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Meridien on the Electronic Threat

By Nina Mehta

Open-outcry exchanges are in for a rude awakening, according to “The Rise of Fully Electronic Securities Exchanges,” a new report from Newton, Mass.-based Meridien Research. They are vulnerable to competition from electronic exchanges and will face an “erosion in market share and eventual extinction” if they do not begin moving toward electronic order-routing, matching, clearing and settlement systems.

“Smaller upstart exchanges have a lot of maneuverability and can pose a threat to the entrenched open-outcry culture at much larger exchanges.”
—Dana Stiffler

The research report focuses on derivatives exchanges, since they have been the pioneers of automated trading, especially in Europe. Researchers talked to officials at Eurex, the Chicago Mercantile Exchange and the Swiss Exchange (a cash exchange), as well as vendors of front-end trading systems that provide access to electronic exchanges. The report, says Dana Stiffler, a research associate at Meridien Research, found that “smaller upstart exchanges have a lot of maneuverability in what they're able to do, and they can, as the Eurex case shows, pose a threat to the entrenched open-outcry culture at much larger exchanges.” Put differently, there's no telling where the next Eurex will come from, but there will clearly be more blood in the water in coming years. Open-outcry cash exchanges, the report found, will also have to address similar electronic challenges in coming years.

The report offers a close analysis of Eurex, the electronic exchange formed by the merger of the Deutsche Terminborse and Soffex in 1998, and the exchange's theft of the Bund market from Liffe. The migration of the Bund took many by surprise, since most market watchers assume that contracts with healthy trading records and liquidity will stay put unless hit by a catastrophic event. Three years ago, Liffe dominated the Bund market. “Eurex started to chip away at Liffe by offering incentives such as fee holidays, free front-end systems and free [systems] advice,” says Stiffler. “But later Eurex was able to compete solely on price. Eventually, it just came down to transaction costs.”

The report lays out the timeline: In March 1996, the Deutsche Terminborse began its offensive by providing screen-based access to the Bund market in London. Six months later, the DTB had 28 percent of the market and Liffe had 72 percent. A year later, in August 1997, Liffe's share had dropped to 52 percent. And in August 1998, the DTB owned 99 percent of the market.

Differences in the exchanges' transaction costs are just as stark. In April 1997, the cost per trade was $0.66 at Liffe and $0.33 at the DTB; by April 1998, Liffe had cut its price to $0.30 per contract in order to compete, but the DTB had lowered its price to $0.17 per contract. In the end, price trumped Liffe's long-established liquidity.

The Meridien report also points out that alliances and mergers between exchanges are driven largely by the needs of technology development and distribution. When electronic exchanges merge or partner with each other, the incentives are a larger choice of instruments and trading strategies for exchange members, lowered costs as a result of combined clearing and settlement functions, increased trading volume, and therefore more liquidity on a single platform. When a traditional floor-based exchange partners with an electronic exchange, there is usually “a technology transfer from the electronic exchange, combined with a non-compete agreement on contracts,” says Stiffler. And when two traditional exchanges partner, the reason is usually “an attempt to reduce costs and/or stave off competition from upstart electronic exchanges.”

To preserve their markets in a competitive landscape, traditional exchanges will need to provide improved access to their markets. Last year, the report notes, only 2.5 percent of institutional brokerage clients had direct desktop hook-ups to exchanges; 20 percent of these firms, however, are expected to have such links by 2004. As a result, exchange traders who only trade contracts in the pits are likely to find themselves in difficult straits as automated trading extends its reach. Moreover, with institutional investors demanding faster and more direct access to exchanges, trading firms are not waiting for second requests. The Meridien report includes an analysis of the buying process at two trading companies—GNI Inc. and ED&F Man—and evaluates other Eurex front-end providers such as Front Capital Systems, GL Consultants and OM Technology.

For more information about the report, see www.meridien-research.com.

Help for the OTC Energy Market

Adapting the exchange-of-futures-for-physicals concept to energy swaps is proving more controversial than anyone expected.

By Nina Mehta

Most exchange-traded contracts in the derivatives world are born without undue hassles. They have a purpose, a market, and are watched over by the Commodity Futures Trading Commission if and when their usage grows. But there's always the occasional contract born into controversy after an overlong gestation.

In January, the CFTC approved the New York Mercantile Exchange's proposal to establish an exchange-of-futures-for-swaps transaction. The transaction, similar to the existing exchange of futures for physicals, was approved for Nymex division energy markets in order to enable the offsetting of risk in certain over-the-counter swaps transactions through a prearranged futures position. The CFTC okayed the original proposal, submitted on February 22, 1997, but required the addition of a three-year pilot period and special reporting requirements.

“We're trying to permit a facility to allow for what's now non-exchange-type exposure to be brought and related directly to the futures market.”
—Patrick Thompson

Almost immediately, CFTC commissioner Barbara Holum issued a statement chiding the commission for the additional rules, which she said would “impose economic costs [on market participants] without any compensating regulatory benefits.” This was after scolding the commission for its “unwarranted” delay in approving the Nymex proposal in the first place.

Nymex locals, however, would have been glad if the initiative had stalled entirely. On January 28, about 200 independent traders turned up at a general floor meeting to object to the introduction of the new contract. They were concerned that it would detract from floor trading and would give OTC deals a leg up by permitting counterparties to do deals off the exchange floor and then bring the transactions to Nymex to eliminate counterparty credit risk. Locals at the meeting were also vexed that issues surrounding the agreement were not properly understood by Nymex chairman Daniel Rappaport and other board members present, according to a Securities Week report.

The new transaction parallels the current exchange of futures for physicals. “Let's say I want to be a buyer of the physical, and I want to establish a related price in the futures market against that,” says Patrick Thompson, president of Nymex, explaining the EFP contract. “So I buy the physical and sell the futures contract. The counterparty, who wants to sell the physical, sells the physical to me and buys the futures contract from me simultaneously.” In an EFS deal, a swap gets substituted for the physical component of the EFP deal. “We're trying to permit a facility to allow for what's now non-exchange-type exposure to be brought and related directly to the futures market,” adds Thompson.

But that's what bothers the locals. The EFP contract was already unpopular with independent traders, “and that transaction was theoretically limited,” says a local. “There needed to be a cash position—that was a real restriction. With an EFS, there's no physical component at all. Anybody can do it against an OTC transaction.” It is unclear how large an audience the new contract will attract, and whether it will increase brokerage volume, but the advantage for Nymex is that the exchange gets to count the additional turnover as floor volume.

Although EFPs now represent a sizeable chunk of the marketplace, notes Thompson, “liquidity to the floor members has really been unaffected or has grown as a result of it, and we expect the same type of results with EFSs—that they will be an adjunct to the market and will ultimately stimulate more market activity on the trading floor.” Locals, however, are concerned that EFS deals involving futures with expiries one-to-three months down the road will affect spot trading prices and liquidity. The Nymex leadership will “dance around this and sweet-talk the exchange membership,” predicts one local. “There's pretty much unanimous opposition [among floor traders] to this proposal. In a Clintonesque way, they'll soulfully listen to our concerns and in the end ram it down our throats. The trading houses want it and the exchange does too.”

Nymex has delayed the introduction of this contract from February 1 until probably early April. In the meantime, the exchange says it will hold informational seminars to explain the workings of the contract to independent traders.

Wall Street Pitches Variable Forwards

High-net-worth investors were dealt a serious blow in 1997, when the Taxpayer Relief Act removed all the tax advantages of short-against-the-box and single stock equity swaps—strategies that allowed investors to monetize stock positions with minimal tax consequences.

UBS's MMAP contract allows investors to monetize a stock holding today, with no tax consequences, and turn it over in the future.

Of course, it was only a matter of time before the financial wizards found an artful way around it. Last year, a new crop of products known generically as variable forward contracts began popping up at United Bank of Switzerland, Merrill Lynch, Donaldson, Lufkin & Jenrette, and other places. They look, smell and feel like standard equity-collar-cum-loan products, but with several important twists that appeal to high-net-worth investors with concentrated equity holdings.

Let's say, for instance, that you inherited $10 million in Lycos stock, but you don't like the roller-coaster volatility. One alternative would be to combine an equity collar with a loan. Under this strategy, you'd buy a cap and a floor on the stock and receive income in the form of a loan, equaling the current value of the stock holding. Under current tax law, however, the proceeds from the loan can only be used for “non-purpose” spending. In other words, you can buy whatever material object you want—a mansion, or even a million Twix bars—but you can't diversify your assets by using it to purchase another financial instrument.

A far more effective solution is the variable forward. Products such as UBS's Maximum Monetization and Asset Protection (MMAP) contract allow investors to monetize a stock holding today, with no tax consequences, and turn it over in the future—usually three or five years. A synthetic costless collar is embedded into the forward—complete downside protection is ensured, and upside participation is available. The more upside an investor wants, the lower the up-front premium. The benefits: in addition to tax avoidance, the investor can use the proceeds any way he or she wishes, including portfolio diversification. Moreover, the investor participates in a percentage of the upside until expiration, having enjoyed full downside protection.

“Variable forwards have really been picking up steam in the last six or seven months,” says a dealer who is hurrying a similar product to the market. “A lot of investors are keen for these things.”

Are there any drawbacks? UBS's marketing literature offers one: variable forwards could be subject to future tax law scrutiny. The IRS doesn't take kindly to tax-avoidance investment strategies, and, like short-against-the-box, the variable forward could have a short shelf life. By then, however, Wall Street will already be back at the drawing board.

Goldman Surveys Last Year's Global Index Scene

For more than 10 years, Goldman Sachs has provided exhaustive, year-end recaps of the developments in global equity indices and their attendant derivatives products. The 1999 report, called “Global Index and Derivatives Review: 1998 in Perspective, Issues for 1999,” published this January, offers readers 57 pages of tables, graphs and extensive erudition on all things index-related. While the entire report is a must-read for equity derivatives traders, offering extensive tables on index contract volumes, sector products and so on, some of its findings are particularly essential to end-users and dealers as well.

Perhaps the most important: after explaining that, for only the third time since 1980, U.S. large-cap growth stocks outperformed value stocks by a wide margin last year, the report suggests that the same conditions could exist in Euroland this year. It offers three long/short strategies for investors to capitalize on this potentiality: a long Euro Stoxx 50 position against a short basket of European futures; buying a portfolio of large stocks and simultaneously shorting a medium-cap portfolio with minimal sector bias; and a group of stocks expected to be sensitive to expected euro rebalancing flows vs. a short futures position.

The report argues that historical prices converted into euros are often wrong, some data providers who convert prices for historical data into euros using fixed conversion rates usually assume fixed conversion rates between euro currencies, leading to accuracy problems. It also analyzes the implications of this situation for performance measurements and models.

Another interesting topic: the astonishing rise of equity derivatives in Korea in 1998, particularly in the last half of the year. It notes that cash volumes in the fourth quarter were almost four times the 1997 average, while futures volumes during the entire year were five times higher and options values eight times higher. “Individuals were responsible for most of the growth,” the report notes, “dominating trading in cash, futures and options. Mispricing was significant (+5 percent to -5 percent) for both nearby futures as well as calendar spreads, which points to attractive opportunities given the tremendous liquidity of the market.”

For a copy of the report via the Goldman Sachs web site, contact Rochelle Sokol at rochelle.sokol@gs.com.

Merrill Pays Out Again

Fresh on the heels of its $400 million payout to Orange County, Calif., Merrill Lynch late last year paid the Kingdom of Belgium $100 million to end a long-running dispute over a series of derivatives losses that, at one point, totaled $1.2 billion.

The losses stemmed from a series of currency knockout and “power knockout” options written between 1989 and 1993. Power options are enormously risky structures, since their payouts are squared—meaning the notional amount of a contract may only represent the square root of the potential liability. In this case, Belgium took naked positions to reduce its exposures to currencies—one of which, it seems, was the dollar—in exchange for premium. The losses peaked at $1.2 billion when the dollar weakened earlier in the decade, but its subsequent strengthening reduced the losses.

Still, losses must have been substantial, since Belgium demanded that Merrill repay $300 million in compensation. The two parties negotiated for two years before settling on $100 million, and have continued to do business together in other areas.

The issue raises a critical question: Why did the Kingdom of Belgium, a novice player in the derivatives markets, embrace such risky products? Details of the case are sketchy, since neither party is talking and their attorneys are bound to confidentiality clauses. (Denis Forster, counsel for the Kingdom of Belgium, and Edward Yodowitz, an attorney for Skadden Arps Slate Meagher & Flom who represented Merrill in the episode, both declined to comment.)

But one person familiar with the case describes Raphael Geys, one of Merrill's salesmen in London responsible for the deals, as “smooth” and “slick,” while Belgium alleged that Merrill Lynch misled it repeatedly. Merrill denied that misrepresentations were made, but nevertheless agreed to pay $100 million—not exactly a forceful declaration of innocence.

“This was a case where a complex product that's difficult to model was sold by a sophisticated firm to a relatively unsophisticated sovereign end-user,” says the source, who notes that Geys is now looking for a job. Predictably, Merrill says Geys resigned for reasons “completely unrelated” to the incident.

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