End-users of exchange-traded derivatives don’t care where the instrument is traded, or which exchange is linked with which. What they want is liquidity.
Apparently ignoring this point, almost every exchange with global pretensions has been trying to form trading links across time zones with other exchanges. It’s an expensive exercise and the benefits are questionable. Will these mostly unhappy liaisons continue, or will exchanges recognize that they must either merge or slug it out until only a handful are left standing? Perhaps what they should be concentrating on is mechanisms that improve clearing and margining across exchanges, which could benefit everyone.
The as yet incomplete ties between the London International Financial Futures Exchange (Liffe) and the Chicago Board of Trade (CBOT) and the Chicago Mercantile Exchange (CME) have the highest profile, but other European exchanges have also been active in forging links. The Deutsche Terminbörse (DTB) has signed an agreement with the CME for its DAX stock index futures to be traded in Chicago. The German exchange has also agreed a letter of intent with Soffex in Zürich to develop a common technical platform, which adds the DTB to an existing alliance the Swiss exchange has with the Chicago Board Options Exchange (CBOE) and the Options Clearing Corporation (OCC) in Chicago. Given the paramount importance of clearing in any exchange link, the participation of the OCC with its new NxTRACS system is particularly significant.
CBOT plights its troth
The Marché à Terme International de France (Matif) decided earlier this year to quit Globex (the ailing 24-hour electronic derivatives exchange, a joint venture between the CME, Matif and Reuters). It is now developing closer domestic ties with the Société des Bourses Françaises (SBF) and has signed a letter of intent with the CME, Nymex (the New York Mercantile Exchange) and Monep (Matif’s equity options counterpart in Paris) to rationalize trading and clearing. The two French exchanges will adopt the CME/Nymex Clearing 21 system, while the US participants will reciprocate by taking the SBF’s NSC trading system. Apart from continuing discussions on links with the CME and Liffe, the CBOT has been busy in emerging markets, with letters of intent signed on the joint development of new exchanges in Argentina, China and Poland.
But there is scepticism among exchange members as to whether linkages (unless they involve clearing) offer much of value to the membership. “It certainly adds value in an exchange’s marketing pitch to state that they are a truly global exchange,” says Richard Berliand, managing director for exchange traded products at JP Morgan in Europe. “Critically, while the battle rages in Europe as to who is going to be the global exchange every little advantage counts, but it must be said that most of the value is being added on the supply rather than the demand side. Is it adding any value to the end client? Bluntly – probably not.”
Liquidity is the thing, says Berliand. “End clients don’t really care whether they are trading on the CME’s Project A, Globex or via open outcry as long as there is liquidity,” he says. “With the exception of the [mutual offset trading system] link between Simex [the Singapore International Monetary Exchange] and the IMM [the International Money Market division of the CME] most of these links are not demand-driven and consequently are not adding measurably to the levels of liquidity.”
Nor have there been efficiency gains from the links, Berliand reckons. “They are not contributing anything to saving costs, in fact probably quite the opposite,” he says. “It is significant that the CBOT membership (as distinct from the executive) have had second thoughts on the Liffe/CBOT link. We believe that the executive at both Liffe and the CBOT are categorical in their commitment to it, whereas I don’t see a lot of enthusiasm from the membership at either end.”
Linkages that develop into consolidation are quite another matter. “For those people who are multiple exchange members, with very diverse geographical presences, unification and consolidation of exchanges’ functions are an absolute must,” says Berliand. CBOT and the CME seem finally to have taken this view on board with their joint strategic initiative committee, which started work last spring, headed by Merton Miller, finance professor at Chicago University’sgraduate school of business. CME chairman Jack Sandner may have started in a bullish frame of mind – “everything is on the table, from buying pencils together to merging”, he said – but despite reaching an agreement on common banking arrangements, Miller had to threaten to resign in order to goad the two parties into agreeing an extension of the committee’s life in late November.
Glorious independence
JP Morgan’s Berliand, an ardent advocate of exchange cooperation, is not overly optimistic: “I think we have to be realistic about politics. If you look at the Chicago markets clearly the locals have the strongest say in exchange strategy. At Liffe it’s the FCM [full clearing member] community and at Matif it’s perceived to be the executive. If you can’t get the CBOT and CME together, where you have the largest membership overlap, and where control is in the same sets of hands [the locals] and under the same legal system, what hope is there of getting Liffe, Matif and DTB together?” Berliand feels that amalgamation is more likely among the smaller exchanges that depend on equity derivative products. “The cost base of exchanges such as Monep, Soffex and [Spain’s] Meff RV may not allow them to continue in glorious independence,” he says.
Outside Europe, emerging markets seem the obvious candidates for the next growth spurt in mutual offset and linkage agreements. Mark Eynon, head of exchange traded derivatives at SBC Warburg in London, isn’t convinced. “If you look at where they are emerging, it’s in equity products. Linking Taiwan with the S&P500 future is not a driver. In 20 years you may find that the debt markets in Asia have changed from being emerging markets to OECD quality, and you might see some new agreements then. In fact even globally I don’t think you’ll necessarily see a stream of new links in the future, especially in view of Emu [European economic and monetary union], which if it goes ahead will lead to a rationalization of contracts. I think it far more likely that advances in information technology, order routing and brokerage facilities will enable the business to be done much more easily in the domestic centres than is currently the case.”
The issue of costs is equally crucial for exchange members. “The market is more competitive than ever and yet the cost of transacting business is going up,” says Philippe Buhannic, head of listed derivatives at Credit Suisse First Boston in New York. “There are some very clear steps that need to be taken. A vital one is the globalization of clearing systems, such as the recent Matif/CME initiative. At present you have the rather absurd situation where we have to maintain multiple interfaces to multiple clearing systems and multiple costs.”
Buhannic also points to the savings that would come from direct feeds to the trader’s own computer systems. “There’s redundant technology and hardware,” he says. “You end up paying for 25 different trading screens, some of which provide very little business. Exchanges should stop providing hardware and just supply APIs [application programming interfaces], which would save all of us a lot of money. Other anomalies include such things as being unable to post margin on some exchanges that is denominated in anything other than the local currency, which in supposedly global markets is surprising. Standardization of collateral on the key exchanges could be a solution.”
“There is no question that the big issue at the moment is cost,” says Charles Minnaar, vice-president at the New York Cotton Exchange, whose exchanges include the New York Futures Exchange (Nyfe) and Finex (formerly known as the Financial Instrument Exchange). “The reason is that you can go into the OTC [over-the-counter] market and transact with greater flexibility and lower cost than you can on an exchange. I think the way that exchanges will try and address that issue is through mergers and consolidations; I don’t believe that small exchanges can survive.”
A Jack of all trades
Buhannic also sees the division of labour between the exchanges and their full clearing members (FCMs) as increasingly contentious. “Where the exchange stops providing services and where the FCM should start is a critical point. We need to differentiate ourselves as an FCM, if you can’t do that there is no way that you can hold your prices or grow your business. Exchanges seem to want to do everything. In the US they are even trying to become broker dealers, which puts us potentially in direct competition with an organization in which we are effectively shareholders. They should leave such things as electronic order routing to us and stick to what they do best; providing good-quality clearing and a high level of security of transaction.”
There is a view that total volume will expand after Emu on the back of increased activity by participants from outside Europe, particularly the US. The attraction for them will be the opportunity of trading a single liquid block of European debt and the associated hedging tools, rather than disparate sovereign issues and derivatives, as at present. Given this possibility, it is hardly remarkable that US exchanges have been the recipients of so many approaches for links.
CME president Rick Kilcollin predicts: “After Emu, markets that have been trading separate products will effectively be trading the same thing. Typically only one contract will survive, so the exchanges are manoeuvring to make sure that theirs is the one. Part of this process is the need to have optimum global distribution, which has led to an interest in seeing their products traded in the US. I think that we’ve benefited from this. From our point of view it’s great, as it gives us the opportunity to trade products that we wouldn’t otherwise see.”
Although no single European exchange can yet claim outright supremacy, Liffe is strongly positioned with its existing suite of Eurocurrency interest rate products. For the first two months of the year its volume exceeded CME’s, putting it second only to the CBOT. By contrast, a worrying development for Matif has been the gradual exodus of members’ support and ancillary staff to remote locations, particularly London. The comparatively high cost of maintaining such operational support in Paris means that the larger players are tending to leave only staff who need to be in day-to-day contact with clients. Although that in itself is hardly conclusive, coupled with Matif’s recent decline in volume (February’s was down more than 20% on January’s) and strong performances from Liffe and DTB, the exchange starts to look vulnerable.
Any competition between Liffe and DTB for European supremacy would also involve the battle between open outcry and electronic trading. At present the three main user groups that would decide the issue (locals, professional users such as swaps traders and end-users such as money managers) are in equilibrium. Liffe, as a predominantly open outcry exchange, has the local business, while the end-users will trade wherever there is liquidity. The group that may yet disturb the status quo is the professionals. An electronic medium is particularly attractive to them. It enables a swaps trader, for example, to hedge his position on the exchange at the same time as putting on the other leg of the trade with the counterparty. It is therefore with this user group that the DTB is starting to make inroads. But it will still be several years before their impact on liquidity is sufficient to make end-users shift exchanges.
The perennial debate over the relative virtues of open outcry and electronic trading has been enlivened by the objection from some CBOT members to Liffe having exclusivity for US T-bond futures and options after the Chicago pit session closes. Their argument is that the CBOT’s Project A system, whose liquidity dramatically improved in 1996, would do the same job at a lower cost. After a postponement because of technical problems, some are citing this latest objection as evidence of the basic incompatibility of the two exchanges.
SBC Warburg’s Eynon, a deputy chairman at Liffe, is mystified about the furore. “The idea of having the two markets open simultaneously is good news for traders trying for efficient price discovery. At the time of the original discussions for the link we were trying to think of a way of establishing this anyway.”
Exchanges with OTC aspirations
Some exchanges, such as the DB and Sweden’s OM, have a long-standing commitment to electronic trading as their sole method. The Nordic exchanges are also strongly committed to expanding their electronic activities via linkages, with the Swedish and Finnish derivatives markets signing an agreement to this effect last October. Both the Swedish OM and the Deutsche Börse derive a significant part of their total revenue from selling electronic trading platforms to other exchanges; in the case of OM it will probably account for more than 20% of group turnover in 1997. To many British observers, the prospect of an exchange successfully developing its own electronic trading system (let alone selling it to anyone else) has novelty value, but the Deutsche Börse has recently notched up sales and successful implementations to the Hong Kong Stock Exchange and Malaysia’s Kloffe (Kuala Lumpur Options & Financial Futures Exchange).
According to Patrik Egervall, president of OM Systems International, electronic trading has a number of benefits that are particularly relevant in the current environment. “It represents the easiest route for creating linkages with other exchanges and for launching new contracts with uncertain potential,” he says. Egervall points out the further possibilities for exchanges with OTC aspirations. “On the Stockholm exchange,” he says, “a large part of the clearing is from OTC trading, where we assume the role of mutual counterparty. In our product range we include swaps and various other OTC components, so the core functionality is already there.”
The traditional approach, particularly in the US, has certainly borne out the role of electronic trading in nurturing new contracts, but once a contract starts to show healthy volume, it is moved onto open outcry. “If you could replicate the price discovery benefits of open outcry electronically then it would have the edge, but so far no electronic system has been able to do that,” says Steve Kim, equity derivative analyst at Merrill Lynch in New York. “For institutions and their typical trading volume I think open outcry is still the best method. The burden of proof is on electronic systems to come up with something that shows them superior to open outcry.”
