Volatility is the stuff of derivatives. These days most of the market’s volatility is pouring out of the boardrooms at the futures exchanges on and around LaSalle Street. From there senior executives of the U.S.'s two dominant exchanges, the 156-year-old Chicago Board of Trade and the 106-year-old Chicago Mercantile Exchange, have been trading charges and countercharges with rival Eurex, the large and rapidly growing all-electronic SwissGerman derivatives bourse that is preparing to elbow its way into U.S. markets shortly.
Last January, Eurex, jointly owned by Deutsche Börse and SWX Swiss Exchange, announced plans to create its own market in U.S. Treasury note futures, a mainstay of the CBOT. Eurex has always been keen to grow into U.S. markets, and if its new exchange grabs a meaningful share of the CBOT’s market, the bourse is likely to go after the other big opportunity in dollar interest rates: the CME’s Eurodollar futures contract, the benchmark short-term U.S. fixed-income hedging vehicle. “If [the CME] can help preserve the CBOT’s franchise, in essence they protect their rear from the next step, which is Eurex’s listing of CME contracts,” says Allan Zavarro, head of global futures at ABN Amro in New York.
This bout has very high stakes. Eurex challenges the time-honored open-outcry system of floor traders and market makers who have ruled the Chicago exchanges since inception. The Board of Trade and the Merc are moving rapidly to embrace electronic trading and have combined their clearing units to realize greater economies of scale and become more convenient and cost-effective for institutional investors and futures brokerage firms.
But Eurex is a formidable rival. In 1998 it snatched the German bund futures contract, which had traded for years on the London International Financial Futures and Options Exchange (now Euronext.liffe). Market participants were stunned by the speed with which end users switched to Eurex’s electronic platform. Victory won’t be as easy in Chicago: U.S. interest rate products, after all, already trade within their home market, and the two Chicago exchanges have sophisticated electronic trading systems. Still, if Eurex can attract institutional end users, it could threaten the preeminence of these two players.
The U.S. exchanges are doing their utmost to keep Eurex from opening as planned. Through intense lobbying, they pressured their regulator, the Commodity Futures Trading Commission, to take the Eurex exchange application off the fast track. If Eurex’s U.S. launch were delayed long enough past its planned February 1 opening, Treasury note futures contracts expiring at the end of March would be rolled over onto the CBOT’s electronic trading platform, making traders less likely to experiment with Eurex.
In November the U.S. House Agriculture Committee, which oversees the CFTC, heard testimony to review Eurex’s application to launch a U.S. exchange. CME chairman Terrence Duffy suggested in congressional testimony that Eurex’s U.S. venture raised “compelling jurisdictional questions,” since its parent, Eurex Frankfurt, is “based in Germany and not subject to the Commodity Exchange Act” governing the U.S. markets. Duffy further argued that the CFTC should require evidence that “wash trades,” or offsetting transactions designed to bolster volume, and “other abusive trading practices allegedly permitted in Germany will not impair the fair operation of our regulated U.S. markets.” A Eurex spokesman says that the “regulatory concerns that have been identified by our future competitors are entirely speculative and unfounded.”
Eurex fought back doggedly throughout the autumn, filing an antitrust lawsuit with the U.S. District Court for the District of Columbia, charging the two Chicago incumbents with anticompetitive behavior in trying to block its entry into U.S. markets and misleading Congress about its intentions. “The two,” Eurex noted in its October complaint, which it expanded in December, “have engaged in a pattern of conduct intended to unlawfully maintain and enhance CBOT’s monopoly in the relevant markets, and CME’s economic interest therein, and to keep prices high, stifle competition and eliminate consumer choice through exclusionary behavior.” CBOT chairman Charles Carey responds: “Where is the monopoly? In Germany. They have no competing exchange for their products.” A Eurex spokesman replies that its “success is proof of our ability to compete. We are the leader in our industry.”
For their part, derivatives users and players, from major dealers to investors and corporations, welcome the prospect of intense competition among the exchanges. Their goal is simple: to reduce costs and ease transactions.
Already, users note, the CBOT and the CME have combined clearing operations, benefiting market users. Says Bill Russell, London-based head of European futures for Citigroup: Eurex “has dramatically changed the landscape. The CME and CBOT now have a common clearing platform, and with that you’re starting to see a reduction in rates across the Chicago exchanges. Most people believe it’s because of the actions of Eurex, which isn’t even open [in the U.S.] yet.”
Efficient execution is all-important to pension managers, corporate treasurers and other large derivatives users, who look to the Chicago exchanges and the major derivatives dealers to provide them with cost-effective hedging tools. The firm they single out most often in Institutional Investor’s tenth annual ranking of leading derivatives dealers for providing excellent service is J.P. Morgan, which rises a notch in 2004 from second in last year’s sur- vey. Also gaining is Deutsche Bank Securities, which improves two slots to second, and UBS, which gains three notches to third. Citigroup tumbles three places to finish at No. 4, and Goldman, Sachs & Co. drops from third to fifth.
Within II’s five individual categories, J.P. Morgan again wins the top spot in credit and interest rate products and tailored solutions. Deutsche Bank, fourth in equity derivatives last year, takes first in that asset class this year, relegating last year’s leader, Goldman, to second; and UBS takes the laurels in currencies, besting last year’s winner, Citigroup, which falls to fourth.
These dealers faced markets that were relatively calm in 2003, compared with the tumult of 2002. Those markets nonetheless continued to enjoy growing volume -- particularly in fixed-income derivatives, driven by massive mortgage-backed securities hedging -- despite major capital markets gyrations. “Overall, I’d characterize 2003 as a remarkably involatile year,” says Steve Rodosky, a portfolio manager overseeing $60 billion in Treasuries and derivatives at Pacific Investment Management Co., based in Newport Beach, California. To many investors and analysts, the surge in volume indicates how far the marketplace has come in recent years. Diane Garnick, chief U.S. portfolio strategist at Dresdner Kleinwort Wasserstein in New York, explains: “Investors are finally beginning to see [equity] options as a tool to more accurately express their investment views. You can see that in the open interest increasing.”
Even last summer’s spike in the ten-year Treasury note yield -- from a 45-year low of 3.11 percent in June to 4.61 percent in September -- caused only a ripple in implied vola-tility in interest rate options; for 2003 as a whole, bond yields were little changed. Traders say that implied volatility stayed under control because market participants realized that the bond sell-off was amplified by mortgage hedgers.
Rising equity markets and tightening corporate bond spreads led to declining volatility in both the equity and credit derivatives markets over the past year. “The challenge investors have faced is how to find yield in an environment where global credit spreads have tightened significantly since October 2002,” says Tim Frost, London-based head of European credit trading at J.P. Morgan.
In currency markets the dollar continued to fall in 2003, hitting an all-time low against the euro at year-end. But its orderly decline caused implied volatility in the major currencies to increase only gradually over the past year.
Lower volatility reduces the need for clients to hedge risks, and bid-ask spreads have been tight, but volume growth helps offset the tighter margins for dealers. Driven partly by the bond sell-off and the continuing mortgage refinancing boom, over-the-counter and exchange-traded volumes rose significantly in the first half of last year. According to the International Swaps and Derivatives Association, notional principal outstanding for interest rate swaps and options and cross-currency swaps grew 24 percent, to almost $130 trillion, in the first half of 2003, and credit derivatives jumped to $2.7 trillion, up 25 percent over the same period. The notional value of global exchange-traded derivatives rose 16 percent in the first quarter of last year over the previous three months, to $198 trillion, then surged an additional 24 percent in the second quarter, to $246 trillion, according to the Bank for International Settlements. Exchange-traded derivatives vol- ume eased 9 percent, to $223 trillion, in the third quarter, the BIS says.
Seizing -- or holding on to -- a big piece of this volume is what the brawl at the exchanges is about. So long as it does not get too bloody, futures brokers and derivatives users hope the bout will spur additional tangible innovations like the long-overdue combination of CBOT and CME clearing operations. “The merger of clearinghouses had been talked about for a very long time -- it was almost a rite of spring,” says Craig Pirrong, a finance professor at the Bauer College of Business at the University of Houston.
The traditional Chicago exchanges, working together after years of rejecting one another’s overtures, predict that the common clearing link will pare customers’ margin and guarantee fund requirements by $1.6 billion. Eurex promises that its plan to offer cross-margining of U.S. dollar and euro- denominated interest rate products will cut customers’ margin and collateral requirements by $2.5 billion.
As much as they cheer the changes Eurex’s ambitions have already prompted, many market participants agree that the European interloper faces long odds. Moving so much liquidity to a new exchange will not be easy. “I’m not saying Eurex doesn’t have a chance, but I think it will have a very difficult time replacing the two Chicago exchanges as the primary exchange in North America trading interest rate products,” says ABN Amro’s Zavarro.
Proprietary trading houses and hedge funds may switch to Eurex because of lower rates, because they trade frequently and thus face high transaction costs, notes Citigroup’s Russell. But big pension funds and asset managers are likely to wait to see the level of open interest that Eurex builds and whether it will be able to execute cross trades and block transactions.
The Chicago exchanges have been wary of these and other institutional trading facilities, arguing that they impede price discovery -- the determination of the price for a security or commodity by competing buyers and sellers -- by not exposing orders to traders in a centralized marketplace. The bourses also say such changes favor larger investors. Craig Donohue, the CME’s CEO, notes that Eurex’s exchange application raises “fundamental policy issues.” He is concerned that Eurex will use “block trades to broadly facilitate the internalization of order flow, where an intermediary can cross customer orders on their own book or take the opposite side of a customer’s order without exposing it to a competitive execution.”
Adds Bernard Dan, CBOT president and CEO, “Eurex’s strategy is to build volume by bringing the market upstairs, focusing it on a few and creating an interdealer market.”
Not surprisingly, Eurex disputes this view. Speaking at a November 2003 Futures Industry Association meeting in Chicago, CEO Rudolf Ferscha noted that block trades and other institutional services do not compromise liquidity or market integrity. Eurex, he added, is committed to attracting new pools of liquidity to the exchanges via these facilities that will enlarge the futures market for all participants.
Big institutional investors want enhanced liquidity as well as the ability to execute in large size, at set prices and quickly. “The reality is that a huge fraction of the New York Stock Exchange and Nasdaq volume is done as blocks, and it doesn’t seem to impede the price discovery at all,” says Todd Petzel, managing director and chief investment officer at Azimuth Trust Co., a recently launched offshore money management firm, and former CIO of Commonfund Asset Management Co., where he oversaw $29 billion in assets.
Regardless of which exchanges are left standing at the bell, it’s a safe bet that they will be almost totally reliant on electronic trading for financial futures within a few years. Maintaining the floors for the benefit of locals, floor brokerages, market makers and those customers that want the option to trade in the pits is extremely expensive for the exchanges and makes them less competitive, particularly as volumes increase and fees decline. The markets themselves have already spoken. At the CBOT electronic trading of the ten-year Treasury note began in 1994, and 78 percent of November volume in that contract traded electronically; volume in the CME’s electronically traded E-mini Standard & Poor’s 500 index futures contract, launched in 1997, is now nearly eight times larger than that in its older, primarily pit-traded counterpart.
The “greater liquidity and anonymity traders enjoy from trading futures electronically have reduced the market impact [the effect of large orders on market price] cost of trades,” says Howard Tai, an equity derivatives and foreign exchange specialist at Kansas City, Missouribased American Cen- tury Investment Management, with $85 billion in assets. On the floor, he says, the bid-ask spread may be tighter, but large volumes cannot be executed because the price will move against the trader too quickly, increasing the market impact of the trade.
The CME’s recent stock index futures launches, including last spring’s debut of the Russell 1000 contract, trade exclusively on screens. “This is a sign of things to come,” says DKW’s Garnick.
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