Derivatives Exchanges 2007 - Wealth Adviser · currency trading Derivatives Exchanges 2007 Feb 2007. ... other types of derivative as a source of alpha. According to traders active

Hedge fund demandfuels globalderivatives boom

Merger deals pushexchanges tocentre-stage

Cutting theGordian knot ofcurrency trading

DerivativesExchanges 2007

Feb 2007

In this issue…03 Funds fuel the global derivatives boomBy Simon Gray

06 Innovation at exchangesBy Stefan Engels, Eurex

09 Cutting the currency Gordian knotBy NYBOT

10 Merger deals move derivativesexchanges to centre-stage By Simon Gray

DERIVATIVES EXCHANGES Hedgeweek Special Report Feb 2007 www.hedgeweek.com | 2

CONTENTS

Special Report Editor: Simon Gray, [email protected]

Sales Manager: Simon Broch, [email protected]

Publisher/Editor-in-Chief: Sunil Gopalan, [email protected]

Marketing Director: Oliver Bradley, [email protected]

Graphic Design (Special Reports): Siobhan Brownlow at RSB Design

Photographs: Siobhan Brownlow; German National Tourist Board

Published by: Hedgemedia Limited, 72 New Bond Street, London W1S 1RR

Tel: +44 (0)20 7692 7398 Web-Site: www.hedgeweek.com

©Copyright 2007 Hedgemedia Limited. All rights reserved. No part of this

publication may be reproduced, stored in a retrieval system, or transmitted, in any

form or by any means, electronic, mechanical, photocopying, recording or

otherwise, without the prior permission of the publisher.

Publisher

Many hedge funds have benefited richly fromthe recent surge in corporate activitysurrounding the exchanges sector. Forexample, hedge funds are thought to havebeen among the big winners as shares inthe New York Mercantile Exchange surgedfrom USD59 to as high as USD152 at onepoint during the stock’s first day of tradingon the New York Stock Exchange.

They have also sought to cash in on themerger of the Chicago Mercantile Exchangeand the Chicago Board of Trade, thecompetition between the NYSE andDeutsche Börse for Euronext, and thesuccession of bids from other exchangesand private equity firms that have more than

doubled the share price of the London StockExchange in less that two years, culminatingin the recent hostile bid from Nasdaq.

But arguably any profits earned by fundsfrom these transaction are fair reward fortheir contribution to making derivativesexchanges one of the hottest niches in theglobal financial industry. Many exchangesand traders say hedge funds can account foranything up to half of all total tradingvolumes and are driving growth in the valueof outstanding derivatives in the order of 50per cent over the two years to mid-2006.

For example, the CME and CBOT, whichare aiming to complete their merger in thefirst half of 2007, attribute much of their

O V E R V I E W


Funds fuel the globalderivatives boom

By Simon Gray

combined 25 per cent growth in tradingvolume over the past year to activity byhedge funds. The CME has establishedtrading incentives for hedge funds in a bid tocapitalise on the continuing strength ofcapital flows into alternative funds frominstitutional investors.

Not only do hedge funds’ trading benefitthe derivatives exchanges through the feesthey pay, they make the marketplace moreattractive to all participants by increasing thepool of liquidity. Last July the MercantileExchange formalised this effort by creating adedicated team with a brief to attract morehedge funds to become customers, and theorganisation says it has already had somesuccess in convincing more funds tobecome members of the exchange. TheCBOT is also active in marketing directly tohedge funds.

The growth of institutional investment hasintensified competition and contributed todriving down returns in the traditional hedgefund investment fields of equity and fixedincome instruments, boosting theattractiveness of the commodity markets andother types of derivative as a source ofalpha.

According to traders active in the markets,the influence of hedge funds can be seen inpatterns such as a tenfold spike in thetrading of gold futures and options at CBOTover the year to October, catapulting theexchange into the position of leading USmarket for listed gold futures. They are alsoviewed as responsible for a surge inEurodollar trading on the CME.

The expanded horizons of hedge fundshave had a positive impact on the businessof the New York Board of Trade, but theirinfluence on the organisation’s activityextends back beyond the past decade,according to Joe O’Neill, NYBOT’s seniorvice-president for product development. Henotes that both the establishment of theexchange’s financial instruments business,Finex, and its expansion to Europe throughthe establishment in 1994 of a Dublin tradingfloor, were prompted in part by hedge funds.

“We’re getting more and more involvementfrom hedge funds,” he says. “The wholeFinex initiative was launched by a couple ofhedge funds back in 1984, and the Dublineffort was to make sure we got round-the-

clock exposure, which was also to meet theneeds of some hedge funds that wanted tobe able to access the market more than justin US hours.”

O’Neill argues that while important to thegrowth of NYBOT, which has just completedthe merger it agreed last year with theIntercontinental Exchange, hedge funds donot necessarily represent the largest share ofits trading. “I wouldn’t say they are drivingour markets,” he says. “Hedge funds areimportant, but trade is still a very importantpart, especially of our agricultural markets. Itaccounts for around 50 per cent of ourmarkets, while hedge funds are probably agood proportion of the other 50 per cent.”

Eric Bolling, an independent energy traderfor the past 19 years on the New YorkMercantile Exchange, believes that hedgefunds are particularly attracted to energymarkets because of their role as a driver ofinflation. “There’s been a huge influx ofhedge fund money into all the commoditymarkets, but especially the energy markets.Over the years hedge fund managers havecome to realise that the best way to protecttheir equity portfolios from higher inflation isto be long on energy, and the best way todo that is through energy futures.”

He says that 2002 saw a “perfect storm”for energy prices as the US prepared toinvade one major oil producer, Iraq, tensionsgrew with another, Iran over nucleardevelopment and the war against terrorism,

O V E R V I E W


➧ p7

Reap from the most vital sources –Equity Options at Eurex

Enhance your trading with Eurex Equity Options: Now including options on Spanish and Swedish shares, you can choose from

nearly 200 different equity options at Eurex. With its continuous Market-Making scheme, Eurex offers high transparency

and liquidity covering the majority of European benchmark products. Benefit from tight spreads and attractive wholesale

pricing with fee caps for large blocks, and enhance your trading with Dutch, French, Finnish, German, Italian, Spanish,

Swiss, Swedish or EUR-denominated U.S. equity options: Wishing you an abundant business! www.eurexchange.com

The information published in this publication is for general information purposes only. It is not intended to constitute invest-ment advice nor is it intended for solicitation purposes. Eurex is not responsible for any errors or omissions contained in thispublication. Before trading, persons should consider the risks involved and the legal requirements of the relevant jurisdiction.The product mentioned in this publication is currently not available for offer or sale to, or trading by, United States persons.

The current surge in corporate activitysurrounding the world’s leading derivativesexchanges can be viewed as an eloquentreflection of their increasingly prominent rolein the global investment industry, not least ashedge funds employ a range of derivatives inever more complex strategies. Over the twoyears to mid-2006, the notional value ofinterest rate, equity-based and creditderivatives rose by almost 50 percent toUSD283.2trn, according to the InternationalSwaps and Derivatives Association (ISDA).

Greater ease of product access, cost-effectiveness, price transparency andespecially liquidity are incentives formanagers to employ exchange-tradedderivatives. These factors are growing inimportance as increasing competitionbetween funds and lower volatility intraditional asset markets puts pressure onmanagers to develop new techniques fordelivering returns to their investors.

Once a little-remarked feature of the globalfinancial system, derivatives exchanges arenow enjoying the spotlight. Over the pastdecade the sector’s traditional leaders inChicago have found themselves underincreasing challenge from the market modelsand trading technology offered by Europeanrivals, led by Eurex, which is operated jointlyby Germany’s Deutsche Börse and SWXSwiss Exchange, and LIFFE, the London-based subsidiary of the Euronext exchangesgroup. And the current round of IPO andmerger announcements in the United Statescan be considered as a reflection of thegrowing competitiveness of the market.

During the 1990s, Eurex has become theworld’s leading futures and options exchangeby leading the way on fully electronicoperation, and now has about 400 members in19 countries worldwide. It offers a broad rangeof international benchmark products andoperates the most liquid fixed income markets.During 2006 more than 1.5 billion contractswere traded, confirming the efficiency of theEurex market model and its superior liquidity.

A key benefit that distinguishes Eurex isits integrated structure, which lowers costsand increases transparency for itsparticipants. The integrated clearing houseprovides central counterparty services forinstruments traded on Eurex, as well as theEurex Bonds and Eurex Repo tradingnetworks, the Frankfurt Stock Exchange andthe Irish Stock Exchange.

To understand the needs of themarketplace, Eurex has developed closerelationships and open communicationchannels with its users, both through directdialogue and its membership oforganisations such as AIMA. It has alsohelped to promote research of value to thealternative investment industry.

Eurex’s ability to provide participants withhuge pools of liquidity through an efficientstructure and at competitive cost has made ita key player in the global success story ofthe derivatives industry, and it’s alwayslooking to the next challenge to meetcustomer demand.

At the beginning of 2007, following thetrend of hedge funds increasinglydemanding direct exchange access, Eurexintroduced volume discounts for exchange-based transactions and launched atechnology roadmap to meet the challengeof growth driven by algorithmic trading.Hardware and software improvements inareas such as processing performance andstorage will reduce system response timessubstantially and boost the throughput ofthe system to more than one billion quotesa day.

Eurex’s innovation can also be seen in thelaunch on March 27 of the world’s firstexchange-traded credit derivatives contract, afuture based on the iTraxx Europe five-yearindex series. With the global creditderivatives market expanding from USD1trnin 1996 to USD20trn a decade later, theability to list these instruments will improveoperational efficiency, risk management andmarket access in this fast-growing area. ■

E U R E X


Innovation at exchangesBy Stefan Engels

Stefan Engels is a member ofthe institutional investor salesteam at Eurex

and for the first time oil prices surged pastits long-time high-water mark of $40 a barrel.That convinced hedge fund managers thatthe long era of cheap energy was over andthe time was opportune for investment.

“They began to realise they’d better getinvolved in the energy markets, and as themarkets started to rally, more and moremoney went into it,” Bolling says. “Thesethings took shape in 2002, and the pool ofmoney flowing into the energy markets hasconsistently got bigger and bigger over thepast four years.”

For hedge funds active in the energymarket, the advantage of exchanges is theirliquidity. Says Bolling: “Hedge funds aregetting involved using the electronicplatforms, but exchanges are still the way ofentry. There are exchange-traded fundsbased on the price of crude oil, but there’sno ETF that will protect them in a naturalgas spiking environment, at least not onethat’s liquid enough to trade, so they have tocome here.”

The involvement of hedge funds in theenergy markets is visible, he says, throughan exaggeration of existing trading trends.“We’ve seen that whatever move ishappening for fundamental reasons becauseof demand or supply disruption, the swings

are becoming bigger and the volatility isbecoming greater, because there’s moremoney chasing similar products. In addition,hedge funds’ market behaviour is differentfrom that of traditional players. They’re veryprice-driven, whereas traditional players suchas energy producer and refiners tend to bevery fundamentally driven.”

Bolling believes that upsets such as theAmaranth Advisors collapse, which stemmedfrom risky bets in the natural gas market,may prompt investors to demand a switchfrom off-exchange trading. “Bringing some ofthat trading to the exchange would make itmore accountable and transparent. HadAmaranth been trading on an exchange likeNYMEX [the blow-up] probably wouldn’t havehappened, because they would have had topost so much margin, and red flags wouldhave been raised left and right.

“If I were a regulator or an investor Iwould definitely push for hedge funds to putthis stuff on the exchange, where prices arereported and positions are reportable.Managers may not want the scrutiny andtransparency, but I would have a tough timearguing that to the Amaranth investors. Ifhedge funds came under CFTC oversightthrough trading on an exchange, that wouldbenefit everybody.” ■

O V E R V I E W


p4 ➧

TWO INDEXES THAT COVER THE WORLD

With NYBOT®’s currency index futures and options, you’ve got the world ofcurrencies covered. You can buy and sell the global direction of the U.S. dollaror the Euro in one trade. Both currency indexes — NYBOT’s benchmark U.S.Dollar Index® and our new Finex® Euro Currency Index — are trade-weighted.Each tracks and reflects the global value of the cash market on a real-time basis. Isn’t it time you started using the power of indexing to invest in currencies? For more information about €CX and USDX® futures and options, visit nybot.com orcall Anthony Scamardella in the U.S. at 1- 800 - HEDGE - IT or 212 -748 -4097.In Europe, contact Pauline Leahy at 353 -1- 607- 4000.

finex® euro currency index futures & options

A Powerful New Way to Trade the Euro

u.s. dollar index futures & options

Celebrating 20 Years of Trading

© 2007 New York Board of Trade. Finex, NYBOT and U.S. Dollar Index are registeredtrademarks of the New York Board of Trade. Futures and options trading involves riskand is not suitable for everyone. Trading on the NYBOT is governed by specific rules asset forth by the Exchange. Those rules are subject to change. Contact a licensed brokerfor additional information including commissions, fees and margin requirements.

®

The New York Board of Trade is a regulated subsidiary of the IntercontinentalExchange (NYSE: ICE).

True professionals can make a difficult tasklook easy, but this is not the case forcurrency traders. Over the past two years,the performance of six widely-followedindices for currency-only money managers –the Barclay Currency Traders Index, theBTOP FX Index, the Center for InternationalSecurities and Derivatives Markets asset-weighted index, the CISDM equal-weightedindex, the Parker FX Index and the AFXindex – has been either negative orinsignificantly positive, with the exception ofthe CISDM equal-weighted index over 24months (up 7.82 per cent).

However, professional traders can makelife unnecessarily difficult for themselves bygetting lost in all of the interlocking factors,including macroeconomic fundamentals,geopolitics and each country’s yield curve,that affect the $2trn-a-day global currencymarket.

Of an estimated 8,000 hedge funds and1,800 currency commodity trading advisors,only 124 – about 1.3 per cent – can bedescribed as currency-only funds, whoapproach the markets across more than 30commonly traded currency pairs and withtargeted trade durations from minutes tomonths. Some are discretionary traders,while others hew to rigidly constructedquantitative systems. The majority are trend-followers, but many short-term quantitativetraders adopt countertrending or mean-reverting strategies.

Many longer-term traders rely on interestrate ‘carry’ strategies to earn more in thecurrency lent than in the currency borrowed,and the most sophisticated construct bothplain-vanilla and exotic option strategies toachieve narrow return targets. But one realityremains: the low proportion of currency-onlytraders is either a tribute to the virtues ofinter-market diversification or evidence of just

how difficult it is to reside only in thecurrency markets.

Alexander the Great was a terrificsimplifier who, according to legend, solvedthe intractable puzzle of the Gordian knot bycutting it with his sword. Currency traderscan duplicate this solution by replacing awide array of currency pairs with the simpledollar index (DXY). Nearly all traders,whether they choose to admit it or not, reallybet on whether the US dollar will rise or fall,and search out vehicles with which toexpress this opinion.

The DXY is a basket of six majorcurrencies: the euro, yen, sterling, Canadadollar, Swedish krona and Swiss franc. Eachcurrency is liquid and has a reliablestructured interest rate market; collectivelythey create an index that represents thedirectional flow of the USD globally with tight,efficient low cost bid-ask spreads. Futuresand options on the DXY trade at the NewYork Board of Trade, the primary marketplacefor price discovery. DXY spreads are 2-3 pipswide, far narrower than could be achievedby trading each currency individually.

Just as traders can over- or underweightstocks in an index, they can over- orunderweight currencies in the DXY, and moreactive investors can even arbitrage themember currencies against the DXY. Inaddition, currency managers with multiplecross-rate exposures can use the DXYfutures and options as a hedge.

Sceptics may say the DXY is little morethan the euro, whose weighting is 57.6 percent, in disguise, but in fact there have beenlong periods of divergent performancebetween the euro and the DXY since theformer’s introduction in January 1999. Asingular focus on the euro will result in aUSD-focused trader missing large moves in,say, the Canadian dollar or Japanese yen. ■

N Y B O T


Cutting the currencyGordian knot

The flip side of the surge in the global hedgefund industry since the turn of themillennium is the dramatic expansion of theworld’s derivatives markets. By the middle of2006, according to the International Swapsand Derivatives Association, the value ofoutstanding value of interest rate, equity andcredit derivatives had grown to more thanUSD280trn, half as much again as two yearsearlier, and there is no sign of the paceslackening.

The parallel expansion of hedge fundsand derivatives is no coincidence. Thegrowth of hedge fund investment over thepast decade has been accompanied by amassive diversification of strategies awayfrom the traditional approaches of long/shortequity and global macro in which derivativeshave played a crucial role. Once obscureinstruments such as credit default swapshave become everyday features of thealternative investment management industry.

Derivatives exchanges have moved tocentre-stage along with the instrumentstraded there. Institutions such as the Chicagocommodities exchanges, not so long agoviewed by the outside world as somewhatarcane appendages to the US agriculturalindustry, are now acknowledged not only asimportant trade centres for trade dealers butas the playground for hedge funds seekingout inefficiencies and opportunities in an evermore bewildering range of markets.

And valuable assets in their own right,too. The past couple of years have seenderivatives exchanges become coveted andincreasingly highly valued assets amid thegrowing free-for-all that has followeddemutualisation of many of Europe’s leadingstock exchanges – and in which hedgefunds themselves have played no small part.An early indication was the acquisition of theLondon International Financial FuturesExchange (Liffe) by Euronext (itself created

Merger deals movederivatives exchanges

to centre-stage By Simon Gray

O V E R V I E W


from a merger of the Paris, Brussels andAmsterdam stock exchanges), snapped upunder the nose of the London StockExchange.

The second half of 2006 has seen anacceleration in the appreciation of derivativeexchanges’ value following a series oftransactions, bids and financial operations onboth sides of the Atlantic, starting with theannouncement in September that theIntercontinental Exchange (ICE), an Atlanta-based marketplace for energy products,would acquire the New York Board of Tradefor around USD1bn in shares and cash.

The transaction, which was completed atthe end of January, brings together NYBOT’sactivity in commodities including cocoa,coffee, cotton, ethanol, orange juice, woodpulp and sugar, as well as currency andindex futures and options, with the ICE’sglobal marketplace for futures and OTCenergy contracts based on crude oil andrefined products, natural gas, power andemissions.

The deal marks another step in thegradual disappearance of mutually-ownedinstitutions, of which NYBOT was one, but akey attraction for its members is access tothe ICE’s commodity trading technology,which will sit alongside the New Yorkinstitution’s traditional open-outcry trading.Says NYBOT senior vice-president forproduct development Joe O’Neill: “We arepart of the process that is leading toincreasing consolidation in the sector.”

Arguing that this approach is necessaryfor institutions seeking to serve themaximum range of customers with thewidest range of products, he adds: “Itcertainly improves your product mix, and inour case it also provides us with anelectronic trading platform. We have thehistory in the products we trade and thetrade support, so we’ll continue to serve ourcustomers, whether they be trade customers,hedge funds or speculators.”

As with many of the exchange link-upsnow being proposed or examined, there isan important international dimension to theICE-NYBOT merger. ICE conducts its futuresmarkets through a regulated London-basedsubsidiary, ICE Futures, and it also hasoffices in Calgary and Singapore (as well asChicago and Houston), while NYBOT has

had a trading floor in Dublin’s InternationalFinancial Services Centre, FINEX Europe,since 1994.

O’Neill expects this process ofinternational diversification to take advantageof opportunities in other geographicalregions and time zones to continue followingconsummation of the merger with ICE. Hesays: “We’ll probably see more interestingventures in Asia, to add a third time zone.We have memorandums of understandingwith the Singapore Commodity Exchange(SICOM), with the Zhengzhou CommodityExchange in China, and with the Tokyo GrainExchange. We are working to develop ourrelationships in that part of the world.”

The ICE-NYBOT deal was followed lastOctober by the announcement of a mergerbetween the Chicago Mercantile Exchangeand the Chicago Board of Trade, creating a

O V E R V I E W


combined organisation with a marketcapitalisation of some USD25bn, and with anaverage trading volume of nearly nine millioncontracts per day, representing a notionalvalue of approximately USD4.2trn.

What the participants promise will be theworld’s most extensive and diverse globalderivatives exchange aims to provide itscustomers with global access to a widearray of benchmark exchange-tradedderivatives based on the US interest rateyield curve, equity indexes, foreign exchange,agricultural and industrial commodities,energy and alternative investmentinstruments such as weather and real estate.

The deal has been widely interpreted as ariposte by the Chicago exchanges to thechallenge posed by the leading Europeanderivatives exchanges, Euronext Liffe andFrankfurt-based Eurex, which was created bya merger of the German and Swissderivatives exchanges and is jointly ownedby Deutsche Börse and SWX SwissExchange.

The adoption by the European exchangesof electronic trading gave them a competitiveadvantage as the Americans initially clung toopen outcry, and Eurex even took on theChicago exchanges on their home turf byopening for business in the Windy City in2004, although making major inroads intothe US market has proved a toughproposition.

Meanwhile, the share price of the NewYork Mercantile Exchange, the world’sleading marketplace for oil and energycontracts, surged by around 125 per cent onthe first day of trading following its initialpublic offering in November. From an issueprice of USD59, the seven per cent ofNYMEX shares floated on the New YorkStock Exchange soared as high as USD152before closing at USD132, giving the 134-year-old exchange a market capitalisation ofUSD11.6bn.

While market participants believe there isstill room for further consolidation amongderivatives exchanges – for example, addingthe Chicago Board Options Exchange to theCBOT-CME merger – in some areas the pointappears close to being reached where themarket efficiency benefits start to beoutweighed by the disadvantages ofdiminishing competition.

For example, one of the (several) factorsthat eventually forced Deutsche Börse towithdraw its bid to merge with Euronext,leaving the field free for the pan-Europeanexchange group to link up with the New YorkStock Exchange, was the prospect of theEuropean Commission ordering a fullcompetition enquiry into the implications ofEurex and Euronext Liffe falling undercommon ownership.

Liffe chief executive Hugh Freeburg hadcalled on London market players to rejectthe proposed Deutsche Börse-Euronext dealnot only because of the potential threat toLondon’s derivatives market were Liffe to becontrolled by Eurex in Frankfurt, but onaccount of the market domination that wouldbe exerted by a combination of the twoexchanges, which would control 92 per centof the European derivatives market. WithEuronext now apparently set to complete itsmerger with the NYSE, the continent’sderivatives duopoly seems safe for theforeseeable future. ■

O V E R V I E W


Documents

Derivatives Exchanges 2007 - Wealth Adviser · currency trading Derivatives Exchanges 2007 Feb 2007. ... other types of derivative as a source of alpha. According to traders active