Buy-side to benefit from new era of derivatives competition

Competition in the European derivatives market is intensifying as exchanges are increasingly offering on like-for-like contracts and expanding their market offerings, with potential benefits for the buy-side.

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Competition in the European derivatives market is intensifying as exchanges are increasingly offering on like-for-like contracts and expanding their market offerings, with potential benefits for the buy-side.

Recent developments have seen exchanges such as Turquoise, part of LSE Group, launch a broader range of derivatives products, with a number of single stock dividend futures added to Borsa Italiana on 20 May and 19 single stock options arriving in London on 10 June. Meanwhile the launch of NLX today brings a new player to the European interest rate futures market that is currently dominated by Eurex and Liffe.

Furthermore, effective from 1 June, Eurex is re-launching its Three-month Euribor futures with new trading and market making incentives. With so many announcements in recent weeks, competition among derivatives exchanges is stepping up a gear.

Market participants believe there is a need for greater competition in the market, as certain exchanges have been dominant in trading particular derivatives contracts for many years. Increased competitiveness could drive down prices, though also risks fragmenting liquidity.

Charlotte Crosswell, CEO of NLX, a new London derivatives exchange owned by NASDAQ OMX, said: "A lot of people have tended to lump derivatives together in one big bucket, then look at the market and assume there is competition among venues. However, the reality is that very few of the derivatives exchanges are going up against each other by offering the same types of contracts."

London Stock Exchange Group's head of equities and derivatives, Nicolas Bertrand, claims the market is sorely in need of more choice. "The current derivatives duopoly in Europe is not particularly good for investors. Competition will lead to a better environment for participants. The more diverse product offering and the lower frictional costs of trading will contribute to higher overall liquidity", he said.

Equity exchanges have certainly seen increased competition since the introduction of MiFID in 2007, with new players entering the market and taking flow from the more traditional exchange operators like LSE and Deutsche Börse. However, the derivatives market has not seen competitiveness increase to the same extent due to limitations in the way contracts are traded.

 "If you compare the derivatives market to equities, derivatives exchanges can't compete in quite the same way because a lot of the contracts that are traded are tied to a particular central counterparty (CCP)," explains Andrew Chart, senior director of origination and structuring at Newedge's prime clearing services.

Eurex and Liffe have dominated the derivatives market in Europe and have been reluctant to open up clearing on their exchanges, which is currently handled by their own CCPs, because of the potential to lose out on valuable fees.

The buy-side stands to benefit from greater competition among exchanges and on clearing through lower fees.

Tony Whalley, head of dealing at Scottish Widows Investment Partnership, said: "Clearly, the main benefit of increased competition is that clearing costs will come down. Of course, the buy-side needs to take a proactive approach with the brokers, as often the benefits of lower prices can tend to get kept by the broker."

It is not only structural issues that are likely to impact the extent of competition among derivatives exchanges. Offering multiple trading venues for the same type contract also runs the risk of excessively fragmenting liquidity.

Crosswell said: "Market participants are obviously concerned about liquidity being fragmented and for that reason I don't think we will see more than a few different exchanges competing on each contract. With NLX, we want to leverage a first mover advantage to get into the interest rate derivatives market."

She believes there is an opportunity for more competition in the market, but it is limited within each contract type, as market participants are unlikely to support five or more different platforms, especially if some operate very similar business plans.

However, liquidity fragmentation may not pose a major problem for buy-side traders. According to Whalley: "Provided total liquidity is still there, the arbitragers in the market will create additional liquidity so it shouldn't have an impact if it is spread across different venues."

Despite the limitations, there seems to be an opportunity for European derivatives trading to become more competitive and dislodge many of the dominant players thanks to incoming regulation.

Chart suggests that interoperability is the key to opening up competition in the derivatives market.

"If MiFID II can tackle the problems around interoperability and open up competition in the clearing market then it would be a real game changer for derivatives", he adds.

Crosswell agrees: "Clearing is what is really driving these changes in the market and regulatory changes that will enable more choice will lead to more new market entrants."

The European markets infrastructure regulation (EMIR) will also have a significant impact on competition among exchanges and clearing houses, by forcing all OTC derivatives through a clearing house and ensure they reported to a trade repository.  NLX chose Value-at-Risk margining, used by its nominated clearing house LCH.Clearnet, specifically to align itself with the OTC instruments that are set to migrate to central clearing and exchange trading when EMIR is implemented.

Opening up the clearing market is by no means certain, however; exchanges have voiced concerns that access provisions between CCPs could undermine key tenets of market structure and increase overall risk.