The 1999 Equity Derivatives and risk management congress

PARTICIPANTS

Patrick Young, editor of Applied Derivatives Trading, an Internet publication, and author of Capital Market Revolution John Harding, vice president of product research and development, Chicago Board of Trade Joe Kolman, editor, Derivatives Strategy Ralf Dreyer, director, Eurex Chris Hall, senior trader, Saratoga Douglas Shaw, head of derivatives investment, Gartmore Investment Management PLC Richard Bolchover, director, Close Fund Management Ian Morley, director, AIB Govett Asset Management

Excerpts from a roundtable discussion at the Equity Derivatives and Risk Management Congress, sponsored by The Chicago Board of Trade and Eurex, held September 7, 1999, at the Four Seasons Hotel in London.

Patrick Young: Can derivatives exchanges compete? My gut reaction would be no. These days we’re seeing an increasing number of cheaper and ever-more-accessible electronic crossing networks and other electronic trading networks. It’s difficult to see why we need to have exchanges at all. Are they simply too expensive? Should we encourage over-the-counter business to come to exchanges, or would it be better to allow current exchange business to move to ECNs—and therefore “go OTC,” simply offering a clearinghouse apparatus to make everything work a lot better?

John Harding: The Chicago Board of Trade has been around for 150 years. I wouldn’t write it off just yet. The alliance with Eurex is coming toward its final stages. If it goes through, the alliance will be the dominant world system in terms of contracts traded. If it doesn’t go through, the CBOT will spend money upgrading its own system.

I wouldn’t underestimate the infrastructure underlying the open outcry exchanges, particularly when it comes to ECNs. It only costs $10 million to build a pit. The real issue is, What is the competition going to be? When you talk to people who trade futures, the real cost isn’t the commission or the fees. It’s simply the bid/offer spreads. That is the real cost of doing the transaction. In fact, the other issues are relatively insignificant compared with that.

There are a number of people who are not sure the electronic revolution is going to come as quickly in the United States as it came in Europe because of the significant communications and infrastructure in the United States committed to open outcry.

“These days we’re seeing an increasing number of cheaper and ever-more-accessible electronic trading networks. It’s difficult to see why we need to have exchanges at all.” —Patrick Young Applied Derivatives Trading

It’s quite feasible that open outcry can last many years to come. And the CBOT’s goal is basically to try to hedge its bet, trying to have a foot in both camps. If electronic trading is coming tomorrow, the CBOT will have an advanced electronic system; if it doesn’t come, that’s fine too.

Young: The cost basis may be very important. But I don’t see how the likes of the CBOT can manage to maintain a floor-dealing environment and an electronic-dealing environment, and still offer a cheap service to the end-user. I’m sure it can offer a quality service, but can it be cheap enough? Liffe offered wonderful execution quality in Bund futures, but lost it all to Eurex, because Eurex offered quality execution much cheaper.

Harding: Historically, it is extremely difficult to transfer volume from one exchange to another. The only obvious success is the Bund. I’m not sure if anyone can answer this question: Would the business strategy have worked if it had been a German exchange trading German products against an English exchange?

Ralf Dreyer: I think the development of ECNs shows that the competition between open outcry and electronic exchanges is definitely over. Everybody sees an opportunity to establish electronic exchanges. These new exchanges not only want to make money but also want to give market participants a marketplace that concentrates liquidity, expands transparency and distributes information.

But I also think you have to look to new types of functionalities. The exchanges are in a good position to attract OTC business with things like block-trading facilities, basis-trading facilities and delta-volatility-trading facilities.

Let me give an example of something we did with the DAX option in 1997. We saw more and more OTC look-like DAX options coming into the market, and found there was a tremendous need from the market to do bigger blocks. We looked at our market and asked ourselves if a block-trading facility for stock and interest rate options would split liquidity from the regular order book. Our market participants said they thought it wouldn’t. And after we introduced it, we discovered that there was additional volume and no negative effect on the liquidity in the regular market.

The last piece of the puzzle is clearing. One of the biggest things market participants will need in the near future is help reducing their capital requirements and help making their capital flows more efficient. With multilateral clearing facilities that offset between cash and derivatives markets and provide margin offsetting and so on, we could expand our position and compete better against the other markets, whether they be OTC or other exchanges.

Joe Kolman: Has the OTC market made everything too opaque?

Douglas Shaw: Not from my perspective. Ninety-eight percent of what I do is on-exchange, and every time I go off-exchange, they say “OK, but it all depends on where you get your hedge done on the floor of Liffe.” The markets aren’t divorced at all. I don’t think the type of trading is important. When Matif went electronic, it made no difference to me. Instead of routing the order down to the pit, I route it to somebody who trades with a screen or over the Internet. What is important is that the exchanges provide new contracts that meet the needs of their clients.

Dreyer: There are two ways of introducing new products. You can develop your own products or you can have a dual, or competitive, listing. At Eurex, we believe in connecting markets because we think the most critical issue is liquidity. We think it’s much easier to get liquidity from a well-established market on one platform than to go for a dual or competitive listing of products. We proved it with the Soffex-DTB cooperation. We will try to prove it again with the alliance between the Helsinki Exchange and Eurex, which went live in late September.

“The exchanges are in a good position to attract OTC business with things like block-trading facilities, basis-trading facilities and delta-volatility-trading facilities.” —Ralf Dreyer Eurex

And then there’s the potential for cooperation between Eurex and the CBOT. If you look at the most liquid market with the most attractive benchmark products worldwide—the Treasury bond, the Bund, and index options and futures, then I say, yes, we can easily compete. Eurex already has 5,000 terminals outside Germany, in 16 countries. And if we get this cooperation between the CBOT and Eurex, you can imagine how the picture will look then.

Another idea is using alternative business channels to attract more OTC business. A good example is what we did with our warrant business. We cut our admission fee until the end of that year to attract more warrant business to the exchange. Another example is the success the American Stock Exchange has had with its Spider and Diamond products.

Richard Bolchover: One of the problems is that exchanges haven’t been run by end users. In the United Kingdom, the major participants in the OTC market are also the owners of the exchanges, so there’s an inherent conflict of interest at the heart of how exchanges are going to develop. If exchanges offered ownership to investment institutions and gave them a real say in the way their business developed, they’d be a lot more successful. In the United Kingdom, the big index players have created a company that bypasses the stock exchange and the market-makers. It’s about time the dog started wagging the tail.

Kolman: What do people think of the BrokerTec venture, a group of leading investment banks that wants to develop a single screen on which you can trade all world derivatives contracts? That seems to be a reasonable idea in theory.

Young: BrokerTec approached all the exchanges around the world and seemed to be asking the leading exchanges to write its business plan. But it’s difficult to see whether it’s a credible exchange or some sort of lobbying tool put together by the likes of Goldman Sachs and others in order to exert pressure on the exchanges.

It’s a reasonable idea. But last year Cantor Fitzgerald came to most of the members of what became BrokerTec with a plan that would have done something very similar, and they decided they wouldn’t support it. Then six months later, they decided to launch BrokerTec. That’s the interesting political point here.

Harding: Cantor has failed in the United States. It had a lot of support from the Street, but it failed because the Street won’t trade with itself. Markets aren’t made by Saloman Brothers picking Goldman Sachs’ pocket and vice versa. They’re made by real end-users. Pension funds, asset managers and so on come to the exchange for value, and that value is either in the liquidity or the clearinghouse, for which the end-user is willing to pay in the form of the bid/offer spread.

“Markets aren’t made by Salomon Brothers picking Goldman Sachs’ pocket and vice versa. Pension funds, asset managers and so on come to the exchange for value, and that value is either in the liquidity or the clearinghouse.” —John Harding Chicago Board of Trade

Kolman: A few years ago, the Chicago Board Options Exchange and a number of other exchanges thought they could compete with the OTC market with flexible option structures. Why did those products fail?

Dreyer: I think the CBOE’s flex option was pushed by the exchange rather than by market participants. At that point in time, the CBOE thought of the OTC market as a competitive rather than as a complementary market. But from the exchange point of view, the OTC market is like the tip of an iceberg. The part of iceberg we can see is the part we can try to standardize.

What the market needs now is an OTC clearing facility, and an exchange like Eurex is in a good position to provide that since it has an integrated clearinghouse.

Chris Hall: If exchanges want to get business from the OTC market, they have to offer the same products as the OTC market. We tried to put pressure on Liffe to extend the flex contract from a two-year, any-strike, any-expiry product out to five years, because most of the FTSE OTC products traded in London at the moment are between three and five years. These days, Liffe is talking quite seriously about exchange-trading everything that generic OTC players are trading outside the exchange at the moment. If I don’t want my trade to go to the open market but I want to trade a copycat option, then I might ask to trade a flex option that expires the day before. There’s no reason why I shouldn’t be able to do that.

Kolman: What happens if you try to use the Liffe’s facilities for that?

Hall: Actually, if you throw a flex option into the pit at the moment, you’ll only get prices from two companies, because nobody else can be bothered to make them.

Shaw: I’ve also tried that, and I’ve had a lot of difficulty dealing a plain vanilla piece of business. The people at Liffe have talked to a lot of people in London about how flex options can be improved. But I think that flex options are now less of an exchange-traded product than a clearinghouse product. In other words, you come to Liffe with the people you would have dealt with in the OTC market. Then you use the offices of Liffe for a nanosecond before you get rerouted to the clearinghouse. So in that sense Liffe is not providing any function at all aside from being the portal to the London clearinghouse.

Hall: For companies such ours, Saratoga, a local options market-making company, clearing is very important. We can bring a lot to the OTC market. With all deference to the larger banks, we trade 35 percent of the exchange-traded FTSE options, and we can give better prices than Goldman Sachs. But we can’t accept somebody else’s credit lines. It may not matter to Goldman Sachs if somebody refused to pay them 20 million quid for six months, but it makes a hell of a lot of difference to us. If an exchange is going to clear it, then we can trade it.

Bolchover: I don’t think the exchanges have gone far enough. They’ve gone only part of the way. There are two advantages of trading on an exchange—pre-deal and post-deal. The post-deal advantage is the clearinghouse function. But the pre-deal benefit is providing the market with transparent price discovery. What Liffe was proposing was really only the second part and not the first part. That’s a step in the right direction but it’s not enough.

Ian Morley: It strikes me that most OTC trades—maybe 90 percent—are actually plain vanilla, and only a few are really exotic. Most of them should be easily accommodated on exchanges.

“It may not matter to Goldman Sachs if somebody refused to pay them 20 million quid for six months, but it makes a hell of a lot of difference to us. If an exchange is going to clear it, then we can trade it.” —Chris Hall Saratoga

When they first came out, flex options reminded me of Fords in their early days. You could have any one you liked as long as it was black. But it cannot be beyond the powers of imagination to make flexes truly flexible.

To a certain extent, you’ve got to get over the problem of opaqueness. The one thing I don’t want is to trade in large volume and have it broadcast around the world ahead of me. If you can overcome that problem and make flexes truly fungible and available, I think they can take on an extremely large share of the market.

Shaw: If it’s a public market, how can you be there but not be public?

Morley: I raise the problem, not the solution.

Shaw: The exchanges will never be able to answer that. They will remain the neutral coffeehouses they’ve always been. All they have to offer is a meeting place for clients to get done the business they require.

Morley: I think the obituary notice for open outcry exchanges has been written. It just hasn’t been dated yet. The exception to that are the commodities exchanges, because they have deliverable goods. But the real safety for exchanges is in clearing. If the exchanges can convert themselves into clearinghouses and transfer and diversify counterparty credit risk—which, after all, is the nature of the clearinghouse—they will be able to protect their clients in a meaningful way from single-party credit risk. And that’s perhaps where their future will lie.

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