Cboe Global Markets, Inc. (CBOE) Earnings Call Transcript & Summary

[Audio Gap] S&P 500 Variance Futures slated to begin trading in September -- September 23rd of this year, just in time for the election, which is shaping up to be another exciting one. To talk about our new product, we have with us today John Hiatt from our CBOE Lab team. That's the team behind basically all the new products that's coming out, the brains behind the operation I'd like to say. But in addition to John, who's going to give an overview of the product, we're really also excited to bring you kind of the -- a more complete perspective of the whole ecosystem that's going to be trading and also supporting this product from a liquidity standpoint. So with me today also, we have Alexis Lefebvre, who is the CIO, Co-Founder and Portfolio Manager at Melqart Asset Management, a U.K.-based hedge fund. We have Nick Volbi, who is the Head of Equity Derivatives Index Trading at Morgan Stanley as well as Tom Seewald, COO at Akuna Capital, who's going to be one of the market makers supporting this product. So very excited to have everyone here and as a kind of a matter of housekeeping we're going to go through some prepared content, prepared moderated discussion. There will definitely be time for Q&A. We're very excited for Q&A. [Operator Instructions] And in terms of timing, this will be a 30-minute webinar, so 20 minutes roughly of prepared content and 10 minutes of Q&A. So without further ado, I'm going to turn it over to John. John, could you walk us through kind of just, again, overview given the time constraints of this new product?

Sure. Thanks, Mandy. Good morning, everyone. So as Mandy mentioned, subject to regulatory review on September 23rd of this year, we plan to launch cash-settled futures on the realized variance of the S&P 500. If you see on the first slide here, you'll see a formula for the final settlement value of the contract labeled [indiscernible]. And basically, what we're settling to is the annualized sum of the squared returns of the S&P -- daily returns of the S&P 500. The contract is going to trade in variance units and be quoted in terms of the variance of the S&P 500. So price of 400 would mean an implied volatility of 20 on the first day that the contract is listed. The contract size, as I mentioned, is one variance unit, and it trades in variance units. So it will clear immediately. It was just somewhat different than our previous version of variance futures that we launched in 2012 and traded from 2012 to 2022. If you see on the upper right of the first slide that we have here, these are the contract months that are going to be launched on September 23rd. So basically, we'll have the first 6 months of contracts and then a contract expiring in June of 2025 and December of 2025. Each of the contracts will begin accruing realized variance on the date that it's listed with the very first return or very first price observation that is the close at the -- on the day that the contract is listed. And then you'll just sum the close-to-close returns for all of the days, except for the final day. The final price observation will be the opening settlement value of the S&P 500 on it, the contract expiration date. That's the same value that we use to settle SPX options on that date. So you'll have a string of returns that you'll square to find the final settlement value, which are closing returns -- based on closing returns. And then the final return will be based on the previous night's close and then on the final settlement value. So if you look at that contract table, if we start on September 23rd, that first contract that expires on October 18th will settle to approximately 1 month of realized variance. The November will settle the two months and so on through the March contract, which will be 6 months of realized variance. The June and the December contracts are a little bit more, the June contract will sum 9 month realized variance and the December just over a year. The only other thing that I'd point out on the first slide is the idea of market disruption dates. So if it's the case that you had something like the National Day of Mourning for deceased President, and that happens during any of these contracts, the way the contract functions is that, that date will be considered as 0 variance day. So we're not accruing any variance on a disruption event. So the number of returns required to compute the final settlement is established at the start of the contract, it really doesn't change when a market disruption event occurs. Mandy, you can go on the second slide. So you have the final settlement is just the sum of the squared returns of the S&P 500. Daily settlement values for the contract are going to be a combination of the realized variance that's accrued to the date that you're on plus what's implied for the remainder of the contract. That's pretty much how the contract will trade throughout the trading day as well. There's one other thing to note about it is that on the day that you enter a trade in the contract, you have exposure to the S&P 500 index level at the time that you make that trade. So if you're thinking about the price of the contract intraday as you're trading it, it would be a combination of three terms, the accrued realized variance to the previous night's close. And then the variance of that close -- previous nights close to when you're trading the contract, so you have exposure to the S&P 500, and then you have another term that's the implied variance from the remainder of the contract. You could advance the slide again, Mandy. As I noted, we're going to be trading in variance units. So you can think of the vega exposure of one variance unit according to the formula that you see on this page. And it's just 2x the implied volatility of the contract and then you're multiplying it by how much of the contract is remaining or the distance or days to expiration basically. If you were thinking that you wanted, say, 100,000 vega in exposure, you would just divide 100,000 vega by the term that you see there to figure out how many contracts you needed to trade. So if I were saying that it's the first day of trading, and we were quoting an implied volatility of 20, which would be 400 on the variance futures price, you would divide 100,000 vega by 40 to come up with your number of variance units, and you would get about 2,500 contracts that you would need to trade. You can advance the slide again, Mandy. So when the contract is live and we begin trading, this site isn't up yet. We go -- we have a certification test before we launch the contract that starts next Monday, and there'll be a link on our Resource Hub, where you can see this variance calculator. And basically, what this is going to do is allow you to convert the futures price that you'll see in the two-sided market while you're trading the contract into an implied volatility in the first box here. And then you can also go back from an implied volatility to what the futures price would be or you could convert your vega notional that you want to trade into an order size or a number of variance contracts that you need to do. Another thing that's nice about the variance calculator is that if you look near the contract expiration, the drop-down for which contract you're trading, you can download the contract schedule which will give you what's the accrued variance to date, how many days of realized variance are you actually going to settle to, how far through the contract you are, so that you can do all of the conversions between Vol and Vega and the number of futures and futures price. You could advance the slide. The next slide is just the Resource Hub that we have up today. You could link to the site. As I mentioned, if you look under the Resources tab on there, you'll see the variance calculator once we get into cert next week. You can see the contract specs that we filed to trade the contract. And any questions, including what you'll see on Cboe data feeds for the contract in terms of accrued variance and the number of days of accrued variance that will be settling to the contract.

Great. Thanks, John. I'm going to leave this slide up for a little bit longer, so that people want to copy down the link. The slide deck itself will also be available after the webinar. But maybe another question to you, John. And you mentioned this is not our first time launching variance future. So just to kind of -- I wanted to know what's been the customer feedback this time around? And what's different about this launch versus prior iterations that make you more confident that it will be successful?

Sure. So this is actually the third time that we've tried to launch a future that settles to the realized variance of the S&P 500. The original contract we did was back in 2004. And when we did that, every contract settled to 3 months of realized variance of the S&P 500 and the contract expirations tied to the March quarterly cycle. It was quoted in variance -- number of variance futures, variance units and a variance price as well. Then back in 2012, some of the feedback that we had gotten on that contract was it was difficult to go from an implied volatility, and a vega notional exposure, which is typically how the contract is traded in the over-the-counter market to what we were quoting variance futures and variance futures price. And so our second version of the contract, we actually did some development work so we could allow the contract to trade in terms of a spot starting implied volatility and a vega notional exposure, that required many of the market participants that would trade and clear the product to do development work themselves in order to trade it because we would pend a trade until the end of the trading day so that we could observe that day's S&P 500 closing price so that we can convert from variance futures price to number of contracts into -- we convert the implied vol into a number a variance futures price and the vega notional into a number of contracts. So this time around, I think what's really different and how the market has changed is there's been some changes to uncleared margin rules that have affected the viability of trading variance in the over-the-counter market. So there are people who are looking for an exchange solution this time. And it's the case that most of the people that have contacted us and wanted to trade variance in a listed environment, would prefer to trade it the way that we have it today in variance futures prices and a number of variance units simply because then you don't have to do the development work that was present in the second contract.

Got it. Super helpful. Okay. So I'm going to now turn the conversation or open up the conversation to our other panelists and Alexis, I'm going to go to you first. Can you just talk to us about how -- what instruments are you currently using to trade vol and what's your kind of been your experience trading, in particular, variance over the past couple of years, maybe pre versus post pandemic?

Sure. So we actually trade vol through variance swaps, which are OTC and listed options, S&P and E-mini and VIX options as well. So for us, internally, all of this is tied up together in our VIX system and everything else. And we kind of look at it as a whole. However, in reality, variance swap is OTC and for a lot of kind of systems and institution, VIX is actually a different asset than S&P. So in terms of risk aggregation and margining and all this stuff, it's not really tied up together. So variance swap actually traded OTC causes a certain amount of issues. So the first one is that we need VIX dash for every third party that we trade with. And also, we will have VIX in listed format and variance swap and instruments format which might sit at different places. So first is VIX dash, second issue is instruments at different places. The second issue I think for us has been valuation. So at the moment, you can either use market or you can use counter-party marks, but I can trade the same variance swap with 2 people and have 2 different marks. So in terms of valuation, it's not a deal and you can rely on market, but that causes other issues. And I think the last thing that I think will be beneficial in having this kind of listed product is the actors. I think banks have been in and out of the market depending on appetite, especially with issues that have been caused by previous kind of fund defaults where The IA was very big, and that reduces a lot of capacity to trade. Now with a listed contract, we will have access to not only banks, but kind of professional market makers and possibly a wider universe than that going forward. So it's liquidity, it's kind of counterparty sets and really valuation that would change for us.

Great. I think you already touched upon a lot of the points that I want to ask on the second question. So maybe just a recap, I was going to ask you what's most enticing about this product. But I think you talked a little bit about the liquidity and the transparency. Maybe just what's top of mind in terms of what appeals to you the most about this upcoming launch?

Yes. And I think there's also going to be more granularity down the line. I think if you take the template of what VIX has been, it started with a few contracts. And then now we're at the point where there's contracts every day and there's a possibility of like VIX intraday. So I think at this point, if the product takes off and it all works well, we'll be able to trade variance, but also forward variance. So we'll be able to trade each day completely individually so that actually really pushes our ability to trade event risk without having to spread it. So if you look at 6 months to 12 months down the line, if successful is actually a lot more possibilities for us to be more nimble.

Got it. Very helpful. Okay. Next, I want to turn it over to Nick, who's going to be one of the sell-side trading desks to hopefully active with this product once we launch. So Nick, can you just give us an overview maybe of kind of which client segments are currently active in trading variance? And just how that market has changed again, now versus, say, pre-COVID?

Sure. I'd say it's a very wide client segment, ranging from hedge funds to asset managers to pension funds and insurance companies. I'm definitely excited about the prospect of being able to provide block pricing on these variance futures. . I think anybody who traffics in the VIX futures and VIX options market should be thinking about the benefits of being able to express directional use and volatility with direct exposure realized vol in a listed instrument. The potential user base of the product is wide. I do expect initial interest to come from the existing OTC variance swap market participants. Looking for lower margin and collateral alternatives to OTC variant swaps. And as Alex has mentioned, some of the transparency that you get from the listed market that sometimes you don't get with OTC with people having different valuations. I think with the liquidity and volumes in the S&P listed options market and the VIX futures market and the VIX options market, S&P variance futures are an obvious missing link in the listed S&P vol complex given the arbitrage relationships that exist amongst these. So the product is going to naturally fit into the complex. And I think it's not only going to satisfy existing demand, but it's also going to allow for the development and growth of other products that can utilize listed variance futures as a vehicle for expressing directional views unrealized volatility without the path dependency of option-based expressions. In terms of what's changed now versus pre-COVID, it's definitely -- I think it's interesting that there's been huge growth in the listed options market, especially in the S&P vol complex. But we've actually seen probably the OTC variant swap market, which had been roughly active for 2 decades. It's actually probably a small as it's been over the last 2 decades as a result of the increased margin and collateral requirements. So I think this listed alternative comes at a really appropriate time.

Great. And then maybe just a follow-up, who kind of -- who would you -- who do you see as being kind of the biggest beneficiaries of having a listed product? Because you mentioned existing vol players kind of thinking the day 1 users, but any other kind of beneficiaries that you see from this product?

Yes. I mean, I think certainly, the vol arb community on the hedge fund side, which has grown in size is going to be the most active participant and I think for them as being really active in turnover. This is going to be a very beneficial product, especially with the cross-margin benefits that you'll get from the -- across the rest of the listed S&P vol complex. So anybody who's trafficking in that complex and really trafficking with the bend towards thinking about the world from an implied volatility perspective. And that universe has certainly grown I think, is going to be an actual beneficiary of this. And there's certainly been a gravitation over the last 15 years, I would say, from moving away from OTC products and toward listed products, and we've seen this happen in a variety of different instruments and the success has definitely been pretty substantial.

Okay. Tom, I'm going to turn over to you now. I know you were very active trading the prior version of variance futures that we listed way back. So I guess my question to you is what are you kind of looking forward to this time kind of based on your prior experience? What's different this time in your view that would make it a successful product?