London Metal Exchange’s (LME) Chief Executive Officer Martin Abbot declared, “We hope to make the LME a household name in the next few months,” in an opening presentation in Chicago late November on the exchange’s new cash-settled mini futures contracts on base metals.
To anyone who has followed the tradition-laden 130-year-old institution, it was a stunning announcement. The world’s largest exchange for base metals was reaching out to the financial community in ways it never had before and seemed never destined to do.
Coming just a few months after the Chicago Board of Trade (CBOT) began allowing side-by-side trading of electronic and open-outcry trading for grains, the LME announcement that it was allowing standard futures contracts, geared towards fund managers, to trade on top of its complex instruments, geared towards hedgers, capped a year of change and served to signal that 2007 would bring more of the same. Indeed, the range of new products on the 2007 horizon is staggering, as is the range of former innovations driving them. The clearing of over-the-counter (OTC) products, for example, has become a major-money earner, with the New York Mercantile Exchange (Nymex) alone listing 283 OTC products as of December 2006.
“Eighty percent of all derivatives trading is OTC and the percent is growing,” says Eurex boss Andreas Preuss.
Several of the new products on the drawing board for 2007 are exchange-traded versions of existing OTC products, and still in the brain-storming phase are instruments designed to enhance and support OTC functions. Thanks to liquidity-driving algorithmic trading, several contracts representing liquid spreads — including spreads among OTC products — are coming into focus, while other spreads are becoming more and more liquid. As a result, 2007 could be the year we see futures launched on swap spreads, energy spreads and obscure commodity spreads.
Of course, for new products to
succeed, they will have to fill a niche that existing products don’t, says Pat Catania, a former director of product development at the CBOT now advising India’s National Commodity & Derivatives Exchange (NCDEX).
“More business has been developed through product education than through product innovation,” he adds, recounting a white paper a few decades back that created a surge in trading of Treasury bonds. “The paper was all about how to hedge Brady Bond risk using T-bonds,” he says. “And it ended up generating more extra volume in
T-bonds than any new futures contract on Brady Bonds ever would have got.”
LESSONS OF HISTORY
Michael Gorham, who runs the Illinois Institute of Technology’s (IIT) Center for Financial Markets in Chicago, lends quantifiable credence to Catania’s thesis. He recently oversaw a study that found that the death rate of new contracts isn’t as high as most of us would assume, and that the contracts with the best chance of succeeding are those based on “internal imitation,” which are products based on other products launched by the same exchange. Such products failed just 50% of the time; while “true innovations,” which are futures on products never traded before, failed 57% of the time; and “imitations” of products on other exchanges failed 64% of the time.
Of 842 new products introduced globally since 1955, 366 are still traded today, although some barely. Of the products introduced, 405 were internal imitations, 298 were true innovations and 139 were imitations.
And what can be more internally imitative than options on an exchange’s existing products? Although not covered in the survey, volume in those instruments is growing faster than either futures or securities.
CREDIT DEFAULT FUTURES
The most ballyhooed product to hit the futures landscape in 2007 will be futures on the iTraxx Europe Credit Default Swap (CDS) Index, set to launch on Eurex in the first quarter.
The product is clearly targeted to smaller hedge funds and other users who don’t have the ability to compete toe-to-toe with the major banks. These innovative instruments may prove to be a lucrative product for traders able to foresee major defaults in the years ahead.
Something similar to insurance contracts on a company’s credit worthiness, a CDS begins with one company loaning money to another company. If the loan is made in the form of a corporate bond, the lender may decide to insure those bonds by paying a premium to an insurer, who promises to either deliver equivalent bonds or cash to the lender if the debtor experiences a credit “event” — meaning anything from a default to a credit downgrade or a debt restructuring.
If the insurer wants to pass the credit risk to a third party, he does so by executing a CDS. The definition of what constitutes an event is, predictably, a key element of the price of a CDS — along with a myriad of other factors.
The price of a CDS on corporate debt has become not only a benchmark of creditworthiness akin to that of ratings agencies, but the foundation for more complex structured-credit products.
What’s more, as a secondary market for CDSs has evolved, the International Swaps and Derivatives Association (ISDA) has had to come up with more and more protocols for defining what happens when an event occurs or how to prevent certain players from buying up more CDSs than they can handle.
But for protocols to work, a consensus has to be forged among a diverse group of players — not always easy in such complex instruments, which is why it has taken so long for the first CDS futures to be take shape.The iTraxx Europe and Asia CDS indexes were launched in 2004, but it wasn’t until the middle of 2006 that ISDA was able to extract a consensus among users on how to deal with an event by an index component.
The underlying product for Eurex’s new futures contract is the iTraxx Europe index, which contains 125 companies and is administered by the International Index Company (see “Tracking innovation,” below). Another set of indexes, the CDX indexes, cover North America and emerging markets and are administered by DCS Index Company.
Both companies roll their indexes every six months, meaning they review the constituents of the old indexes and launch new ones, which last five years. Old indexes don’t expire when rolled, but instead keep trading until their time is up. A poll of investment banks determines which companies are excluded and which are added.
If an event takes place before an index expires, the component that experiences an event is dropped from the index and a new index with 124 components is formed, leaving two indexes with the spread between them representing the market’s perception of the value of the debt of the component that experienced the event. If more components experience events, they are also dropped, leaving yet another index to trade.
In theory, that offers traders a chance to pick up some change if the components that experienced the event ever revive, although Eurex’s new head of product development, Brendan Bradley, says that isn’t likely to be a viable futures play. “This could happen in the OTC market, but liquidity tends to drain from the wider index to the smaller one almost immediately,” he says.
The development of CDS indexes has made it possible to launch CDS futures, and Bradley says indexing of other markets, combined with the trend towards cash-settled commodities products, could unleash a slew of new futures contracts. “A lot of pension fund mandates expressly forbid the trading of deliverable products, but they want access to the diversification benefits of commodities,” he says, pointing out that The California Public Employees’ Retirement System (Calpers) just allocated $500 million for commodities trading.
Cross-Continental competitor Euronext.Liffe is set to launch futures on a whole array of European Union government bond indexes developed by subsidiary MTS, by far the Continent’s leading platform for secondary bond trading. These new products are four real-time bond indexes — one pan-European with separate indexes for Germany, Italy and France — built on actual market prices, which is an industry first, coming from the MTS markets. They’re designed to provide a more accurate benchmark for European
government bond interest-rate risk than Eurex’s bund contract, in part by offering a truly pan-European, cash-settled product, but most interestingly by offering “total return,” which means coupons or dividends are reinvested into the index so that the return is more reflective of what a portfolio manger should achieve.
“To me these are significant differences and mean that we aren’t necessarily targeting the bund but rather trying to change the nature of the bond futures market,” says Scott Stark, chief executive officer of MTSNext, a joint venture of Euronext and MTS. “The challenging part is educating the bond market that there might be a better way to do things.”
Then there are American Depositary Receipts (ADRs), which are shares of foreign companies trading in the United States. Not only do dollar-denominated ADRs trade on the London Stock Exchange (LSE), but EDX, which is the LSE’s joint venture with OMX, launched a Russian ADX index on Dec. 1.
Unfortunately, this one doesn’t meet the U.S. Securities and Exchange Commission’s (SEC) definition of a broad-based index, and can’t be offered in the United States, but you can bet someone will come up with such a product before 2007 is over. If a U.S.-based exchange doesn’t come up with it, Eurex could win that race, especially because it now has the ability to offer dollar and sterling-denominated contracts. In fact, that ability will probably lead to a flurry of U.S.-oriented products out of Frankfurt.
Indian exchanges have been introducing futures on scores of obscure products, but it’s not clear when those will be up to speed for U.S. traders. For now, the most exciting new non-energy commodity contract looks to be dollar-denominated futures on palm oil, which have been trading in ringgits on the Bursa Malaysia Derivatives Bhd for years.
In early 2007, they will be trading on the Joint Asian Derivatives Exchange (JADE), a joint venture between CBOT and the Singapore Exchange (SGX), which will run on the e-cbot platform.
“This means we’ll have palm oil, soybean oil and canola oil all on one platform,” says CBOT Chief Executive Officer Bernie Dan.
“Palm is the largest vegetable oil product in terms of tonnage of exports from origin,” says Clive Furness, who runs commodity consultancy Contango Markets. “It’s traded by the same trading companies and traders as trade soybean oil, and the spread between them is heavily traded, but with the currency and platform difference between the two major contracts, real-time arbitrage is nigh-on impossible.”
JADE also hopes to be launching futures on new indexes it is developing with the Financial Times/London Stock Exchange index group.
Energy has been the fastest-growing commodities sector this decade and is set to continue leading int 2007, with carbon trading coming of age and the new Dubai Mercantile Exchange (DME) launching its new contract for sour crude oil — the stinky stuff that comes out of the ground in much of the Middle East. The product could be a hit because the two current global benchmarks — Brent crude and West Texas Intermediate (WTI) — are “sweet” varieties being pumped out in lower and lower amounts.
Brian de Clare, president of Global Energy Horizons, gives the new product more than a fighting chance. “The DME is situated in a producing zone, which has often sunk products because it ended up skewing them to the producers,” he says. “But Dubai has loyalties to both the consuming and producing world and is seen as neutral territory.”
CARBON COMES OF AGE
Another market we should see a lot more of in 2007 is greenhouse gas emissions, or carbon trading, which most trading desks now handle as part of their energy books. “We have seen the biggest correlation, sometimes up to 90%, between the price of carbon and the calendar price for German power,” says Patrick Weber, a carbon trader with Dresdner Kleinwort (see “ HYPERLINK "http://www.futuresmag.com/cms/futures/monthly%20issues/Issues/2007/01/Editorial/Trader%20Profile" Trader Profile”).
The reason, he says, is simple. “The carbon emissions price is a marginal cost for a power producer,” Weber says. “Although certificates are allocated for free, they are regarded as opportunity costs and therefore its value is included into the power price. It’s the same rationale for coal and gas because these are the main inputs for power generation.”
So, if a power producer generates electricity with coal instead of gas, it will also generate larger emissions and will then have to buy more emission allowances, which puts emissions into the power price — a correlation that will increase if the United States joins whatever global cap-and-trade regime replaces the Kyoto protocol once it expires in 2012.
That means you can add so-called “clean” spreads to the “spark” spread (the difference between the cost of electricity generated by a gas-fired power plant and the gas required to produce it) and the “dark” spread (ditto on the coal side) to create clean sparks and clean darks.
A “clean spark spread” is a spark spread that factors in carbon allowances, while a “clean dark spread” is a dark spread that does the same. Such trading has already led to correlations among energy and commodity markets in Europe and as the United States deals with whatever regime follows the Kyoto protocol, you can bet you’ll see similar trends taking place here.
For traders, however, the most interesting aspect of carbon trading may be the quest for a global benchmark as Certified Emission Reductions (CERs) hit the market. These are clean development projects launched as part of the Kyoto protocol’s Clean Development Mechanism (CDM), which allows companies in countries that signed the Kyoto Protocol to fund them in return for CER certificates.
For now, CERs are traded relative to European Union Allowances (EUAs), which are emission allowances given and, most likely soon to be sold, at an auction price to European polluters.
Weber says they’re currently priced in a range between 80% and 90% of the value of EUAs delivered in 2008, which is when the European Union’s first phase of emissions trading ends. “This has created a swap market, with swaps being priced based on the spread between the two,” he says.
“Long-term, the question is which will be the price-setting mechanism — the EUA or the CER.”
His view is that a global CER price will emerge as a benchmark, with local schemes trading both as stand-alone markets and in relation to the global benchmark.