Exchanges are moving into OTC derivatives as these instruments become more standardized and can trade on exchange-like electronic platforms.
With an eye on expanding its market share in over-the-counter derivatives, Atlanta-based InterContinental Exchange will acquire YellowJacket Software, an electronic trade negotiation platform that traders use to consolidate quotes and structure complex trades in the weather and energy markets. In light of the huge volumes that occur in the OTC derivatives markets, few observers are surprised by the move.
"Exchanges want to get a piece of the OTC market back," observes TABB Group senior analyst Kevin McPartland, who covers the futures and options exchanges. "The OTC markets have exploded -- they see that they are losing some potential business to the collective OTC markets, and they want to make sure they keep that trading on their exchanges and on their technology." McPartland adds that technology has become an increasingly important competitive differentiator for all exchanges.
In fact, technology has been the basis of the ICE's rapid expansion and acquisition of other exchanges, including the International Petroleum Exchange (IPE), the New York Board of Trade and the Winnepeg Commodities Exchange. The ICE operates three futures exchanges in the U.S., Europe and Canada, and has expanded its trading and clearing activities into a full range of energy, soft commodities, foreign exchange and stock index futures.
Today, ICE provides a single high-speed, electronic platform for trading ICE futures and OTC-cleared products. It offers one architecture that supports futures and one that supports OTC markets, according to an ICE spokeswoman.
With the acquisition of Yellow Jacket, for which financial details were not disclosed, the ICE now has the potential to tap the liquidity from the OTC weather, natural gas, crude and power derivatives that are transacted on Yellow Jacket's network. While "ICE operates a widely distributed electronic trading platform for highly liquid products, Yellow Jacket serves the highly structured instruments and illiquid trades," says the ICE spokeswoman. "Certainly Yellow Jacket occupies a very interesting space in the technology side of the derivative market."
Founded in 2002, Yellow Jacket's core application is YJEnergy, a secure, peer-to-peer communications network used by OTC derivatives traders that rely on public instant messaging networks, such as Yahoo and AOL, to disseminate quotes to one another. "A trader at any given moment may have several instant messages coming in," explains the ICE spokeswoman. "This tool enables them to aggregate information and assemble where market prices are for the trade they want to do." The platform provides the added value of price transparency, the ICE spokeswoman notes.
Currently, 130 clients use the YJEnergy product, including big hedge funds, banks, utilities and power companies. The ICE, however, is looking at how it can leverage the technology beyond energy and weather derivatives. "We see this not just as an energy or commodities tool, but it could potentially apply to complex asset-class trades, such as fixed income instruments negotiated OTC," says the ICE spokeswoman, who adds that Yellow Jacket will be a wholly owned subsidiary of ICE.
One of the potential synergies between the ICE and Yellow Jacket is clearing. According to the ICE spokeswoman, Yellow Jacket currently submits OTC trades for clearing to several exchanges. "We're integrating that ... [into] ICE's cleared products," she says.
Liffe, SuperDerivatives Connect
But the ICE isn't the only exchange that is venturing into technology deals to penetrate the OTC derivatives space. On Feb. 26, Liffe, the London-based futures exchange owned by NYSE Euronext, partnered with SuperDerivatives to give users of the derivatives pricing and analysis platform direct access to the Liffe Connect electronic trading platform. "The partnership was driven by market demand from market makers and from buy-side investors who are looking for the right market to realize their investment goals," says Ed Crouch, global head of corporate and strategic development for SuperDerivatives.
Banks, brokers, asset managers and mutual funds use the SuperDerivatives products to price OTC derivatives. Now, market participants can access Liffe's direct execution capabilities and market data, while combining that with the analytical and productivity functionality that SuperDerivatives brings to the table with its platforms, says Crouch.
"There are certain structures that can be traded on the exchange, and that's the right venue, and there are other structures that can't because they are OTC structures," explains Crouch. "This gives [customers] a single platform so that people can choose what the best execution venue is for whatever it is they are trading at the moment." For example, if a trader were executing a back-to-back trade, for which he had an exchange-traded product on one side and an OTC product on the other side, he could execute both on the Liffe/SuperDerivatives platform, Crouch adds.
In addition to facilitating direct execution via Liffe Connect, the interaction of the two platforms "provides greater transparency and price discovery in that market participants can use the technology to have a greater sense of what appropriate prices are in these different venues," Crouch asserts, noting that while Liffe is the first exchange to which SuperDerivatives has linked, the vendor is in discussions to link to other exchanges. "The idea is that it helps increase volume on the exchanges," he says.
Still, Liffe can trade only listed derivatives, points out Mayiz Habbal, SVP of Celent's securities and investments group. "With this kind of linkage, Liffe is not going into the OTC buisness," he says, "SuperDerivatives is giving its users the option -- if they need to diversify their strategies, they can go into the listed derivatives. [The deal] is a connectivity provisioning more than anything else."
OTC, Exchange Convergence?
Habbal and other industry sources see the technology deals such as the ICE's acquisition of Yellow Jacket and SuperDerivatives' partnership with Liffe as leading to the convergence of the OTC derivatives and exchange markets. According to Habbal, the exchanges are trying to move into the OTC derivatives business dominated by interdealer brokers (IDBs). "[Exchanges] are preparing themselves to really venture into that market that the IDBs are operating electronically," he says.
The combination of electronic trading, more standardization of OTC derivatives contracts and the consolidation of the IDBs are fueling the convergence of OTC and exchange-traded environments, argues Habbal. An estimated 75 percent of the OTC derivatives market, he notes, is handled by three IDBs -- Tullett, ICAP and GFI. "And within the standardized instruments [i.e, credit default swaps and short-dated interest-rate swaps] they are the equivalent of running exchanges," Habbal maintains, citing the findings of a Celent research report, "Interdealer Brokers' Migration to an Exchange-like Platform," that was slated for publication in late February.
In the report, Celent divides OTC derivatives into three categories: First, they are introduced as exotic or illiquid instruments; then they evolve into liquid or flow instruments; and finally, they migrate into an exchange-type of environment, according to Celent. "Once the instruments become standardized and more liquid, they can be traded electronically," Habbal contends.
"For the exchanges, they see this as their next market," Habbal adds. "They're looking at how the interdealer brokers who specialize in this type of instrument have transformed their environment into an exchange."
As evidence of the trend, TABB's McPartland notes that the Chicago Board Options Exchange (CBOE) recently launched an electronic platform for trading Flex options, which basically are customized single-stock and index equity options that allow traders to create options with custom price strikes and expirations. While CBOE used to execute the Flex options through the floor, now brokers, liquidity providers and their customers can negotiate trades securely via CLFEX, an Internet-based, fully anonymous trading system developed for CBOE by Stockholm-based Cinnober Financial Technology. The system is based on Cinnober's TRADExpress Trading Engine and also utilizes the OTC platform Ctrade.
In yet another sign that OTC derivatives may be converging with exchange markets, on Feb. 28 Nasdaq OMX announced a $7.5 million stake in Agora-X, a new electronic communications network (ECN) for institutional commodities trading in energy and agricultural products. "The OTC trades are a complement to the exchange-traded products," says Chris Concannon, Nasdaq OMX's EVP of transaction services. But there are unique benefits to OTC products, he adds. For example, "You don't have the same position limits and restrictions that you find on exchange contracts," Concannon says.
Source URL: http://www.financetech.com/showArticle.jhtml?articleID=206905693
Publish Date: 25 March, 2008
