According to the latest figures from the Bank for International Settlements, trading on the international derivatives exchanges continued its strong upward trend during the second quarter of 2005. Combined turnover in fixed income, equity index and currency contracts increased by 11% to US$372tr, after a 20% rise in the previous quarter (see chart 1).
The product sector exhibiting the strongest growth is fixed income, primarily short-term interest rate futures and options (see Chart 2). Within that, the biggest beneficiaries of increasing volumes are the two main Chicago futures exchanges – Chicago Board of Trade (CBOT) and Chicago Mercantile Exchange (CME).
Three primary factors are helping to boost volumes at the Chicago exchanges at the moment, according to Richard Berliand, global head of futures and options and prime brokerage at JP Morgan.
“First is the rise in volatility in the US markets in contrast to the low volatility in Europe, especially at the short end of the curve. Second is the drive toward electronic trading, which has been a repeat of what happened in Europe when those markets went electronic – the norm is that an electronic market attracts a higher level of volume from existing users and a large number of new users.”
Third, according to Berliand, is the continued rise in popularity of arcade trading across the globe. (This is trading by individual traders from shared locations, which are called arcades. Orginally started by groups of ex-pit traders when exchanges went electronic, it is now more widespread.)
“The proportion of market activity coming from arcades has grown in all markets and that has helped the US enormously as well. It is part and parcel of the move to electronic trading, but arcade activity has become a very important part of the flow.”
Chicago’s move towards electronic trading now appears to have reached critical mass – electronic volumes in both exchanges’ flagship interest rate products now account for the majority of trades – and is accelerating accordingly. But it is doing so with a considerable time lag after the same change happened in Europe.
“The change in the US was delayed because the competition pressure was not as strong as it was in Europe,” explained Patrick Cirier, chief operating officer, Europe, Fimat International Banque. “The Bund switch in 1998 showed that when fierce competition arrives liquidity could move very quickly, but it took the threat of competition from Eurex US to accelerate changes that had to happen eventually.”
The shift to electronic trading and the consolidation of CBOT’s and CME’s clearinghouse has benefited the industry in terms of reducing costs, according to Cirier. But, he adds: “Whether that continues remains to be seen. It seems that CBOT now believes it has regained pricing power, but we will have to see how the market reacts.”
CBOT has announced that it is increasing its US Treasury futures electronic trading fees by 60%, having reduced them ahead of the of the Eurex US launch last year. That move is central to Eurex's ongoing lawsuit alleging that CBOT and CME broke US antitrust laws by lowering their fees to predatory levels. The decision has been met with criticism from market participants and has highlighted concerns about such behaviour being part of a potential broader trend, as direct competition between exchanges – for the time being at least – diminishes and CBOT moves towards becoming the last of the world’s major derivatives exchanges to become a publicly listed company.
“The behaviour of the exchanges and clearinghouses is generally changing towards more of a for-profit model because they have gone through IPOs,” Cirier observed. “This could potentially be bad news for market participants, however. In Europe, there has been talk for a long time of aiming towards a single clearinghouse or a smaller number of exchanges to reduce costs, but that only works for a not-for-profit organisation. Now, with all exchanges and clearinghouses changing to for-profit organisations, there needs to be room for competition.”
In early September the London Investment Banking Association (LIBA) spearheaded a campaign for fee reductions in exchange-traded derivatives. LIBA argued that, despite substantial growth in volumes and a consequent reduction in the unit cost of production within the exchanges, fees to users have remained broadly flat. Alan Yarrow, chairman of LIBA explained: “Given market developments and technical progress, users are asking, fairly and reasonably, to share the benefits.”
If market users are unwilling to accept increased or even maintained fees and – thanks to the law of diminishing returns – it is unlikely that volumes will continue to grow exponentially, the exchanges will have to find alternative ways of making money. In addition, the fact that many are now run as public companies puts more pressure on them than ever before to continue to grow revenues and even more importantly their bottom lines.
To this end, there are a number of potential strategies open to exchanges. Perhaps least likely is to attempt to attract liquidity from another market’s existing successful contracts.
As JP Morgan's Berliand said: “In order for one exchange to compete with another on an existing product there has to be an obvious point of inefficiency – which can be anything from pricing, to technology, or regulatory constraint – in the target market, and that exchange must be unable or unwilling to address that point of inefficiency. But if you identify an inefficiency and the target exchange has the capability to address it, you are taking a massive bet that it will choose not to do so when you go to challenge it. The reality is that, when faced with such a challenge, even exchanges that are very backward looking will adapt quickly.”
An alternative approach to growing revenues is to launch new products. However, Berliand suggests that this is not always effective at improving performance in the short term.
“Launching new products can work, but a lot of exchanges are now so big that it’s tough to see that it will have a huge immediate impact on the bottom line – new products take a while to grow, so it’s not going to be a quick hit. But every exchange should always be innovating in that area.”
A more obvious way of quickly increasing profits is through reducing expenses, Berliand argued. “The biggest way exchanges are going to reduce expenses is by merging with one another, because by doing so they have the opportunity to eliminate one or other’s technology platform, which is commonly an exchange’s single biggest cost.”
However, he added: “To do that, it [a merger or acquisition] needs to be done without aggravating the competition authorities, and that’s why there has been so much debate in the UK and will subsequently be in Brussels about putting together some or any of the major cash equity and listed derivatives exchanges in Europe.
"I believe that we will see further mergers where the regulators will allow it and where the exchanges manage to address the issue of pricing not being exploitative in a monopolistic environment.”