Exchange-traded market set for bigger future
28 Feb 2011
The exchange-traded derivatives market was for a long time the very poor relation of the over-the-counter market: predictable and dull, its margins were poor and the people who did it were usually
the type of guys proper bankers would cross the street to avoid.
Some of these qualities have, perhaps, not changed much over the past few years but, in the wake of the crisis and subsequent regulatory initiatives, exchange trading of derivatives is set to
become very big business indeed. NYSE Euronext and Deutsche Börse in February announced their intention to merge to create the world’s biggest futures exchange, and the creation of a global listed
derivatives instrument powerhouse is central to their plans.
Derivatives – mainly futures and options contracts at the moment – already generate more income for exchanges than equity contracts, but the contribution is set to increase sharply. The Commodity
Futures Trading Commission has made no secret of the fact that it wants a much greater share of the currently OTC derivatives market to be traded on an exchange.
It is estimated that the new group formed by the merger of NYSE Euronext and Deutsche Börse – yet to be christened – will derive 37% of its net revenues from derivatives trading and derivatives
clearing. In comparison, equity trading will supply less than 30%. But the proportion of revenues contributed by derivatives will surely increase as regulatory pressure pushes more and more
instruments on to an exchange. The Dodd-Frank Act requires so-called “standardised” swaps to be traded on a swap execution facility.
The characteristics of a swap execution facility have yet to be determined, but the requirements for clearing are more specific and unavoidable. Under the provisions of Dodd-Frank, standardised
swaps must be cleared through a derivatives clearing organisation. Clearing is thus central to the ambitions of NYSE Euronext to smash the hegemony over the US futures market that the CME has long
At the beginning of this month, the CFTC granted “derivatives clearing organisation status” to New York Portfolio Clearing, the clearing house developed by NYSE Liffe (the US futures unit of NYSE
Euronext) in conjunction with the Depository Trust & Clearing Corporation. Approval by the Securities and Exchange Commission is expected within the next couple of weeks, according to a spokesman
for NYSE Euronext in London.
This venture could be the CME-buster. By housing the clearing of cash instruments with their derivatives hedges under one roof – so-called cross-margining – only a single margin position needs to
be put on and thus costs will be reduced. Rather than going to one institution to put on a trade and then to another to clear it, users will be able to do it all in one place.
All of this was up and running before the merger with Deutsche Börse, but the union gives NYSE Euronext even greater heft in its bid to rule the world of exchange trading of derivatives.
So far, the CME, which has 98% of the US futures market, has adopted a position of aloof unconcern to the ambitions of NYSE Euronext, but the merger with the Deutsche Börse is likely to cause a
little more alarm on South Wacker Drive.
The CME has launched a clearing venture of its own. In February it announced it had recruited 10 dealers as inaugural members of its OTC interest-rate swaps clearing service, which was first
unveiled last October. Since launch, the service has cleared around $1bn of interest rate swaps, but, just as clearly as does NYSE Euronext, it knows which way the wind is blowing and that
derivatives clearing is set to be very big business in the next few years.
There is a lot of jockeying for position going on in the exchange world. There are mergers, talk of more mergers, new clearing ventures and new contracts. The exchanges are growing a lot and growing fast.
There are several observations to be made about these doubtless exciting times for exchanges. The first is that the break-up fee of $340m set by NYSE Euronext and Deutsche Börse seems rather
punchy. It has been set high to discourage rivals – like the CME for example – from seeking to disrupt the merger by bidding for one of the two exchanges itself.
However, it is $52m larger than the break-up fee set by the CME when it united with the Chicago Board of Trade several years ago, and appears a little unrealistic.
It also seems likely that the merger has been so structured to give NYSE Euronext a leadership role. As clearing seems central to the ambitions of the new group, and as Deutsche Börse’s experience
with the clearing of CDS has been, to say the least, a little unhappy, perhaps this is not surprising.
Finally, and more importantly, the creation of super-exchanges, like the union of NYSE Euronext and Deutsche Börse, and the addition of clearing facilities to these exchanges means that a lot of
risk is being concentrated in one place.
LCH Clearnet announced in February that the portfolio of SwapClear, its interest-rate swap clearing unit, contains 850,000 trades with a notional value “in excess of $252 trillion.” Numbers like
that should make the regulators’ head swim.
In fact, they seem remarkably insouciant about the concentration of risk going on at the moment. The regulators are hot for exchanges and hot for clearing houses, but one wonders if institutions
are being created that are – like several banks apparently were – too big to fail.
Regulators have created great incentives for exchanges to develop their businesses and create clearing operations as well, and seem to see this action as the panacea that will prevent a recurrence of the events of 2007/2008. Like generals are known to do, perhaps they are fighting the last war rather than the next one.