Loans market is developing confidence and stability
After years of a hesitant existence, the UK property derivatives market is developing confidence and stability that has generated a momentum of excitement. Property derivatives had a small cohort of advocates since the mid 1990s, but for most of that period only Barclays Capital was involved. The market remained illiquid and one-sided. Apart from rare activity, the market did not start to grow until 2005. Transactions happened occasionally but volumes were very low. The first publicly traded property derivatives were the futures that were traded on the London Futures and Options Exchange (FOX), introduced on 9 May, 1991. Pension funds used property derivatives when they first came out. The exchange offered four contracts based on indices for commercial property capital value, commercial rent, residential property and mortgage rates. The underlying indices of the FOX contracts were the IPD capital growth index, the IPD rental growth index, the Nationwide Anglia House Price (NAHP) index and the FOX Mortgage Interest Rate (MIR) index. While the IPD indices are based on appraisals and reflect commercial properties, theNAHPis a transaction-based hedonic index on residential properties (see property indices).
Unfortunately, trading was suspended just a few months after the launch. It became public that trading volumes were artificially boosted using so-called wash trades, i.e. offsetting deals that in the end produce neither a gain nor a loss. However, real trading volume was much lower than expected. The discovery of this mischief hastened the contracts’ demise. In sum, the market was open only from May to October of 1991.
Market participants report loan enquiries
The first French property swap was traded by Merrill Lynch and AXA Real Estate Investment Managers in December 2006. The undisclosed notional amount was linked to the IPD Total Return French Offices Annual Index. By mid 2007, the French market has developed a permanent two-way pricing, i.e. bid and offer prices are constantly quoted. By the end of the fourth quarter of 2007, GB£ 787 million have been transacted in 63 trades. Most trades have been done on the office component of the French IPD index.
Moreover, market participants report enquiries on derivatives relating to the National Institute for Statistics and Economic Studies (INSEE) residential house price index.
The first option on an IPD index outside the UK was traded in January 2007, referenced to the German IPD/DIX Index. Goldman Sachs acted as intermediary for this trade, which was one of the first property derivative transactions in Germany. Subsequently, BNP Paribas offered a capital protected note on a basket consisting of IPD UK All Properties, IPD France Offices and IPD Germany All Properties. IPD publishes official transaction data starting with the second quarter of 2007.
The market picked up quickly, with 44 trades on a total notional value of GB£ 283 million from the second to the fourth quarter of 2007. In May 2007, Deutsche Bank Research expects the German market to reach € 25 billion by 2010. HypoVereinsbank states that a volume of € 150 billion is possible in the long run for Germany and € 300 billion for the European Union.
The numbers represent about 1% of the respective physical property market.
Development of the property credit and taxes
The development of the property derivatives market has so far centered on the UK and the US. However, both interest and transaction volumes are growing throughout Europe and Asia. Market participants expect first trades in Denmark, Ireland, the Netherlands, Spain and Sweden after first trades in Australia, France, Germany, Hong Kong, Japan and Switzerland. As the quality of indices improve, more and more countries will see first trades. Also, thePan-European IPD index creates strong interest from retail investors and from US pension funds. The trend is unlikely to spread to some countries where the data basis, needed to construct a reliable index, is insufficient.
Quickly increasing volumes are also expected due to the interest of insurance companies to hedge their liability risk, which depends heavily on real estate price changes. Liquidity will probably only change if more banks are willing to warehouse risks, i.e. take a risky position.
More mature markets will lead to more standardized derivatives traded on exchanges. However, the OTC market is likely to be the dominant derivative format in the near future.
The property group Grosvenor and ABN Amro traded the first property derivative in Australia, based on the Property Council/IPD Australian Property Index, in May 2007. The trade took the form of a two-year total return swap.
Relative payday loans demand
The International Securities Exchange (ISE) launched a derivatives market based on the Rexx commercial real estate property indices in November 2006. The market will operate using the Longitude framework, a matching engine based on a Dutch auction process.
At the launch, a subset of the Rexx indices was chosen based on anticipated demand. For each index offered, a series of auctions was held prior to publishing the Rexx index, which allows market participants to trade digital and vanilla options as well as forward contracts on the index value.
The auction format differs from a traditional, continuously quoted market in several ways. Instead of requiring a discrete match between a buyer and a seller, the auction aggregates liquidity across all strikes and derivatives. The prices in the auction are determined by the relative demand represented by all the orders received up to that point. As the auction operates as a Dutch auction, all trades are cleared at the final auction market price, even if that market price is better than a trade’s limit price. According to ISE, auction participants include pension funds, commercial property managers, investment banks, hedge funds, portfolio managers, REITs and CMBS. Besides serving as an underlying part for the ISE platform, the Rexx index is also said to be used in the OTC market.
Derivatives trading and payday loans
Derivatives trading in the RPX started on 17 September 2007 on an over-the-counter (OTC) basis with maturities expected to be from one to five years. Initially, licensed banks to offer products in the RPX market included Morgan Stanley, Lehman Brothers, Merrill Lynch, Deutsche Bank, Goldman Sachs and Bear Stearns. Trades are quoted in terms of price appreciation in percent for a given maturity date and executed as quarterly price return swaps exchanging a fixed payment against the quarterly index appreciation. For example, if one counterparty buys the index with a maturity of one year at 4 %, he or she pays 1% every quarter in exchange for the actual quarterly index returns.
The interdealer broker ICAP announced the creation of a joint venture with Radar Logic to develop the RPX market in August 2007. In September 2007, ICAP intermediated the first derivative transaction, a total return swap, based on the RPX. The counterparties were two of the licensed banks. Further, Radar Logic has plans to roll out similar indices that allow trading in commercial real estate.
Options designed to follow payday loan prices
The Chicago Mercantile Exchange (CME) offers futures and options contracts designed to follow home prices in 10 US cities, as well as an aggregated national index. CME opened trading in contracts based on the S&P/Case–Shiller Home Price indices on 22 May 2006.
CME housing futures and options are cash-settled to a weighted composite index of national real estate prices, as well as to specific markets in the following US cities: Boston, Chicago, Denver, LasVegas, Los Angeles, Miami, NewYork, San Diego, San Francisco andWashington DC. Trading in the housing contracts has been relatively thin in the first year, with an average daily volume of about 50 contracts. The notional value of all outstanding futures contracts was slightly above US$ 77 million in August 2006. In total, the traded notional was approximately US$ 340 million in 2006. In early 2007, volume was still low and only about 25 contracts a day were traded on average. According to the CME, there is a “huge educational need” for this new derivatives market.
Critics say that the design of the contracts has held the market back, as they only go out to one year while most investors want to hedge for longer periods of time. This issue was addressed in September 2007, when the CME extended its contracts on the S&P/Case–Shiller index out to 60 months.
