New risks, new efficiencies, new customers

FOW’s second Awards for Innovation built strongly on the popularity of the 2009 Awards, with lots more entries, especially from technology companies.

During the year covered by these Awards, from April 2009 to March 2010, exchanges, clearing houses and brokers brought to market an impressive array of new products, treasury management innovations and systems to foster trading and risk management.

But it is on the technology side that new products are flooding to market. Responding to this, FOW has split its Award for Best Innovation by IT and Software Companies into four categories: Trading and execution, Connectivity services, Risk management and Options.

Each category received many entries, so that in this sector, as well as the Awards for Banks, Brokers and FCMs, we have also given Silver Awards.

Each company submitted an application in the spring, which were judged by an independent and anonymous panel of senior market participants. As such, the Awards reflect the impartial view of market experts on what innovations really have the potential to create new risk management opportunities, or to change the way derivatives are traded.

FOW offers its congratulations to all the winners, and its thanks to all the companies that entered for the Awards, and to our expert judges. I also thank Tom Osborn for managing the whole Awards process adroitly and writing the reports. Jon Hay

Once again, FOW and its judging panel of global market participants sought to reward genuine innovation, rather than a tweak here or an upgrade there. New products, new indices and even entirely new markets – primary and secondary – all got a look-in.

As usual, there were plenty of colourful nominations for our regulatory award (once again, sadly, no regulator put themselves forward – though FOW’s judges were more than happy to fill the gap) but no overall winner. Read some of the politer suggestions on FOintelligence.com.

Volume and connectivity issues – on both buy and sell sides – have dominated the year’s news, be it the banks and high frequency trading firms passing the parcel of blame following May’s flash crash, or the exchanges scrambling to roll out new trading engines during the final quarter to cope with massively increased throughput. Several records closed out the year volume-wise, centred on that volatility-loving asset class, equity options (as well as the CBOE’s benchmark Vix Futures, of course – more of which below).

It sounds trite to say that, once again, crisis drove innovation, but that’s precisely what happened. Whether it was Eurex and SIX restoring faith in the collateral secured instruments market, GFI and CB Richard Ellis restoring liquidity to sluggish property funds or Financial Technologies reaching out to Indian farmers cut adrift by the crisis, the market drew on all of its phenomenal resources – many of them human – and came out fundamentally stronger than ever. 2011 should be interesting. Tom Osborn

Measuring herd behaviour

Having established volatility as an exchange-tradable asset class almost single-handedly, is the Chicago Board Options Exchange determined to make correlation the next investment boom?

In partnership with Standard & Poor’s, the exchange has designed the first index tracking the average correlation of the US’s 500 most liquid stocks.

The newly public bourse has been celebrating record volumes on its futures platform as the year closes, with strong trading of its Volatility Index Futures and a post-election glut of pent-up demand hitting the US markets.

In a competitive field, the CBOE and S&P’s product rode out the clear winner. “It’s an innovative idea that stands out among the other nominees,” as one judge, a consultant, put it.

Though the new instrument is not yet tradable as an index future or option, it has been hailed as a useful investment tool.

Starting in July 2009, CBOE began disseminating daily values for the index, backdated with historical values back to 2007. Using S&P 500 Index options prices, together with the prices of options on the 50 largest stocks in the index, the Implied Correlation Index offers investors insight into the cost of S&P 500 options, compared to that of options on the underlying individual stocks.

The index can provide trading signals for volatility dispersion or correlation trading strategies. A long volatility dispersion trade involves selling at-the-money index option straddles and purchasing at-the-money straddles in options on index components.

When implied correlation is high, index option premiums are rich relative to single stock options. Traders can then sell the rich index options and buy the relatively cheap equity options.

In times of stress, stock prices tend to move together – investors tend to get hammered, however diversified their portfolios. The correlation index might just be a way to profit when the market is losing its head.

Restoring confidence in shattered markets

To say investor appetite for structured products has declined in the past couple of years is an almost humorous understatement.

In the wake of Lehman Brothers’ collapse, fears grew that many issuers of credit derivatives would be unable to meet their obligations. Amid a snowballing sense of paranoia, with bank stocks plummeting and brokers ordering staff to cease trading with other brokers, finding out where counterparty risk lay became a waking nightmare.

Sensing a need, Eurex and its strategic partner, Switzerland’s SIX Group (which has a minority stake in Eurex), created a class of exchange-traded collateral secured instruments or COSIs.

The product structure is designed to enable structured products to be traded with secure collateralisation through a clearing house, and straight-through processing.

The instruments are listed on Scoach, SIX Group’s platform for structured products, with Eurex Repo offering end-to-end processing.

To minimise issuer risk, the COSI issuer and the collateral provider agree a framework, with SIX Swiss Exchange becoming the collateral taker. Based on this arrangement, the value of a certificate traded on Scoach is secured by regular collateral.

Traders can monitor all collateral positions in real time with no manual intervention. Collateral is independently revalued every banking day. If the COSI no longer has sufficient collateral securing it, a margin call is made, requiring the collateral provider to make up the shortfall on the same day.

The COSIs were designed with a crystal clear liquidation procedure in the event of an issuer default. Only highly liquid securities, such as European government bonds, are eligible as collateral. Daily monitoring performed by the custodian ensures that individual securities do not give rise to a cluster risk – paramount for investor security in the present environment.

Exchanges are waking up to the fact that, in the battle for clearing supremacy, sophisticated treasury management is a vital advantage.

Russia’s top branch bears fruit

No doubt keen to capitalise on the popularity of index investing in Russia, RTS’s futures and options division Forts launched futures on its RTS Standard Index of the 15 most liquid stocks listed on the RTS Standard market.

The cash-settled, rouble-denominated contracts complement the bourse’s existing RTS Index Futures, which track in dollars the top 50 blue chips on the exchange. The new contracts are popular with investors looking for long equity exposure, as well as stock pickers wanting to hedge the market risk on long and short positions.

The futures are a good proxy for those wishing to gain exposure to Russia’s buoyant banking and resources sectors, whose stocks make up most of the top 15, without direct investment. As many international investors will attest, the unpredictable nature of the market means individual firms can fall prey to events with alarming speed.

The new contracts have already gained traction, averaging around 300,000 trades a month since their launch in February. And as the typical 20m-plus monthly volumes for bigger brother RTS Index Futures show, the contracts have strong growth potential.

Sophisticated simultaneity

Forts’ parent exchange RTS also scooped the customer service award for Eastern Europe this year, thanks to an innovative strategy that unifies the settlement of deliverable equity futures contracts on Forts, and of equity transactions on the RTS Standard market.

The aim is to reduce the cost of carrying out arbitrage trades and decrease operational risk during execution, by executing two trades simultaneously, and allowing clearing members to net their obligations on the two markets.

At the end of the last trading day for a futures contract, which is also the settlement date, contracts are settled through a transaction on the RTS Standard market during the evening clearing session on a T+N basis.

A position opened as a result of a futures contract settlement can be closed on the RTS Standard market, creating a single order book for the derivatives and cash markets.

The technique should reduce brokers’ and clients’ expenses during deliery and the collateral required for futures contracts before delivery. RTS says clients had been asking for this innovation ever since the RTS Standard market was launched.

Sophisticated pricing for the grassroots farmer

An initiative which draws together participants by economic need rather than solely by investor demand is a rare and heartening spectacle in 21st century derivatives markets. But that’s what Financial Technologies managed to do last year, setting up its network of National Spot Exchanges for local farmers in its native India.

The system enables farmers in remote regions to sell their products on an electronic market and collect their money on the same day, giving them the same price assurance mechanisms as large corporate growers enjoy.

As one prominent Asian market participant among FOW’s judges put it: “In an environment where international capital markets, banks, and even exchanges are struggling to define themselves in terms of social value, it’s gratifying to be able to reward and publicise an example of our industry delivering just that.”

“I really like the idea behind that model, as it offers the benefits of ‘our’ financial world to the small farmer in a remote area in India,” agreed one prop trader.

Founded in a distant region of Bihar, the exchange allows small farmers to sell their produce electronically, direct to processors and exporters in different parts of the country. As a result, even smallholders producing five to 10 bags of corn are able to sell products on the exchange without the aid of an intermediary. Expansion has been rapid, with 11 states now providing delivery-based spot trading in 24 commodities. The bourse already boasts more than 300 members and 1,900 trading terminals.

“This was an easy choice,” affirms one judge. “It’s about growing the industry intrinsically, and catering for remote small and marginal farmers, and moving with the economic times. Too many exchanges are listing products that are not harnessing real demand-based tangible economic development and growth. This initiative seems to be moving in tandem with the economic needs of India.”

“The clear winner here for me was NSEL,” agreed one prime brokerage banker. “It is a truly innovative idea, bringing the benefits of transparent pricing, credit risk remediation and hedging that we associate with wholesale listed derivatives markets to small-scale producers. It reminds me a lot of microfinance (which may have been the inspiration for this marketplace), and I hope that similarly it will provide some very tangible benefits to subsistence growers in some of the more remote parts of India.”

Go long, go very long

As returns in long term interest rate futures started to dry up after the crisis, investors either looked for longer payoffs or simply stepped out of the market.

Trading in CME Group’s benchmark 10 Year Treasury Futures declined by a quarter last year – though they hung on to their crown as the world’s most traded bond futures. In Five Year Notes, the decline was still more stark, with 2009 volumes crashing 41%.

The Merc did not go into defensive mode. It hung tight, listened to investor demand, and launched its Ultra T-Bonds: futures designed to mimic the duration of a 30 year US Treasury bond. Launched in January 2010, the contract became the CME’s fastest growing interest rate product in its first six months on the market. During the heady days of May, the contracts were trading more than 40,000 times a day.

Judges were impressed by the speed with which the exchange’s product development team managed to get the T-Bonds to market: “CME has been able to create an attractive product for various investors with different backgrounds and needs in a very short period of time,” said one senior market player. “The development of this product shows us what can be achieved in a good working relationship between business partners in a relative short period of time.”

Others praised the exchange for launching at a time to best catch the return of liquidity to the LTIR market: “The remarkably quick uptake suggests this was an excellent response to customer demand,” one UK consultant concluded.

Curing a compliance headache

Not content with running away with this year’s clearing awards, Eurex and CME Group are the biggest winners in exchange innovation in the field of customer service, too.

A system which will already be familiar to many users of Europe’s largest derivatives exchange, Eurex’s electronic eXchange admission service aims to make it easier for trading members to monitor their registered personnel, via a web-based portal. Launched at the beginning of December 2009, eXas has been a highly popular innovation with market players on both sides of the Channel; 100 of the bourse’s 400-strong membership are based in the UK. Members access the tool via a password-protected member section on www.eurexchange.com.

The service aims to streamline firms’ disparate user applications, allowing them to initiate and process all relevant steps for admissions, registrations and de-registrations of exchange traders and qualified back office staff via a web-based, location-independent solution. The service was designed to ensure that strict warranties and legal requirements are maintained at all times.

Eurex says traders have already felt the benefit in reduced application times and a more transparent service. Outstanding application tasks are intuitively flagged, while entered information can be saved and carried over to a new session. Authorised users can now view and edit the entire suite of user profiles for each member.

Application errors are drastically reduced compared with the old system, reducing traders’ time to market. Before, applications could take several days of email chains and lost phone calls. Now, the registration – or de-registration – of a user only takes about 10 minutes. Multiple user profiles can be modified and terminated online in a single action.

Expect other exchanges to follow suit.

CME goes back to its milky roots

When the New Zealand Exchange declared its intent to launch the first truly global skimmed milk powder futures contract in the last quarter of 2009, market response was strong.

Unfortunately for NZX, which has pinned its hopes for building a derivatives market on this product, the world’s three largest multi-asset exchanges – CME, Eurex and Liffe – have also piled into the same space.

It is still too early to tell how liquidity will evolve for the various contracts, but the European-based instruments may be at a disadvantage. The peculiarities of the European dairy market, governed by the Common Agricultural Policy, separate it to some degree from the rest of the world. Eurex’s dairy derivatives are also cash-settled.

The US market suffers from no such strictures, and CME’s Globex platform knows few bounds. Provocatively, CME (founded in 1898 as the Chicago Butter and Egg Board) chose to focus its new International Skimmed Milk Powder Futures on the Asia Pacific region too – and pre-empted NZX’s long-planned launch by four months. Physical delivery points include Auckland, Los Angeles, Melbourne, Newark, Rotterdam and Seattle.

Though the Merc’s existing dairy suite is tradable globally, the exchange was keen to harness international demand for the powder, of which New Zealand is by far the largest exporter.

Six global physical delivery points is impressive for any commodity product. CME spent two years working out how best to serve likely demand hubs for its existing products before ultimately realising that there was enough demand for a global contract. Chief among its reasons for focussing on Asia was the region’s growing demand for protein-based foods, with milk powder invaluable as an easy-to-transport source.

None of the new global milk contracts has taken off spectacularly, but one thing’s for sure: when it comes to demand driven by changes in global demographics, the major exchanges have their fingers on the pulse.