Record growth in derivatives business is driving a wave of mergers between exchanges, which are keen to get in on a burgeoning market. Edward Russell-Walling reports.

Consolidation among stock exchanges is far from over. Two of the latest moves illustrate that equity derivatives are now proving a good reason for exchanges to hook up.

The Eurex offer for International Securities Exchange (ISE) and Nasdaq’s agreed bid for OMX are both driven, at least partly, by a desire for more exposure to ballooning on-exchange volumes in index futures and options, and single stock derivatives.

Transatlantic giant

Deutsche Börse’s Eurex has offered $2.8bn in cash for New York-based ISE. Eurex is the world’s largest derivatives market and has built its franchise largely on fixed income products. ISE, on the other hand, has used technology to become the world’s largest equity options exchange. If they pull it off, the merger will create the biggest transatlantic derivatives marketplace.

In much the same way, the US’s Nasdaq, a derivatives-free zone, has been drawn by OMX’s position and technological competence in the equity derivatives market. The Nordic OMX claims (a distant) number three spot in Europe’s equity derivatives league. Teaming up with Nasdaq, however, could generate what the US exchange predicts would be “a highly competitive derivative markets offering”.

The zesty growth in this business is borne out by a variety of statistics. Worldwide, exchange turnover in futures and options on stock indices grew by 33% in the first quarter of 2007 alone, to $60,000bn, according to the Bank for International Settlements. This was a new quarterly record – boosted, no doubt, by volatile financial markets in February and March.

By the end of May, Eurex was able to report a 50% rise in year-to-date equity index futures and options volumes compared with 2006. The number of trades in its single stock futures and options contracts was up by 17%.

Euronext Liffe recorded a more modest 20% growth in equity index product volumes over the same period, while individual equity product volumes rose by 14%. The Chicago Board Options Exchange announced record monthly equity option volumes for this May, and a comparable year-to-date rise of 18%.

Various influences have fuelled all this activity, including increasingly sophisticated trading strategies and new participants in the market, the continuing evolution of structured products and even, according to one observer, a generational shift in attitude towards the use of derivatives in general.

Arnaud Joubert, head of equity derivatives research at Société Générale Corporate & Investment Banking (SGCIB), says: “The growth rates we have seen in the past year or two can’t be explained simply in terms of growth from existing players. Some of it is driven by new market participants, such as algorithmic traders.”

Human touch

While a number of exchanges now offer an automated back end to over-the-counter (OTC) transactions, with central counterparty clearing and settlement services (of which more later), the front end still involves two human beings and a telephone line.

Where speed is of the essence, exchange-traded products are more appropriate, and nowhere more so than for the ‘black box’ trading strategies that are now used by some hedge funds and other sophisticated investors.

Black box or algorithmic trading relies on computer programs to transact, responding to pre-set conditions and parameters often before human traders have become aware of the new information. By their very nature, these algorithmic strategies can only be executed on an exchange or electronic platform.

This type of trading (often used to take advantage of arbitrage opportunities) has been used with cash equities for many years; now its use of equity derivatives is spreading. One third of all US stock trades were initiated by such programs last year, rising to 40% on the London Stock Exchange, with both shares forecast to rise. As they do, exchange-traded derivatives business will inevitably receive a further boost.

Traditional investors, such as pension funds and insurance companies, have been extending their use of equity derivatives over the past few years to add value to their portfolios rather than merely limiting risk. They are also investing in a slew of structured products that offer some equity-like upside along with capital guarantees. Although these are custom-built products, they invariably lay off risk via exchange-traded instruments.

Added-value trades

The same applies to new, increasingly popular forms of activity, such as relative value trading, dispersion, variance and volatility trading. “These are all high added-value, bespoke strategy trades transacted in the OTC market, but most are hedged in the listed market,” says Mr Joubert.

Exchange-traded equity derivatives are all about access to market, says Mr Joubert – especially in regions such as Asia where, otherwise, you have to be a local player – and access to liquidity. “Exchanges are very useful for big volumes and low transaction costs,” he says.

The exchanges’ embrace of technology has added to the market’s momentum. Dixit Joshi, head of equity derivatives at Barclays Capital, says: “The exchanges have improved their technology significantly over the past few years and, although they are still on the high side, they have reduced their costs. This combination of investment in technology and slightly lower costs is driving a lot of their growth.”

Mr Joubert believes the rise of a new generation of investors has fundamentally changed the way in which institutions regard derivatives generally, and that this has helped to unleash the flow of trade through markets listed and unlisted.

“There’s a new generation coming in and they are more familiar than older people with derivatives,” he points out. “Calls, puts and exotic options were part of their training. They were taught that listed options are a very powerful tool to adjust the risk profile of their portfolios.

“The older generation saw derivatives as complex, for emergencies, and were reluctant to use them. But even classical asset managers are now more keen to learn about them and use them.”

Exchanges are responding to this growing appetite by expanding their product ranges and by trying to capture business, in one form or another, from the OTC market.

Eurex recently introduced single stock futures on 19 UK companies, its first ever sterling-denominated contracts. It has launched a futures contract based on the Vienna Stock Exchange’s RDXxt index on Russian stocks, together with single stock futures on its underlying constituents and options on four Russian depository receipts listed in London.

This was a response to London’s introduction last December of futures and options contracts based on the FTSE Russia International Order Book index, and on its 10 most liquid underlying depository receipts.

“The main benefit is that we have been able to allow more participants to come into this market,” says Lee Betsill, managing director of EDX, the London Stock Exchange’s equity derivatives business, which is 24% owned by OMX (and perhaps soon by Nasdaq). “We have added six Russian banks as members, which are now able to trade with London investment banks because they can report trades for clearing. Previously, London banks had severe credit limits against Russian banks,” he says.

Cleared-only service

EDX also offers a cleared-only service on 26 underlying Russian and Kazakh stocks, as it does for its Nordic offering. This allows banks to trade bilaterally and report transactions to the exchange for clearing. This is also the principle behind Euronext Liffe’s Bclear service, launched in 2005. It registered its fifty-millionth contract last December and its one-hundred-millionth in May.

Ade Cordell, Liffe’s head of equity derivatives wholesale services, says: “There is an operational risk element associated with trading OTC,” noting that growth in the front office has led to more logjams in the back. “But the bulk of what they are doing in the OTC market is ‘exchange lookalike contracts’ which, in our mind, belong on the exchange.”

Bclear is Liffe’s way of repatriating that business, while addressing traders’ concerns about using an exchange – cost, fragmentation and confidentiality. Customers trade OTC and report via Bclear, clearing through LCH.Clearnet. Fees are competitive and capped, and users can hide their trades or not as they choose. “We initially looked at the top 300 blue chips in Europe,” Mr Cordell says. “Today we cover 650 companies and expect close to 700 by the end of this year. Bclear has the potential to be a global platform, with not just US and European underlyings – we are being asked to make Asian companies available.”

Internationalisation of the business is the next item on the agenda. Although regulatory hurdles have kept the US and European equity derivatives markets largely separate from each other, the string of transatlantic mergers – including the New York Stock Exchange’s ‘merger’ with Euronext Liffe – will hasten their integration.

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