25 October 2011

Hedgeweek: Exchange-traded derivatives provide silver lining in dark clouds

The developed markets, especially the US, have a clear lead in terms of innovation, with exchanges such as the CME Group, Eurex, NYSE Euronext, Nasdaq OMX and CBOE Group being among the top ones. The introduction and success of products such as exchange-traded fund options and volatility index derivatives are a testament to this. These exchanges have benefited from high profitability and are now exploring the opportunities available in the emerging market as well. The partnership between the CME Group and BM&FBovespa, as well as the cross-listing of index futures between a number of exchanges, are signs of this development.

The OTC derivatives market dwarfs its exchange-traded counterpart. In 2010, the exchange-traded market was a little more than 8 per cent of the OTC market in terms of notional outstanding. This puts into perspective the monumental task regulators and market participants have in terms of the introduction of central clearing for OTC derivatives. Clearing has been successful in the exchange-based environment, but the volumes are more than tenfold in the OTC market, and the effort required to make the OTC market safer is unprecedented. Comparing exchange-based derivatives with the cash equity market, we can see that the performance of the two differed widely in 2009 and 2010. The cash equity market has seen falling volumes and turnover, with few of the leading global exchanges experiencing growth. By stark contrast, the leading derivatives exchanges all experienced growth in 2010. The volatile conditions were part of the reason that liquidity moved into derivatives.

An important recent development for the exchange-traded market is the introduction of legislation that is going to make central clearing compulsory in markets such as the US and Europe. This is going to increase the complexity of trading such products and will drive some volumes towards exchanges, where the complexity and cost of trading standardised derivatives is expected to be lower.

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