ANALYSIS: Risk-free rates to play key role in European futures – FOW panel

Speaking at a FOW Trading London panel on Thursday, the head of rates futures sales trading at Goldman Sachs said European Market Infrastructure Regulation (EMIR) 3.0 has the potential to fragment liquidity in short-term interest rate (STIR) futures as Frankfurt-based Eurex challenges the dominant London-based ICE Futures Europe.

“With the active account requirement, there is the potential to drive a diversion of liquidity further. Fragmented liquidity does not really benefit the end user particularly well, while we have not really seen good examples of how this type of regulatory input can co-exist with fragmenting liquidity in a way that benefits the market,” said Douglas Kerr (pictured) during the panel, representing his own views rather than those of Goldman Sachs.

“Market forces will take it one way or the other, but as per the risk-free rate movement, regulation really is the only thing that drives end users to make the change across from one contract to another.”

Despite concerns about fragmenting liquidity, Kerr expects Eurex to benefit from this enforced migration of liquidity onto mainland Europe and he sees futures based on risk-free rates doing well also.

“I think the endgame to this will more than likely be a move toward euro short-term rate (ESTR) further down the line and a similar move to risk-free rates to what we saw with the old Libor contracts in the US and UK,” said the Goldman head of rates futures sales trading.

“Eurex will be very well-positioned on that move, given the active account changes. Hopefully there isn’t too long where liquidity becomes an issue across multiple exchanges and hopefully the market can settle on a way forward that is beneficial to everyone and keeps the liquidity that currently exists within the market.”

Eurex launched in November 2023 a partnership programme to incentivise firms to trade its STIR futures ahead of European regulation aiming to reduce Europe’s reliance on London-based markets like ICE Futures Europe.

Eurex traded 24.5 million contracts of the flagship Euribor contract last year, according to FOW Data, compared to 374 million lots at incumbent ICE Futures Europe, meaning the German exchange had a market share of 6.3%.

In futures linked to the European risk-free rate, Eurex traded last year 26.2 million contracts, according to FOW Data, which was a market share of 54% while ICE had 38.5% and CME had the rest.

Speaking at the FOW Trading London panel on Thursday, Eurex global head of fixed income and currency derivatives sales Markus Georgi said “time will tell” if both Euribor and ESTR products survive.

“The two products could coexist peacefully for the foreseeable future. It is still too early to say whether the ESTR will ultimately prevail. Euribor is still the incumbent rate in the futures market but ESTR is growing steadily. Unlike in the US and the UK, where regulatory pressure led to a more rapid transition to risk-free rates, the switch from Euribor to the ESTR in Europe seems more gradual,” said Georgi during the panel.

“STIR futures at Eurex are expected to continue growing, especially with the active account requirements under EMIR 3.0 coming into effect. In terms of margin efficiency, it does not matter which product will prevail. What is important is that we cover STIR alongside with Bund, Bobl, and Schatz futures as well as euro swaps under one single CCP at Eurex.”

Two European STIR markets is not necessarily beneficial to traders used to a single pool of liquidity, another panellist at FOW Trading London said earlier on Thursday.

“In the listed markets, I think it is interesting that regulators and policymakers in general seem to think that a single pool of liquidity for a contract or asset class is necessarily a bad thing. I appreciate competition concerns influence that thinking but, as a previous market participant, we always knew that a single pool of liquidity was better for us in terms of taking and managing risk,” said Steven Hamilton, who was ICE’s global head of financial derivatives from 2019 to 2022.

“(With) a hybrid model where you have two pots of liquidity necessarily there with only a certain amount of risk in the market and a certain amount of liquidity providers prepared to show that risk in the market, this ends up being a less preferable outcome than one single pot of liquidity.”

Last week, senior European policymakers said they plan to change regulation to make Europe more competitive by reducing fragmentation and lowering barriers to entry.