Milan: the ideal derivatives community?

Milan: the ideal derivatives community?

Milan’s Idem market was the talk of the town at June’s International Derivatives Expo in London. “Idem had a sensational month,” as John Damgard, head of the Futures Industry Association, put it in his conference introduction.

Xavier Rolet, the former Lehman Brothers banker and now chief executive of LSE Group, called Idem (pictured) in his keynote address “a unique platform, designed to meet the needs of institutional investors, market makers, and retail players.”

A quick look at the Italian Derivatives Exchange Market’s monthly figures (see chart below) shows what all the fuss is about. May 2010’s total of just over 9m contracts traded smashed all previous records, up more than 60% on April 2009’s then-record 5.5m and virtually treble the monthly average for the past few years.

OK, May was a freak, marked by volatility on global markets and high derivatives volumes the world over. In June, Idem’s volume fell back to 5.8m contracts. But that was still more than any other previous month.

The exchange’s core products are single stock futures and options. But while the options volume is reasonably steady, futures trading fluctuates wildly, with a strong seasonal pattern, peaking in April-May-June and September-October-November.

Thus, the main reason why May’s trading total of 9.06m contracts exceeded April’s 3.67m figure by 5.39m contracts was a 350% swelling of single stock futures volume. That category put on 4.37m extra trades in May – 81% of the total growth.

A diverse community

Idem lists 15 stock futures and 44 options, mainly on stocks in the FTSE Mib Index of Milan’s 40 most traded stocks, as well as some leading midcaps. Some 60%-70% of trading is in a handful of contracts, however, and the bourse’s big market makers provide nearly all the liquidity.

But ask market participants what’s driving the sudden boom, and the answer is clear: diversity. By which they mean a healthy interaction between retail investors, hedge funds, asset managers and brokers. Though the whole user base is not huge, its composition is balanced, and could be seen as a model.

is a very regionalised market,” says Fabio De Zordo, UniCredit’s managing director of equity derivatives flow in Western Europe. “It’s one of the best when it’s a bull market, and one of the worst when it’s bearish. Italians only like it when things are buoyant.”

Not many exchanges can lay claim to a trading pit on the site of an ancient Roman theatre. And the Italian love of communality endures, in spite of the pit being reduced to the status of a spectacular museum. “We all know each other,” laughs De Zordo.

Much of this close pool of talent was honed at the nearby Università Commerciale Luigi Bocconi, he says, one of Europe’s most respected business schools, just a tram ride away.

Another talking shop and promoter of innovation is the Associazione Italiana Certificati e Prodotti di Investimento, the investor forum populated by many former Idem floor traders.

“In Italy, during the last two years, the banking landscape has changed and we have seen some consolidation of the banks,” says Gabriele Villa, head of private investors business development at Borsa Italiana. “We have seven or eight big banks operating on the market, and maybe 50 or 60 very small brokers.”

“It’s quite a small community. During the crisis, quite a few disappeared,” agrees De Zordo. “OTC decreased a lot with the crisis – now we prefer to cross everything. Italian investors prefer Italian markets and Italian underlyings. It’s quite an insular community.”

Retail therapy

Insular, perhaps, but this small group of equity derivatives traders is surprisingly diverse, and has driven and sustained the bourse over its 16 year lifespan. No wonder smaller investors – brokers and their private retail customers – are so highly prized and cultivated by the exchange.

“Our value added is that we can provide the same level of service to big and small clients,” says Villa.

“In Italy, in general, there is a large interest in derivatives,” says Nils-Robert Persson, chairman of Cinnober, the Swedish exchange systems company which has worked with Idem for several years. “My impression is that the Italian brokers and banks are happier to trade on exchange than the rest of Europe. The market share of exchange-traded instruments versus OTC is greater in Italy than it is in the rest of Europe.”

“I think Italians have a good appetite for risk,” agrees a trader at one of Idem’s market making banks. “But we are also large buyers of Italian bonds. The main reason equity derivatives are popular here is because they are easy and cheap to trade.”

Idem’s pricing structure for equity derivatives aims to please large and small players alike. Under a scheme introduced last year, primary market makers receive hefty discounts of up to 80% for block trades in stock futures and options – an incentive that has eaten into the bourse’s trading fee income.

But smaller players get a look-in, too. Proprietary traders, institutional and retail brokerages now pay a maximum of €1.80 for trading and clearing on a trade of up to 25 lots.

“We are the only exchange, in Europe for sure, offering this type of incentive for a small-sized stock futures business,” says Villa proudly.

While it is hard to estimate, sources suggest retail investors account for as much as 15% of the exchange’s trading volume. Mostly they trade single stock futures and Mini-FTSE Mib Futures – stock option and index traders tend to be institutional investors. A dozen online brokers help private clients to trade direct, while five to 10 proprietary trading firms offer arcade-style access to remote professionals.

And Milan’s traders are keen to point out how the Italian model bests those of some EU neighbours. “I think the key problem for the UK is stamp duty,” one says when asked why retail futures trading is more popular here. “In Italy, we don’t have stamp duty – we still don’t understand why you do.”

A stamp duty reserve tax of 0.5% is payable in the UK on all sales of shares or options.

Persistent liquidity

But despite the market’s attractions and advantages, Italy’s private derivatives traders are a select bunch. “We’re not talking about a large group of people,” says Villa. “Our research indicates that there are around 10,000-15,000 retail investors in Italy. It’s a very concentrated market. On Mini-Mib Futures, their activity is quite important, even more than 40% of volumes.”

A good part of this retail trading is arbitrage trading programme strategies, in which investors trade indices and stock futures simultaneously. The situation is similar in the Spanish, French and German retail markets, though the cost in Germany is somewhat higher.

Smaller investors are also closely shielded by the country’s market regulator, the Commissione Nazionale per le Società e la Borsa, says De Zordo. “We are probably one of the most closely regulated markets in Europe. There are lots of controls on prices on Borsa Italiana, lots of checks on price consistency. But this means it is less dangerous for the retail investor.”

Perhaps the real value of so much retail activity on the market is the persistent liquidity it supplies. “The liquidity they generate is amazing, compared to high frequency trading,” says one market source. “When you look at a book made by HFT, its very stop-start.” In other words, the liquidity can disappear as quickly as it appears – as global investors discovered to their cost on May 6. “When something goes wrong, the book will be empty.”

Looking for new ideas

Product development is another lever in Idem’s effort to keep the punters satisfied. In April, it introduced futures on the FTSE Mib Dividend Index, responding to strong demand from institutional investors.

Unlike futures on some blue chip Italian stocks, this contract’s liquidity is less likely to be stolen by Eurex and Liffe, since the main market makers are Italian hedge funds and pension funds. Some of them rely on regular dividend payments from their large equity holdings, and so need to hedge the risk of big companies not coughing up.

Though the dividend futures have yet to gain traction, Idem expects trading to be busiest around March to May and September to November – the dividend seasons.

What else would the market like to see? “It would be good to have the Vix of other marketplaces,” says a trader at one local bank. “They do it in the US, so why not here? Trading volatility is very general here. Even people who don’t trade VStoxx use it to watch the market, both people in retail and those with big equity portfolios.”

Eurex’s VStoxx Futures track the implied volatility of the Euro Stoxx 50 Index.

“The use of derivatives by asset managers will also increase,” De Zordo believes. “There has been legislation to allow this. If a recovery, we will see the return of huge, huge flows – Italians love a boom!”

Data capture

And it seems Borsa Italiana has had a reputation for being innovative, going back to before the LSE takeover – right down to the minutiae of market data packaging.

“We got a request five years ago to develop a new market data system for the Borsa Italiana,” explains Persson at Cinnober. “I admit that we at the time didn’t consider a market data system as the most challenging area to develop. So we were actually a little bit suspicious, until we understood what they would like to do. Borsa had an idea, and in fact they were the first to do it in a commercial way, to not only feed out their own market data, but also to sell it in different forms.”

The result is the highly flexible, bit-by-bit saleable DDM Plus system, which has been copied by exchanges across Europe trying to diversify their revenue streams.

“Its value is that it’s very flexible and configurable – you can a have a snapshot view any time,” says one market player. “For ordinary retail , it’s fantastic. You’re receiving a very, very frequent snapshot of the market.”

“Borsa Italiana is a fantastic exchange, because they are so efficient in their own testing,” continues Persson. “They are sophisticated. They are operating a large exchange much more efficiently than most similar exchanges. They’re very cost-efficient. Borsa Italiana are very happy customers. Nowadays, their volumes on average are five times as high as their peak value was five years ago.
“We have done two upgrades for them . One was based on the fact that their volume was so high, so they needed a hardware upgrade. The other factor is that they’re now switching from the Click system to the Sola system.”

High ambitions

The LSE Group’s move to a new trading platform, TMX Group’s Sola, looks finally to be kickstarting synergies between the London and Milan exchanges, three years after the takeover was completed.

Synergies are one thing – taking on Europe’s two dominant derivatives exchanges, Eurex and Liffe, is another.

Rolet caused a stir at IDX when he used his keynote speech to voice what he called “modest ambitions”, but which some at the event scoffed at as wildly over-ambitious.

LSE’s plan, Rolet said, was “to offer a credible alternative to established European derivative exchanges within the next nine months.” Details were scant, but the main idea seemed to be offering a range of pan-European single stock futures. (See interview with LSE’s Nicolas Bertrand, published yesterday.)

But is the idea “more of a wish than a business plan”, as NYSE Liffe’s global head of derivatives, Garry Jones, suggested afterwards? What does Villa think?

“It’s something we had to do to start to create real synergies between EDX and Idem,” he acknowledges. “We started working with EDX in 2007, but currently we have different products and different platforms. After the migration, we will have a single trading platform with the same functionality, the same bandwidth requirements, everything.”

Only then, Villa insists, can the Group make a start on Rolet’s dream of competing with Eurex and Liffe. At the moment, for instance, Italian investors wishing to trade EDX’s Nordic stock options have to pay for two exchange memberships, in spite of moves to lower these costs.

“At the moment it’s not easy for our clients to trade EDX products, and vice versa,” says Villa. “After the migration, we can look to creating greater synergies between the two markets and developing our product range internationally.”

Clearing house waits to hear strategy

There have even been suggestions that Borsa Italiana’s clearing house, Cassa di Compensazione e Garanzia, will be offered alongside LCH.Clearnet as an alternative clearer once the platform merger is complete.

“As you can imagine, the LSE is now very interested in post-trade. They’re moving to develop it in Europe,” says Federico Sguera, a business development official at CC&G. “We can our expertise, but we don’t know how they will proceed.”

So could a combined platform really hope to compete with Liffe and its Bclear platform, whose May volumes for equity derivatives totalled 72.5m, and Eurex (just over 100m)?

“This is a big question,” says one market player, weighing his words carefully. “Probably, Xavier was a little bit ambitious . But the idea is there. Look at Idem. Idem was a very successful local market, but with the ability to get volume from foreign clients in Europe on Italian products.”

Adding EDX’s cross-border client base to Idem’s wide-reaching appeal will make the two exchanges greater than the sum of their parts – or so it is hoped.

Whether this can be achieved in the nine months promised by Rolet remains to be seen. “He has a lot of things to deliver now,” as one seasoned European market player puts it. “We’ve had a lot of talk for the last 12 months; now it’s time to deliver.”

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