The State of Listed Derivatives [UPDATE]

Contributor: David Morgan

DECEMBER 2012 UPDATE:

2012 has seen the multi-year boom in listed derivatives trading suffer an abrupt reversal, with a 10%+ decline in year-on-year volumes. The boom had seemed to be indestructible, buoyed up as it was by the surge in world commodity markets and growth in currency futures volumes. Several other factors also contributed: wider buy-side market awareness, particularly in emerging markets, more flexible investment mandates at many firms, and the need to hedge against persistent cash market volatility.

ORIGINAL POST:

2011 saw the highest volumes ever recorded across the world’s listed derivatives markets. Despite some quieter early months in 2012, the longstanding volume growth trend still appears to be in place, led by the surge in commodity trading and by booming currency futures volumes. Several factors continue to drive this trend: wider buy-side market awareness, particularly in emerging markets, more flexible investment mandates at many firms, and the need to hedge against persistent cash market volatility.

But look more closely, and things don’t seem quite so rosy. Deal sizes are shrinking, driven in part by growth in the use of algorithmic trading strategies, and client demands continue to grow for DMA and algo access to an increasing number of global exchanges. Coping with these amid rapid changes in market conditions, such as the commodities boom, and in increasingly competitive conditions, is clearly no rest cure. And trading and clearing costs for the brokerage community remain relatively high: the pricing pressures due to inter-market competition in equities have not yet translated to the world of derivatives, with its proprietary contracts and vertical trading/clearing silos.

Adding to these direct business pressures, in the wake of the global financial crisis the derivatives sell-side is also receiving unprecedented levels of regulatory attention. The largest issues are of course those associated with global regulators’ drive to push OTC business onto electronic platforms and central clearing. As the OTC and exchange traded markets become more alike, we can expect significant impact on the way that brokerage firms structure themselves to address their clients and interface to trading venues. But while we wait for these changes to take effect, the primary regulation-driven focus in most exchange-traded brokerage businesses is on risk management.

This former Cinderella area of business operations is now central. Derivatives position risk forms part of firm-wide considerations, but two core issues are specific trading room concerns:

1. Pre-trade risk management traps some major risks – including many erroneous and/or limit-breaking orders – at the most appropriate time: before they hit the markets. Responding in some cases to direct regulatory demands, many firms are extending and tightening their electronic pre-trade controls, with latency considerations ultimately determining how much it is practical to do before sending an order to market. Guidelines published by FIX Protocol Limited, recently updated and extended to cover futures and options, are a useful contribution to developing best practices. In Europe, the 2012 ESMA Guidelines for automated trading engines are also relevant: fortunately for firms striving to stay in compliance, the ESMA risk management requirements are broadly consistent with the FPL recommendations.
2. The biggest issue in commodities is of course position limits. While legal tussles continue over the Dodd-Frank/CFTC rules, implementation may be required by year-end 2012, and we await ESMA’s crafting of the MiFID 2 principles into new European regulations. Full compliance with the CFTC rules in their current form implies assessing real-time global positions in a range of commodities: this will be very demanding for U.S. firms trading internationally and across multiple listed and OTC markets. There must be concerns about potential regulatory arbitrage as long as these rules are not applied worldwide.

Keeping up with all of this change is not easy. But it’s not only about compliance: it is enabling risk managers to win budget and resources for projects that they have long thought important or even necessary. The end result, one hopes, will be fewer concerns about business survival if we face another market meltdown.

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