Saturday, 20 October 2018

Derivatives 2005 - Patent problems

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Software vendor Trading Technologies (TT) has surprised the exchange traded markets this year with successful moves to enforce its futures trading execution patents. TT’s success is serving to stiffen US derivatives exchanges’ resolve to use patents as profit centres in a post-mutualisation world. Securitisation officials are trying to head off their own set of patent woes. Jean Haggerty reports.

Financial market participants are often confused by patents. “The thing about patents is that once a patent is granted, you need to show that it is not novel and that it should not have been granted. [Patent law] doesn’t operate on a balance of probability like a normal suit,” said Paul Forrester, an attorney at Mayer, Brown and Rowe in Chicago.

Discovery of a patent covering distressed collateralised debt obligations (CDOs) triggered Forrester’s interest in patents on securitisation technology. Patriarch Partners principal Lynn Tilton was granted US intellectual property rights on collateralised debt obligations (CDOs) with 30% in distressed assets.

The distressed CLO market is not an active market one, but that it not the point. The success of the securitisation market is that market participants all regard innovations as common goods. A move away from this stance and towards securitisation technology ownership poses a serious threat to synthetic CDO innovation. “It could have a chilling effect and that is more troubling than who is right and who is wrong,” Forrester said.

It is difficult to imagine what the mortgage-backed security (MBS) market would look like today if a patent on computing MBS had been granted years ago. The fact that patent royalties typically carry a roughly 10% charge is both a concern for market participants and a reason for securing patents.

Mainstream securitisation technology does not appear to have been captured in any patents granted by the US Patent and Trademark Office (PTO).

To head off such a situation, the Bond Market Association’s American Securitisation Forum earlier this year started providing the US PTO with the information and resources to help it distinguish which securitisation patent claims are novel.

It is debatable whether the over-the-counter (OTC) derivatives market requires a similar approach. The patent grab that is underway in the listed derivatives market and that is starting to attract attention in the securitisation market is not as apparent in the OTC derivatives market.

JPMorgan’s move to patent an employee stock option programme that it arranged for Microsoft in late 2003 ranks among the most recent, high-profile patent moves coming out of the OTC market. For JPMorgan, the programme, which let Microsoft employees trade in underwater options, did not pan out as hoped: it involved taking roughlyUS$8.8bn of notional exposure to Microsoft just before option volatility collapsed.

More than anything else the difficulty in enforcing patents in the OTC derivatives space is what has curbed OTC patent proliferation, market participants say. Since Merrill Lynch became the first major firm to add in-house patent attorneys several years ago, all of the other major Wall Street firm with substantial derivatives businesses have followed suit.

“It is very much a sleeper issue,” Forrester said. “The problem is that there are financial institutions on both sides of the equation,” he added. Even though the burden of proving that a patent should not have been granted or that it is not being violated rests with the patent challenger in court, lawyers for the major Wall Street firms for the most part are filing patents rather than thinking defensively about patents, some officials say. Litigating a patent normally takes at least a year and costs about US$2m for the first patent and US$1m for each additional patent.

Compared with the OTC market, the listed derivatives market offers more fertile ground for patent pursuit. Exchange volumes are more transparent, providing greater ease of tracking potential infringement. Furthermore, exchange volumes are soaring. According to the latest Bank for International Settlement statistics, global turnover in listed derivatives increased by 11% to US$372trn in the second quarter (see chart).

Some industry officials say that financial business method patents and proprietary product patents encourage innovation. Without patented or trademarked products, the main way for derivatives exchanges to compete is on price, they note. Embarking on this strategy could be a slippery slope for recent converts to public status and it would be flat-out debilitating for new entrants, they point out.

“From day one the problem with patents is the disconnect: financial markets are global and patent law is regional,” said Vergil Daughterty, chief executive of Economic Inventions, a licenser of intellectual property that is strategically aligned with the US electronic communications network, NexTrade. “The challenge is managing a business that has to start out globally,” he added.

Economic Inventions in 1996 became the first firm to win patent protection on an exchange-traded product when it received a patent on expirationless options.

An estimated 90% of patent infringement cases are settled before trial. The fact that, on the legal front, most changes in regard to patents favour inventors and provide for better invention protection means that firms will feel under pressure to settle a dispute even if the patent in question has dubious merit, some officials say.

The list of firms that have settled patent infringement suits with TT appears to lend some credence to this claim. Many small firms have settled with TT, while large firms, including Man Group, Refco, Peregrine Financial Group (PFG), GL Trade and eSpeed, have vowed to contest TT’s allegations.

TT has settled lawsuits with nine firms including Kingstree, GHCO, Patsystems, Ninja Trader, RTS, Strategy Runner, Rolfe & Nolan and TransMarket Group. One out of court agreement has been reached.

“For us [the area of alleged patent infringement violation] is a narrow area, a small part of our business,” Russell Wassendorf, PFG’s chief executive officer, said in July after TT filed a patent infringement lawsuit against his firm. In total, TT has filed 17 patent infringement suits since it received its electronic trading patents related to MD Ttrader in July 2004. MD Trader is a market depth style order entry screen that is incorporated into TT’s X_Trader software.

According to TT, more than half of the futures order flow directed to the world’s largest futures exchanges originates from its screens. TT’s software is the most popular among traders active in the US Treasury market.

Futures exchange customers, rather than the exchanges themselves are infringing, TT says. Among exchanges, TT says that it has improved competition by giving market participants freedom of choice between comparable products on different exchanges. “When TT made the decision to offer connectivity to Eurex US products, the Chicago Board of Trade immediately chose to cut transaction prices,” TT pointed out in an open letter to the futures industry last year.

TT’s campaign to charge a cash trading levy on futures transactions received a boost in February when a US federal judge said that he disagreed with eSpeed’s assertion that TT’s patent was invalid. As eSpeed acts as an order router, it directly competes with TT.

Although the judge did not stop eSpeed from using software from TT, the decision increased the likelihood that TT will see its demands met. TT is seeking a fee of 2.5 cents on all trades conducted over the big four futures and options exchanges in return for a waiver of patent rights.

Theoretically, had each of the ‘big four’ futures exchanges been participating in the 2.5 cents solution, TT would have received US$130m (5.2bn sides x 2.5 cents) during the 12 month period ending last December, and much more this year.

Most industry officials believe that the issues raised by the TT suits are for the courts to decide. Only if TT is seen holding up the industry and if all of the industry is made beholden to one order entry system would legislative action be required, futures officials say. A few bills aimed at changing the language around business method patents have been drafted in recent years, but generally the issue is not one that engenders a lot of public support.

In time, the issues surrounding patents should be self-correcting and industry consensus will develop, Forrester said, noting that it is debatable whether 20 year patent protection is suitable for financial products.

This long protection period could accelerate patent proliferation by exacerbating market participant’s worries that another firm may get a patent on an innovation that it created, causing the innovating firm to pay royalties on its own creation.

Unlike eSpeed, which led and won suits against all of the major US futures exchanges alleging patent infringement related to the Wagner patent that it purchased in 2001, TT developed the technology supporting its patents claim itself.

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