Richard Olsen and his partner Michael Stumm built the Oanda trading platform in part to show it was doable, and in part because they truly seem to believe that if you get more people participating in open, transparent and liquid markets, you’ll end up with the kind of fair and stable financial system that markets are supposed to deliver.
Contrast that with the over-the-counter (OTC) world, where a few well-educated, but not particularly diverse, minds are determining the prices on which trillions of dollars worth of global instruments are based.
A cynic would blame the top-tier banks that run everything and keep the markets closed and clunky to bloat the bid-offer spreads that generate their profits.
Someone less jaded might argue that closedness and clunkiness are necessary traits of the OTC beast, which is no beast at all, but rather a sort of financial market Miles Davis or Kurt Cobain — a cantankerous and temperamental genius, whose idiosyncrasies we willfully tolerate to enjoy the benefits of their work.
Olsen says their value has been greatly exaggerated.
“If you have one group of people who all read the same newspapers and all go to the same restaurants agreeing on a price,” he says, “you get a price that can go to completely unreasonable levels, and eventually the bubble will burst, and that’s what’s happening now.”
The price he’s referring to, of course, is that of credit default swaps (CDS) and other credit-default instruments, but the analysis can be applied to all markets dominated by OTC transactions.
WISE CROWDS?
His point touches on several fascinating debates, chief among them being whether broader participation in the pricing of such instruments would have prevented, or at least minimized, the current credit debacle.
“I don’t think you can say the whole credit crisis would have been averted if people were trading credit products on-exchange,” says Eurex Product Strategy boss Brendan Bradley. “Only a small percentage of credit instruments are suitable for exchange trading now, and most of the structured instruments out there never will be.”
Rick Redding, the Chicago Mercantile Exchange’s director of products and services, agrees, but adds that time has a way of commoditizing some fairly obtuse instruments.
“Weather derivatives are a case in point,” he says. “These were pure OTC instruments until we launched our futures contracts, and now both products are doing well.”
HEDGOCRACY
Credit default products have been launched by exchanges from Frankfurt to Chicago, beginning in March with Eurex’s launch of Itraxx Europe credit default index futures and its sub-index, Itraxx HiVol, as well as Itraxx Crossover.
So far, however, all have failed to attract significant volume and the HiVol hasn’t traded at all despite that OTC traders themselves are more and more using credit default indexes like Itraxx to benchmark their risk.
Common wisdom says the big banks have simply not used their credit books to support the products because they fear a successful exchange-traded index would lead to exchange-traded single-name products — and single-name products generate the fattest margins.
Bradley, however, says it’s more likely that investment banks have just moved on to greener pastures, and points out they also make their margins in second- and third-generation products such as index tranches and Constant Proportion Debt Obligations (CPDOs), which involve swapping baskets of high-risk and AAA debt with complex guarantees with issuers in the event something goes sideways.
Redding adds the day will come for credit default futures as more and more hired guns leave the big banks and join the buy side.
“The markets are evolving, and a lot of the people who designed these products at the big banks are now setting up hedge funds,” he says. “These are people who are used to structured products and they also know how to break them down into their components — which is where you find the commoditization.”
He says that skill, combined with the smaller balance sheets that hedge funds carry compared to tier-one banks, will bring hedge funds in as liquidity providers, regardless of what the big banks do. “You’ll find these groups are not only willing but able to provide liquidity in the credit default markets,” he says. “The exchange can encourage that by getting the right mix of parties involved.”
FOLLOWING PROTOCOL
In “Crossing the matrix,” July 2002, we highlighted the evolving technologies and protocols being championed by the International Swaps and Derivatives Association (ISDA) and others to promote instantaneous credit checks and straight-through processing of OTC transactions. Since then, leading futures exchanges and the Society for Worldwide Interbank Financial Telecommunications (Swift) have thrown their support behind the use of Financial Information Exchange Markup Language (FIXML) to promote standardized pre-trade protocols across platforms.
“In the credit market, the index products are already commoditized and standardized, which is how we developed our contract specs in conjunction with the sell side,” says Bradley.
Like Redding, he believes some portion of the credit default business could migrate to exchange order books, but also believes a significant portion may remain OTC executed but exchange cleared.
“It’s an old story that the more standardized, commoditized versions migrate to exchanges, where they can get the benefits of straight-through processing and a CCP,” he says. “Our argument to the sell side is that they can free up credit lines on these standardized products and use those credit lines for products with more margin.”
Amanda Sudworth, Euronext.Liffe’s director of interest rate products, says the time isn’t yet right to offer a central order book in a market that remains based on bilateral transactions.
“Banks are just not willing to quote on central order book,” she says. “They are willing to quote a price on a periodic basis, but don’t want to be squirting prices into LiffeConnect 10 hours a day.”
Like most exchanges with a central clearinghouse, hers has had success offering clearing of OTC transaction, most recently with BClear, which launched October 2005, and makes it possible for users to swap OTC transactions for “look-alike” futures and options. The platform currently serves the equities community and she says it’s helped support the surge in single-stock futures traded on Euronext.Liffe.
“The key is that BClear is complementary to the OTC world, and not competing with it,” she says. “We’re offering services that weren’t previously available in terms of very much simplified straight-through-processing and central clearing and the major banks are an integral part of its success — they provide the liquidity.”
But engaging in those products ties up valuable credit lines, and Bradley sees that as a lure to bringing top-tier volume to exchange-traded and exchange-cleared products.
But engaging in those products ties up valuable credit lines, and Bradley sees that as a lure to bringing top tiered volume to exchange traded and exchange cleared products.
Redding agrees, “The arguments in favor of central clearing are still strong,” he says. “You have the counterparty argument, which means protection, and you also have the economic argument of netting.”
And Bradley points out that order books do serve a purpose when the liquidity providers are also liquidity takers — citing Eurex Repo, where volumes tripled when the credit crunch broke.
In many ways the failure of the Itraxx contracts to attract substantial top-tier volume to date echoes the launch of the SwapNote by the London International Financial Futures Exchange (Liffe) nearly seven years ago. Like the Itraxx futures, SwapNote is a viable niche product, but nothing compared to massive value of the underlying cash market.
Sudworth says the Swapnote’s niche status flows more from the existence of other interest rate products and also disputes our placing the contract in the “convergence of OTC and exchange-traded” category.
Her point is well-taken. After all, an exchange that manages to capture clearing business certainly feels it has converged with the OTC world; but from the perspective of a retail trader, clearing of OTC transactions falls short of delivering a truly sized, commoditized and democratized product of the sort Olsen says are possible.
Even OTC clearing, however, isn’t immune to the not-so-benign neglect of the big banks. When LCH.Clearnet (then just the London Clearing House) set up SwapClear in 1999, it was supposed to level the playing field in terms of counterparty risk — with all players being backed by LCH’s default funds. Instead, the big banks continued to trade among themselves keeping the business of their most lucrative clients off SwapClear, thus maintaining a top tier of execution with a slightly lower risk premium.
These days, the big banks engage in a sort of credit line/counterparty arbitrage, using SwapClear to free up their credit lines but trade among themselves when the lower risk premium outweighs the freedom to maneuver.
That’s the dynamic that has played out at Eurex as well, and now the CME Group Inc. (CME) “Clearing360” project is taking it to the next level. The project launched earlier this year with FXMarketSpace, a joint venture with Reuters regulated by the U.K.’s Financial Services Authority (FSA), and the first in a series of “bridges” between the OTC and exchange-traded worlds that Clearing360 will eventually construct.
FXMarketSpace makes it possible for users to “substitute” the exchange’s Eurodollar, Euroyen and Libor futures contracts for OTC swaps and forwards tied to the same underlying cash instruments, and offers flexible settlement dates and contract sizes — essentially bringing a bit of the flexibility of the OTC world to a standardized futures contract.
The exchange purchased Swapstream last year and plans to offer cleared swaps in early 2008, followed by the ability to substitute swap structured products for baskets of futures.
The result will likely be more liquidity to existing interest-rate futures and options products, but also increasing commoditization among OTC products or among the components of structured OTC products.
