Derivatives are considered to be risky, but were in fact developed as a risk management tool. High-profile cases have shown that misuse of derivatives and lack of proper risk management cause problems for even the largest corporations.
By using the right derivative in the right way institutions can hedge their market risk exposure and, by doing so, protect their income and cost streams. This offers a most important commodity, certainty, and as a result new opportunities arise. Projects can be ascertained with more accuracy because a portfolio is offering a hedged return. A fully hedged and risk-free portfolio will probably never be achieved, but one can reach a near-perfect match.
Derivative exchanges offer a standard product in that the only negotiable element is the price. Contract specifications, such as underlying value, maturity date and tick value, are all predetermined. The advantages are that a derivative trade can be executed more easily, cheaply and efficiently. The disadvantages are that the requirements of the real physical world are not often fully matched by the products offered in the exchange-traded derivatives world. In these cases parties need to search the over-the-counter (OTC) market for a more suitable product match.
We act as a general clearing member for exchange-traded derivatives. In this role we act not only as a guarantor for the performance of the trade for its clients towards the clearing house but also as an administration agent and financier. Central clearing houses with their clearing members mitigate counterparty risk in the exchange-traded markets. This is the main advantage these markets have over the OTC markets, where transactions are exposed to the default risk of the opposite party to the trade – so-called counterparty or credit risk. As a result, the number of parties one can trade with is restricted to highly rated institutions and even these are restricted in their actions by steep capital requirements. This point drives many institutions to use exchange-traded derivatives, even if the product does not offer a perfect match for their requirements. It is a necessary trade-off between a perfect hedge and cost. For that reason you find many large and highly rated oil companies using the International Petroleum Exchange for hedging purposes, ‘tailoring’ their hedge to cover their exposures. Similarly, large institutional investors like pension funds and insurance companies use Eurex, Liffe or AEX to hedge their equity and fixed income portfolios.
The main change in the derivative markets is the advent of technology. For such a highly innovative market, the exchanges have been very slow to embrace technology. Out-dated membership structures, with a variety of members ranging from locals and brokers to global banks, have allowed exchanges to resist change for a considerable time, but developments are moving fast. Possibly due to higher levels of competition (Eurex versus Liffe), Europe is leading the way, leaving the US trailing by at least a year and a half. This is ironic considering the way the US has led the world in derivatives trading and technology development to date. Again membership structures and a lack of significant screen-based competition are to blame.
At present exchange members have a monopoly in trading on the exchanges but technology and the emergence of electronic communications networks will widen the number of people who can access the markets. Private individuals can already trade through a broker on a number of derivative exchanges via the internet from their PC. Professionals still require quicker and direct exchange access and need expensive infrastructure. Professional traders who do not wish to invest these amounts or do not have the expertise in the necessary IT development can now join a number of arcades that offer trading access and support. We offer one of the largest trading rooms of this type in London.
The impact of technology will be particularly noticeable for brokers. Financial institutions that once relied on brokers for execution are taking matters into their own hands. Many are applying for exchange membership so that they can access the market directly. By installing a trading PC on their desks institutions can cut their execution costs significantly albeit that at the same time they will assume the risk of out-trades. As a result executing brokers will have to position themselves differently in this new market. Many will move from an executing broker to an advising broker, or offer internet or order-routing facilities to private investors. Financial institutions that relied on information from the broker will continue to do so but will probably no longer use the execution services offered on the main markets in which they participate.
In future years technology will allow professionals as well as private individuals to trade from any point in the world. Exchanges and regulators will rely on general clearing members (GCMs) to uphold the integrity of the market even more than they are required to do so now. Every investor will still require a GCM to clear his trades and the exchange will rely strongly on the compliance department of the GCM for compliance to exchange rules. The exchange will change from an institution that provides a trading floor, including building and market information, to a computer hub. The ‘face’ of the exchange will be the institution that traders and investors deal with on a day-to-day basis – the GCM. Prospective market participants will go to their GCM for information on trading platforms and details on how the market works. In many cases institutions or traders will actually access the exchange through the infra-structure of the GCM. The GCM will provide most of the functions that the exchange performs now.
Electronic trading does not require the use of significant property. The exchange can be based anywhere and anyone can connect to it. This will allow exchanges to link up with each other through communication lines and offer a combined exchange. In the past linkages and partnerships generally failed because a merger of the physical exchanges was not possible, regulatory difficulties and the vested interests of the various members. Technology is breaking down these barriers; physical mergers can be achieved through computer links and exchanges are demutualising to change their ownership structures. Within the European Union, laws are being harmonised to allow a freer flow of capital and goods. This should take away the historic barriers and create truly merged exchanges. The Euronext initiative between the Amsterdam, Brussels and Paris exchanges is the first promising attempt to achieve this.
Wim den Hartog is director of derivative clearing international and Frederick de Neree is senior accounts officer at Fortis/Mees Pierson