Life in an Equity Low Volatility WorldA CME Group Global Survey

How the world advances

July2014 1

TABLE OF CONTENTS

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

The Trend Is Not Your Friend . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

Banks and Customers – Their Changing Roles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

The Horizon . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

Going Forward . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

July2014 2

INTRODUCTION

Withthelastmeaningfulspikeinequityvolatilityhaving

occurredthreeyearsagoinAugustof2011,andhistorical

periodsofprotractedvolatilitylastingtwotothreeyears,

conventionalwisdomwouldsuggestthattheequity

marketisneartheendofthislowvolatilityregime.

However,thereisnothingconventionalaboutthecurrent

environmentortheunprecedentedmarketintervention

bycentralbanksthathaskeptvolatilitylevelsdepressed

whileelevatingequityprices.Whilemarketconditionsare

expectedtochange,thischangeisnotlikelytooccurat

leastforanother12to18months.

Inanefforttobetterunderstandthecustomerimpactof

thecurrentlowvolatilityequityenvironment,duringlate

JuneandearlyJuly,CMEGroupengagedinadialogue

withtopequityclientsacrossassetmanagers,banks

andhedgefunds.Thefollowingreportsummarizesthe

feedbackandobservationsshared.

• A cyclical trend: Avastmajorityofcustomers

agreedthatthecurrentvolatilityenvironment

representsalow-pointinacycle,ratherthanalong-

termtrend.Somebanksdissented,labelingthetrend

asasecularshift.However,notonerespondentsaid

thatmarketfundamentalshavechangedorthata

newnormisbeingestablished.

• Outlook disparities: Severalbankssaidtheyare

constantlylookingtopitchnewproductsorideas,

includinglowvolatilitystrategiesand“volselling

programs.”Anumberofbuy-sidecustomerssaidthey

areimmunetothesesellingadvancesandtheywould

prefertoseeinnovativeideasonhowtomoreefficiently

extractriskpremiuminthemarket,forexample.

• Feeling the squeeze:Reducedvolatilityinnon-

equityassetclasseshascausedassetallocations

toshifttowardequities.Thisshifthasencouraged

firmstoentertheequitytradingspaceandforced

newandestablishedfirmstoincreaseequity

executiontechnologyandinfrastructurespend.Due

toeconomiesofscaleinequitytrading,lowershare

volumestranslatetohigherper-tradecostandless

agencyexecutionfortraditionalbankequitybusiness.

• A return to volatility:Whileafewcustomerssaid

theearliesttheycouldseeanuptickinvolatility

isneartheendof2014,correspondingwiththe

DecemberFOMCmeeting,mostcustomerssaid

volatilitywillreturnwithareductionincentralbank

intervention,likelyinmid-to-late2015.

• Getting creative: CustomerssaidthatCMEGroup

providesthetoolstohelpinvestorsmanagerisk;

however,thechallengeisthatthereiscurrently“too

littlerisktomanage.”Customerssuggestedlisting

newequityandnon-equityproducts–fromS&P

500dividendfuturestolistedcreditspreads–and

increasingthenumberofobservablepricepointsin

keyproductstoexpandtherangeofproductsand

allowforgreaterdisagreementonprice.

July2014 3

THE TREND IS NOT YOUR FRIEND

An overwhelming majority of customers, 89 percent,

agreed that the current volatility environment does not

represent a secular change in market structure but is

simply the low-point in a cycle, which has historically

occurred once a decade.

Opinion was fairly homogeneous among the buy side, with

the majority of dissenting views on cyclicality coming from

the banks. This is likely due to several factors, but most

notably the structural changes that have been forced on

the banks by new regulations in the last five to seven years.

The increased cost of capital, compacted balance sheet

and reduced ability to take on risk has fundamentally

shifted the banks’ business models towards more agency-

style execution services. Revenues previously generated

through risk-taking and directional market views must now

be replaced by fees generated on day-to-day transaction

volume. This shift creates an extreme short-term view where

banks need to generate flow for the purpose of printing

trades and collecting fees. This suggests that the divergence

between the cyclical and secular views may be more a

question of market role and timescale of revenue than

anything else.

Market cyclicality is not new for equities.

However, the unanimous consensus is that

the current volatility environment is the

manifestation of central bank activity around

the globe: a zero interest rate environment,

excess liquidity, purchasing of risky assets

and their perceived willingness to provide

additional intervention and accommodation

should the need arise. Despite this

discussion of central bank policy and

intervention, not one respondent suggested

that market fundamentals have changed, or

that a new norm is being established.

While the market is setting all-time record-high index levels

and, at the same time, multi-year low levels of both implied

and realized volatility, many respondents pointed out that

this is not unusual in the grander scheme and anticipated

that implied volatility, as well as short-term rates, would

continue to drift lower in the near term. The reason for this

is that the seemingly “one-way markets” in equities has

pushed portfolio and fund managers to shift assets out of

other asset classes and into equities. As these are generally

buy-and-hold positions, overall levels of equity market

turnover drop, as does realized volatility. Fund managers

that use overlay strategies (usually selling upside call

options on long physical positions) to generate additional

yield exert additional downward pressure on levels of

implied volatility. While there are some small balancing

effects to this picture, notably funds replacing long physical

positions with calls (to limit their losses in the event of a

market correction) or purchasing puts for protection, the

general trend is one of an excess of supply of volatility

sellers and a ceiling-like behavior of implied volatility. The

frustration with this governor on volatility was captured

by the sentiment from one respondent who said “income

nature of selling volatility to increase yield needs to stop.”

In terms of the discomfort and vexation experienced by

some market participants around the current low-volatility

environment, part of the issue is perception. For many,

the current period feels more uncomfortable than other

similar periods simply because of the magnitude of the last

few volatility spikes and how clear the memories still are.

With historical perspective anchored by VIX levels of 45.79

and 48.00 in May 2010 and August 2011, respectively,

several clients said that “volatility at 10 is more normal

than volatility at 40,” others said that the market would be

remiss to ignore the fact that since the burst of the dot-

com bubble, everyone has experienced a decade and a half

of “this time is different” arguments that were subsequently

shattered by geopolitical events and market behavior. If a

sobering reminder is still needed, customers should recall

July2014 4

how they were positioned and how benignly participants

behaved in 2008 when the VIX skyrocketed from 16.30 in

May to 80.86 six months later on November 20.

BANKS AND CUSTOMERS – THEIR CHANGING ROLES

Historically, when implied volatility is trending down, the

sell side tends to do better than their buy-side customers

as a function of their ability to take positions, commit

capital and facilitate trades, while earning commissions

and positive trading revenue from risk positions. During a

low volatility period “nobody wins,” as the active traders

in both communities lack opportunities to outperform.

When volatility returns to the market, both the buy- and sell

side are overly exuberant in the pursuit of profit and cause

exaggerated short-term spikes in volatility that, in turn,

elicit aggressive pricing and fee compression as dealers

compete over the return of revenue.

All customers with whom CME Group engaged are seasoned

market veterans; not only did they remember recent periods

of both high and low volatility, but they have also successfully

traded through them. However, it generally appeared that

the buy side had well-established strategies for investing in

both market environments and had shifted their approach

to their low volatility model. Real money managers appeared

to be slightly more comfortable than their hedge fund

counterparts, more so because they enjoy a broader

passive-index based mandate; some hedge funds can only

operate within a narrow trading mandate, such as long

volatility, or long/short overlays, where non-performance,

while perhaps understandable, is still nevertheless painful.

While the impact of this environment is almost universally

negative for banks, a few participants quantified this impact

and said they were down between 12% and 20%, which

supports public warning statements and 10-Q filings made

by the major banks over the last several months. More than

one-third of the bank respondents commented that in this

environment, the cost of doing business for clients has

become magnified. Some customers who otherwise would

hedge their trade will demur in this environment. A hedge

fund trader said, “there is a sense of apathy or lethargy that

has crept into the approach to hedging; people are content

to wait to a relative point in time where the hedge is cheap.”

So, it is of no surprise that during this sustained period of

reduced volatility, the bank dealing desks are looking at

ways to increase and create revenue – not all of which are

well-received by customers.

More than half of the sell-side respondents said that they

have increased their efforts to reach out to their clients

and provide additional services, e.g. research on topical

issues, new product ideas, educational pieces, etc., in a

bid to ensure that customers reach out to them whenever

a trading need arises. But the buy side said they often

perceive recent sell-side pitches as too short-dated and

focused on the current quarter, while the customer is

focused more than one year out. Several asset managers

and hedge fund traders said that they have noticed a

disparity between bank and customer time frames: “banks

are looking one to three months out and are in a survivalist

mentality, while [their customers] need to look five to ten

years out.” Some buy-side customers said the sell side is

looking for ways to “print volume and write tickets.” One

manager said that banks are pushing short-term strategies

aimed to increase ticket charges and revenue; at the same

time, they are floating artificial bearish strategies aimed to

offset their natural long inventories.

Several banks said that they are constantly looking to pitch

new products or ideas, including low volatility strategies

“There is a sense of apathy or lethargy that has

crept into the approach to hedging; people are

content to wait to a relative point in time where

the hedge is cheap.”

July2014 5

and income replacement strategies (also known as “vol

selling programs”); these programs are becoming more

expensive for customers and could perpetuate the low

volatility environment. The more clients deploy these “vol

selling” strategies, the more the volatility is suppressed.

Several hedge funds that are long volatility strategies

said that staying true to their mandate is becoming more

expensive; they are playing more defense than offense

and looking for new ways to implement their strategies at

lower costs. One area where buy-side customers said they

are willing to pay premiums is for tail event protection;

though this also arose as something that the banks want,

suggesting a healthy demand but lack of willing suppliers.

Buy-side customers said they would rather

see innovative ideas on how to more efficiently

extract the risk premium in the market, buy

longer-dated protection at these depressed

levels and short variance in the near-term

without going short gamma (in case that

impending sell-off actually happens).

Several buy-side customers said that they are not currently

interested in product and idea pitches, so they are immune

to the banks’ advances. Twenty-eight percent of these

customers are looking to actively reduce risk and are

trading less and observing less natural flow in the market.

Common themes attributed to less trading include:

• the desire to reduce positions and carry cost until

opportunities return to the market.

• that “no one wants to be a hero,” so there is less event-

driven trading, which means no pre-event positioning

and no reversion or liquidation trading post-event.

• that risk tolerance is lower in this environment, where

funds are running a fraction of the VAR they did

months ago.

Some buy-side customers surveyed are not as

transactionally-minded as their sell-side counterparts

and deploy a multitude of index-benchmark as well as

absolute- and relative return strategies, both within equity

markets and across asset classes. Allocations to equities are

generating stable returns, and given the lack of opportunities

in other asset classes, equity allocations and fund inflows are

growing at the expense of fixed income allocations. For funds

that are mandated to be long volatility, though, this is a “very

painful environment,” as they are being carried out of their

trades, they said.

Perhaps surprisingly, bank equity trading desks are not as

unilaterally pleased with the shift of capital to equities as one

might expect. The reduced volatility in other asset classes –

particularly in rates – has caused risk capital and investment

budgets to be shifted towards equities in an effort to

generate more favorable returns. This trend has encouraged

new entrants into the equity trading space and forced both

new and more established equity houses to increase their

spending on equity execution technology and infrastructure.

These cost increases, when combined with reduced volumes

and volatility, have compressed margins for the incumbent

equity desks. Due to the economies of scale in equity trading

businesses, lower share volumes mean higher per-trade

cost and, therefore, less agency execution for traditional

bank equity businesses. This, in turn, hurts revenues from

trading and direct market access (DMA) businesses, which

causes still more liquidity to evaporate. This somewhat self-

perpetuating negative spiral creates a paradox that reinforces

a low volatility environment and presents the question: does

low volume cause low implied volatility or vice-versa?

Several buy-side customers, who rely on sell-side dealers

for providing OTC exposure, noted that there is a belief

that with the return of volatility there will likely be an

accompanying market sell-off – a reversion of the currently

diverging fronts. The real issue is that “this time will be

different.” Volatility will return in force, but unlike the last

July2014 6

low volatility era of Q4-2004 through Q1-2007, due to post-

2008 regulatory and capital restrictions, the banks will not

be able to step in on the sell-off to facilitate customers,

which will only lead to more volatility in the overall market.

The issue of dealer inability to facilitate customers is not

hypothetical, and in fact is already occurring. One hedge

fund in particular spoke about how they are taking the

other side of their dealers’ flow, and that the dealers are

outsourcing risk to the hedge fund.

For the index-benchmarked assets, the low volatility

environment is not particularly problematic given that

it has been accompanied by a slow grind higher and a

sufficient degree of dispersion in single stock returns

within sectors to allow for some outperformance through

stock selection. Several respondents cited the current

low volatility environment as providing an opportunity to

express directional views with less risk – either through the

purchase of downside protection or, more often, expressing

long views through options. Furthermore, a handful of

customers said that they are shifting their risk allocation

away from index volatility to single name volatility, where

it is generally a more active volatility landscape. Others

said that their success at stock-picking is dependent upon

whether or not it was an incremental strategy and possibly

insulated by a high-beta passive strategy, or their only

mandate. Without volatility in the market, stock pickers and

active-only managers have a tougher challenge, as they are

funding their picks longer with fewer correct calls and fewer

high payoffs, according to one customer.

For funds focused on absolute return and yield generation,

the current environment is considerably more challenging,

as the low absolute volatility levels make selling downside

puts less attractive (selling cheap insurance policies with

the market hitting all-time highs); the excess supply of

upside calls has pushed implied volatility levels so low

that very little additional yield can be generated from

them. Several customers who employ more sophisticated

volatility strategies – such as playing the difference

between implied and realized volatility, or trading

dispersion – said that while conditions are challenging,

there are still opportunities to generate returns. The

challenge occurs in pursuit of these rare trading prospects,

in that the trade quickly becomes crowded and it is hard

to monetize the opportunity. The trade develops fast

and is hurriedly propagated by analysts, and there is not

enough profit to be extracted to satiate the overwhelming

number of veteran traders lying in wait. Unless one reacts

quickly enough to participate in the initial move, the trade

opportunity dissipates as the crowd dynamism mines the

value back to unattractive volatility levels.

THE HORIZON

When do market participants anticipate an uptick in

volatility? At the short end of the spectrum, a handful of

respondents anticipated a pickup near the end of 2014,

citing the December FOMC meeting as “the earliest

possible point” but not necessarily a definitive catalyst.

A majority of those asked felt that volatility would return

once central bank intervention – notably Fed policy – was

reduced, likely in mid-to-late 2015. Many respondents

agreed that it would not necessarily be the act of raising

rates that causes volatility to spike, but rather the first

unexpected rate hike after the initial Fed move. One trader

elaborated further that the rate policy change required

must go beyond the tapering of Quantitative Easing. While

the Fed may already be tapering, there is an expansion of

central bank intervention in Europe and Asia, which means

there will be sources of cheap liquidity – and therefore a

cap on volatility – for some time.

In the longer term, there were several respondents who

felt that the gradual reduction in central bank intervention

was inevitable and would be easily digested by markets

and that this low volatility period could last for “many

years” – well past 2016. These customers were less

July2014 7

concerned with the impact on volatility of the removal of

the current monetary policy tools and more concerned by

certain worrying scenarios they see on the horizon and how

central banks will respond. Specifically, they are concerned

about the materialization of inflation and how the Fed’s

reaction may lead to increased volatility. While inflation

was a common theme, some felt that changes to policy

aimed at addressing unemployment or labor participation

rate may have a greater impact on volatility. A dissenting

voice – who believes that the current volatility environment

is driven by the economic cycle – said that the next shock

may come in the form of a US recession in a zero interest

rate environment and the uncertainty around what the Fed

will do and how markets will react.

In addition to the dampening effects of current monetary

policy, the lack of economically-significant geopolitical

events further exacerbates the market. Based on

respondents’ feedback about the current geopolitical

landscape, whatever the event is that eventually

drives implied volatility higher, will be unforeseen

and unimaginable. While more than three-quarters of

customers agreed that an unforeseen event or disaster

would bring short-term volatility back to the market, the

event in question would need to be catastrophically unique

and demonstrative of a clear and present danger to broader

developed-market contagion to change the atrophic nature

of the current volatility regime. Most respondents echoed

similar sentiments through a geopolitical lens, where a few

noted that the market shock could also come in the form

of an unforeseen technical or trading error that is severe

enough to remove market participants and or venues.

Traders cited the recent upwelling of activity in Syria and Iraq

as interesting, but not an event that they, or the market, need

protection from. The news, while distressing, has become

commonplace and is already reflected in asset prices. A

handful of participants said that the bellwether to watch for

a signal that geopolitical events are likely to impact equity

volatility is the price of oil. When oil reacts, it is the signal that

the interests and anxiety of the market has been collectively

piqued, and the precipitating event could be the market

catalyst needed to break the current volatility status quo.

A smaller subset of market participants said that since the

2008 financial crisis, there is a longer trend developing,

where today’s environment has not occurred by accident,

and is not purely cyclical. They said that regulators wanted

to “intentionally suppress the market volatilities,” in order to

“reduce leverage and proprietary trading in the long term.”

Through Basel III, the Volcker Rule, Dodd-Frank and their

non-US equivalents, the market has seen leverage reductions

and increased capital requirements, which have forced banks

to reduce their presence in the market and, by implication,

have cooled the whole market from a risk and volatility

standpoint. Overall, the question appears to be whether this

legislative-enacted force suppressing volatility will last much

longer than the current lack of catalysts in the short-run.

Non-US markets moving to new highs,

coupled with Treasury yields moving back

above 2.5% while the S&P 500 dividend

yield has moved below 2%, may attract

investors to other strategies and cause

them to abandon their current yield

strategy in the US Equity market.

GOING FORWARD

As part of this outreach, customers were asked a simple

concluding question: “What can CME Group do to help?”

This was, for many, the hardest question to answer. Clearly,

there is little that an exchange can do to alter the current

central bank-induced low volatility environment, and as one

respondent expressed, CME Group provides tools to help

investors manage risk; the challenge now is that there is

“too little risk to manage.”

July2014 8

There were, however, several suggestions as to where CME

Group could add value by expanding the equity product

complex to provide a more complete toolkit for investors.

In the delta-one space, there were requests for CME Group

to list dividend futures on the S&P 500 (the most common

request) and total return index futures. Among volatility

products, the recurrent themes were extending the range of

maturities on options on the E-mini S&P 500 future to five

years (and beyond), as well as products for trading variance

and skew in future format. There were also several mentions

of non-equity products, notably listed credit products and

spreads, and additional alpha-generating products, such as

liquid high-yield or investment grade product.

Customers also suggested changes related to CME

Group’s trading environment and market structure. Several

customers suggested lowering exchange fees as a way to

support their performance, but one or two also extended

this argument into a new area of dynamic tick sizes.

Specifically, could the tick size in certain key products, such

as E-mini S&P 500 or Eurodollar futures, be adjusted to a

smaller increment during lower volatility environments?

Customers said that increasing the number of observable

price points allows for greater disagreement on price,

which in turn, increases trading that results in additional

volume and volatility.

CONCLUSION

The goal of CME Group’s outreach was to better understand

the current low volatility environment in equity markets

and how it is affecting buy- and sell-side clients. While the

dialogue provided significant insights into the relationship

between the current market environment, global central

bank policy and changes in regulation, no single culprit

emerged and unfortunately, no antidote was discovered.

What is different about the current low-volatility regime is

that that unlike previous periods that could be attributed

to “natural market forces”, this period has clear and well-

defined causes - globally-coordinated central bank policy

and excess liquidity. The ease with which equity markets

have absorbed significant geopolitical events in Syria and

Iraq underscores just how dominant central bank policy is

as a driver of current market conditions.

The evolving business model of the sell side has also

reinforced the lower levels of volatility. Banks have migrated

to a more agency-based model as regulation has limited

their ability to take on risk and commit capital – both on

a proprietary basis as well as in customer facilitation.

This shift has removed one of the most active segments

in equity trading from the marketplace, leading to lower

volumes and lower volatility.

On the buy side, the current market environment has

impacted distinct client groups in very different ways.

The steady grind higher of equity markets has provided

strong absolute performance for the more traditional, low-

turnover end of the asset management spectrum, while the

active community has experienced significant headwinds

due to higher costs, lower liquidity and less reward for the

risk taken.

The interaction of all these factors has resulted in an

environment of persistently low volatility with rising

markets over the last several years. The question that

remains is what will be the catalyst that returns volatility

to the market? Absent a change in market participants’

ability to access capital and increase risk, or an accelerated

cessation of central bank intervention, the catalyst to move

the market to a new and more dynamic state is left to the

market itself. To this end, history suggests that market

triggers and the “unknown unknown” tend to occur at the

most unexpected times and in unforeseen places, which

leaves market participants watching, waiting, and hoping

that this market does not disappoint.

July2014 9

FOR MORE INFORMATION ABOUT CME GROUP’S EQUITY INDEX OFFERING, CONTACT THE EQUITY INDEX PRODUCTS TEAM:

CHICAGO

Scot Warren

+1 312 634 8715

scot.warren@cmegroup.com

Tom Boggs

+1 312 930 3038

thomas.boggs@cmegroup.com

Richard Co

+1 312 930 3227

richard.co@cmegroup.com

NEW YORK

Tim McCourt

+1 212 299 2415

tim.mccourt@cmegroup.com

Giovanni Vicioso

+1 212 299 2163

giovanni.vicioso@cmegroup.com

LONDON

Matt Tagliani

+44 20 3379 3741

matthew.tagliani@cmegroup.com

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