Options: Laying siege to Fortress Europe

Options: Laying siege to Fortress Europe

In 2002, almost as many equity and index options were traded in Europe as in the US. Europe had 12 markets, the US five. Now, the US market is three times as big as Europe’s. Many believe the difference is that while the US industry has moved with the times and become more competitive, Europe’s has changed little. As David Wigan reports, both the incumbents and new entrants want to innovate – but have to struggle with an entrenched structure of isolated exchanges.

Comparing the European equity options market to its US counterpart is a little like standing the ugly duckling next to its sibling the swan. While the latter has matured in recent years into a majestic beauty, the former remains shabbily inconspicuous and shy of anything that smells like deep water.

With US exchanges battling for market share, and initiatives such as penny pricing attracting armies of first time investors, option trading volume took a tiny dip in 2009, but apart from that has grown every year since 1992, swelling nearly fivefold since 2002. European volumes, meanwhile, managed to double between 2002 and 2008, and have since declined.  

Illustrative of the contrast are recent trading statistics from NYSE Euronext, which says trading in its European equity derivatives business declined 26.6% in February, compared with the same month in 2010, to 30.4m contracts. In the same month, turnover of US options on its Arca and Amex exchanges was 33.3% higher than a year ago, at 86.2m contracts. (To be fair, most of the fall in Liffe’s European volume was in equity futures, not options, but options were still down.)

For a true cross-Atlantic comparison, it should also be pointed out that equity and index futures, as opposed to options, are more actively traded in Europe, with a record 1.16bn contracts in 2010, against 752m in the US, down from a 2008 peak of 864m. But this only goes a little way towards making up Europe’s deficit of more than 2.5bn contracts in options.

“US options markets have seen tremendous growth in recent years, with investors attracted by technology advances and a hyper-competitive exchange environment,” says Andy Nybo, principal and head of derivatives at Tabb Group in New York. “European trading, meanwhile, has stagnated, with investors often preferring alternative investments to manage exposures, while higher costs and a disparate liquidity framework contribute to the general malaise.”

Stuck in the past?

While the slow progress in European options may be partly explained by markets behaving too predictably over the recent period, and a fall in volatility before the recent upheavals in the Middle East, analysts say a key difference from the US is structural advances that have not been replicated in Europe.

Penny pricing, introduced in the US in 2007 to allow options to be traded in one cent increments, helped boost volumes and narrow bid-offer spreads. Some 75% of US options are now informally estimated to be traded that way.

Such has been the success of the US exchange-traded market that it is attracting business away from the bilaterally traded arena. Notional global outstanding of OTC equity options was $4.5tr in June 2010, according to the Bank for International Settlements, compared with $7.5tr two years before.

And still more exchanges are expected to open, said executives speaking at the Futures Industry Association conference in Florida in March. Up to five more options venues could be operational in the next three years, bringing the total to 14, CBOE chairman and CEO William Brodsky was reported by Bloomberg as saying. In 2000 there were five.

Apples and pears

Some argue that a direct comparison between US and European volumes is unfair, because of the granulation of trading in Europe. London options trading, for example, is largely dominated by institutions, with retail investors preferring alternative products such as spread bets and contracts for difference. Amsterdam, on the other hand, is driven by retail flow.

“Comparing the US and Europe is like comparing apples with pears,” says Ade Cordell (pictured), co-head of equity derivatives and OTC services at NYSE Liffe in London. “There are different products and territories and audiences, and a wide array of offerings vying for attention.”  

More than a dozen national stock and derivatives exchanges in Europe host equity and index options trading, with little overlap between their products – and, unlike the US, no shared clearing house. Each market is thus separate from the others, although those of Belgium, the Netherlands and France do share a common clearing house, LCH.Clearnet SA, and a common owner. NYSE Euronext also owns London-based Liffe, but this market is cleared by NYSE Liffe Clear, using the default fund of LCH.Clearnet Ltd in London.

Despite this fragmented structure, large scale trading is highly concentrated: Eurex, with 679m contracts in 2010, had 64% of the market, and the combined NYSE Euronext exchanges, trading between them around €2tr of derivatives daily, another 22%.

Some 285m of Eurex’s trades in 2010 – more than all the volume traded at non-Eurex and Liffe exchanges – were options on the Euro Stoxx 50 Index, the second most active index option in the world after that on Korea’s Kospi 200. Besides that, it offers options on the Dax 30 Index, and on German, Dutch, Scandinavian, French, Italian, Russian, Spanish, Swiss, and US equities.

Big and bigger

Now the two European titans are coming together, having agreed in February a $25bn merger which will generate 37% of its combined income from derivatives trading and clearing. Rumblings about a counterbid by some combination of Nasdaq OMX, CME Group and Intercontinental Exchange had by late March come to nothing.

News of the merger came less than a week after London Stock Exchange Group agreed to merge with TMX Group of Canada in a C$3.2bn ($3.25bn) stock deal, while also in February Bats Global Markets, the fourth largest operator of US equity markets, struck a deal to buy Chi-X Europe, the region’s largest alternative trading system.

The flurry of consolidation reflects the challenging top line outlook for exchanges. Revenues for the European sector have shrunk by 15% since 2008, according to a recent report by Morgan Stanley and Oliver Wyman. Driving the decline has been shrinking fee income from cash equities. Pan-European cash equity revenues were €650m-€700m in 2010, from a total value traded of €9.1tr. That indicates an average revenue take for the exchanges of about 0.75 basis points.

Revenues are under pressure from multilateral trading facilities, introduced in 2007 by the Markets in Financial Instruments Directive (Mifid). MTFs fragmented the cash market, allowing any stock to be traded on many venues instead of just one, as was previously the norm. Average revenue takes per trade at MTFs are around 0.1 basis points, exerting an enormous downward force on exchange revenues. As a result, exchanges’ volume share has also fallen, from 70% in 2006 to 52% in 2010.

Sheltered so far

Derivatives exchanges have so far not been subject to this kind of competition, and moreover, have weathered the financial crisis fairly well, generating 3%-5% annual growth rates by number of traded contracts, according to Morgan Stanley and Oliver Wyman.

Since the financial crisis, regulators have pushed market participants to move derivatives trading on to exchanges and other venues. Market experts estimate that 20%-30% of single name equity options are traded on exchanges, the Financial Times reported in February, with the rest OTC. About 70% of equity index options are thought to trade on exchanges, the paper says. However, estimates vary widely – some bankers reckon a higher share of trading is listed.

In this derivatives environment, where exchanges retain much more market power than they do in cash equities, there is already concern among traders over the implications for fees.

“In Europe you don’t have anything like the competing fee structures you see in the US,” says Gerald Perez, managing director of Interactive Brokers in London. “The main reason for that is the lack of fungibility across contracts.”

Whereas in the US, all the options exchanges offer options on the same blue chip stocks, in Europe it is still mainly one option, one exchange. Equity index derivatives remain largely competition-free on both sides of the Atlantic, because of the power of the index providers to grant exclusive licences to exchanges.

Thus, S&P 500 Index Options are only traded at the Chicago Board Options Exchange and CME Group, just as Euro Stoxx 50 contracts have only been available at Eurex and CAC 40 Options at NYSE Liffe Paris.

On the single stock side, competition is beginning to creep in. For example, European investors can trade some Dutch options such as TNT or Arcelor Mittal in Amsterdam, and the same names through Eurex in Frankfurt.

“Now the two operators are merging, so the question is whether we are going to see the same competition in the future that we saw previously,” Perez says. “There may be a question of whether we are going backwards or forwards on this issue, and whether exchange fees are going to increase or decrease.”

Guarding the indices

Several big structural obstacles lie in the way of creating a more flexible, competitive European options market.

One is the index licensing issue. Stoxx, for example, is wholly owned by Deutsche Börse and SIX Swiss Exchange. Why would it offer licences to directly competing exchanges, unless obliged to do so by regulators or the courts? (The Singapore Exchange began in December to offer Euro Stoxx 50 Futures and Options, but these are in a different time zone and currency, and Eurex believes the instruments will boost liquidity in its own contracts.)

In July 2010, a Chicago court ruled that International Securities Exchange – ironically, owned by Deutsche Börse – did not have a right to offer S&P 500 or Dow Jones Industrial Average options, in competition with CBOE and CME’s long-held duopoly. Exclusivity was upheld.

With some of the most popular and liquid risks locked away by incumbents, it is harder for new trading venues to break in. “Right now we have concentration because contracts are single venue securities, with exclusive intellectual property licensing and without open access to clearing,” says Mark Hemsley (pictured), chief executive of Bats Europe. “To introduce competition in intellectual property we need to be licensed, and at a fair rate. We also need fungibility and open access to clearing, also at a competitive rate.”  

Fragmented clearing

Hemsley highlights the second major roadblock to opening up the market – the structure of clearing in Europe.

The US model is to have a single clearing house, the Options Clearing Corp, for nearly all listed equity and index options business. All nine pure options exchanges are cleared by the OCC, so that open interest is entirely fungible between them. A position opened at one exchange can be closed at another. Any new exchange need only secure access to the OCC to be able to join the game.

In Europe, every exchange has its own clearing house, with no netting of exposure between exchanges. Even though NYSE Liffe and EDX London both use LCH.Clearnet for clearing, there is no commingling between the exposures, and anyway both exchanges are building their own clearing houses to keep more of the clearing revenues in house.

This means a new exchange would have to persuade customers to set up a whole new clearing relationship, with no efficiencies of scale with their larger business at existing exchanges.

Another feature of the US system is mandatory price transparency between all exchanges, under the National Market System.

Hemsley believes Europe should introduce a consolidated tape, so that prices from all MTFs and exchanges fed into a single data stream – though he adds that the idea has yet to attract significant support from exchanges.

Competitors emerge

Despite the difficulties facing new entrants, a small band of players is preparing to challenge the Liffe-Eurex options hegemony. Bats and Chi-X want to move into derivatives trading at some point, London Stock Exchange is in the process of migrating its EDX business to its new Turquoise Derivatives platform, where it will offer a wider product range, and Amsterdam-based Tom (The Order Machine) plans to move into single stock options in the coming months.

“We are certainly interested in the opportunities that derivatives give us,” Hemsley says. “However, we do not have any specific timeline right now because our priority this year is the consolidation with Chi-X.”

Turquoise Derivatives, partly owned by 12 investment banks, will upgrade its technology at the beginning of May and then start introducing new products. It aims first to launch index options, initially based on the FTSE indices, which LSE partly owns, and then single name options and other products. Other exchanges have refused to sell Turquoise licences for index-based products.

“Through combining with EDX it means we have an established community already in place and our trading platform, which is already used elsewhere in Europe, is faster than Eurex and Liffe,” says Natan Tiefenbrun, commercial director at Turquoise in London. “In addition, we will have the unique advantage of offering trading against UK equities side by side.

“The only trading venue Stoxx has given a licence to is Eurex in Europe and the only clearing venue Stoxx has given a licence to is Eurex Clearing in Europe,” Tiefenbrun says. “We are strong advocates of customer choice and this exclusivity does not promote competition or choice.”

Nevertheless, Turquoise will pursue the full suite of European index options products, Tiefenbrun (pictured) says.  

Like Bats, Turquoise wants the European clearing market to be reformed. For advocates of competition in clearing, the ultimate end is a system where parties trading on any venue can choose where their contract is cleared, and for that position to be interchangeable with contracts at other clearing houses.

Many doubt that this full scale ‘interoperability’ is possible, even in theory – certainly, any implementation is likely to be at least a decade away. A more realistic medium term target for the new trading venues is to win access to the big clearing houses.

“I would love to offer my members the choice to clear different products via their choice of CCP,” says Tiefenbrun. “So even if the product was not fully fungible with others cleared by the CCP, if it was correlated there would be tremendous margin savings for the industry.”

Piggyback products

One way in which MTFs might break the exchanges’ dominance would be to offer lookalike products, mimicking the exchange-owned index options.

Hush-hush talks at several operators in recent weeks have focused on the potential for creating products with names like the EU 50, which would be traded on the MTF at exactly the same price as the Euro Stoxx 50, and would then be routed by the MTF to the exchange for execution. For customers to get netting efficiencies and limit counterparty risk the products would need to be centrally cleared.

The process, known as internalisation, mirrors the operation of the UK-based CFD market. Advocates claim it is “very much welcomed” by regulators as a step toward breaking down monopolies in derivatives.

Recent tariff reductions by Eurex suggest the incumbents are aware of the need to keep users happy, but that is no guarantee that the new players will have an easy ride. Quite the opposite.

Morgan Stanley and Oliver Wyman say the LSE’s Turquoise proposition “could face challenges” in breaking the stranglehold of existing product suites and exchanges.

“Although some users would most likely welcome more competition in execution, it could well come at the price of diseconomies from fragmented clearing collateral and reduced collateral netting benefits,” the analysts say. “Better opportunities for LSE could exist in index products based on Asian or emerging markets, leveraging the FTSE joint venture or partnering with other index providers.”

Tom’s tale

Meanwhile, another newcomer is applying the final touches to its derivatives offering as it awaits licence approval. Dutch MTF Tom expects to launch a range of equity options in about the last quarter of this year.

Chief executive Willem Meijer says Tom hopes to leverage its connections with Dutch retail investors through shareholder BinckBank, the largest online retail investment bank in the Netherlands, to make inroads in single name products.

“We will start with single stock options and with the help of our stakeholders we expect to build a very significant market share very quickly,” says Meijer. “Once we have that, we expect the incumbent exchanges to be a lot more willing to discuss issues like open interest, as it will be a blockage for them not to.”

Tom will compete aggressively on price, Meijer says, and will in future address the issue of obtaining intellectual property rights for index options.

In late February its broking arm won a two year legal battle to obtain broker membership of NYSE Liffe Amsterdam. Liffe had wanted to know how Tom’s MTF would work before allowing this – a condition Tom had refused.

“It’s unclear why Liffe wanted to stop us becoming a member,” Meijer says. “But I think they did it because they are afraid of competition in derivatives.”

After the case a Liffe spokesperson in Amsterdam said: “We want to protect the integrity of our markets and we fully intend to use all routes open to us to do so.”

Liffe’s reservations are understandable – how many exchanges would welcome rival trading venues plugging into their systems, with no questions asked?

But little by little, the structure of the European options market is beginning to change, with more room for competition. Time will tell if that makes the products more popular.

But if the US example is relevant, it shows a continent-sized market can support multiple exchanges offering similar sets of products. And it suggests that when these markets are fully interconnected, as the US ones have been since 2000, they can grow very rapidly.