The transformed environment of the derivatives industry after recent market turmoil
Regulated markets play a crucial role in market-based economies
Derivatives provide a tool for investors to implement strategies for managing counterparty, market and liquidity risk. Order matching, i.e. the transfer of investors’ trading intentions into actual trades, price discovery and centralized clearing are at the heart of the production function of derivative markets. They thereby play a key role in market-based economies.
Key success factors in the industry are product innovation, the provision of services across geographies, as well as operational and process efficiency: Product innovation relates both to new products in existing asset classes as well as to the creation of new asset classes and new products therein. The provision of services across geographies plays a key role, as competition in derivatives markets is global. This is – besides different risk characteristics and the primary market aspect – a fundamental difference to cash markets. Global competition exists, on the one hand, among derivative exchanges; and on the other hand, between derivative exchanges and OTC markets which represent their most important competitors, having an estimated market share of more than three quarters on average across all products. Nevertheless, it is important to point out that derivative exchanges and OTC markets share a symbiotic relationship in product generation and distribution, where standardization offered by exchanges and flexibility from OTC jointly provide value to market users and their specific trading and hedging requirements. Operational and process efficiency requirements call for leading edge technology to enable market operators to realize scale and scope economies, and to drive down unit costs per trade.
Technology at the customers’ sites, and the dramatic change of order handling by customers triggered by DMA and algorithmic trading, requires derivatives markets to enter uncharted territories concerning system capacities and operational speed in order execution and market data provision, with investments in the range of double-digit million US-$ per year. Today, algorithmic trading represents more than one third of overall trading volumes at many derivatives markets around the globe.
Algorithmic trading and services provided for it, e.g. co-location services, are the most important growth drivers for most derivatives exchanges. Numerous new, and often small, players with new business models became significant order flow providers to derivatives markets, running highly sophisticated algorithmic models that implement arbitrage and spread-based strategies in proprietary trading; and slicing and dicing models to minimize market-impact for agent orders. Furthermore, new execution technologies enable the ultimate end-customers like hedge funds or traditional asset managers to build up their own trading desks and to manage order execution themselves. Thereby, they re-insource order execution responsibilities that were completely delegated to their sell-side service providers before, and they are successively building up the necessary skills for accounting, settlement and IT processing of derivatives. The derivatives industry is benefitting from the extended use of derivatives products specifically by this customer group.
Will these key drivers persist? Or will the derivatives industry face a dark age of reduced trading volumes, and of highly regulated or even government-owned risk-averse customers that will mainly make use of derivatives markets to keep open positions hedged in their underlyings as quickly as risks are identified?
A final and incontrovertible answer to this question requires a crystal ball. But let us discuss the impacts and challenges of the current crisis.
The crisis should not lead to changes in proven market-based principles
Although trading volumes and liquidity in futures and options markets have held up well compared to their peers in other asset classes, the recent economic and financial downturn triggered by the U.S. real estate credit crises did not pass over the derivatives industry without trace: While in equity derivatives, the increased volatility has fuelled investor demand, and in early 2009 traded volumes are even higher than in 2008 for major markets (see World Federation of Exchanges, http://www.world-exchanges.org/statistics/ytd-monthly), in many other products the growth rates of the last years have significantly slowed down.
Regulators are expected to require more capital for financial institutions’ trading activities – e.g. the proposal to implement an “incremental default risk charge" in the Basel II framework in 2011. In parallel, banks will resist leveraging up again to former levels in the short- to mid-term, and will increase both internal checks and costs for traders to take risky positions. Furthermore, the buy-side, i.e. both traditional asset managers and specifically hedge funds, have been battered by huge redemptions that will decrease their demand in underlying products as well as in derivatives contracts.
Besides these immediate effects on trading volumes and customers’ risk attitude, the crisis has clearly highlighted the important role of exchanges as neutral organizations in market-based economies. Regulated and supervised central markets are able to provide fairness in terms of access to the market and to market information, anonymity to traders, and liquidity in order execution, as well as tailored instruments and efficient processes for risk management. Regulators, the governments, market participants and even the public have realized that centralized clearing and risk management not only serves individual institutions by mitigating bilateral risks, but is key to financial stability by preventing systematic risks.
Trading systems and operations were fully available during the crisis, even in times where market activity reached all-time peaks, and thereby enabled market participants to transfer changing economic conditions and news immediately into market transactions. Any attempts to close markets for the sake of reduced volatility proved to be counterproductive. Post-trading infrastructures have shown their resiliency and value in recent market turbulences, and even the default of Lehman Brothers has not resulted in noticeable distortions at the level of clearing institutions. This is based on the inherent insurance principle in centralized clearing of listed derivatives that assures the fair and neutral valuation of risk and its natural limitation by collateral requirements.
OTC markets are competitors to on-exchange markets in the areas of product generation, order flow generation, order matching, and the clearing layer. Therefore, guided by the principle of functional regulation, OTC markets should be governed by similar rules as regulated markets if they conduct similar business. Unjustified regulatory differences should be eliminated. The crisis has shown that there are massive transparency issues in OTC derivative products, and that improper information on actual trades and trade flows in OTC markets might lead to undetected excessive risk accumulation on the books of single players.
The current initiatives to implement effective and adequately regulated and supervised CCP structures for products like credit default swaps into the OTC value chain are major steps that would redress these problems. These structures will not only reduce counterparty risks in OTC trading, but will serve to prevent the far-reaching global impacts of weaknesses of systemically important financial institutions in the future, and therefore improve the resilience of the global financial system as a whole.
The crisis also shed new light on two key themes of the industry: high frequency trading and competition.
- If traders are enabled to move huge cash or derivative positions within milliseconds in high frequency trading, risk management has to be able to keep up with trading at the speed of light, specifically in volatile markets. Therefore, real-time or event-triggered risk management at the clearing layer is the exact flip side and a consequent extension of algorithm-based tools that move positions in sub-milliseconds in the trading layer.
- If diversity, competition and choice in the trading layer between regulated markets and OTC execution are enforced to reduce the cost of trading, the clearing layer must ensure market integrity and systemic stability when business and risk models of individual players prove to be inadequate. Therefore, neutral governance and the highest standards in risk management between clearing institutions is vital for the stability of markets in turmoil, instead of a competitive race to the bottom.
Although there is an obvious need to rethink the structure and regulation of the global financial system, we should always keep in mind that today’s wealth was built in free markets where diverse and both positive and negative individual initiatives contributed to social welfare. Like doctors, regulators should take prophylactic measures by setting an adequate framework and by addressing unhealthy excrescences. But they should avoid interventions and activism where the medicine might even cause more illness. Such prophylactic measures have to primarily target the integrity and efficiency of markets and the prevention of systemic risk. Furthermore, they have to enable institutions like exchanges to conduct their own self-regulatory and market-lead measures, e.g. the monitoring and surveillance of trading. “Irrational exuberance" in regulatory and interventional measures and losing sight of the fundamental principles that drive our markets might be worse than the crisis itself. Immediate and coordinated responses to the crisis have avoided a complete meltdown of the financial system, but the patient should not be kept in a regulation-induced coma by extensive medical treatment. Instead, regulatory and supervisory changes have to lay the foundation to enable innovation and sustainable market-led future growth.
The current discussions on “more regulation versus better regulation” or “microprudential versus macroprudential regulatory policies” do not sufficiently address a key point: It is not only about more or better regulation, and it is not only about the policy focus; it is also about tools to enforce, willingness to enforce, and skills to enforce regulation. Instead of even more colleges and committees, we need effective regulators and supervisors that (i) are able to meet the industry eye-to-eye concerning expertise as well as analytical and information processing capabilities; (ii) are able understand products like complex OTC-derivatives, or to ask the right questions based on excellent market and institutional knowledge; and (iii) are receiving compensations on the higher end of the industry instead of the lower end, as we witness today.
There is no doubt about a need for more transparency, but transparency is not an end in itself, but a means to draw the right conclusions and to ask the right questions by the right people. Therefore, principles like transparency concerning transactions, prices and risk positions, as well as neutral and effective risk management that have proven their value on the regulated markets side during the crisis, have to be further strengthened and extended where applicable to other markets. They must also be aligned with effective regulation and supervison.
In this context, it is the responsibility of organizations like neutral and credible regulated exchanges and clearing providers to take the lead proactively and constructively to shape the current regulatory discussion. This will include balancing the need for functional regulation and more transparency in OTC markets with not disrupting their economic value, inherent flexibility, and innovation capabilities for financial transactions.
For the derivative industry the crisis is both an opportunity and a responsibility
To sum up, the current crisis is an unprecedented opportunity for derivatives exchanges and clearing institutions to offer new products, and to position themselves relative to OTC markets by providing state-of-the-art tools for managing counterparty risk, enabling reductions in capital requirements and the highest process efficiency.
Without claiming to be complete, and obviously depending on individual exchanges’ business models, there are five key strategic imperatives that will enable derivatives exchanges to further improve their competitive positioning during and after the crisis:
- Protection of the three key assets in the production function of derivatives markets, i.e. (i) liquidity formation; (ii) price discovery; and (iii) effective risk management whilst constantly monitoring product and trading innovations in OTC markets for possible integration
- Expansion of distribution capabilities to the ultimate buy-side end customer whilst preserving valid business models for sell-side institutions that provide basis liquidity in mid- to less-liquid instruments
- Continuous product innovation and evaluation of further possible geographic extensions to assure organic growth, whilst being prepared for offensive and defensive M&A activities
- Provision of tailor-made services for specific customer groups whilst sustaining a level playing field among these groups, and a diverse customer base to assure flexibility concerning changing market dynamics
- Technological leadership and high-speed platforms in order execution and data provision whilst preserving the highest levels of market and operational integrity
Regulated exchanges and clearinghouses are central hubs that are able to assure market integrity, efficiency and liquidity. They are able to manage customer, and most importantly, systemic risks even in times of massive market disruptions and turmoil. It is their task and opportunity as neutral organizations to partner with customers and regulators in developing and shaping the regulatory and market structure in the current thunderstorm, and so be well positioned for the sunny days to come thereafter.
About Peter Gomber
Prof. Dr. Peter Gomber holds the Chair of Business Administration, especially e-Finance at the Faculty of Economics and Business Administration, University of Frankfurt/M., Germany since December 2004. He is a Member of the Board of the E-Finance Lab, an industry-academic partnership between Frankfurt and Darmstadt Universities and twelve industry partners. There he is heading Cluster 5 entitled “Managing the Securities Trading Value Chain”.
His academic work focuses on market microstructure, regulatory impact on financial markets, institutional trading, and innovative concepts/technologies for electronic trading systems. Prof. Gomber is an Associate Editor of the “Journal of Trading” and of the “International Journal of Electronic Banking”.
He published several articles on the above topics in international journals and was awarded with the Reuters Innovation Award 2000, the University Award of DAI (Deutsches Aktieninstitut) 1999, and Best Paper Awards of international conferences. In May 2007 he was awarded the IBM Shared University Research Grant.
Before joining the University of Frankfurt, he worked for five years as a Director, Head of Market Development Cash Markets and Xetra Research at the Trading & Clearing Services Division of Deutsche Börse AG, Frankfurt. There he developed new products and market models for cash market trading on Xetra. Furthermore, he headed strategic and regulatory projects and was responsible for the provision of Xetra and Eurex Backend Insourcing and Technology Sales Services to international exchanges like the Irish Stock Exchange, the Wiener Börse and the Shanghai Stock Exchange.
Prof. Dr. Gomber graduated in Business Administration and acquired his PhD at the Institute of Information Systems at the University of Gießen, Germany. In addition, he has worked as an independent consultant to international exchange operators and software houses.