Adrian Farnham’s outlook on the current state of European exchange traded derivatives is bleak. The chief executive of London Stock Exchange owned Turquoise Derivatives, which last month took over the LSE’s EDX derivatives platform, sees it as a closed shop dominated by the duopoly of NYSE Liffe and Eurex.
The two exchanges are, he believes, closing off competition that could bring down costs for the end user through their market dominance, control or planned control of clearing and ownership of the intellectual property of indices on which index derivatives are based.
He is not alone in his concerns over competition in the sector. As FOW reported last month, the proposed merger of Deutche Börse and NYSE Euronext, and with that the possible merger of Liffe and Eurex, has reopened the debate on competition in the European derivatives space. The
EU is currently considering the antitrust issues associated with the deal and last month, UK Treasury Secretary Mark Hoban MP, said at a seminar that it was “odd” that exchanges can own the intellectual property to highly liquid instruments.
Advocates of the status quo claim, with some justice, that liquidity is king in derivatives trading, and that fragmenting liquidity pools will be of detriment to the end user. Derivatives exchanges, for that reason, tend towards a natural monopoly and this is of no detriment to end users, indeed, it creates a healthier marketplace, the argument goes.
New world order
However, Turquoise Derivatives has launched not only to develop EDX but to call for a new world order in exchange traded derivatives: a procompetition, fungible model where markets compete on price, efficiency and customer service, where contracts can be opened on one market and closed on another and clearing is structured on an interoperable model.
On the face of it, it is easy to be cynical. Of course a new exchange would call for fungibility and a pro-competition model is obviously a better one for a platform starting out with a tiny market share. However, Farnham says his message is more than just a bid to get off the ground.
“What we understand is that the timing right now is positive for this idea of introducing competition in exchange traded derivatives,” he says.
“We currently have a positive regulatory background for this change with its push towards more transparency and more central clearing. That environment works well with the Turquoise philosophy. We have been created to deliver liquid, transparent and displayed public markets. The regulatory market is encouraging towards that.
“We very much think that our customers want competition in the market. The structure in Europe today is two very large derivatives market in Liffe and Eurex, which may end up in one even larger market. The market structure is such that there is a lack of competition pressure in derivatives. Take the licences on index products, for example. It is three to four times more expensive in Europe to trade exclusive index products than non index products. For us that is an opportunity for competition.”
FTSE 100 futures
This month Turquoise Derivatives will attempt to create that competition with the commencement of trading in FTSE 100 Index futures contracts. Launching FTSE 100 Index Futures is a direct challenge to NYSE Liffe, whose London market has a liquid contract on the index.
In March, the month before Turquoise announced the plans to launch the contract, 4.89m FTSE 100 Futures were traded at Liffe, as well as 2.08m European-style options on the index. Liffe also had 25,500 FTSE 100 Dividend Index Futures traded and 18,800 FTSE 250 Index Futures.
These instruments collectively form about 15% of the volume in equity and index derivatives across Liffe’s European markets, which totalled 45.9m contracts in March. Eurex’s equity derivatives market is even bigger, with 130m contracts in March, of which 78m were futures and options on the Euro Stoxx 50 Index.
A life in opposition
For Turquoise, however, taking on the giants is its raison d’etre. The Multilateral Trading Facility was launched in 2008 in the wake of the Mifid regulations that opened up equity trading to competition.
“We were frustrated with the way the exchange landscape was evolving,” says Farnham. “There was still a model in which there was one big venue per country and little opportunity for new entrants to break through. Clearing was expensive, trading was expensive. There was a perception that the market could have better trading systems and we launched to realise that potential.
“From a trading perspective Turquoise along with the other MTFs (Chi-X and Bats) was able to deliver a truly European marketplace with new low latency technology and a compelling pricing tariff.”
At the time of the launch, banks were trying to solve the problem of how to introduce competition in
Europe. Turquoise, which was then owned by nine investment banks, worked with the DTCC to create a European subsidiary, EuroCCP.
Farnham says that at the time, US securities were being processed for $0.01 where in Europe it was twenty times that price.
“By bringing EuroCCP over to Europe, we were able to create a whole new pricing framework on a totally different scale to what had existed before,” he says.
Despite launching on the day that Lehman Brothers collapsed, the early signs were positive and Turquoise soon hit its target market share in the first year of 5% and the exchange rapidly became the largest mid point dark book “a position that we expect to grow further”.
However, it struggled to get above the 5% level in lit trading and lost significant ground to fellow MTF Chi-X. In March 2009, liquidity provision agreements with its founding banks ran out and Turquoise’s market share plummeted.
Still loss making, the MTF was sold to the LSE in 2009. For the LSE, the deal marked more than the acquisition of a rival. It was the beginning of its push into derivatives. Since it missed out on the acquisition of Liffe in 2002, a rare mistake by the former chief executive Clara Furse, LSE had been written off in terms of its potential in derivatives.
When Xavier Rolet assumed the helm in 2009 he soon made a move into derivatives a priority at the exchange. The LSE had been operating EDX, a small derivatives platform specialising in Scandinavian and, later, Russian equity products, since 2003.
The exchange had mustered a niche in its Scandinavian equity derivatives but this was dependent upon a deal with OMX. When Nasdaq acquired OMX in 2008, the deal was soon terminated and EDX was left floundering. Attempts to launch similar products to what it had been trading with OMX failed and, despite successes in the Russian equities market, there was no clear path for growth for the exchange.
“The reality was that EDX was a small derivatives business with the scope to grow and had the people, process and technology,” says Farnham.
“I had a conversation with Xavier
“In addition, the LSE has the ability to work closely with FTSE and and other index providers to help us develop a new index product and a clearing relationship with CC&G and LCH.Clearnet that will allow us to offer an innovative and open clearing model. We had the network of HFTs on Turquoise and the partnership with the banks. Putting the two together would enable us to take on Liffe and Eurex.”
“A big task”
Taking on the two most liquid derivative exchanges in Europe will not be an easy job especially by going head to head, fighting for liquidity on one product. Many have failed where Turquoise chooses to tread. For example, Eurex ultimately failed in its attempt to take on the Chicago Board of Trade in US Treasury bond futures in 2003, in one of many examples of such failures.
Indeed, ask anyone in the industry to name a time where a contract has successfully been won from one exchange and you will get the same answer: futures on German bunds which Eurex took from Liffe in 1997 in a matter of months due to the advent of electronic trading.
Farnham is under no illusions as to the scale of the challenge. “Introducing competition in exchange traded derivatives will be a big task. The LSE and Turquoise see this as something we will need to be committed to for a number of years. The opportunity is substantial and so the commitment needs to back that up. We are not expecting overnight success,” he says.
Unlike in electronic trading in 1997 when Eurex wrenched the bunds from Liffe, there is no silver bullet for Turquoise as it launches its assault on the market status quo. Regulation opened up competition in equity trading but derivatives is a different game. Turquoise has a range of weapons in its arsenal but they constitute more silver shrapnel than silver bullet.
No silver bullet
It will launch its FTSE 100 futures with a maker/taker market model, the first such instance of this in the European derivatives market. Under the model, the exchange will pay liquidity providers for their dealings on the market. A rebate of 5p a contract for passive flow and 20p a contract for aggressive flow.
This compares with a standard 25p charge on alternative platforms. Turquoise will also be the first to cap charges for OTC block trades in index futures. It says its per-contract clearing costs will be a third lower than competitors’ charges.
Another area in which it claims it has the upper edge is in technology. The exchange will be using its SOLA technology, which according to Farnham is “extremely low latency”.
The technology offers average response time of 690 microseconds (orders) and 870 microseconds (bulk quotes), the company says. In addition, SOLA technology is right next door to Turquoise trading technology and the LSE cash trading technology. Anyone who is connected to the LSE or Turquoise will get a free cross connect to Turquoise Derivatives.
Having the underlying right next to the derivatives will be the “best possible place” to make prices in UK and pan-European derivatives, says Farnham. Combined with maker/tariff the proposition is “compelling offering for liquidity providers”, he adds.
Clearing will be provided through CC&G clearing services, with LCH.Clearnet as CCP, a move that, at least for the time being, has ended speculation that Turquoise will with the LSE, build its own clearing house.
Remoulding the landscape
All this might offer an edge over Liffe but will it be enough to wrest control of the FTSE 100 futures contract?
Farnham believes that the game is changing and it is the pro-competition participants in the market that will win out.
“LSE is the most interoperable market in Europe. What we are doing is developing that model. Bats Chi-X Europe might be entering the market and others might be coming in as well. What we have agreed is that the Turquoise open interest will be available for margin offset against any other venue that chooses to work in the same open and competitive way that we do,” he says.
“If Bats Chi-X Europe creates a derivatives platform and chooses to use LCH.Clearnet, we will create an ecosystem where if customers have off-setting positions with Turquoise on one side and another pro-competition trading venue on the other, there will be margin offset within that ecosystem. We think that is a much better model for customers compared to the narrow, walled-in vertical silo model that exists today.
“We understand that derivatives are different
A gamble it is but there is a sense in the market that the tide is turning in favour of competition within the derivatives industry. Last month, Michael Spencer, chief executive of inter-dealer broker Icap, called for increased competition in the exchange traded derivatives sector. An article in the Financial News quoted Spencer as describing the regulatory failure to address alleged monopolistic behaviour among derivatives exchanges as “incredible”.
“Customers don’t want monopolies, but the existing models of derivatives exchanges are monopolistic. It’s incredible that this issue hasn’t attracted the attention of the antitrust authorities before,” Spencer said.
Spencer’s comments came as the EU begins its investigation into a possible merger between Deutsche Börse and NYSE Euronext. Last month, speaking at the Cass Business School, Joaquin Almunia, the EU Antitrust Commissioner advocated a message of the creation of competition within stability. Stability was important, he said, but there must be competition as well. The two are not mutually exclusive.
Farnham says: “The current regulatory push is about safety. However, we believe that once regulators understand the implications of this push, they will want to balance that with some pro-competition elements within the regulations.
“Safety and security must be the priority but we think that the politicians and the regulators will want to ensure that while they create a safer market they don’t create a market that is closed to competition.”
According to Farnham the long-term vision of Turquoise is to create a market similar to the US equity options market where there are a number of competing venues and an infrastructure that enables a choice of clearing venue and margin offset. “That is the healthiest model and the model we are trying to create in Europe. We believe that Europe will get there eventually,” he says.
Back to reality
For the time being however, Turquoise must compete in the current world. Early moves to change the game have proved unsuccessful. Turquoise asked for a licence to trade Stoxx futures, a request that was rebuffed. Also, in the run up to the launch of the FTSE 100 futures, Turquoise approached Liffe to explore ways of creating fungibility and/or margin offset between the two markets on correlated contracts.
Liffe, understandably perhaps, refused. However, that refusal has encouraged rather than deterred Farnham. “Our proposition would have given more customer benefit and the customer should be looking at why it is that these markets are not providing their customers with this kind of benefit. We asked for it. We didn’t get it so we are competing head-to-head,” he says acknowledging that “in the short term” he is playing a binary, zero sum game.
Despite the challenges, Farnham is bullish about the prospects for Turquoise Derivatives. “Two or three years ago, there were people who said that there would never be change in the equities market but now the new entrants have 30-40% market share. We are the leading dark pools trading venue. That has already happened, it is not going to go back.
“We think that the trading opportunities from the co-location of cash and derivatives within the LSE data centre plus the new maker/taker tariff that pays for the provision of liquidity will lead to attractive bids and offers on the screen. Our job is to convince customers to look at the prices on the screen and slowly build open interest until we get to the tipping point.”
Whether that tipping point can be reached and what it will be remains to be seen and many in the market were sceptical about the chances of success for the new entrant.
However, the success of MTFs in gaining market share in equities cannot be ignored. While derivatives is a different beast, moves by EU regulators to open up derivatives markets to competition may provide a significant boost for Turquoise.
In addition, the success of Turquoise Derivatives is not dependant on the success of the FTSE 100 futures contract. The group still trades the burgeoning Russian derivative contracts on the RIOB index, “an unpolished gem”, according to Farnham.
In addition, the platform has plans to launch options and futures on singles stocks in both the UK and Europe as well as creating a bluechip pan- European index. Farnham says it will also look at various other asset classes including fixed income, government bonds and ETFs.
When, as is widely expected, Bats Chi-X enters the derivatives market following their merger, a move anticipated for next year, the pro-competition school may gain some traction. For Turquoise that will be a long wait and a test of its resolve.
Launching with a direct challenge to Liffe, rather than with a unique product is a bold move and one that Farnham may live regret. However, the provision of a cheaper alternative to the incumbents will be welcomed by the market and if Farnham can pull it off, whether with the FTSE futures or with subsequent launches, he might perhaps succeed in his mission to change the European derivatives landscape for good.