OTC Solutions in an Exchange Environment

Author Name: 
Richard G. DuFour, Executive Vice President, Chicago Board Options Exchange (CBOE)
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The 2008 financial crisis post mortems agree that growth of the OTC markets and the increased complexity of new instruments outstripped the industry’s capacity to manage them. Weaknesses in the OTC markets became evident all too rapidly during the crisis as the value of assets traded became difficult to assess, banks lost confidence in each other, and illiquidity spread. 

The silver lining in the dark cloud – if there was one – is that the meltdown highlighted the benefits of regulated exchanges. The looming question now is whether the proven successes of regulated exchanges combined with a history of effective counterparty clearing will be enough to move OTC trades onto exchanges and/or prescribe clearing arrangements.

When the Dodd-Frank bill was signed into law in June 2010, it generally boded well for exchange trading and centralized clearing for more standard OTC products. However, trading of derivatives is just one of many parts of the bill. With new faces on the Hill and the formidable task of determining how various pieces of the bill will be implemented, it may be some time before the specifics emerge. Currently, attention is focused on the much larger risks of interest rate swaps and credit default swaps, with equity derivatives, at least for the time being, on the backburner.

Whatever the outcome, long before the 2008 financial crisis ensued there have been efforts to bring exchange-traded and clearing benefits to the OTC table.  As institutional use of options started to blossom in the late 1980s and early 1990s, the Chicago Board Options Exchange (CBOE) recognized the need of some participants for flexibility in the terms of equity and index options contracts. As a result, in 1993 the CBOE created FLEX® options contracts in an effort to attract OTC business to the exchange world. 

With FLEX contracts, users could modify certain exchange-traded options specifications – contract size, expiration date and exercise style – yielding contracts with characteristics similar to those in the OTC market. In addition to customization, FLEX contracts added the benefits of price discovery, price transparency and the safeguards of counterparty clearing not found in the OTC market. 

In 2010, trading volume in CBOE equity and index FLEX options reached a record 10.9 million contracts, up over 200 percent from 2009 and a whopping increase of more than 1000 percent from 2008. In addition, CBOE’s market share of all U.S. FLEX options trading doubled from 32 percent in 2009 to 64 percent in 2010. 

Like many new concepts in the financial world, successes in FLEX trading at CBOE did not happen overnight. It took a great deal of work with regulators and ongoing education with potential customers to bring the benefits of these new tools to light, a process which continues today.  

In fairness, however, it was the events of 2008 that had the greatest impact on increasing activity in CBOE FLEX contracts. While none of us would want a return to a crisis period like that one, it did nonetheless draw attention to the need for a more robust means of managing risk within an organized and regulated framework. FLEX options trading, as a result, provided one good solution. 

Other events, taken together, also have added to an increase in trading volume over the last couple of years. 

In the early years of FLEX trading, volume gained only modest traction, in part due to restrictions imposed by the Securities and Exchange Commission (SEC), which limited the scope of customization that FLEX contracts could pass on to users.  A long-standing barrier to institutional use of these products involved the SEC’s imposition of blackout dates for FLEX options on expiration Friday and the two business days before and after. The blackout dates coincided with active trading periods for institutions wanting to hedge exposures on or close to an exchange expiration date. In 2009, the SEC, by then more familiar with how FLEX contracts had performed – and perhaps more inclined to consider the benefits of bringing OTC trades onto regulated exchanges – allowed CBOE to remove blackout date restrictions. 

Another previous SEC hurdle, which limited the length of contract maturity dates to a maximum of five years for equity FLEX contracts and ten years for index FLEX contracts, was removed last year when the SEC approved the expansion of the maturity date to 15 years. 

Finally, last year the SEC instituted a pilot program that lifted contract-size restrictions for FLEX contracts. Previously large contract size requirements – originally mandated by the SEC to assure that FLEX contracts would be used by institutions, not small individual investors -- proved too large for institutions such as insurance companies. Comment letters to the SEC from insurers with more modest contract size needs likely was a factor in the SEC approving the change. 

Thus, the easing of these regulatory restrictions played a significant role in opening the door to a wider audience of users for FLEX. 

In addition to the events of 2008 and changes in regulation, technology also has played a part in pushing FLEX volume higher. Prior to 2007, transacting FLEX trades was a manual process transacted on CBOE’s trading floor. Prompted by the need to streamline access in an electronic world, CBOE introduced CFLEX®, still the first and only U.S. Internet-based execution platform for electronic trading of FLEX options. With fast, anonymous order handling for OTC participants, CFLEX has substantially enhanced institutional investor access to FLEX products.  

We could not be more pleased that regulatory changes and CBOE’s technological efforts have made CBOE’s FLEX products more practical and convenient for institutions than ever before. Although CBOE has experienced tremendous volume growth in FLEX options over the past two years, only a fraction of OTC market participants have made the transition into FLEX. CBOE intends to continue to work with OTC market participants and regulators to modify our FLEX offering so that more institutions can benefit from centralized clearing, price discovery and transparency.

About Richard G. DuFour

Richard DuFour is an Executive Vice President of the Chicago Board Options Exchange. His current responsibilities include strategic planning, research, product development, international relations and the joint venture for trading single stock futures. In previous positions at the CBOE he spearheaded the planning and development of a new trading facility (1980-1984), established The Options Institute (1985) and was responsible for the Exchange’s marketing and public relations activities (1987-1989). 

Prior to joining the CBOE in 1980, Mr. DuFour spent ten years in management consulting where he conducted and supervised a wide range of assignments. Areas in which he has conducted studies include strategy development, organizational analysis, financial feasibility, mergers, facilities planning and management information systems. During the period 1976-1980 he was responsible for a $125 million expansion program at Rush-Presbyterian-St. Luke’s Medical Center, a major university medical center in Chicago.  

Mr. DuFour hold a bachelor’s degree from Notre Dame University and an MBA from the University of Michigan. He did post-graduate work at the University of Michigan in the Center for Far East Asian Studies. While affiliated with Rush Medical Center he held an appointment as an assistant professor in Health Systems Management and authored a number of articles on the future of the health care industry. 

Mr. DuFour serves on the boards of OneChicago and of the Lincoln Park Renewal Corporation. He also serves as Secretary of the International Options Markets Association and is on the Working Committee of the World Federation of Exchanges. He is a member of the Economic Club of Chicago.