Derivatives 2005 - Good times roll
With derivatives exchanges reporting record volumes virtually every month, the industry appears to be in excellent health. The Chicago exchanges in particular have gained from moving electronic. Mark Pelham reports.
The listed product sector currently exhibiting the strongest growth is fixed income, primarily short-term interest rate futures and options. Within this segment, the biggest beneficiaries of increasing volumes are the two main Chicago futures exchanges (see chart) – the Chicago Board of Trade (CBOT) and the Chicago Mercantile Exchange (CME) – which have at last embraced electronic trading, a notable contributor to their recent success.
Dave Nicholls, head of global finance at Deutsche Bank, observed: “The reduced expense of going electronic has helped the exchanges grow because marginal transactions can be expressed for limited cost. For example, some multi-legged trades used to be too onerous to execute for the small spread you are trying to achieve, whereas now reduced commissions allow more relative value trades to be executed.”
Reduced costs and increased flexibility have also helped to attract new users to the exchange-traded derivatives markets. For example, there has been acceleration in arcade-based activity as a direct result of electronic access and, perhaps most significantly, hedge fund use.
The growth of the hedge fund industry has impacted all financial markets to a greater or lesser extent, but the evolution of exchange-traded derivatives trading has impacted the hedge funds themselves.
Patrick Cirier, chief operating officer, Europe, Fimat International Banque, said: “They are bringing new things to the market, benefiting from the technology improvements. You see hedge funds that were doing limited strategies now turning over a lot more business because the systems now enable them to do so – they give them the ability to adjust trading positions much more precisely and quickly than ever before. That in turn, is contributing to the volume growth on the electronic exchanges as well.”
It is unlikely that current year-on-year growth levels will continue to be maintained now that the boost from electronic trading has been factored in to volumes. Exchanges will therefore have to look elsewhere to encourage further growth.
One possibility is for exchanges to merge with each other, which has the added benefit of being a quick fix for bottom line, if not headline volume, growth. In doing so, however, there are potential difficulties with competition authorities – and not all exchanges have obvious merger partners.
Another method of increasing volume is to attract liquidity from other exchanges. There have been a number of successful attempts to do so over the years; such as the move by Eurex to attract liquidity in the bund contract away from Liffe. But more recent efforts have failed – notably Eurex US and Euronext.Liffe’s forays into the US rates market.
The latest moves of this nature – Eurex US and the Philadelphia Exchange going toe-to-toe with the CME’s FX futures and the CBOT’s US Treasury products respectively – have not yet had time for a winner to emerge, but futures dealers suggest that these plans only have a limited chance for success.
Consequently, most observers believe that if exchanges are to consistently grow volumes they will have to broaden the scope of the products they offer. This is likely to be a long-term process.
Richard Berliand, global head of futures & options and prime brokerage at JPMorgan, said: “It is difficult to identify any new exchange tradable financial instruments that are transformation products – things that will change the face of the listed derivatives world in a couple of years, rather than just being nice to have. Swap futures, for example, have proved to be in this latter category, and have not really taken off. It is the same story with single stock futures – they have not transformed the world, even though I think they will continue to grow and, over time, will become a profitable product offering for exchanges.”
The exchanges will continue to look to the OTC market for new product inspiration, according to Nicholls. “The larger OTC markets that do not yet have a full exchange-traded equivalent is where I think we will see increased transactions in the future – notably credit, commodities and emerging markets. Credit products, for instance, present real opportunities now that the iTraxx indices have made some products homogeneous.”
However, Berliand said: “We now have exchanges making announcements about launching credit derivatives products. The question is whether these markets are yet sufficiently commoditised that they are well suited to an exchange listing. Over a period of 10 years, the credit products world will likely be very interesting in the listed arena. However, I do not think they will be of the scale of listed interest rate or equity derivatives.”
Berliand suggested there was more near term scope for growth in commodity products, albeit from a far lower base than the financial sector. “I think the commodity markets are going to grow very significantly in the current commodity cycle, bearing in mind the cycles are long and the investor interest is high. Energy and metals will be the primary focus, but I think there will be growth in the other areas as well,” he said.
Cirier noted that a range of commodity products – from freight to emissions and plastics – had been launched to date with mixed results, with few so far generating significant volume because of their specialist nature. He believed the situation would ultimately change, with such markets generating sufficient liquidity to attract non-specialists.
“We are starting to have an exchange-traded derivatives market that covers the entire shape of the energy complex, which includes oil, gas, freight, climate and emissions. That now gives traders better hedging and arbitrage opportunities than ever before,” he said.
Cirier continued: “One of the most interesting products is emissions, because it is an easily tradable contract and is settled relatively simply. There are some firms already involved in the market either directly or via the EFP/EFS posting mechanism and their number is growing. We should see some further regulatory changes next year and that will enable liquidity to grow, but eventually the product has room to attract non-specialist players and generate quite large volumes.”
Large volumes are eventually expected from exchanges in emerging markets, principally in Asia. Cirier said: “All the large Asian economies are tomorrow’s growth. But I think the markets still need to open up a bit more to really allow for open trading. There has been a great hype about India, for example, but volumes are still not there because there are regulatory difficulties and tax implications. So we are probably a few years away from Asia having a larger impact on a global scale.”
Bankers are keen for progress to be accelerated in emerging markets, not least to complement other initiatives. Nicholls said: “We are interested in developing OTC instruments in emerging markets, but to do so you really need an exchange-traded product. This can be achieved offshore through non-deliverable forward markets, but there is uncertainty over the regulatory position on synthetic versions of exchanges, so it is less controversial to utilise local markets.”
Staying on the right side of regulators is perhaps most important in China, the market seen as having the greatest potential. After years of reluctance the country’s regulators now appear keen to develop onshore derivatives markets – trading licences have been granted to a range of local and foreign institutions, some OTC interest rate and FX markets are being established and there is talk of exchange-traded financial derivatives being launched next year.
Nicholls said: “Openness in China’s financial markets is substantially greater than it was a year or so ago. I believe we will see rapid development in a short period of time there, which will lead to the same happening in other south east Asian markets, such as Thailand and Indonesia.”
While exchanges may be looking to the OTC derivatives market for potential new products, there is also the possibility for them to generate additional revenues by tapping OTC business through providing services that are not available off exchange. One initiative that has significant potential is EDX and Euronext.liffe’s venture into OTC equity derivatives, according to Berliand.
“There is very strong competition between the OTC market and the listed market in equity options. You only have to look at the amount of activity that has moved from listed back to OTC over the past few years in Europe to see that,” he said.
In an effort to redress the migration to the OTC market, Euronext.liffe scheduled a launch for Bclear – an on-exchange cleared service for the OTC equity derivatives market – on October 24. The exchange said that Bclear would form the core of three integrated services to offer customers straight-through-processing for wholesale equity derivatives transactions.
Berliand said: “The equity options market will have a central order book for small size transactions and an OTC market for wholesale sized trades that is booked on exchange: the latter will be at fees that are drastically lower than were previously available. There is a strong possibility that it will take hold quite quickly because the level of professional users in the market is high and they are very price sensitive.”