The next upheaval for exchanges – centrally cleared CFDs

The next upheaval for exchanges – centrally cleared CFDs

In 1982 the London International Financial Futures Exchange opened for trading. In a fairly short time futures and options became hugely popular as financial instruments, and by early 1997 Liffe was the largest derivatives exchange in Europe.  

It was a market shared by large member firms and smaller individual liquidity providers, or locals.

However, unnoticed and beyond the glamour of regulated exchanges and open outcry trading, another revolution was starting.

Bookmakers began to offer ‘bets’ on financial instruments and commodities. In fact, the first real financial bet had been developed by Stuart Wheeler as long ago as 1974.

Unlike the large derivatives exchanges, these bookmakers began to make the financial markets truly accessible to small retail investors. In the early 1990s UBS Warburg adopted an instrument very similar to an equity swap called a contract for difference (CFD).

Another way of describing the instrument is like a cash-settled future whose sale price is always the market price today, and which allows the buyer to choose the moment of expiry. If the market price has gone up at the point of expiry, the seller pays the buyer the difference. If the underlying has fallen, the buyer pays the seller.

It was this derivative that would be adopted by the retail and wholesale markets, generating huge profits over the last 20 years for providers. With a few exceptions, the exchanges that list the underlying instruments have completely missed out on the revenue from these leveraged products.

Nice and easy

Compared with futures and options, the CFD was always much simpler to understand. It seemed more intuitive, as the price traded could be the price on the underlying market.

The overnight financing charges were also easy to grasp, whereas futures would have expiries, expected dividends, ex-dividend dates and financing all built into the price.

GNI was one of the first Liffe member firms to recognise the significance of CFDs by launching GNI Touch, but the take-up by retail investors was limited as the product was still too complicated and expensive. It appealed more to wealthy individuals and small proprietary trading firms.

It took Stuart Wheeler’s firm Investors’ Gold, now called IG Group, to really push this instrument for the retail business.

While brokerages and banks did the same for the wholesale market, the exchanges concentrated on the underlying instruments including futures and options, missing the boat on these relatively immature derivatives.

Revolution by stealth

Over the last 10 years a velvet revolution seems to have taken place. CFDs have become hugely popular derivative instruments.

It has been estimated that between 25% and 40% of all equity trades on the London Stock Exchange are now executed by institutions as hedges for CFDs offered to their customers.

That is a huge amount of institutional flow, in spite of the product’s drawbacks of low transparency associated with OTC products, and no central counterparty (CCP) clearing.

The retail market has also grown incredibly. In the UK a CFD can be executed by individuals as a financial spread bet (FSB). Both are classed as CFDs by the Financial Services Authority, it’s just that an FSB is a CFD offered to UK residents that attracts no capital gains tax.

Both FSBs and CFDs enjoy an exemption from stamp duty, the 0.5% tax UK residents pay on buying shares.

To the detriment of the exchanges and institutional brokerages, the image of retail CFDs as a low class betting instrument seems to have kept these hugely skilled and well capitalised institutions at a distance.

As a result, the spread betting companies have been left to continue developing their retail businesses unhindered, with little or no competition from brokerages or exchanges.

The established financial institutions should have grasped this opportunity by the horns and left the likes of IG Group, CMC Markets and others for dust, but with a few half-hearted exceptions, they didn’t.

As a result, earlier this year IG Group became worth more than the London Stock Exchange.

Having started life as a financial bookmaker, IG has helped create one of the world’s most profitable derivatives markets. It is not a multilateral trading facility, and certainly not a regulated exchange or clearing house – though in many ways it now behaves like all three.

IG is regulated as an investment firm under Bipru, the Prudential Sourcebook for Banks, Building Societies and Investment Firms.

The traditional exchanges such as LSE keep talking about ‘going after the retail market’ and ‘launching derivatives’, but it already exists, and it looks like IG Group.

Winning model

At the time of writing this article the market capitalisation of IG Group was over £1.9bn. Admittedly, part of its rapid growth can be attributed to the development of market access through web browsers and the growing bandwidth and reliability of the internet.

However, IG Group has realised that getting a large enough flow of orders has meant it can effectively internalise almost all its trade flow, while acting as counterparty and clearer.

By acting as the counterparty and only allowing customers to lift IG’s offers or hit IG’s bids, then it does of course technically accept market risk against its customers.

However, each day IG Group has about 45,000 unique users and over 300,000 trades. This presumably creates an order flow that often offsets most of the risk in a short space of time.

On the rest of the un-netted risk, IG manages to make money as customers lose. Beyond this, it hedges itself in the conventional derivative or cash markets.

But it is the continual churn between bid and offer that really generates the company’s returns.

So an exchange-type offering would not be as profitable, although it would be relatively simple to sell this profitable order flow to a plethora of financial institutions or trading groups that would readily buy it, in the form of trading fees or revenue share.

Fighting over scraps

The exchanges have always been focused on high volume business. However, IG Group and its competitors are able to generate higher margins than the exchanges from much smaller volumes and turnover because the margins in the retail market are still relatively large, even before factoring in ‘risk revenue’ from unhedged trades.

While MTFs such as Chi-X and Bats Europe are fighting tooth and nail for share of a wholesale market, and struggling towards breaking even, IG Group operates with a pre-tax profit margin of more than 50%. In the full year to March 2010 its revenue was £298.6m. IG could acquire both MTFs if it wanted to.

Would it? A deal like that would deliver the required exchange technology, if that’s where IG believes the future of retail CFDs lies. It would also be a significant move into the institutional market to balance against IG’s retail presence. But it would add little to the company’s profitability, while also threatening its existing business model.

About half the revenues for companies like this comes from running a risk book, and from the churn of bid-offer spreads. An exchange model would remove both revenue streams, although the CFD provider could sell the risk revenue.

It is therefore unlikely to be IG Group or one of its competitors that busts the existing business model. Some other competitor is going to have to do it for them.

Ways to compete

It seems that the other main reason exchanges are not directly involved in the retail market is that they feel it is the job of their members to offer retail access.

But with the present trend towards disintermediation and members competing with the exchanges, the present structure could easily change.

If the exchanges really do wish to stay at arm’s length from retail customers, then they still can – while participating in the CFD market.

With over 150 firms including Barclays accessing the financial bookmakers and offering their own white-labelled execution platforms to retail clients – effectively allowing them to trade on a CFD provider’s platform through a Barclays branded interface – it’s time the exchanges got round to offering their members a similar arrangement.

The model Barclays uses with its partner City Index is most likely the traditional white label deal whereby customers can trade at City Index’s prices and the two entities share the revenue from spread, commission and client losses.

Exchanges could offer a similar electronic platform but allow their members to take the role of counterparties, thereby assuming all market risk. This could then be novated to a CCP which would assume member default risk and charge margin against the market risk.

But the exchanges would need to work out how to make money, since most trades on IG, CMC and City Index are commission-free and customers are used to this model. This would be the challenge but not insurmountable.

A further problem is that banks might be unwilling to switch from a traditional CFD provider to an exchange because it could mean giving up their customer order flow to other members on the exchange.

The banks would need to be offered a solution that works in terms of revenue. This could involve banks, or their investment banking arms, becoming the counterparties to some of their order flow so as to generate revenue by taking risk. Or flow could be outsourced to electronic trading firms like Getco for a fee or share of risk revenue.

This would require some innovative and complex changes to the traditional exchange order book model, but nothing that hasn’t been done before both from a technical and regulatory point of view.

False start

Of course, on-exchange CFDs have been tried before, for example by the Australian Securities Exchange, but the reality is that they were just listed without improving access for retail customers.

At the same time, the product was robbed of non-standardised financing. The exchanges have tended to charge a standard financing fee over Libor or the equivalent, no matter who the counterparty is.

This had the effect of stopping member firms from offering their customers tailored financing costs. Big funds had to pay their prime brokers the same finance charge as weak customers.

This is one of the main reasons why the LSE’s attempts to get CFDs going last year were shelved. The members’ very profitable CFD desks used to make large amounts of money from financing. If rates were standardised, they could no longer do this – but had to charge the same as every other desk. That meant they could not leverage client relationships or take account of other business the client did with the bank.

The banks therefore do not want a standardised CFD contract that standardises the financing rate.

Regulatory reform

Unfortunately for IG Group and its equivalents, a cloud is looming. CFDs’ weaknesses of poor transparency and counterparty risk are about to be ‘fixed’ by the regulators.

This fix is twofold. First, it seems inevitable that more transparency will be required. This means running an MTF, with all the fair pricing and reporting that goes with it.

Second, CFDs might be classed as OTC derivatives subject to mandatory central clearing. That would mean IG Group, for example, would no longer be the counterparty.

In principle, IG Group could solve these problems. It could set up an authorised and regulated MTF that is accessed by a separate Bipru entity. Any market risk could be held in this Bipru firm, or even a separate firm offshore, to limit regulatory capital requirements.

IG would of course also need to find margin for the CCP on trades where a direct customer-to-customer offset could not be found. And, along with its customers, IG would have to pay a clearing fee. But perhaps it is already too late for IG?

First mover

Probably in the next two or three weeks, Betfair, the online sports betting and gambling website, will launch the London Multi-Asset eXchange (LMax). The beta version is already live.

Betfair already processes 5m trades a day on its sports platform – more than all the European exchanges handle in equities, according to the Wall Street Journal.

In October Betfair floated 15.2% of its existing capital on the London Stock Exchange. The shares would come from some of the company’s founders and other shareholders and did not raise any new money for Betfair.

The IPO was priced at £13 a share, valuing the company at £1.39bn – a little shy of the £1.54bn valuation implied by Softbank’s 23% (now 10%) investment in 2006.

At the moment, most of Betfair’s profits (£17.8m pre-tax in the year to April 2010, from revenues of £341m) are generated from its sports betting business. Forward earnings are predicted to be around £50m.

Betfair’s was the first successful sports betting platform to use an exchange model, in which punters bet with each other, rather than with a bookmaker. Betfair merely reaps commission on successful bets.

The company gained critical mass in this kind of sports betting as a first mover, and it seems it wants to do the same again with the financial CFD market.

Two innovations

Betfair’s USP will be to offer an exchange model for CFDs which will be centrally cleared and focused on the retail market.

This is its first breakthrough. Initially the structure will be that LMax operates an MTF, with LCH.Clearnet as clearing house. The clearing members of the MTF will be LMax and other liquidity providers – not the retail and wholesale customers themselves. But it is a step in the right direction towards a fully centrally cleared market for retail and wholesale participants.

Betfair’s second breakthrough is that it has solved the issue of risk by selling its order flow to its liquidity providers, including Goldman Sachs (which owns 12.5% of LMax). In theory, this opens the market up to other institutions and hedge funds that would require a centrally cleared contract. They could all be trading on the same platform and matching against retail customers on multiple products and asset classes.

Unfortunately, as the exchanges will tell you, relying on market makers for liquidity and tight execution spreads will be an uphill struggle.

Furthermore, it is not likely to be cheap for retail customers, as they will have to pay the exchange commission, and the project is significantly delayed. LMax was incorporated in 2007.

At the moment Betfair seems to be planning to offer, initially commission-free, a wholesale platform to a retail customer base that in all truth would probably rather carry on just hitting and lifting bids and offers, as long as the spreads are tight enough.

However, few would doubt that this is clearly the right direction for the entire financial derivatives trading market. The breakthrough will be an exchange or MTF that offers one platform with multiple leveraged products, covering many asset classes, for all types of wholesale and retail customer types, while allowing for full price discrimination – meaning that brokers can charge different commissions to different customers based on relationships or volumes.

Besides this, LMax will offer real time margin calculations and pre-trade risk, with low latency web access. The list goes on, but the innovation and pure arrogance of the technical solution is quite overwhelming.

Exchanges’ chance

Notwithstanding Betfair’s bold step, once the exchanges are able to innovate and implement these kinds of technical solution, they are ultimately best placed to solve and handle all the issues discussed.

Indeed, this is a golden opportunity for the exchanges to finally offer a truly retail product direct to the retail market, and enter the global CFD space, profiting from a leveraged instrument that has so far passed them by.

For too many years the bookmakers have pushed beyond their remit and even beyond the remit of the old member firms – driving, as with LMax, right into the exchanges’ territory.

However, exchanges have the complex skills required to offer centrally cleared CFDs on a regulated, electronic, low latency market, with all the infrastructure and resilience this business requires. It would seem high time for them to fight back.

The good news

So where are the exchanges and MTFs? Chi-X has already announced a centrally cleared CFD product for FTSE 100 equities. At first this is likely to attract only institutions.

But Chi-X has a robust electronic marketplace with all the regulation it needs to enter the highly profitable retail market (barring a few additional permissions). It just needs to develop the operations and software associated with offering a retail business.

More important – and again, this is something where the larger exchanges have a real competitive advantage over the likes of Chi-X – is accessing global distribution networks. This is after all a global product.

Perhaps even exchanges putting together joint ventures with some of their members and using the brokers’ global or at least European retail distribution networks would be a move in the right direction.

It seems inevitable that the MTFs and exchanges should now make the final step needed to offer these products to the retail market.

Imagine – an exchange or MTF actually telling its shareholders that fees and margins have started increasing, and that its products have entered a global growth, high margin and profitable market.

Instead of MTFs aiming for a £50m valuation (or £300m if you believe their own rhetoric) based on market share and the prowess of their IT departments, they can start aiming for £1bn valuations based on good, old-fashioned profits and the strength and agility of their business models.

Unfortunately for the pure derivatives exchanges, the problem of a booming and fully accepted centrally cleared wholesale and retail CFD industry is a lot more serious. Admittedly, exchanges in the US – where CFDs on all products except FX are banned – will be spared for now. But with a product that looks set to have all the advantages of a futures contract, including transparency and CCP counterparty risk, but with the additional upside of an intuitive and tailored product, not to mention fungibility, who will be left to trade futures?

Perhaps we still have some way to go before the day that FOi changes its name to CFDi, but come it may...

Simon Brown is founder of Cambridge Quants, a consultancy in the UK. He has previously been a consultant for NYSE Euronext; co-founder of Altex-ATS, an OTC derivatives MTF; and head of proprietary automated software at Refco. He started his career in the City as a pit broker/trader at GNI after leaving British Telecom Research Laboratories. The author has never worked for any spread betting company, but does consulting work on CFDs and associated clearing for companies including exchanges and MTFs.