Toronto and Montreal are hoping new modernization efforts will boost sluggish interest

Canada's stock and bond markets are among the largest and most liquid in the world. But the same can't be said of the country's corresponding derivatives markets. Canadian securities markets account for 2.5 percent of world capitalization, while its derivatives markets only clocked in at 0.3 percent of world volume.

Why haven't Canadians been bitten by the derivatives bug? In the last few years, the Toronto Stock Exchange (TSE) and the Montreal Stock Exchange (MSE) have taken a hard look at why no one wants to trade in their derivatives products. This has meant consultants, benchmarking and trips to visit other more successful exchanges. The upshot: big investments in new technology, either planned (TSE) or executed (MSE), and plans to market themselves a whole lot better.

By gentlemen's agreement, the TSE handles stock-index derivatives and the MSE has control of fixed-income derivatives. Single-stock options are traded on only one of the TSE, MSE and Vancouver Exchanges, with the assignment of each option decided by a vote.

Development of the derivatives markets in Canada has been slow. The largest contract in the country is the three-month future on bankers' acceptances traded in Montreal since 1988, though this contract wasn't truly liquid until three years ago. The pivotal fixed-income contract is the futures contract on Government of Canada bonds (the 10-year GCB) introduced in 1989. This contract survived a challenge by the Chicago Board of Trade, which listed a similar contract last summer but delisted it within months because the volume never rose above a trickle. "We weren't surprised," says Styves Langlois, assistant to the senior vice president of markets of the MSE. "The liquidity is in Canada."

Keep in mind that Canada's fund managers are more conservative than their neighbors to the south. That means many are prohibited from using derivatives in any shape or form. But both Montreal and Toronto have education efforts underway to change the thinking.

The biggest challenge faced by exchange-traded derivatives is from the OTC markets and from traders who turn to the United States to hedge positions. "We need to convince everyone that trading the BAX is a lot easier than OTC, that the correlation is better with the underlying and there isn't any currency risk as there would be if you hedge in the United States," says Langlois.

In Toronto, the pitiful volume figures sent the TSE back to the drawing board. Early last year it started a strategic review, which quickly indicated that there was "general dissatisfaction with our listed futures and options, especially when compared with Chicago," says Stephen Rive, director of derivatives markets development at the TSE.

The specific findings were even worse. It turned out that index managers were shunning the exchange's flagship futures contract-the Toronto 35 Index-in favor of doing the same trade in the cash markets using baskets of stocks. That is because the TSE is a fully automated market and the futures pit is open outcry. To get a price in the cash markets takes one phone call; the broker can do everything from his desk. To execute via the futures market means the broker has to hang up, call down to the pit-well, you get the picture.

Thus a key element in the blueprint for the future that the TSE announced in January is to upgrade systems to provide for full automation. "It will lower the cost to the exchange eventually and to the participants," says Rive. "They won't need to keep a full-time trader in the pit, particularly when the volumes aren't large enough." The MSE also underwent a technology conversion two years ago, but stopped short of moving to full automation; their new system provides for automated order routing, but keeps the pit.

The TSE blueprint is currently in the market for comment, with votes expected later this year by the boards of the Toronto Stock Exchange and the Toronto Futures Exchange, the affiliate of the TSE that runs the derivatives business. The document does not suggest any new changes to the lineup of contracts at the exchange, although suggestions for a Toronto 50 or 75 were considered to take the place of the Toronto 35. "We decided to stick with the two main indices, the Toronto 35 and the Toronto 100, because these mirror most closely what customers seem to be doing in the OTC markets," says Rive.

But the blueprint does contain one controversial proposal to do with single stock options. The TSE suggests that single stock options be interlisted at will by the three exchanges as stocks are. "Having the option complements the stock," says Rive. That makes life easier for customers, but the MSE for one isn't in favor. "There isn't enough liquidity in these options to support dual listings," says Langlois. For the seemingly courteous business of exchange-traded derivatives in Canada, fireworks may be on the horizon.

Brooksley Born, the new chairperson at the Commodity Futures Trading Commission (CFTC), has got off to a good start with her exchange constituents in one respect at least. Exchanges have long complained that the CFTC approval machinery on new contracts was too slow and irrational. It is this feature that they frequently point to when blaming over-regulation for loss of market share to foreign exchanges.

In her preliminary interviews, Born has stated that she's looking into a two-track approval system, "when nonproblematic contracts could become effective very quickly."

It was surely a coincidence, but shortly after this peace offering the CFTC approved the CME's and PSE's futures and futures options contract on the Dow Jones Taiwan Stock Index, which made its first trade January 8. This contract-Dow Jones' debut in the index wars-has had a tough birthing, in large part because of opposition by the Taiwan Stock Exchange. The Taiwanese, who want to start local futures on this index but are way behind schedule, have refused to share information with Chicago and San Francisco. Without an information-sharing deal, some observers felt (wrongly, as it turned out) the CFTC would delay approval and perhaps even say no.

There was an end-of-the-world quality to the report of the Risk Management Center of Chicago, released just before Christmas, and sponsored by the Chicago Corp. Two years in the making and 400 pages long, the report bemoaned Chicago's slump in share of global market from 60 to 31 percent in this period-in part from the opening of some 38 new futures exchanges since 1980 and also, the report claimed, regulatory burdens that foreigners don't have to deal with.

The report also lamented the growth of OTC products, proposed new taxes on futures and options, and suggested restrictions on derivative usage. Yet another of its downbeat perceptions: efforts to extend trading hours in Chicago have not made much difference against Europe's natural advantage in time zones, which ovelap trading in the United States and Asia.

The gloomy forecast, however, contrasted strangely with the euphoric tone of the exchanges' end-of-year announcements. The CBOT set new records for daily trading on December 19, beating the mark it set in 1994. The CME ended the year with nearly 200 million contracts traded and open interest surpassing the 7 million mark. Though only the third-busiest year in CME history, this was in the teeth of the second-least volatile year for interest rates in three decades.

Interneters puzzled at the meaning of a term in risk management should bookmark http://www.amex.com for the interactive version of The Dictionary of Financial Risk Management by Gary Gastineau and Mark Kritzman, senior vice president of the American Stock Exchange and managing partner at Windham Capital Management, respectively. The dictionary offers capsule definitions for thousands of different uses of the terminology and excellent explanatory diagrams. The latest print edition, which is published by Frank J. Fabozzi and costs $45, is a revision of the original 1992 edition. (For information, call 215-598-8950.)

The exchanges' battle to control radio-linked hand-held computers on the floor grew more determined a few weeks ago when the Pacific Stock Exchange (PSE) reprimanded Interactive Brokers LLP for violating a month-old handcuffing of the technology. This brought to an end a friendly deal between the two parties in which Interactive was the sole member of a pilot program that used the new technology for options trading. (PSE plans to introduce its own hand-held devices in the middle of this year.)

The rule used by the PSE to frustrate Interactive, a subsidiary of Timber Hill, which has invested some $30 million to develop and market a global order delivery system for use in open outcry exchanges, stated that the hand-helds could only be used for the receipt of non-broker dealers orders, a deal flow in which Interactive has little volume. Angry letters have been fired on both sides, with Timber Hill's chairman Thomas Peterfly arguing that the new restrictions imposed on hand-helds are "artificial barriers" that allow "floor traders to live off a time and flood advantage".

Peterfly possibly underestimated the virulence with which exchanges would resist his technological incursions. Other exchanges that have thwarted him include the Chicago Board Options Exchange and the Chicago Board of Trade. In the former instance, the CBOE has asked for SEC approval of a rule proposal filed in 1995 banning hand-helds from two-sided orders. And last November the CBOT passed a rule that said hand-held order management gizmos can only be used around the pits by clerks or broker assistants. Peterfly believes that the result "would unnecessarily slow down the trading process by making it more labor intensive and error prone-to the point where the technology would no longer present any advantage."

Future historians may one day look back at 1996 as a milestone in the maturation of German financial markets. First there was the landmark IPO for Deutsche Telekom's DM 15 billion privatization, so well hyped that it is likely to boost the low levels of equity ownership amongst Germans. On the very first day this stock set a world record for volume. Second, the Deutsche Terminbörse (DTB) nosed ahead of France's MATIF as the second ranking European derivatives exchange after London's LIFFE, thanks to a 33-percent surge in volume, the biggest of any European exchange.

The DAX equity option was the most heavily traded, with 26 million contracts during the year. Some of this surge is attributable to the electricity generated by the Telekom deal. Only a few weeks after that event, the DTB announced steep cuts in DAX transaction fees-25 percent for in-house and customer accounts and (coming this April) 50 percent for marketmakers-challenging OTC rivals to offer a better deal. "The fee reduction will make the DTB DAX option even more attractive, especially since no capital backing is required to support market exposures, which is the case with OTC trading," noted DTB's general manager Jörg Franke.