Are New ESG Derivatives Diluting Liquidity?

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Stockholm (NordSIP) –  Momentum continues to gather pace for ESG derivatives, with political and legislative drivers providing wind at the back. Professional investors, used to managing risks with derivatives and increasingly more sustainability-aware, express their tentative support of the nascent market. Naturally, global exchanges, including Eurex, Intercontinental Exchange (ICE), CME Group, Nasdaq, Chicago Board Options Exchange (CBOE), Euronext and Japan Exchange Group, are all eager to launch new equity index futures and options contracts tied to ESG benchmarks.

The latest additions come courtesy of Eurex. On May 18th, the stock exchange announced that they will expand their ESG derivatives suite by including futures on the MSCI ESG Enhanced Focus Indexes. These indexes aim to maximize exposure to companies with a stronger ESG profile and reduce their exposure to carbon dioxide and other greenhouse gases, as well as to potential emissions risk of fossil fuel reserves by 30 percent.

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According to the press release, the new contracts are a natural step forward in the evolution of ESG derivatives, moving from pure exclusion of companies to integrating ESG scores and carbon metrics. In a first step, in March 2020, Eurex introduced futures on MSCI ESG Screened Indexes covering USA, World, EM, EAFE, and Japan. The MSCI ESG Enhanced Focus index futures add to the second generation of ESG derivatives by integrating ESG ratings as part of the constituent selection and weighting process.

“We welcome the fact that Eurex and other exchanges are moving to more advanced methods of selecting ESG investments away from the negative screening concept of just excluding companies in certain sectors,” comments Despina Xanthopoulou, Director Business Development and Sustainability at Lynx Asset Management for NordSIP. Lynx has been monitoring the emergence of equity index futures that incorporate ESG factors into their construction process for almost three years now. With the ambition to be an early adopter, they started trading the Stoxx Europe 600 ESG-X futures contract during the first quarter of 2021. “We are currently monitoring over 30 ESG equity index futures across different countries and regions for potential inclusion in our portfolios, although liquidity in most of these is still very low,” adds Xanthopoulou.

Magnus Linder, senior trader at Swedbank Robur, has a somewhat more nuanced take on the new launch. He shares with NordSIP his concern that the wave of ever more innovative ESG-products might drain liquidity from the existing ones. “Lately, it has turned into a veritable war between exchanges,” he says. “They are all competing to launch new creative ESG products.” He understands that time-to-market is important in this environment, yet wishes that some of this creative energy would instead go into improving the ESG characteristics of the derivatives that are already in use.

Being the largest investor in listed ESG derivatives in the world means that liquidity is paramount for Swedbank Robur. According to Linder, they still prefer trading derivatives based on STOXX Europe 600 ESG-X index as these are similar to Robur’s sustainability policy and easier to hedge. “Given the choice between a slightly improved ESG profile or better liquidity, I’d say I would go for the latter,” he explains. That said, Linder adds that Robur is currently conducting thorough due diligence on the new derivatives and following closely the development.

According to Eurex, the launch of their new derivative offering is motivated by increased investment demand. “More advanced methods to select ESG investments are driving us to the next phase of ESG derivatives. We are already seeing this in the increasing demand for more sophisticated ESG index models in the ETF markets and hear similar requests from other active investment managers,” comments Randolf Roth, Member of the Eurex Executive Board in the press release.

Image credit: © kentoh Shutterstock

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The coronavirus epidemic has further accelerated the rise of ESG into the investment mainstream. As deficits skyrocket, bond investors have an opportunity to engage with governments on climate change, argues Thomas Dillon, Senior Macro ESG Analyst at Aviva Investors.

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