The economy may be shrinking, but that hasn’t stopped futures exchanges around the world from expanding their global connections.
Alex Lamb, senior vice president in charge of development and marketing at RTS, says he’s scrambling to keep up with demand for beefed up connectivity between U.S. brokers and exchanges in Mexico, Brazil, and Sydney, among others. “In the past, you had to get memberships and all the physical infrastructure in place if you wanted to access a foreign market,” he says. “But more and more firms are now concluding that it’s no longer a prohibitive barrier to get foreign market access, and there are enough global clearing brokers that a retail broker can probably find an acceptable deal to offer retail at a non-prohibitive price.”
And easier access to global markets is just one of the bright spots for retail traders even as banks scale down their proprietary trading operations. There’s also low commissions and less resistance to the creation of commoditized and tradable over-the-counter (OTC) clones, meaning more room for the development of products reflecting the kind of risk previously only available to major investment banks.
Unfortunately for exchanges, fewer entities have an appetite for that risk, so as exchanges see their slice of the global derivatives pie increase, the pie itself may take years to reach its previous size.
The International Capital Market Association (ICMA) in February surprised no one when it announced that the size of the European repo market had shrunk 26% from June through December.
Anecdotal evidence indicates the trend has only continued since then, and futures exchanges like CME Group, Eurex, NYSE.Liffe, and the Intercontinental Exchange (ICE) also have seen their volumes drop. Those four, however, also can find something to celebrate in ICMA’s numbers: namely, the percentage of repo transactions executed electronically climbed almost 10% over the same period — from less than 25% in June to nearly 28% in December.
These numbers reflect two clear trends: a reduction of leverage among banks, which is arguably bad for the derivatives sector in the short term, and a pent-up demand for central clearing among banks, which is good for exchanges, traders, and the financial system. Indeed, the loss of volume hasn’t impacted the bottom line of exchanges as much as you might expect. CME Group volume has been steadily decreasing since early last year, with interest rate volumes taking the biggest hit, but because fewer large customers qualified for volume discounts, the plunge in volume has been a wash as far as earnings are concerned.
MOVING ON-EXCHANGE
A recurring theme of the past few years has been the attempt by exchanges and clearinghouses to lure OTC business onto their platforms by dangling the carrot of reduced counterparty risk. That argument won credence in the wake of Lehman’s implosion, when positions held on LCH.Clearnet’s Swapclear platform were promptly settled and many of their bilateral positions ended up in the global heap of toxic debt over which lawyers and accountants will be haggling for years.
Now regulators have added a stick to the persuasive mix, with EU Financial Services Commissioner Charlie McCreevy — long critical of Europe’s fragmented clearing and settlement apparatus — raising the specter of mandatory clearing and settlement of credit default swaps (CDSs) if banks don’t adopt the process on their own.
“Central clearing of CDS is particularly urgent to restore market confidence,” he said in February. “Given the size of derivatives markets, I am looking at whether other measures might be necessary to make sure they are adequately supervised and do not pose unnecessary risks to financial markets.”
The comment came as McCreevy’s Commission huddled with regulators from EU member states, the European Central Bank, and even the U.S. Federal Reserve, the Securities and Exchange Commission (SEC), and the Commodity Futures Trading Commission to discuss international regulation of the $28 trillion CDS market — exactly the kind of cooperation that Christopher Cox, who was President Bush’s chairman of the SEC, had dismissed when it was proposed last year by German Chancellor Angela Merkel.
McCreevy has long argued that central clearing would make it easier for regulators to keep an eye on global systemic risk, and at least nine major banks and brokers have promised to begin clearing standardized OTC derivative transactions by July. That represents another major reversal from the past decade, when JP Morgan Chase, Deutsche Bank, and others openly resisted calls for more transparency and standardization in their cozy but massive markets.
Now the CME, Eurex, ICE, NYSE.Liffe, LCH.Clearnet are all scrambling to win the potentially lucrative business of clearing those OTC transactions. To lure users, they are offering to share revenues and even ownership of the clearinghouse with clearing members, although each exchange has a slightly different business model.
CME, for example, is teaming up with Citadel Investment Group to create a subsidiary called the Credit Market Derivatives Exchange, which will be owned jointly by the exchange and clearing members and will both match trades and clear them. ICE, meanwhile, already has nine investment banks on its side after incorporating the Clearing Corp into ICE operations.
ICE’s U.S. clearing operation already has been approved by domestic regulators, while CME is still waiting. NYSE.Liffe has already launched its operation in London (an operation owned by NYSE.Liffe but administered by LCH.Clearnet). Eurex, meanwhile, is fine-tuning its clearing operation and may be up and running by the end of March. LCH.Clearnet says it will launch its effort by December, but it’s not clear how this will impact the existing project it runs with NYSE.Liffe.
Both CME and Eurex have offered exchange-traded CDS products in the past, but failed to attract significant volume. That, however, was in the era of the mighty investment bank.
From the perspective of a retail trader, the most significant trend may be the one we highlighted last year: more and more global markets are becoming available to retail traders.
“We have several customers who have taken all of our technology, including our hosting and market access functionality, and packaged that behind their own GUIs (graphic user interfaces), and they in turn distribute their GUI to retail customers,” says RTS’s Lamb. “To distinguish themselves from the run-of-the-mill broker, they have to add international markets.”
RTS is wired into 55 exchanges, and Lamb says the focus recently has been on upgrading existing connections and building up multi-market infrastructure for existing customers.
“The exchanges are coming up with new and ever more complicated platforms, so the weight of work per existing exchange is getting enormous, even though the rate at which we add them is slowing down,” he says.
The trading world is, indeed, becoming smaller and smaller and that means more opportunities for traders, regardless of what happens in the global economy.
