bund Futures of about 175,000, the success and potential of this option segment becomes clear.

Eurex reached out to NatWest Markets, Banca Akros and Anima SGR to see what lies ahead for the Italian economy, its political landscape and the success factors of the OBTP.

Italy's economy, the eurozone's third-largest, has been in the spotlight for a while. That is of significant concern for the EU and the global markets. What are the biggest concerns, how are global markets affected and what lies ahead for the BTP?

Imogen Bachra, European Rates Strategist & Giles Gale, Head of European Rates Strategy of NatWest Markets*: The political news flow and the Italian government’s deficit target for 2019 and beyond, have been the key drivers of yields in recent weeks. So far, the broader markets have been largely isolated from BTP-related volatility. However, any further widening in BTP spreads versus German Bunds would make it harder for markets to ignore the potential of market contagion arising out of Italy. If Italian BTP spreads widen further against the Bund, it becomes harder for other markets to be unaffected by Italy’s idiosyncratic situation.  And, even though Italy’s sovereign debt, for now, has avoided a downgrade to a non-investment grade rating, we think Italian bond yields will continue to face upward pressure in the near-term, arising from ongoing tensions between the Italian government and the European Commission over the country’s draft budget.

What are the potential scenarios arising from the Italian political situation?

Imogen Bachra & Giles Gale: The Commission has, for the first time in the history of the Stability and Growth pact, rejected Italy’s budget, claiming “serious non-compliance” with the recommendations of the Council to Italy in 2018. The Commission has highlighted concerns over the growth rate of government expenditure and the trajectory of the government’s debt. Italy now has until the 13 November to revise its budgetary plan. Currently, the government does not look ready to back down on any of its planned targets, and any significant back-tracking would be surprising.
The process is also likely to be very drawn out once the government responds. Our base case is that more fiscal surveillance will be the first step from the Commission, rather than fines, to address its concerns around Italy’s proposed budget. But a full Excessive Deficit Procedure, resulting in more frequent fiscal surveillance and revised recommendations, may not be employed until 2019. Traditionally, any excessive deficit procedures, or significant deviation procedures (SDP), have not started until the Commission’s Assessment of the Stability Program in May.
But what is important to note here is not the length of the process per se, but how tensions with the Commission may shape Italy’s political landscape in the interim period and how markets respond as a result.  Next year’s European Parliament elections   may become the key moment for Mr Salvini to redefine his vision for reform of the European Union and also a key campaigning opportunity and proxy for national elections in Italy, which may not actually be that far off.

What is your opinion on market volatility and how investors are reacting to the current macroeconomic environment? Have BTP options played a role in the portfolio strategies of banks and institutional investors?

Elisa Poncini, Interest Rate Volatility Desk, Banca Akros: Volatility has increased considerably in recent months and market uncertainty is likely to maintain volatility at significant levels. On BTP options in particular, there is a higher degree of uncertainty due to political issues. Options in this asset class have become crucial for risk management, which is becoming increasingly difficult, given the lack of correlation with other asset classes. 

Luca Noto, Senior Portfolio Manager, Anima SGR: The situation in Italy remains unstable and open, in particular with investor concerns fueled by the heightened draft budget conflict. The current market volatility therefore also reflects uncertainty over possible BTP scenarios. It’s an unprecedented situation where domestic fiscal policy clearly seems to be diverging from the convergence objectives of European policy. For an asset manager, options on BTP futures can be used to build portfolios with asymmetric risks more appropriate to the current situation, where asymmetric shocks may unfold and affect the market.

Imogen Bachra & Giles Gale: Against the backdrop of negative news flow around Italy, it is not completely clear where the marginal buyer of Italian debt lies. International funds seem to be deterred by the uncertainty of budgetary negotiations with the Commission, coupled with the unpredictability of Italian government policy. We think that domestic banks are also on the sidelines, having already warehoused sufficient Italian risk.  Indeed, ECB data show continued buying of BTPs from domestic investors throughout 2018 until August. With little relief expected in the near-term, we expect the upward pressure on Italian yields to continue.

How have Eurex BTP options impacted the trading of OTC BTP options? What type of investor is the typical user of BTP options? Do you expect more investors to get involved?

Elisa Poncini: Being able to price volatility in an electronic market certainly helps to build volatility surfaces, by boosting liquidity and also ensuring greater market access for different types of investors, avoiding a monopoly by the large investment banks.
The main investors in this market are undoubtedly the proprietary trading desks of the major banks, as well as hedge funds and asset managers in general. Flows will continue to increase over time and involve smaller financial institutions.

Luca Noto: Listed options inevitably allow broader participation, even among actors who are not naturally involved in the BTP market. This encourages the formation of  a very liquid and deep market and helping the price discovery of volatility even for a horizon beyond the spot date. In the specific case of an institutional investor, the increase in the number of market makers and the continuous bidirectional flow between the pricing of volatility for listed and OTC options should lead to a narrowing of bid-offer spreads for long-dated options that are not at-the-money, creating a volatility surface that alters the distribution of expected yields.

What are the risks in pricing BTP options?

Elisa Poncini: The main risk in pricing these instruments comes from the lack of correlation between BTP and other asset classes. A problem that has existed for several years and has become more acute in recent months. As a result, it is often necessary to hedge positions through the delta only, with the risk of a spike in the underlying often not sufficiently covered by volatility -despite the high levels- and widening bid-offer spreads, especially combined with market spikes.

Can you give an example of a particular difficult day during the last few weeks?

Elisa Poncini: The most challenging days in recent weeks have been those when BTP movements were most pronounced. Most of the difficulties were encountered when hedging option delta risk. During periods of market tension, it is also difficult to find bonds in the repo market on which short positions exist. In addition to that, the market is still fairly competitive and under these circumstances options are traded/closed with a low profit.

Luca Noto: Since 29 May 2018, every day has been difficult: the high volatility is persistent but stable, with very wide bid-offer spreads.

*Disclaimer: The views expressed in this article are the author's own and do not necessarily represent the views of NatWest Markets Plc

Giles Gale, Head of European Rates Strategy Trading Desk Strategy Natwest Markets

Giles Gale is responsible for European Rates Desk Strategy at Natwest. His interests range from European macro and industry-level themes to relative-value opportunities in interest rates, options and inflation-linked markets. He contributes to and edits Natwest Markets’ Global Macro Weekly.

He joined RBS as a Rates Analyst from Morgan Stanley in 2006. He brings together detailed product and market knowledge gained through wide-ranging roles within Rates Strategy and Trading with a cohesive macro overview. Gale previously worked as an Economic Researcher at the LSE studying the role of new technologies in productivity and as a Business Strategy Consultant at PWC in Madrid.

Imogen Bachra, European Rates Desk Strategist Trading Desk Strategy Natwest Markets

Imogan Bachra is part of the European Rates Strategy team at NatWest Markets. She contributes regularly to the desk’s serial publications and ad-hoc research notes, with a focus on general macroeconomic themes and analysis. More recently, she has also focussed on options markets, generating relative value trade ideas and investment strategies, alongside regular market volatility commentary. Imogen joined NatWest Markets on the bank’s graduate scheme in 2014, working with the Macro Credit Research team, before joining European Rates Research and then European Rates Desk Strategy.

Elisa Poncini, Interest Rate Volatility Desk, Banca Akros

Elisa Poncini is in charge of the IR Volatility Market Making in Banca Akros, The Banco Bpm Investment Bank, running EUR 1.7 billion Volatility Book, where Cap&Floor, Swaptions, Bermuda, CMS and Bond Options are the most sizeable components. She is the Bond Options market maker for Institutional Clients and the Bank’s Proprietary Desk (with its EUR 26 billion Bond Book).

Elisa joined Banca Aletti in 2010 (then merged in Banca Akros) on the Bond and Structured Notes Desk, where she was manager of EUR 700 million Structured Bond Portfolio and responsible of the Interest Rates and Credit Risk Monitoring for IR Market Making desk.

Luca Noto, Senior Portfolio Manager, Anima SGR

Luca Noto is Senior Portfolio Manager at Anima SGR, an independent asset manager based in Milan, Italy, with branches in Luxembourg and Ireland. He is responsible for approximately EUR 4 billion of fixed income funds; he helps to manage more than EUR 2.5 billion in global unconstrained absolute return funds and circa EUR 1 billion of a pension fund. He is also responsible for controlled low-volatility funds and mandates of institutional clients.

Before joining Anima, from 2004 to 2005, he was Fund Manager in a Global Macro Hedge Fund based in Switzerland. Here, he was responsible for global macro themes and the editor of the monthly newsletter to investors; he was also responsible for a book invested in fixed income and foreign exchange rates.


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