Eurex entry will alter US landscape

Financial News

January 4, 2004

The first weeks of this year will be decisive for the big derivatives exchanges. Swiss-German exchange Eurex is waiting for regulatory approval to launch its own US futures and options market, which the exchange hopes to do on February 1. Even if regulatory hurdles mean that it does not meet this launch date, Eurex is expected to get the go-ahead, and its entry into the US is likely to change the local exchange scene.The headlines during the year ahead will again be dominated by the battle between Eurex and its rival US exchanges, which began in January last year when the Chicago Board of Trade (CBOT) announced it would sever its ties with Eurex in favour of a new relationship with the London-based Liffe. Developments this year in Europe are likely to be lower-profile, but they will be no less important.

Richard Berliand, global head of futures and options at JP Morgan, believes that while the action in the US will be "headline-grabbing" and "price-driven", in Europe there will be growing competition in equities and equity options. He said: "Any exchange can list any other exchange's equities or equity options, and liquidity is relatively easy to transfer for off-exchange block trades.

It would be more difficult for the exchanges to try to compete with established contracts such as the Euribor or Bund contracts, which are reliant on centralised deep underlying pools of liquidity."

One of the most important areas of development will be the shift of exchanges and their clearers into the over-the-counter (OTC) markets. Exchanges have always looked to the OTC world to identify areas of growing interest; the contracts they launch are inevitably based on similar ones that have already gained traction.

The rapid growth of the OTC derivatives markets has raised concerns about how banks and other end-users process and settle the growing volume of trades. In March last year, Alan Greenspan, chairman of the US Federal Reserve, said the way OTC derivatives were traded and settled could be "significantly improved". Greenspan's comment that it was "disappointing that so little progress had been made in adopting efficient and reliable means of executing and confirming trades", was noted by the industry.

In June, the London Stock Exchange (LSE) launched an international equity derivatives business, EDX London. EDX's focus is on the development of an OTC equity derivatives trade confirmation and clearing service for wholesale market participants. Soon after, Liffe, the derivatives arm of the pan-European exchange Euronext, announced a similar offering.

Other ventures in the OTC markets included the launch of a global automated matching service for credit default swaps by the US-based Depository Trust & Clearing Corporation (DTCC). Swapswire, a consortium-led initiative that has been offering a similar service for the plain vanilla interest rate swap market since November 2002, said it would launch a similar service.

It is early days to judge the value of any of the efforts. DTCC and Swapswire have several banks on board for their credit derivatives initiatives, but until the wider market joins up, neither will deliver full benefits. So far, EDX has only been able to facilitate confirmation and clearing for Scandinavian equity derivatives, as the LSE and Liffe are awaiting approval from the Financial Services Authority in the UK.

Even so, the market has welcomed both services, and the benefits for the exchanges are also clear.

Alex Wilkinson, head of listed products at Dresdner Kleinwort Wasserstein (DrKW), said: "The number of potential listed derivative contracts is growing, but not as fast as the OTC markets are throwing up possibilities for exchanges. On top of that, I think global regulators will increasingly look to see how they can bring more cost-effective and focused regulation into the OTC markets. Any exchanges that bring OTC business to standardised platforms will therefore be supported by the regulators in their efforts."

In December last year, the International Swaps and Derivatives Association (Isda) issued a paper pushing for the development of post-trade automation in the OTC markets by the middle of next year. The industry body believes this will reduce the operational risk associated with OTC trading, where there is often a substantial lag between the trade and confirmation dates.

Bob Pickel, executive director and chief executive of Isda, said: "By automating these processes, participants will be able to increase volumes in the more standard products, and dedicate more time and resources to more complex, higher margin products."

According to DrKW's Wilkinson, one of the decisive factors in the OTC battleground will be relationships between exchanges and clearing houses. He said: "Exchanges are looking for breadth to expand into the OTC markets - and if their clearing houses cannot serve them in these areas, their growth potential will be narrowed."

Because neither the LSE nor Liffe have the ability to settle trades, both will have to use a central counterparty like LCH/Clearnet. Richard Berliand, global head of futures and options at JP Morgan, said the competitive difference between the two would thus be narrower than if either were using its own vertical silo for clearance. He said: "Their ability to compete will be driven instead by price, marketing, and by the way they leverage their respective franchises. The benefits each can bring through margin offsets will be specific to each member firm, so neither will have an all-out advantage in this area."

Of the clearing houses, DrKW's Wilkinson believes that the LCH/ Clearnet axis will be well-positioned because it owns SwapClear and RepoClear - established multi-market centralised clearing and netting facilities for the interest rates swap, government bond and repurchase agreement markets.

He said: "Other clearing houses will find it difficult to compete with these efforts. Together with Euronext.Liffe's clearing business, these two will put the newly formed clearer in a strong position."

Although Eurex Clearing has not made the same push into the OTC markets that LCH has, JP Morgan's Berliand believes Eurex will continue to focus on the US, rather than launching new products in Europe. It seems it will have its hands full this year.

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