European ETF Issuers Increase Derivatives Use Amid Swap Limits

European ETF issuers are using more derivatives, with 86% reporting an increase over the past three years, according to an Acuiti report released Nov. 12. A total of 96% expect their use of derivatives to grow over the next three years.

The report, “Redefining European ETFs: The Growing Role of Derivatives,” is based on a survey and interviews with 30 European issuers of exchange-traded funds and exchange-traded products. Of the issuers reporting increased use, 36% described the rise as significant.

Investor and client demand was the most frequently cited reason for the increase. Issuers use derivatives for synthetic replication, currency hedging and leveraged exposure. They also use them to offer strategies that could be difficult or costly to build with physical assets.

Defined-outcome ETFs are a growing product category. These funds use options to provide features such as buffered losses, capped gains or minimum returns. One-third of surveyed issuers have launched a defined-outcome ETF, while other issuers have products in development that are expected to launch within 12 months.

Investor education and restrictions under the European Union’s UCITS framework were the most frequently cited barriers to launching options-based ETFs in Europe.

Total return swaps remain the most widely used derivative in ETF construction, despite rising demand for options. Among issuers that use swaps, a majority cited access to market exposures that would be difficult or impossible to replicate by buying assets directly.

Swap counterparty access has affected product development. The report found that 84% of issuers had either been unable to launch a product or had materially changed it because they could not secure a swap counterparty on acceptable terms.

Issuers ranked a counterparty’s support after launch and its speed during product development nearly as highly as pricing. Distribution and investor education were the main factors cited as ways to support further product development.

“Europe’s ETF market is entering a new phase of growth, and derivatives are at the centre of it,” Ross Lancaster, Acuiti’s head of research, said in the report. “Issuers are moving quickly into defined outcome products, and synthetic replication continues to open up exposures that would be difficult or costly to access physically.”

Matt Johnson, Marex’s head of business development for ETF capital markets in Europe, the Middle East and Africa, described counterparty selection as a process that goes beyond price. He said a counterparty can affect an issuer’s ability to create niche exposures and bring products to market quickly.

Derivatives have long been used in European ETFs, particularly in products based on synthetic replication, currency hedging and leverage. The survey found that issuers are applying them to a broader range of investment strategies within the ETF structure.