There are signs that volume in exchange-traded derivatives is growing faster than over-the-counter products. Frances Maguire examines the drivers behind this trend and the impact of clearing on trading in capital markets.
Standardised exchange-traded contracts have always represented the tip of the iceberg, dwarfed by the volumes carried out by banks over the counter in the form of complex, structured, customised instruments. While this is still the case and both continue to grow, a study – published by Morgan Stanley and Mercer Oliver Wyman in June 2003 – found that for the preceding 18 months, exchange-traded derivatives had grown faster than off-exchange products for the first time in a decade.
According to the study, entitled Structural Shifts in Securities Trading, capital efficiency, risk management, shifts in trading strategy and new services are moving an increasing proportion of both cash and derivatives business into clearing houses and exchanges. On the cash equity side, electronic central limit order books are steadily increasing volume, helped by the flight to quality as investors take up central counterparty services (CCP) now being offered, and markets without CCP catch up. In derivatives, there is still room for growth of on-exchange trading, according to the study. The study’s authors write: “We believe this trend will continue as mounting concerns over creditworthiness and capital efficiency encourage investors to trade (or, more accurately, clear) on-exchange and take advantage of centralised clearing.”
Over two-thirds of blue chip stocks are traded on-exchange in Europe. As shown in the table overleaf, three-quarters of globally-traded interest rate derivatives and half of equity derivatives products are still traded off-exchange, signalling a likely continuation of the trend to on-exchange trading and clearing.
This trend towards centralised clearing will most likely be further fuelled by the introduction of Basel II. The study states: “Central counterparty mechanisms can be instrumental in reducing systemic risk (both operational and counterparty): regulators should actively incentivise maximum leverage of these central mechanisms in the fine-tuning of risk management frameworks.” To enable this shift to central clearing, the study predicts derivatives exchanges will continue to cannibalise over-the-counter (OTC) volumes, and exchanges and clearing houses should extend their intermediation and counterparty risk-mitigation model into non-equities classes, namely fixed income, foreign exchange and money markets.
Driving change
The rise of the CCP model has been cited as the key driver in pulling business on-exchange, coupled with the subsequent cost benefits of clearing and netting across assets classes. The collapse of Enron has also been cited as a driver for this flight. Both sides of the Atlantic, The New York Mercantile Exchange (Nymex), the Intercontinental Exchange (ICE) and its clearers have seen increased volume in the somewhat tricky area of clearing OTC energy contracts. While the more standardised gas contracts have helped Nymex clear more than five million off-exchange energy contacts since the inception of its ClearPort facility in May 2002, success at clearing physically-settled, power contracts is proving more difficult with the current models in place. Providing a guarantee for such volatile contracts, based on a commodity that cannot exactly be stored awaiting physical delivering, is proving a challenge to the futures industry.
David Goone, senior vice president for clearing at ICE, says: “Apart from gaining customer acceptance of clearing physical power, it is not an easy process using traditional models. Perhaps a new clearing model is needed in order to clear scheduled delivery – such as next day, or even next hour, power.”
But what is clear, apart from providing a guarantee for OTC contracts that did not exist before, ICE is seeing new business from hedge funds and proprietary traders which were previously unable to trade OTC energy. Mr Goone adds: “This year alone, we have more than doubled the number of firms clearing OTC contracts to 140.” ICE, about to launch cash-settled power contracts to be cleared through the London Clearing House (LCH), will also enable users to leverage the benefits of netting, as LCH also clears ICE’s recently acquired subsidiary, the International Petroleum Exchange.
European in-roads
In Europe, exchanges and clearing houses are making in-roads into OTC volumes by not only bringing OTC business in from the cold in offering central counterparty and clearing guarantees, but also by using the latest technology and offering value added services, such as EDX’s decision to use the new XML mark-up language, FpML, and MeffClear’s new model for clearing (see box).
But for Alex Wilkinson, head of listed products at Dresdner Kleinwort Wasserstein, although the efficiencies of using a CCP are great, the very nature of the OTC/exchange-traded divide means the exchanges will always be playing catch up. “The moment a product becomes standardised enough to be cleared centrally, the OTC market has moved on to new structures.”
That said, Mr Wilkinson believes the continued expansion of OTC clearing will find support among users seeking to control cost. “How we trade varies by product. Some we do CCP only; some both. It depends upon the credit mitigation components. Where the clearing houses have expanded their product ranges to include equities, repos and swaps we tend to use these to the maximum of our own and clients’ ability.”
Further down the line, Mr Wilkinson believes the shift from OTC to exchange-traded and cleared products will hold the industry in good stead when, or if, OTC products become subjected to greater scrutiny by regulators. The continued pressure from regulators for greater transparency and the lessons learned from green housing financial structures, is certainly lessening the appetite for the acceptance of non-standardised products. But for now, it is horses for courses. Mr Wilkinson says: “We choose to trade over-the-counter when there is no exchange alternative and where it is more cost efficient.”
Clearing dictates trading
What is becoming increasingly apparent is how closely aligned trading, clearing and credit lines have become. Few banks will disclose just what proportion of business is traded on or off-exchange as this is competitively sensitive information – ie, depending upon where they trade, competitors could work out their credit, collateral arrangements, and general health of their business. This idea that trading and clearing are now so closely aligned is backed up by Jos Schmitt, partner at consultancy firm CapCo, who would go as far as to say the clearing is almost dictating the trading.
“Already there are legacy CCP systems, and the cost and upheaval of moving to another clearing system is a substantial consideration when deciding where to trade,” says Mr Schmitt. “Where clearing arrangements are in place will dictate where the most cost effective place to trade is.”
It is to this end that Eurex, and now Euronext.liffe, have attempted to penetrate the OTC markets. Until the launch of the Stoxx indices, jointly established with Dow Jones, and upon which Eurex launched derivatives contracts, the only way to gain exposure to a pan-European basket was through mimicking the index trades over the counter. The subsequent success of the move, now a key growth sector for the exchange, reflects the readiness for the products. To a lesser extent, inroads have also been made into fixed income OTC markets with the formation of the Eurex Bonds platform and iBoxx, the fixed income trading platform jointly owned by the exchange and several banks.
Target market
Certainly the size of the equity derivatives OTC market has made it a target for both Euronext.liffe and EDX. Earlier this year, Euronext launched a similar pan-European index family, jointly with FTSE, in a bid to rival the German joint venture. While the indices, FTSEuroFirst 80 and 100, and subsequent index derivative products, have still to gain liquidity, Euronext claims they are broader and more tradeable by their construction than the Stoxx 50 rival.
Furthermore, Euronext.liffe unveiled a match facility at the end of 2003 for universal stock futures. The exchange will launch a flex facility for tailor-made equity options this month, and later in this quarter launch an OTC facility for the trade administration and clearing of OTC equity derivatives through LCH. Initially available for standard and customised equity option trades on UK securities, the OTC Facility will combine the traditional OTC benefits of flexibility without publication of trade price and size, with the exchange benefits of ease of trade administration, access to a central counterparty, efficient use of capital and the freeing up of credit lines.
John Foyle, executive director of Euronext.liffe, said: “These wholesale services are a colourful new hybrid. They combine the traditional flexibility and choice of OTC markets, with the efficiencies associated with exchange business in trade administration and the efficient use of capital. This is a significant expansion, initially in UK stocks, of our existing services for wholesale market customers. It will increase our ability to provide users of the OTC market with greater flexibility when making closing-out trades, the efficiency of netting open positions and the freeing up of counterparty credit lines.”
Main rival
The exchanges have long realised that the OTC markets are more of a rival than any other single exchange. Now that the need and desire to use a central counterparty and, in reality, drive down clearing costs by bringing OTC business into the same clearing entity for netting purposes is causing this shift, the exchanges must look to other volume drains.
According to the Morgan Stanley/ Mercer Oliver Wyman report it is internalisation that will cause the biggest threat to stock exchanges in the future – much more than OTC trading ever did. For derivatives exchanges, it is the push from the futures industry for fungibility that will enable true competition between exchanges. For until now, unlike stocks, derivatives contracts had to be sold on the exchange they had been purchased so return business is a certainty for the futures exchanges.
If the contracts were fungible and could be sold in a different exchange from where they were purchased, derivatives exchanges would be subjected to the same level of competition the stock exchanges have had from the electronic communications networks for trading, and other stock exchanges for multiple listed stocks.
Should derivatives exchanges be judged more thoroughly on the service and value for money they provide, it could bring greater consolidation than the growth of the OTC market ever did.
Smaller players with plenty to gain
It seems it is not only the larger exchanges, such as Eurex and Euronext, and the established clearing houses, that will benefit from the increased order flow from the over-the-counter (OTC) market. The smaller exchanges and new ventures are gearing up for growth by offering new services.
Spain’s late arrival into the provision of a central counterparty (CCP) facility has brought with it the benefits of building from scratch – and a wholly new clearing model has emerged. Meff, Spain’s financial futures market, which went live with MeffClear, a CCP for cash and repo debt instruments, last September, also claims to be Europe’s lowest priced CCP with no membership charges or monthly fees.
MeffClear is clearing government bond repos traded on Senaf, the electronic platform for trading Spanish government bonds, launched three years ago, as well as electronically-traded repos. Additionally, MeffClear is gearing up to clear cash government bonds this month.
Because MeffClear has been built from scratch, and a wholly new model and system for a clearing house has been established, unlike the London Clearing House it does not need a default fund. Also MeffClear is the first European clearing house to monitor risk in real time.
Jose Massa, chief executive of Meff, says: “The service will offer reduced risk for its members compared to other CCPs, as members will only take the risk associated with their own positions or those of their clients. They do not share any of the risk associated with positions taken by other members.”
MeffClear does not have a default fund as customer accounts remain wholly segregated, and are not aggregated or netted, so real time margin calls for individual customers are made, negating the need for default cover. Mr Massa adds: “We believe the whole point of a clearing house is to isolate risk from other members, and this is precisely what MeffClear is designed to do.”
Mr Massa believes the smaller clearing houses have competitive advantages in clearing niche products. He says: “Providing a CCP for other markets and instruments will follow. LCH.Clearnet faces years of migration in bringing together two systems. It will not have time to develop new facilities for its members. MeffClear’s reduced cost base means we can develop instruments that are too small for a larger CCP.”
Another start-up that is entering the OTC market is EDX, a joint venture between the London Stock Exchange and OMHEX. From Q1 2004, EDX will offer confirmation and clearing services for equity options, forwards and futures on pan-European stocks. In phase two, this will be rolled out to exotic options (confirmation only) and equity swaps, when the product range will also be broadened out to include dollar-denominated products.
Tom Wolstenholme, business development director of EDX, says: “What EDX will bring to market is the adoption of FpML, now considered the backbone standard for OTC derivatives confirmations and messaging. Owned and endorsed by the International Securities & Derivatives Association, FpML uses next generation XML to define messaging for financial products.
Mr Wolstenholme adds: “We aim to take the benefits of exchange trading for listed products and put them into OTC products but without changing the business model of our users.” Similar to what Eurex and Euronext.liffe are doing to penetrate the OTC markets, clearing is the key benefit that will differentiate EDX from other OTC derivatives platforms, such as Swapswire. “As soon as banks bring business into one place, they reduce the cost of clearing and the cost of capital,” he says.
