The Inevitable Growth of Derivatives Exchanges

The World Of Derivatives Has Changed

Derivatives exchanges for the trading, clearing and settlement of options and futures is nothing new; they’ve pretty much been a fact for over 30 years. And volume growth at these exchanges is exploding, regardless of the venue - ICE, ISE, NYMEX, CME, etc. They are all flourishing amidst rising market volatility and rising transaction volumes in general. That said, exchanges continue to miss an enormous part of the derivatives trading and hedging activity that happens in the over-the-counter (OTC) market. Back when I was a derivatives structurer and marketer, the OTC market was THE place for derivatives transactions, particularly in the fixed income, foreign exchange, credit and commodities markets. But today things have changed. The meteoric rise of the OTC credit derivatives market has caused many market watchers to question both the degree and extent of this largely unregulated activity, and recent crises that have involved credit default swaps (CDS) and the like are raising questions about issues of transparency, counterparty credit risk, broker/dealer market exposure and documentation.

Why OTC Markets are Still Enormous

Even in light of the clear benefits of exchanges - transparency, standardized documentation, centralized credit, clearing and settlement functions - the OTC markets have continued to thrive. But why?

• Customization: Whether for risk management or for speculation, the standardized (or lightly customizable) contracts offered by the listed markets simply don’t meet the needs of many market participants. Whether for a corporation issuing a bond that wants to precisely hedge a recent issuance (e.g., by swapping a bond with a fixed coupon to floating rate), a project financing vehicle that needs to protect a series of highly variable and choppy cash flows or a speculator that wants to express a particular view through a basket of credit swaps and equity positions, the OTC market is able to address and and all requirements on a highly customized basis.

• Lack of transparency: Let’s face it, banks want as little price discovery as possible because it leads to more generous pricing opportunities. Especially if a hedger or speculator wants to put on a non-standard position, banks stand to make the lion’s share of their profits relative to facilitating large numbers of exchange-traded instruments with razor-thin margins. This is just reality.

• Potentially better terms: This transcends pricing, as bank counterparties may be easier on collateral requirements and credit terms than exchanges. It is in a bank’s interest for derivative counterparties to honor their agreements over their life, and have been known to do unnatural things to keep a derivative counterparty alive for the duration of the agreement.

Rising Volumes Make All The Difference

When I marketed and structured derivative solutions customization was the key driver, as tailored solutions that better met a client’s needs also provided the opportunity to make more money. It was effectively the synthesis of an investment banker and a Sales & Trading professional, offering strategies and counsel in order to deliver the right OTC or public capital markets solution. This was pretty cool. The transactions got papered right, the appropriate credit was approved and the necessary ISDA Master documentation was in place. But maybe I did 50 transactions a year. This is a very different situation than we have today where tens of thousands of credit derviative transactions and trillions of dollars of notional value get done annually.

Risks Of The OTC Documentation Blizzard

Further, prime brokers and their broker/dealers were nearly in crisis around undocumented trades, particulary in the 2004-06 time frame, so much so that the SEC had to step in to force banks operations areas to clean up their act - or else. Imagine a situation where a major institution fails with tens of billions of outstanding CDS’ written on its bonds, and thousands of unconfirmed trades spinning a tangled web of relationships among investors, speculators and hedgers all over the world. It would be a bonanza for litigators but a nightmare for financial market participants and those for whom they manage money. Not a scenario I want to imagine.

Exchanges Are Designed To Help

So what is the answer? Getting the leading derivatives originators to agree on a standardized template for CDS trades, interest rate swaps and the other building blocks of the OTC market, and creating enough degrees of freedom in the contracts such that there is some ability to customize without losing the liquidity of the instruments. The central exchange function is simply so valuable in an a world of exploding volumes and numbers of counterparties, and can serve as a mechanism to ensure best practices with respect to transparency, credit provision and documentation. I am not one to bang the drum for excessive regulation, but by pushing as much trading volume onto exchanges as possible I believe the likelihood of market dislocations will be minimized and “unexpected” crises in the wake of credit and performance defaults will be substantially reduced.

The Inexorable Shift Towards Exchanges

I find it useful to think about ideas by stressing the extremes, e.g., how did things used to be and how might they look at infinity? And to me it is inevitable that, at infinity, almost all transactions will be done on exchanges. Why? The benefits simply outweigh the costs, and there are a number of catalysts in place to support this conclusion: increasingly global and liquid markets; inexorably rising transaction volumes; much larger credit exposures; the difficulties with counterparty credit review; increasingly intertwined financial systems; and the blizzard of paper required to trade OTC with more and more counterparties. Over time, the inefficiency of the OTC market will cause it to take a back seat to the exchanges, and this is a trend that will build momentum over time. Think about Toyota versus GM. Who could have imagined Toyota’s success three decades ago? And now they are pulling away. This is how I think of the exchange model versus the OTC model. The changing of the guard is inevitable. Just wait and see.

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COMMENT:

AUTHOR: Evander

EMAIL: eric.vanderwalde@gmail.com

URL: 

DATE: 05/24/2008 07:38:02 PM

FYI, ICE started exclusively in the OTC market and did no regulated business until buying the IPE.  I haven’t looked at the numbers lately, but I bet their OTC business is still bigger than their futures biz.

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COMMENT:

AUTHOR: Mike

EMAIL: mike@digitalgoggles.com

URL: http://www.digitalgoggles.com

DATE: 05/24/2008 09:39:13 PM

Great post! It’s amazing to me how manual the OTC derivatives world is today. Paper-based confirmations and trading via fax are the norm. While I agree the exchange model (e.g. transparency, standardization, etc) is the future, we are going to see vendors continue to bring automation to OTC trading in the near term.

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COMMENT:

AUTHOR: David Merkel

EMAIL: david.merkel@gmail.com

URL: http://alephblog.com

DATE: 05/26/2008 11:39:02 AM

CDS has margin issues, because of length of contract, and size of exposures.   How much does the exchange require of the buyer of protection to put up to guarantee that he will make his continued obligation, that would have to be paid if the obligation does not default?  Or do they require a lump sum?

How much does the exchange require of the protection seller?  He would be receiving maybe $20 per $1000 of protection for a middling credit, but his potential obligation is $1000.  What margin would the exchange require?

Consider relatively vanilla products like CDX indexes.  How would the exchanges handle margin requirements there?  How much does that change if they try to handle tranched CDX indexes?

I think that pretty rapidly, the exchange has to monitor the creditworthiness of their counterparties, much as an investment bank does.  The exchange, which hopefully would be well-capitalized, would then be a special-purpose investment bank.

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COMMENT:

AUTHOR: OJ

EMAIL: ojstreets@hotmail.com

URL: 

DATE: 05/27/2008 04:15:32 AM

I have believed this for a long time and have been bearish about ICAP (OTC interbank dealer) on the back of it.

It has cost me my shirt. Recent vol has seen IDB profits soar. But the future must be transparent and centrally cleared. The question is: when is the future?

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COMMENT:

AUTHOR: Bill P

EMAIL: lpark@rcn.com

URL: 

DATE: 05/28/2008 10:51:40 AM

There is another force at work here.  If the Fed is apparently going to open up to investment banks as a matter of policy then clearly they will force these same investment banks to deleverage sharply.  

In addition, the primary reason for the bear Stearns intervention was the contra-party risk that these OTC contracts produce.  

Taken together it would seem somewhat inevitable that the OTC positioning of trades is due for severe shrinkage.

It is not clear at all that this would lead to trades taking place on the various exchanges.  What is the most likely outcome is that the trades would be executed OTC.  At that point, for a fee, the exchanges and/or clearing houses would take over the positions and the two parties would be margined by the clearing houses.  The two parties would no longer be contra-parties.

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