Since the global financial crisis, regulators have been pushing for structured products to be traded on exchanges for safety reasons. So why, in the German retail market, is the opposite happening, with more trades being done over the counter?

In the wake of the global financial crisis, the push for more transparency led to expectations that more financial instruments would move from over the counter (OTC) to trading on-exchange. However, in the trading of retail derivatives such as warrants, knockouts and certificates, the reverse has occurred.

The banks that provide these structured products are under pressure to reduce costs, and exchange trading fees are an obvious target. German retail investors trade online via their accounts with brokerages such as DAB Bank, Cortal Consors or Comdirect, and can choose to execute trades on-exchange or OTC. 

For the retail investor, OTC trades are conducted on the basis of a request for quote process from the chosen provider, for example, a knockout on the DAX, the German stock index, provided by Goldman Sachs or RBS. For an exchange trade, the investor is open to price movements as it is executed at best price, though in practice execution is very rapid. Institutional traders will also try to arbitrage products from their rivals, so providers have more control to pick out large arbitrage orders under the request for quote system.

Meanwhile the exchanges point to greater transparency, and better protection for small investors with regards to issues such as mis-trades. With mis-trades, the exchange will make its own ruling, whereas on OTC platforms providers may treat more important clients more favourably in the event of a dispute.

A happy medium

Certainly the product providers are happy to see the market move in the direction of OTC. And this general trend has been exacerbated by the large number of free-trade or flat-trade promotions during 2012, offering online traders cheap access to products in order to win market share. Providers absorb the cost as part of their marketing budgets, and the less flexible and more expensive fee schedules offered by the two exchanges mean that promotions are almost always OTC.

OTC trading figures in any market are hard to assess in the absence of publicly available data. However, in Germany the traditional breakdown has been that roughly one-third of retail structured products are traded on the two retail derivatives exchanges: Euwax at the Boerse Stuttgart and Scoach Europa in Frankfurt (the latter is a joint venture between Deutsche Boerse and Six Group of Switzerland). These two had total volume of €76bn in 2011.

On top of this, another third of retail structured products is typically traded in house on the proprietary platforms owned by Deutsche Bank (x-Markets) and Commerzbank (iCom). These two banks are the dominant players in the German retail derivatives market, and have spent heavily on their own trading platforms.

The other providers, such as RBS, Vontobel and Goldman Sachs, use the 'Cats' platform owned by Citi, which takes most of the remaining one-third market share, though there is a smaller Tradelink platform, which is used by players such as HSBC Trinkaus in parallel with Cats.

Transparency moves

With regard to regulatory oversight, all trades are reported to the German regulator BaFin regardless of whether they are executed on-exchange or off-exchange. However trading volume figures from the direct trading of Deutsche Bank, Commerzbank and Citi's Cats OTC platforms are not public.

Citi's Cats platform does view greater transparency as an important issue, partly driven by EU regulatory initiatives such as the Markets in Financial Instruments Directive, or MiFID. Cats has just released a new online service that allows users to log on and see every single bid/ask price movement on the 925,000 listed products, which on a busy day could mean 2 billion pieces of data. Traders can zoom in on a graph to see price movements, which are broken down to the millisecond. Cats plans to store this historical information, which will also be available to regulators.

"The market is moving towards more transparent direct trading between the online brokers and the market makers," says Chuffy Hunter, the London-based head of Cats business at Citi. "Product providers are looking closely at the overall cost of trading, including not only per-ticket trading fees but also, for example, transaction settlement costs.

"Cats has increased its transaction volume year on year in the German market over each of the past three years, including 2012. The use of independent bilateral electronic platforms is well established in Germany, and is now growing in France." 

Beyond France

Retail derivatives trading in France has traditionally been conducted on Paris Euronext, but some of the largest product providers in the country have signed up with Cats. First came Boursorama, which has an approximate 20% market share, and most recently Bourse Direct, which has a similar share of the French market. Both are now using OTC as well as on-exchange trading.

And in Switzerland, the Swiss Dots trading platform launched in 2012 by online financial services provider Swissquote is also using the Cats infrastructure. The new service was created in collaboration with product providers UBS and Goldman Sachs, though in the future it will be open to other issuers.

As an introductory offer, Swissquote is offering its retail investors trades for SFr5 (€4.14), whereas Scoach Switzerland would do the same trade for SFr7. In Germany, an investor would pay about €8.45 to execute an average order size (in November) of €8894. During 2012, the volume of retail derivatives traded on Scoach in Switzerland, Scoach Frankfurt and Euwax in Stuttgart has fallen by more than 25% versus 2011 levels.

"Many retail investors are tired after several years of one crisis after another, including uncertainty about the euro, so structured derivatives products trading – just like trading for any other financial product – is down significantly on 2011 volumes," says Christian Reuss, CEO at Scoach Europa. "At the same time, product providers are looking to cut costs, and some are trying to avoid paying exchange execution fees, but this means that they do not have to trade transparently or abide by exchange rules. Pushing OTC trading may not make sense in helping win back the confidence of retail investors."

Parallel lines

In Switzerland, Scoach is in the process of setting up a parallel trading platform, only for private placements among banks, giving them a centralised platform to make this business more efficient.

"You need exchanges for the credibility of the product," says Mr Reuss. "Of course we could reduce our fees in Germany or Switzerland further and further by lowering our standards, for example by cutting back on our market surveillance and reporting. But the market needs efficient exchanges and the oversight function that they provide."

Scoach has also been working on introducing more sophisticated order types. One of the latest is 'Orders on Event', linked to specific market events rather than price movements in the actual derivative product. For example, the DAX hitting an all-time high might be taken as a sign of a further breakthrough to higher levels, and this would trigger an order for a warrant. Scoach is also working on post-trade optimisation, combining OTC and exchange flows and saving money for providers by making these processes more efficient.

"We have had a significant reduction in trading volume during 2012 as a result of overall conditions in the financial markets," says Ralph Danielski, vice-chairman at Euwax. "We are already offering highly competitive trading fees, which would be €9.50 plus VAT for a €10,000 ticket for the end investor, which is not far off levels charged for OTC trades. In recent years we have introduced a variety of intelligent order types, such as Trailing Stop, Stop Limit and One Cancels Other, and we are now working on measures that will help reduce back-office costs for providers.

"For example, on the OTC platforms the aggregation of trades is common, instead of clearing each trade separately, and next year we will also begin aggregation of trades, which should help maintain our marketshare versus OTC by cutting costs for product providers."

Intelligent design

Meanwhile, the OTC platforms have also been introducing so-called intelligent order types, and continuing to invest heavily in their computer systems. Deutsche Bank uses its proprietary db-Xmarkets platform to trade certificates and warrants, while rival Commerzbank uses its in-house iCom system.

Both of these product providers have partnered with a third-party OTC trading platform called LOX in order to give investors access to intelligent order types. LOX is owned by Xervices, a subsidiary of Xcom, which is one of the premier suppliers of e-business, e-commerce and e-banking solutions in Germany.

Commerzbank has rolled out the LOX service to nine online brokerages, including Cortal Consors, Flattrade, and its own subsidiary, Comdirect. The online trader has a brokerage account, and might simply buy or sell a position with an order routed direct to the Commerzbank or Deutsche Bank OTC platform for their products, or via the Scoach or Euwax exchanges. However, if they want to use so-called intelligent orders, the order will go via LOX.

"We have invested heavily in our iCom platform to make it one of the most sophisticated systems in the European structured products market," says Anouch Wilhelms, director and products specialist at Commerzbank in Frankfurt. "For intelligent orders executed via LOX, the market maker has no access to the order book. If a barrier is hit then LOX sends a price request through to us, but we just see a buy or sell order, rather than knowing if it has been generated by a barrier being hit.

"We see on-exchange and off-exchange trading co-existing for the foreseeable future. One reason that some online traders favour iCom and other OTC platforms is that they get the execution price information before they do the trade, but it is up to each trader to decide where their orders are executed. Some prefer OTC, while others like to have third-party exchange execution via Scoach or Euwax, and we are happy to see flows from either source."

But though this co-existence may suit the bank product providers, it is more of a problem for the exchanges. In Germany, the two exchanges have a traditional fee model that has been a source of difficulties. Initial listing fees are very low, and have an annual cap to each product provider. In practice, large providers such as Commerzbank and Deutsche Bank average less than €1 to list a new product.

Product explosion

These low listing fees have contributed to the proliferation of products, with more than 900,000 currently listed. Thus the two exchanges generate low listing fees, and spend heavily on IT to provide continuous pricing updates on 900,000 products on their platforms, but see much of the fee income on secondary trading going to the OTC platforms.

A return of investor confidence in Europe and globally in 2013 would clearly help all retail financial products, and lead to a bounce back in structured products trading. In the meantime Scoach is looking for new business opportunities, and one venture involves Hong Kong investors connecting to Scoach (which runs on the Deutsche Boerse Xetra platform) via their brokers, giving them a late evening trading session in Hong Kong.

Scoach Frankfurt has received a licence from the Hong Kong regulators, and already has products denominated in Hong Kong dollars. During 2012, order flow providers have been getting ready to connect to Scoach, and they are close to crossing the finishing line. The first trades for products issued by European providers but traded by Hong Kong investors could happen early in 2013.


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