Derivatives 2006 - Exchanges cash in
The planned US$8bn merger of the CME and the CBOT has increased pressure on other derivatives exchanges to consolidate. But listed futures and options exchanges need to find new product lines, as well as cut costs. Mark Pelham reports.
With automation bedded in and now with shareholders to satisfy, exchanges are having to consider where future growth is going to come from. The obvious route is consolidation. The planned US$8bn merger of the two Chicago markets will increase pressure on other exchanges to forge closer links – if only to cut costs.
As one consultant said: “M&A is simply about the fact that the expense of running an exchange is largely an IT expense. So, if you combine two exchanges, often you can run them on maybe 120% of the IT budget of the one exchange alone. Therefore, there will be many more mergers ahead.”
However, he added: “M&A is about reducing your cost base, but I see the top line growing too. There is a lot of action around emerging markets, whether that is Eastern Europe, Asia or Latin America – there are a lot of new things happening in those kinds of areas.”
Undoubtedly emerging markets do present opportunities for listed derivatives, but it is unlikely that they will benefit the existing major players. Richard Berliand, global head of futures and options at JP Morgan, observed: “There is still plenty of growth opportunity in new geographies. But it is my belief that this will be primarily collared by local exchanges in those geographies rather than by existing exchanges trying to operate outside their own zones.”
Consequently, older exchanges will have to look to other routes for increasing volumes, which inevitably includes broadening their product base. To date such ventures have not met with huge success, even within key futures asset classes.
Swap futures are still yet to take off and even the long-end BUXL future that Eurex revamped last year – which briefly created some interest among OTC dealers – still only averaged around 7,500 contacts per day in September.
So, it might be a question of finding a solution in a new asset class. But there are essentially only two mainstream asset classes which have the ability to become the equivalent of fixed income or commodities that are not yet operating a listed derivatives capability. One is property and the other is credit.
In September, the CME announced that it was teaming up with Global Real Analytics to launch US commercial real estate futures and options contracts based on the GRA Commercial Real Estate Indexes (CREX). These new products are scheduled to begin trading in the first quarter of 2007.
“Commercial real estate represents a significant asset for many institutions and these products will create a liquid and transparent market that can be used by these market participants to help reduce risks associated with holding real estate assets,” said Rick Redding, CME managing director for products and services. “The development of commercial real estate indexes, along with our existing US housing indexes, fits into our ongoing business strategy to offer innovative products and attract new users to the market.”
Ten quarterly cash-settled contracts based on property type and geography will be available. The listings include a composite index; indices on property types, consisting of retail, office, apartments and warehouse properties; and five US regional indices covering Desert Mountain West, Mid-Atlantic South, Northeast, Midwest and Pacific West. Combinations of these indices are also being considered.
GRA CREX data are based on recorded transactions and revised monthly. Trading of CME US commercial real estate indices will occur on CME Globex, the exchange’s electronic trading platform.
Property suffers from a major challenge in that there is no single point of liquidity and therefore no single point of price discovery, and so it does not lend itself to an index approach. Furthermore, there have already been a number of failed attempts to launch property futures.
A completely new product for the futures market is credit. However, the unparalleled success of OTC trading in the asset class over the past two years means that many are now sceptical of the worth of futures contracts, given the tight bid-offer spreads, depth of liquidity and widespread user base of the bilateral instruments.
More fundamental problem
“Eurex and Euronext.liffe have already announced their intentions on credit. However, the big question is whether there is enough demand for an index representing the credit asset class, as distinct from the proven demand for the underlying asset class of the interest rate contracts themselves. The track record for derivatives on spread products has not been good, so I think the jury is still out,” Berliand said.
A consultant argued that there is significant potential for a range of other exchange-based initiatives. “Some products revolving around climate and energy have become extremely timely and could contribute a lot to growth. Similarly, the deal done between Reuters and CME to produce a centrally-cleared FX marketplace has in itself huge potential and is also a concept that could be developed elsewhere,” he said.
In addition, the consultant suggested that there are strong possibilities for genuinely new products to be launched. He observed: “For example, the Man deal with Eurex US. That is one of the biggest and smartest hedge funds in the world saying there is room for new products.”
Man Group and Eurex formally launched US Futures Exchange (USFE – formerly known as Eurex US) on October 01. USFE will aim to expand the derivatives market by serving as a product incubator and innovator to create new listed products, the company said.
The exchange will offer new products targeted at buy-side customers, such as hedge funds and retail investors – sectors in which Man Group has experience and market exposure. The goal is to expand the volume in listed derivatives by broadening the range of exchange traded products to new and existing user groups, rather than competing with established futures exchanges.
Kevin Davis, chairman and CEO of Man Financial, the brokerage division of Man Group, will serve as chairman of the USFE. “This partnership is an exciting opportunity for the futures industry and the customers we serve,” said Davis. “On the basis of a robust and highly scalable global platform, together with additional partners, we will pioneer the creation of innovative products. Man’s long experience serving its global customer base, combined with Eurex’s renowned expertise in operating an electronic trading platform, will create a distinct regulated exchange that will give the marketplace additional trading opportunities.”
There are other benefits to launching new products, according to Berliand. “It is my view that analysts still evaluate exchanges to some extent on their level of innovation around new products. There is a moderately long lag time between deciding to launch a new product and knowing if the thing is going to fly or not. But there is still what can be termed ‘marketing value’ – I mean by that marketing to your shareholders as much as to your users – in attempting to launch new products. Furthermore, the marginal cost in launching a new product in an electronic environment is far lower than in the old open outcry environment,” he said.
Nevertheless, Berliand added: “An exchange has to focus on raising liquidity in existing products because launching a new product is not initially going to make a dent in the 10bn contracts traded in 2005. Growing this by 10% in a year would need 1bn new contracts of turnover and that is highly unlikely to come from new products alone.”
Consequently, the major exchanges are also seeking to find new users for their markets. All of the major players now run incentive programmes of one form or another, typically revolving around reducing fees for a specified time or reaching out to potential participants in other regions.
However, these efforts are likely to attract occasional users, rather than any major untapped sources of liquidity. Instead, the exchanges may have to rely on something even more out of their control – a spike in volatility in their contracts’ underlying asset classes – to produce a boom in turnover equal to that of the past.
Despite the enormous volume growth seen to date, Berliand remains bullish. “Can market volumes keep growing at the current rate? Probably not. However, do I expect to see declines in market activity? No. So, I think there are still good times ahead for the exchange traded derivatives business,” he said.
Berliand argued that volume in existing products will be generated by both new users and increased levels from existing users. “One of the ways to grow volumes is to innovate around the trading process and that is already an area of focus for a number of exchanges – to improve the processing capability of the trading engines and their connectivity. Latency is a key topic and as we reduce the latency in the derivatives markets more high velocity trading is taking place: we find many people who can see algorithmic trading opportunities that exist when latency levels fall,” he said.
Improvements in this area are likely to continue. As Berliand said: “We all got excited when latency fell below 100 milliseconds, but we are now trying to find ways to bring it consistently below ten milliseconds. There should be lots of opportunities when you reach those types of latency levels and they are commonly high velocity and high volume. So, I continue to believe that double digit growth in listed derivatives globally is realistic.”