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Football is a simple game," said English soccer great Gary Lineker in 1990 after a gut-wrenching World Cup semi-final loss to Germany. "Twenty-two men chase a ball for 90 minutes, and at the end, the Germans win."
You can’t help but wonder if executives at the former London International Financial Futures Exchange (Liffe) aren’t thinking something similar as the Germans look to be wrapping up a deal that folds the remnants of Liffe (now known as NYSE.Liffe) into Deutsche Börse as part of the deal everyone’s talking about: namely the German exchange’s proposed takeover of NYSE.Euronext. The takeover would unite two futures exchanges that have been chasing, dodging and battling each other for nearly two decades. The derivatives behemoth would control roughly 93% of Europe’s futures business, putting it on a par with Chicago-based CME Group, which controls 98% of U.S. futures trading.
Calling it a German takeover is, to be fair, something of a misnomer — for Deutsche Börse hasn’t been majority-owned by Germans for nearly a decade. Still, the rivalry between Deutsche Börse’s derivatives subsidiary, Eurex, and Liffe is a storied one. The "Battle of the Bund," for example, was a seminal moment in the triumph of electronic trading. That’s when Eurex’s predecessor, the Deutsche Terminbörse (DTB), wrestled liquidity in the benchmark German interest rate contract, the Bund, away from Liffe in 1997. At the time, DTB was the upstart electronic exchange, and Liffe was the established open-outcry exchange. Andreas Preuss was DTB’s head of business development in those days, and now he runs Eurex. He’s also slated to run derivatives trading for the new entity.
The DTB’s taking of the Bund still represents the only time in history that one exchange managed to wrestle an existing liquidity pool away from a rival — a fact that won’t be lost on regulators as they mull the proposed mega-merger and look for ways to let it happen while making sure it doesn’t run amok.
The announcement (more accurately, the leak — for exchange bosses were forced to make an announcement after word of the pending deal got out) comes amid a flurry of other cross-border deals that include the London Stock Exchange’s (LSE) offer to buy Canada’s TMX Group, Bats Europe’s acquisition of Chi-X Europe, the Singapore Exchange’s (SGX) attempted takeover of the Australian Stock Exchange (ASX) and Wiener Börse’s (Vienna Stock exchange) move to further expand its network of Eastern European exchanges.
Pros and cons
The megamerger offers, in theory, a slew of benefits for market participants — the most obvious being that traders will have all the major European interest-rate futures on one platform using a single clearinghouse. That means easier cross-margining, and ultimately makes trading cheaper.
Then there’s the savings on operating costs. The two exchanges estimate savings will top a staggering €300 million per year after three years. Roughly a quarter of that is projected to come from reduced IT costs alone. This savings probably will not be passed on to the market at large, but instead divided among shareholders.
"That’s something you can bet on," says Christian Baum, who began his career structuring, trading and selling derivatives in the over-the-counter (OTC) sphere before joining the CME’s European sales team and then developing new products for Eurex. Now he’s an independent consultant based in London. "If this new entity has the monopoly on the market, do you think it’s going to get cheaper for the users?" he asks. "If so, it will be the first time in history that’s ever happened."
Regulators go a step further: Not only do they expect the new entity to not pass savings on to users, but they are worried that such a monopolistic behemoth will use its position to ratchet up prices unreasonably over time — at least in Europe.
"The regulatory response could be quite complex and nuanced," says Anthony Belchambers, CEO of the Futures and Options Association (FOA). "You have to remember that most euro-denominated business is traded in London, but the European Central Bank (ECB) and the Banque de France have made it very clear that they would like to see Euro-clearing in the Eurozone"
What’s more, NYSE.Liffe’s clearinghouse, LiffeClear, is run jointly with LCH.Clearnet. That means both regulators and the new entity have incentive to shift business to Eurex Clearing.
"This means you could end up with potentially a very large clearing silo in Frankfurt," Belchambers says. "That’s going to raise eyebrows against the background of what’s going on with the EMIR (European Market Infrastructure Regulation), where the opening of silos is on the agenda."
He believes that the emergence of such a massive clearinghouse could be the straw that convinces regulators to finally mandate the two pillars of clearing reform: Namely, that clearinghouses open their platforms to all comers, and that OTC derivatives go onto clearinghouses.
"The key issue is not about whether a clearing operation is or is not part of an exchange, which can deliver real cost savings and enhanced market efficiencies," says Belchambers. "The real issue is access."
On the monopoly front, several banks have floated the idea of an "economic regulator" — an entity that treats exchanges as utilities and regulates their prices.
Belchambers says that’s not so far-fetched. "We’re getting this drift already," he says. "Regulators are beginning to ask about pricing of products, and even bankers, who normally call for free markets, are saying that, if you have a large, near-monopoly provider, you’ll need a price regulator."
Clearing bonanza
Not surprisingly, the five major banks that control roughly 97% of the OTC derivatives business worldwide have been fighting OTC clearing tooth and nail in Europe, just as they have in the United States, where the Dodd-Frank Wall Street Reform and Consumer Protection Act aims at a similar migration.
Baum believes the potential windfall for exchanges — and for small prop-shops looking to trade OTC derivatives products — has been understated.
"You usually hear that standardized products will go to clearing, while non-standardized products will remain OTC," he says. "The next question is: What is standardized?"
As a product developer at Eurex, he worked with EU regulators to determine what was and wasn’t standardized, and he concluded that 90% of all OTC products are simple enough to be cleared centrally.
"If you look at the statistics, the vast majority of swaps are interest-rate swaps, and the vast majority of those traded — especially after 2008 — are fairly vanilla," he says. "The attitude of the banks, naturally, is that these things are not standardized, because they’re defining standardized as having fixed delivery dates — say, six delivery dates each year, like corn has, and which OTC contracts never have because OTC is in the spot market. The banks make a big deal out of it in their lobbying, but it’s a non-issue."
He says he wouldn’t be surprised to see regulators mandate the opening of Eurex Clearing as a condition for approving the merger.
Even if the regulators don’t force OTC derivatives onto clearinghouses, the high capital requirements currently in the works may do the job — but both scenarios may have unintended consequences, warns Belchambers.
"In the current environment, the prudential rules around clearinghouses are likely to be very much driven by safety-first principles, meaning you’ll have capital rules, default funds — anything to make them as near bomb-proof as possible," he says. "That’s all great in theory, but the trouble is that somebody will have to pay for that, and the result may be that risk management is no longer a viable economic activity — OTC or otherwise — generating an outcome that is less about risk mitigation and more about risk transfer from the derivative to the underlying"
"In an effort to make clearinghouses bomb-proof, you could reintroduce the kind of underlying risk that derivatives were invented to reduce," he says.
Regulatory Backlash
Beyond the mergers, a growing wave of anti-speculator fervor is growing around the world. Many blame rising wheat prices for the current turmoil in the Middle East, and French President Nicolas Sarkozy has implied that outlawing speculation in food products might not be a bad idea.
Algorithmic trading remains under fire after last May’s flash crash that sent the Dow down more than 900 points in a matter of minutes, only to see it bounce right back up. That sparked a mad scramble to develop safeguards (see "Bust or adjust: Inside the error can of worms," January 2011) that exchanges and traders now say are too restrictive.
Recently, sugar went the other way — spiking more than 150 points above equilibrium price, with no news to drive it and no similar moves in related commodities.
World Sugar Committee Chairman Sean Diffley immediately blamed "parasitic" algorithms that aim to "flip" the market by identifying where the stops are and then hitting the area with a barrage of orders that cause a quick — and quickly-reversed — move. It’s a practice as old as the pits — and before the advent of electronic trading it was called "running the stops."
ICE responded by vowing to scratch trades that meet its criteria for being suspect (big, brief moves with no discernible spark, for example) and revived its "implied matching engine" that electronically matches different bids and offers to keep the market running smoothly.
Like all measures implemented by exchanges in the wake of the volatility this past year, it’s an imperfect solution, and time will tell if it’s improved upon or abandoned.
On a larger level, the CFTC, in response to a new mandate implemented under the Dodd-Frank financial reform law, has asked participants for input on how to deal with "spoofing" (entering a massive order, letting the market see it and the cancelling just before it’s hit) and "banging the close" (throwing in massive orders on the close to impact the settlement price), as well as dealing with algorithmic trading in general.
Dodd-Frank calls for new rules to be in place by July, but the new wave of House Republicans voted to slash the agency’s funding by one third — an action unlikely to pass the Senate.
However these events play out, it’s clear that the already turbulent global derivatives landscape has plenty of seismic action left in it, and the growing exchange sector is now pitting regulators against the five major banks, while at the same time lining up with the banks to tell the world that speculation is good.
