Delta-one trading has been an area of significant growth and investment among financial services firms for the better part of the last decade. The expansion of the business has been such that, within the equities division of many investment banks, the delta-one trading desk interacts with a broader range of clients—from pension funds, insurance companies and endowments to family offices, sovereign wealth and hedge funds—than any other single trading group.
Given the focus on this business and the scope of its interaction with clients, there remains a surprising lack of clarity among many industry participants as to what the delta-one desk actually does.
The reason for this is, in large part, linguistic. A "delta-one" product, in financial services parlance, is one that provides the investor with economic exposure to an underlying reference asset without actual ownership of the asset. The term comes from the language of risk analysis, where "delta" is the measurement of the sensitivity of a derivative to movements in the price of the underlying asset class or security. Options contracts, for example, have a delta between 0 and 1, which varies over time and depends on a number of factors (market level, volatility, etc). Delta-one products, by contrast, have a constant unit delta, providing the investor with one-for-one exposure to the underlying asset.
The confusion arises from the fact that most trading desks describe themselves by the product in which they execute trades (e.g. "cash equities", "convertible bonds"), while the delta-one desk describes itself by the type of exposure it provides. The specific product used to deliver this exposure depends on the requirements of the client and includes total return swaps, ETFs, futures, forwards, certificates, and combinations of warrants and options.
Adding to the complexity is the fact that the range of underliers to which clients obtain exposure via delta-one products is exceptionally broad and includes not only single stocks, equity indices and custom groupings ("baskets") of stocks, but, through the rapid evolution of ETFs and other exchange-traded products, also fixed income, currencies and commodities.
In light of the exceptional breadth of reference assets and delivery mechanisms, the fact that the delta-one desk has such a wide-reaching interaction with the client base is unsurprising; very many clients can, in one way or another, benefit from a "synthetic" exposure to an underlier, rather than direct ownership.
It also helps to explain why so many investors are unclear on what "delta-one" means. Very few clients would have interaction with all areas of a delta-one desk and therefore tend to think in product terms. In their own mind they trade with the "ETF desk" or the "swaps desk" while, from a trading perspective, these are different approaches to the same problem and therefore risk managed by the same group of people—the delta-one trading desk.
In this article we will look at the origins and evolution of the delta-one trading business. As a thorough overview of the activities of a mature delta-one desk is beyond the scope of the article, we will focus on a particular business area: the replication of index exposures. Index products make up a significant portion of the delta-one business. A review of the development of these products provides useful insight into the interaction between investor demands, product innovation and sell-side development and how these competing interests have led to the structure of the modern delta-one trading desk.
Within the range of products traded by delta-one desks, equity index products provide a particularly clear example of why an investor would purchase an asset that provided economic exposure to an underlier as opposed to purchasing the underlier directly. The reason for this is quite simply that indices are themselves not tradeable products. An equity index is ultimately a number, whose value represents the weighted average price of a portfolio of securities. When an investor wishes to gain exposure to an index he/she must either:
- Purchase all of the underlying securities of the index in their respective weights and keep the composition up to date as weights change due to corporate actions, rebalances, etc.
- Purchase a product that replicates the index performance.
Unsurprisingly, most investors choose the latter route. The precise replication of an index return through the purchase of the replicating portfolio requires significant operational infrastructure and is outside the abilities of most small asset managers or individual investors. What's more, even for many medium and large investors, it is often much more economical to outsource the responsibility for replicating index returns to someone who is already doing it, and thereby leverage the substantial economies of scale that exist in this business, rather than attempting to start from scratch.
The origins of the delta-one desk can be traced back to the mid-1970s, when investors began to look at passive index investing as an attractive alternative to traditional, actively-managed funds. In late 1975, the first mutual fund offering passive index replication was launched in the United States. While in these early days passive indexation was a heresy to the active management orthodoxy, the model has stood the test of time and has grown into a multi-trillion dollar global industry today.
Passive index funds can be considered the first delta-one products, but are not themselves a product of the investment banking or broker-dealer community. Index funds are run by independent asset managers and the responsibility for replicating the index return sits with the fund's portfolio manager, who purchases the underlying securities of the index and rebalances them over time as the index rules dictate.
This is not to say, however, that investment banks were uninfluenced by the rapid growth of index funds. While the modern delta-one desk was still a long way away, index funds' need to execute large portfolios of stock to replicate benchmark indices was the driving force behind the development of program trading desks and of the associated tools, allowing a trader to purchase all the constituents of a benchmark index simultaneously. These same tools would later form part of the core trading technology of delta-one desks.
Index funds were, and remain today, an extremely useful product for many investors. However, as acceptance of portfolio diversification and indexation grew, investors began to look for ways to use index products in new strategies and the limitations of index funds for more active investors quickly became apparent. Designed as tools for long-term buy-and-hold strategies, index funds are not intended as trading tools and cannot be executed intraday, do not provide leverage and cannot be shorted.
As is often the case in finance, client demand drives product innovation, and investors did not have to wait long for the emergence of a new index trading tool that was better suited to the needs of active institutional traders, and that provided much of the functionality that was missing from passive index funds: equity index futures.
The launch of index futures in the early 1980s represented a tipping point in the development of index replication expertise by sell side firms and of delta-one desks in general. At the time of the launch of the first index futures contract, the market for commodity futures was well established and provided a conceptual framework for what we today call a delta-one product by providing exposure to underlying commodities without direct physical ownership.
Equity index futures represented an extension of this concept to a new asset class, with one important distinction. With commodity futures, the terms of the contract specify physical delivery of the underlying asset at maturity. For equity index futures, the delivery of the underlier is impossible and the settlement of a replicating stock portfolio is logistically impractical. As a result, index futures were settled via a cash payment between buyers and sellers, based on an objective reference price.
Futures contracts were, in a sense, the polar opposite to passive index funds in terms of their flexibility and sophistication. Futures contracts are highly leveraged, requiring only a small margin amount to be posted to the exchange. Additionally, they trade continuously and can be sold short, allowing for bearish market views to be expressed, even on an intraday basis. And while passive index funds were appropriate for both small retail investors and large institutions, index futures were designed for professionals, with individual contract prices in the thousands of dollars.
The most important characteristic of index futures from the sell-side trading perspective was the fact that there was nothing in the structure of the contract itself that ensured the future would trade at a fair price. On exchange, buyers and sellers could pair off at whatever levels they chose, regardless of the movements of the underlying index. What keeps futures in line is the riskless arbitrage opportunity they create.
Index futures have a short maturity (usually quarterly expiry) and a transparent and replicable expiry mechanism—i.e. the determination of the final price at which the contract settles. The fact that, at expiry, the price of the futures contract was guaranteed to converge to the level of the index meant that a "cash and carry" arbitrage was available between the two.
If the price of the futures contract and that of the underlying index diverged, a trader could simultaneously execute a portfolio trade in the underlying basket and an equal and offsetting trade in the futures contracts. By trading two interchangeable assets at the different prices, the trader could capture a riskless profit. The key was the ability to quickly execute the entire replicating portfolio and maintain the basket composition until maturity, at which point the positions could be closed out.
The riskless profit opportunities available from equity index futures arbitrage provided sell-side investment banks and broker dealers with a clear motivation to develop the infrastructure to replicate index returns accurately, and index arbitrage rapidly became a significant business for many institutional firms.
The benefits, however, were not only for the traders. As the number of arbitrageurs increased and the sophistication and speed of their systems improved, the size of the deviation between the futures contract and the underlying index price that could be captured became smaller and smaller.
As a result, futures contracts stayed closer to fair value and became more liquid, which made them more efficient and effective tools for investors. Increasingly sophisticated arbitrage trading also allowed new products to be created on progressively more complex indices, which broadened the range of exposures that could be achieved through index futures. By the early 1990s, most major country indices in the US, Europe and Asia could be accessed through equity index futures contracts, whose only guarantee of pricing accuracy was the arbitrage mechanism of these early delta-one desks.
The next significant stage in the development of index products was the invention of the exchange-traded fund (ETF), which combined the structure of a passive index fund with the trading characteristics of futures that were most attractive to active traders: intraday liquidity, the ability to go short and, with the help of a prime broker or margin account, the ability to obtain leverage.
With futures contracts, the characteristics of the product created an arbitrage opportunity which drove the development of index trading capabilities at sell-side investment banks. By contrast, with ETFs, the structure of the product was made possible by the fact that large institutions had already developed this index trading ability. ETFs not only relied on the same arbitrage mechanisms as futures to ensure that intraday trades remained in line with the fair price, but also leveraged the brokers' ability to execute and deliver the replicating portfolio to the fund (via the create-redeem process) to create a much more efficient mechanism for active trading in a passive index fund structure.
A particular advantage of ETFs, as compared to index futures, was that it was considerably quicker and easier to create new products tracking different indices. As a result, the breadth of coverage of ETFs expanded rapidly to include not just country indices but indices based on sectors, regions, market capitalisation ranges, emerging markets and global benchmarks. The rapid expansion of the ETF market, and the increasingly difficult benchmarks that brokers needed to replicate, was a powerful force that pushed sell-side brokers to develop the index trading capabilities essential to today's delta-one desks.
While US investors were rapidly adopting ETFs in the 1990s, it would be several years before the first ETF was listed in Europe. The needs of investors in the two regions, however, were very similar, particularly with the rise in assets managed by hedge funds which tended to employ more tactical and top-down trading strategies. The result was the growth of the market for equity total return swaps.
Total return equity swaps are over-the-counter agreements in which the two parties agree to exchange payments based on the performance of an underlying reference asset. In the case of index swaps, the reference asset is an equity index. Unlike futures and ETFs, however, swaps had the advantage of zero tracking error, due to the fact that the swap contract specifically references the underlying index in the definition of the payments to be made. For intraday pricing, the real-time calculation of the index level, which is disseminated by the index calculation agent, provides a common reference point for both broker and client.
While the structures of ETFs and swaps—the former a regulated mutual fund and the latter an over-the-counter ("OTC") derivative—are very different, the interaction between client demands, the product structure and the development of the sell-side infrastructure was very similar. Just as ETFs relied on arbitrageurs to keep the price in line with the fair value, the only source of liquidity in the swap market was the brokers who provided prices. Similarly, both the index swap and ETF markets could only come into existence once the sell-side trading desks had the infrastructure to replicate index returns accurately.
Converging To Delta-One
The amalgamation of the various index-replication businesses under the banner of "delta-one" began in earnest at the turn of the millennium, driven by the increasingly global needs of investors and development of more sophisticated investment tools.
The first Asian ETFs were listed in 1999, followed by the first European products in 2001. While assets were slow to grow at first, the seeds of the ETF industry had been planted in all major markets and within ten years, global assets under management would exceed one trillion dollars. Around the same time, trading in total return swaps increased considerably in the United States as the rate at which investor demand for new exposures outstripped the pace at which ETF issuers could create new products, pushing investors towards custom-tailored products which were only available via swap.
The new millennium also saw a significant increase in the number of investors looking for global investment opportunities. This further promoted the growth and integration of the sell-side index replication business as clients accustomed to the products and services available in one region looked for the same abroad, helping bring best practices from one region to another. Additionally, for those investors who were more comfortable trading in their local markets, an increasing number of ETFs tracking foreign index benchmarks were launched. These created new and more complex trading and arbitrage opportunities and pushed trading desks to integrate their index execution platforms globally.
Arguably the most important developments, however, were in product structure and occurred simultaneously, but in very different ways, in both the US and Europe.
The key shift in Europe was the realisation by asset managers that, in many cases, the trading desks at investment banks had developed their index capabilities to the extent that they could replicate the returns of index benchmarks more cheaply and efficiently than asset managers. The implication of this was to leave index replication to the banks and use total return swaps to create low-cost and tracking risk-free index funds. This led to the creation of the swap-backed ETFs which today make up approximately half of all assets under management in European ETFs.
While the swap-backed ETF structure remained a European and Asian phenomenon, a similar evolution occurred in the United States (and was later transferred to Europe) with the use of index derivatives—both swaps and futures—to create ETFs that would provide leveraged and inverse exposures. Futures had historically been used by index funds primarily for cash management purposes. With leveraged and inverse funds, the derivatives played a much more integral part of the structure and pushed sell-side index trading desks into much greater coordination. Leveraged and inverse exposure would also come to European and Asian ETFs in due course.
ETFs, swaps and futures had, by this point, grown into a truly integrated global business with many large institutional clients active in all three products. The implications for the sell side were clear. The infrastructure, technology and trading skill required to effectively price, hedge and risk manage all of these products (as well as other similar structures such as warrants and certificates) was fundamentally the same, and clients expected the pricing, capital commitment and service they received to be the same, regardless of the specific implementation vehicle chosen. These previously disparate businesses had to be viewed as a single trading group, and the modern delta-one trading desk was born.
In recent years, the range of activities and profile of delta-one businesses have grown significantly, as investors recognise the wide range of uses for these products, far beyond their origins as passive index mutual funds. In addition to new products within equities, ETFs in particular have expanded into non-equity underliers such as commodities and fixed income, which has further pushed the capabilities of the trading businesses.
As the footnotes to nearly every piece of financial marketing literature will be quick to point out, past performance is no guarantee of future results. Nonetheless, as far as delta-one is concerned, it seems likely that the historic trends towards a greater diversity of implementation tools, underliers and clients will persist for some time and that these developments will drive developments in the trading infrastructure of the sell-side, keeping delta-one trading desks very busy indeed.