Can Warsaw seize the opportunity in derivatives?

Can Warsaw seize the opportunity in derivatives?

When the Warsaw Stock Exchange was brought back to life in 1991 after a break of 52 years, it began humbly. Turnover on the first day was equivalent to $2,000. Just five stocks were listed and there was one price fixing a week.

But the exchange was based on solid and relatively modern underpinnings. Trading has been fully electronic from the start, which 20 years ago was not yet the generally accepted norm in developed markets.

Warsaw’s first derivatives contract – futures on the blue chip Wig 20 Index – was launched in 1998. That was the year when fully electronic Eurex (then still called Deutsche Terminbörse) was battling it out with the open outcry Liffe for dominance in Bund futures.

WSE’s management itself admits that its focus over the past decade has been on building up the cash market. The exchange now has 400 companies listed on its main market and 185 on its alternative market. Now that it is generally accepted that the stockmarket’s fundamentals are in place, the spotlight is due to move to derivatives.

There is much to be done in this area and it is where the most exciting new opportunities are to be expected.

It is a good moment, therefore, to consider what the market will look like five years from now. What opportunities will there be and who will stand the best chance of benefiting from them?

Ambition constrained

Warsaw Stock Exchange’s often stated aim is to become a premier exchange and a financial hub for the central and eastern European region. This ambition is backed up by the fact that with 38m citizens, Poland is the largest country in the region and that the Polish economy is still on an unbroken upward trend, despite recession elsewhere in Europe.

The exchange’s growth in derivatives up to now has been held back by several factors: a protracted process to privatise it, an antiquated trading system and a prohibition on short-selling equities.

It is heartening that most of these issues have either just been resolved or are set to be eliminated by 2012. The exchange’s IPO was completed last year, and it began trading as a listed company on November 9.

One of the peculiarities of the Polish market is the very high share of trading by retail investors. In the main cash market, private investors accounted for 27% of trading in 2009.

Polish financial institutions contributed 37%, and foreign institutions 36%, two thirds of which came from the UK.

The retail market share is even higher in derivatives – 51% of volume in 2009, against 39% by Polish institutions and 10% by foreign firms.

This has often been cited as the exchange’s strength, but it may also be a barrier to its further expansion. Retail investors lack the capital and expertise to take the exchange to the next level, if it plans to compete not only with Prague and Vienna, but also with Moscow and Istanbul.

Wanted: prop traders

What the WSE lacks among its members are proprietary trading companies, even though regulations provide for this type of membership.

Their absence makes it more difficult for the exchange to launch new products and means that the markets in its existing products are sometimes less efficient than they should be.

Trading on the world’s major exchanges is becoming more and more competitive, due to the ever-increasing penetration of ultra-fast black boxes. It is also becoming very expensive to all participants, because of the arms race to shave off more milliseconds from latency.

Proprietary trading firms from developed markets are therefore always on the lookout for opportunities elsewhere, where markets are even slightly less efficient, competition less fierce and where they can take advantage of their accumulated expertise. If the right conditions were created, many of these firms would definitely be interested in expanding their activities to Poland.

Breaking out of isolation

It is often observed by international experts that the Polish financial market is rather isolated from the rest of Europe.

Polish pension funds and other fund management companies invest almost all their assets within Poland. In part, it can be explained by the fact that the Polish economy is large enough to provide opportunities for all market participants, so they are not forced to look for business elsewhere.

The privatisation programme pursued by every government since the 1990s, in which the public eagerly participate, also keeps banks and brokers busy.

WSE’s achievements so far have been impressive, but it must not allow itself to become complacent now. To become a truly regional exchange, WSE needs to come up with new products which will be high quality, reasonably liquid and attractive to investors looking for exposure not only to Polish equities, but also to the wider region.

An exchange can rightly call itself an international or regional hub only if its activity transcends national borders, in terms of listings, membership and other activities.

Systems breakthrough

In summer 2010 WSE finally announced that it would buy the new Universal Trading Platform engine from NYSE Euronext, and would enter into a strategic partnership with this exchange.

Although no official date has been given, the new system is expected to be rolled out in early 2012.

This will bring about a few important changes. At present, all domestic members of the WSE use the white label GL Trade front end, provided virtually free of charge by the exchange. Once the new system is implemented, all the WSE’s members will have to purchase front end licences from independent software vendors, a major opportunity for the tech companies.

Access to WSE will be available through Euronext’s Secure Financial Transaction Infrastructure (SFTI) network. This means all Euronext members worldwide will be able to get access to WSE over their existing data lines, though they will still need to complete the membership application procedure.

This will expose Polish institutions to competition from well-capitalised firms with the latest technology and advanced trading knowhow.

Two way traffic

It may also work the other way. Polish firms, too, will be able to take advantage of the SFTI network. Access to Western exchanges will become much cheaper for them, once they have borne the initial hardware and software costs.

This will involve connecting to the WSE’s new exchange engine through a third party application supplied by one of the software vendors. Once that is done, the additional cost to connect to another exchange will be much smaller than it would be nowadays.

At the moment Polish financial specialists listen to stories about the race to reduce latency by an extra millisecond or two, colocating servers to be nearer exchanges and computers cooled with liquid nitrogen as if they were science fiction stories. WSE’s data lines are still limited to 512 kilobits per second.

Naturally, that too will gradually change with the adoption of the UTP engine. Whoever is first to take advantage of higher speeds by deploying the latest technology can expect rich pickings in the Polish markets.

The migration to a new exchange system could be a game-changer. A parallel can be drawn with what happened to the markets in 2002 when Trading Technologies first launched Autospreader, its software that allows for automated quoting and trading of multiple-legged inter-product and cross-exchange spreads.

At first the exchanges got clogged up with data, but eventually bandwidth got expanded and the capacity increased. Both market participants and the exchanges had to adapt.

The lasting consequence of this software is that markets became much more interconnected and the margins on inter-contract spreads became much thinner.

Winners and losers

Most revolutions produce winners and losers, and there is no doubt that market participants in Poland will also have to adapt to new realities or see their profit margins squeezed.

In five years’ time, Polish financial markets will be much more tightly integrated with those of western Europe, and even more so if Poland adopts the euro currency.

New technology at the Warsaw Stock Exchange will shake things up and expose the market widely to other firms in western Europe which have been operating in an advanced environment populated by black boxes and superfast quote machines for years. Polish domestic players will be forced to raise their game.

At the same time, Polish brokers and banks will find it easier and cheaper to conduct business abroad for the benefit of their clients, or for their own accounts.

More technology-savvy members and new liquidity providers, whether domestic or foreign, will allow WSE to further develop its offering in the derivatives markets.

Trading volumes of existing products, such as Polish equity options and single stock futures, should grow. Later, new derivatives may be launched, like equity options based on securities from other CEE countries and futures and options on other asset classes such as natural resources and agricultural commodities.

If the WSE can handle the transition to its new trading system adroitly, and take advantage of it to draw in new customers, the needs of investors seeking exposure to the CEE region will be much better served.

Marek Trepka is a senior consultant at Aequitas Associates, a consultancy that helps exchanges build liquidity. His areas of expertise include exchanges, trading, technology and funds, with a particular focus on central European markets.