To trade 'on' or 'off' exchange?
Many have commented in recent years about a conflict between the exchange-traded and over-the-counter (OTC) marketplaces for equity derivatives. However, the reality is that these two trading environments frequently overlap and therefore they should not necessarily be seen as being in competition.
Nonetheless, in many cases the result of these conversations has created a true dilemma for fund managers on whether to trade equity derivatives ‘on’ or ‘off’ exchange.
Volume has increased continuously in both exchange-traded and OTC equity derivatives and despite numerous initiatives, such as block trading and Flex® options, there has not been a significant migration of business to the exchanges from the OTC market.
Whilst exchanges have traditionally offered the benefits of a low-risk environment with standardised contracts, the OTC market has provided greater flexibility and, up until now, has been seen by some as more cost-effective. The reality is that volume growth has been greater off- rather than on-exchange. The OTC market in Europe is now three-times the size of the exchange business.
The exchange has recognised that many end users will always trade in the OTC market because it is easier to book transactions. However, after extensive consultations with equity end users and a thorough analysis of the OTC market, we believe that we can introduce significant efficiencies to this process.
What Euronext.liffe is offering, is to combine the strongest aspects of the exchange-traded environment with the flexibility of the OTC market. The end result is transparent and efficient markets that allow end users to obtain the advantages of trading on an exchange, while trading in the manner they prefer.
In order to achieve these objectives, Euronext.liffe’s has launched three new wholesale services:
q Cscreen, the pre-trade price discovery platform, will provide straight through processing (STP) to new post-trade administration and clearing services;
q Bclear, the Cleared Service, is an on-exchange administration and clearing service which will provide an environment for the trade registration and clearing of the broadest range of blue chip single stock and index futures and options;
q Afirm, the off-exchange OTC Post-Trade Matching Service will provide both affirmation and confirmation for OTC transactions.
The three services are designed to work together providing STP between pre-trading and post-trading services (see figure below) or can be used in isolation as individual elements of the same value chain.
Cscreen is an established pre-trade price discovery platform that Euronext.liffe bought in April 2005 from Cinnober Financial Technology. The platform is used by brokers and traders to disseminate Indications of Interest (IoI) on vanilla options strategies and variance swaps. There are now 117 different
broker firms connected to Cscreen,
as well as over 270 price makers.
Cscreen can be used by itself or combined with either Bclear or Afirm, to provide STP capabilities. This is an incredibly important development for the OTC equity derivatives market. Few, if any, other systems provide the same degree of STP.
Bclear is perhaps the most important development for fund managers as far as wholesale equity derivatives are concerned. It allows OTC trades to be registered, processed and cleared through LCH.Clearnet Ltd. Users can chose between standard and non-standard maturities and strike prices and they can even design multi-leg structures of combinations of American and European style options, as well as electing for either cash or physical settlement. This provides many of the most important benefits of trading on exchange to OTC players.
Another important aspect is that like exchange-traded transactions, all positions are re-valued on a daily basis, using fair market values. This is something that is meant to be required already for US-listed corporations under the FAS 133 accounting standards. It is only a matter of time that European listed companies will also have to comply with a similar standard, IAS 39.
Bclear offers huge benefits for both hedge funds and more traditional asset managers who might find it difficult to access the OTC market because of a lack of credit lines. As a result of using Bclear, they will now be able to participate as easily in the OTC market as they can trade on an exchange. They will also be able to trade with new counterparties without the need of a bi-lateral agreement and without any counterparty concentration limits. Other benefits for fund managers will be the standardized processing of trades, the availability of one consistent corporate action policy and the familiar regulatory environment provided by the FSA. Bclear is a huge opportunity for the prime brokers to extend their services to start-up funds with little administrative costs.
Firms wishing to access the system either have to be a member firm of LIFFE (Euronext.liffe London) or to have a clearing agreement in place with a member firm. Most of these requirements are likely to already be in place for a huge portion of the potential user base, so the barrier to entry is radically reduced. All funds need is to have a prime broker who a member of Euronext.liffe.
One of the reasons cited by market practitioners as a cause of the growth of the OTC market is the low cost. Euronext.liffe has addressed this issue with a very straight forward fee structure for Bclear. For instance the service will be charged on a fee per lot basis up to a €100 cap for house business carried out by exchange members proprietary accounts and €200 to €400 for their client’s business, regardless of the size of the trades.
The third component of the wholesale initiative is Afirm. This is a matching service for pure OTC trades aimed at the global community with ISDA Master Agreements in place.
The exchange believes that Afirm addresses some very real concerns about the OTC market and it is fully in line with ISDA’s strategic vision for automated trade verification matching and legal execution as outlined in its ‘Going Forward: A Strategic Plan’ paper.
The current OTC post-trade infrastructure is often cumbersome, which raises issues about operational risk. Matching and confirming trades is often a slow and expensive manual task; it is not uncommon for option trades to actually expire before they have even been confirmed.
Afirm is an extremely cost effective solution which provides an environment that allows for T+0 trade affirmations and confirmations. There is no connection cost and no annual charge. The matching or affirmation of trades is charged to counterparties on a per-trade basis, irrespective of the size of the transaction.
In effect, Euronext.liffe is providing a pick and mix solution for trading, clearing and settling OTC equity options with its new initiative. The initiative really is a radical solution that combines the best of the OTC and exchange-traded markets. Effectively, a bridge has been built between them. End users can now more easily chose where they want to trade.
Taking the three building blocks together, A(firm) + B(clear) + C(screen) will result in a reduction of costs, lower legal, operational and counterparty risks for OTC equity option players. With this solution we believe we have provided all equity option users with real choice about how and where they carry out their trades, establishing a new paradigm for the market.