VALDIPOSITION PAPER SERIESListed derivatives trading:challenges, opportunitiesand technologiesDavid Morganmarketing director, trading and client connectivity,SunGard’s capital markets business
Contents2 Introduction Market challenges 3 Client demands Regulation, regulation... How leading firms are responding4 Capacity planning and managed services Risk management5 DMA, algos and HFT Strategy trading Exploiting market fragmentation Where from here?
4 Listed derivatives trading: challenges, opportunities and technologies2Introduction2012 saw the multi-year boom in listed derivatives tradingsuffer an abrupt reversal, with a near-20% decline in year-on-year volumes. The boom had seemed to be indestructible,buoyed up as it was by the surge in world commodity marketsand growth in currency futures volumes. Several other factorsalso contributed: wider buy-side market awareness, particularlyin emerging markets, more flexible investment mandates atmany firms, and the need to hedge against persistent cashmarket volatility. Prime brokerage operations have beenparticularly profitable for the leading firms in this field.Now, in place of all these positive themes, market participantsare increasingly concerned about the volume trend, which isalready reflected in a declining number of CFTC-registeredfutures commission merchants. And there is also of course astill bigger issue to contend with: the looming negative cost(and revenue) implications of new regulation.Market challengesEven during the years of growth, life as a futures commissionmerchant was not a bed of roses. Responding to rapid changesin market conditions, such as the commodities boom, was nevera cost-free exercise: capacity planning in terms of both peopleand systems is challenging. Also the volume growth itself led to asharpening of competitive conditions, as the major investmentbanks used their deep pockets to fund (in some cases greatly)expanded operations in futures and options trading. So allmarket participants have long had to fight hard to preservemarket share, and the resulting pressure on commission rates hasof course been exacerbated by the volume declines. Persistentlylow interest rates are yet another negative factor, both reducingclients’ need to hedge and also restricting the returns on fundsheld in margin accounts.There are also concerns on the part of derivatives market usersabout global market structure. The controversy aroused by2011’s proposed Deutsche Börse-NYSE Euronext merger,ultimately disallowed by the European competition authorities,focused the market’s attention on some long recognized butunaddressed issues: derivatives market concentration, restrictiveintellectual property practices that preclude contract fungibility,and the prevalent vertical-silo model inhibiting competition atthe clearing level. The subsequent proposed acquisition of NYSEEuronext by ICE has heightened these concerns, and they will beonly partly allayed by the short-term price stability guaranteesthat ICE has offered.Differing contract structures mean that even to pursue anarbitrage strategy between major markets is in many cases stilldifficult. When one considers what open competition betweenequities markets has achieved in terms of lower costs for tradingparticipants, then it seems clear that similar potential exists inlisted derivatives. But for now, trading and clearing costs for thebrokerage community remain relatively high.0.00.51.01.52.02.52006 2007 2008 2009 2010 2011 2012Figure 1: Exchange-traded derivatives average monthly contract volumes (billions).Source: Futures & Options IntelligenceThe buy-side strategies are more broad-basedand complex, often ranging across multiplemarkets and asset classes.David Morganmarketing director, trading and clientconnectivity, SunGard’s capital markets business
www.sungard.com/360trading 53Client demandsMeanwhile, commodity trading clients and the investmentmanagement buy-side are not becoming any less demanding.Their strategies are more broad-based and complex, oftenranging across multiple markets and asset classes. Derivativesexchange businesses in many emerging markets are growing,and the spread of connectivity required to satisfy client demandsis increasing as a consequence. Direct market access (DMA)trading demand continues to grow steadily, and parallel growthin the use of execution algorithms has driven the requirement forbrokers to distribute these algos also to their clients’ workstationsand trading engines. And as the high frequency trading (HFT)phenomenon becomes established in derivatives markets as itdid earlier in the equities field, it brings with it another new set ofrequirements – ultra-low latency, sponsored access, exchangeco-location and so on. There is no shortage of areas in which aderivatives brokerage is forced to invest, if it wishes to capturethe best of the new revenue opportunities.Regulation, regulation…As if the direct business pressures discussed above were notenough, in the wake of the global financial crisis the derivativessell-side is also receiving unprecedented levels of regulatoryattention. The largest issues are of course those associated withglobal regulators’ drive to push OTC business onto electronicplatforms and central clearing, though there is of course one verypositive aspect of this move, at least from the point of view of theexchanges. As the OTC derivatives markets are some ten timesthe size of the exchange traded markets (see Figure 2), the OTCmove to clearing is creating an opportunity for listed markets tooffer economically equivalent (or nearly so) futures contracts,which at present offer several advantages: simplicity andcertainty of regulatory requirements, the opportunity for marginoffsets, and lower absolute margin requirements. CME and ICE,in particular, have been quick to respond to this opportunity.As the OTC and exchange traded markets become more alike,this is bound also to have significant impact on the way thatbrokerage firms structure themselves to address their clientsand interface to the markets. But at present in the exchange-traded parts of their businesses, the primary focus is on riskmanagement: high priority is given to timely consolidation ofoverall positions and the associated risks and correlations, andthere is also increased pressure at the trading front end, bothpre-trade and in near-real time. Exchanges themselves areresponding with integration of basic pre-trade checks into theircentral systems, but the greater onus still falls on the broker,and the issue is made more important by the continuing growthof DMA client trading. And most important (not to mentionmost controversial) of all in the commodity markets, there ispreparation to meet the demands of position limits rules fromthe US CFTC and in the EU’s MiFID 2. We look further at theseissues on the following page.How leading firms are respondingMany of the opportunities and challenges mentioned above areeither associated directly with changes in the technologiesavailable to exchanges and brokerage firms, or are susceptible toresponses based on new applications of technology. SunGard isasked to work with customer firms in various ways to help themmap their routes through this complex and fast-changing marketlandscape. Based on our experiences with these firms, in thefollowing sections we summarize what appear to be the majorpatterns and best practices that are emerging currently.Figure 2: Global OTC and exchange-traded derivatives notional outstanding.Source: BIS (Figures exclude commodity and single-equity derivatives)01000002000003000004000005000006000007000002009 2010 2011 2012US$BillionOTC ETD
6 Listed derivatives trading: challenges, opportunities and technologiesCapacity planning and managed servicesCapacity planning is a nightmare in the market conditions thatFCMs face today. Market fashions rise and fall rapidly, and certainevents (Flash Crash, Middle East unrest, Euro crisis….) can ofcourse cause alarming volume peaks as well as price volatility.There are no simple answers: only experience can teach howmuch spare capacity needs to be maintained, at all stages of thetrade management process, in order to handle these peaksadequately. There is no choice in the matter – no-one can risksystem failure, or even slow response, at moments when pricesmay be swinging wildly.One way to respond is effectively to outsource the problem, atleast for non-core process elements, by using managed services.Having market connectivity managed ‘in the cloud’, for example,places the burden of ensuring adequate performance on atrusted supplier, as well as dispensing with onerous technicalmanagement tasks of procuring and managing communicationlinks, and upgrading interface software as exchange platformschange. There has been a rapid trend towards usage of suchservices in recent years, which continues. We expect to seeextensions to this trend in future, with more server-basedapplications (algo and strategy trading infrastructure, forexample) being widely offered and accessed as managedservices: the Software as a Service (SaaS) model is no lessapplicable to trading than to the many other fields where it hasbeen successfully deployed.Risk managementThis former Cinderella area of business operations is nowcentral, and likely to remain so for the foreseeable future, oruntil certain best practices become so obvious and widelyapplied that they can be fully automated and once againalmost forgotten (at least in normal times). We see three mainareas of focus:››Pre-trade risk management traps some major risks – includingmany erroneous and/or limit-breaking orders – at the mostappropriate time: before they hit the markets. Responding insome cases to direct regulatory demands, many firms areextending and tightening their electronic pre-trade controls,with latency considerations ultimately determining how muchit is practical to do before sending an order to market.Guidelines published in 2012 by FIX Protocol Limited,updated and extended to cover futures and options, are auseful contribution to developing best practices: SunGardhas benchmarked the Valdi Selector pre-trade riskmanagement product against these guidelines in order todetermine next priorities (as described in our Position PaperImplementing effective electronic trading risk controls, whichcan be read at www.sungard.com/360trading). In Europe, the2012 ESMA Guidelines for automated trading engines arealso relevant: fortunately for firms battling to stay incompliance, the ESMA risk management requirements arebroadly consistent with the FPL recommendations.››The biggest current issue in commodities markets is ofcourse position limits. While legal tussles continue over theDodd-Frank/CFTC rules in the US, we await ESMA’s craftingof the MiFID 2 principles into new European regulations. There must also be concerns about potential regulatoryarbitrage as long as a uniform framework is notapplied worldwide.››Multi-platform risk management is important in cases where afirm uses several different technical trading architectures, andneeds to consolidate its view of activity across them for risk andmargin management purposes. Optimizing the allocation oftrading limits and margin deposits is normally the core objectivehere. Recognizing this, an increasing number of exchanges canprovide real-time ‘drop copies’ of all completed trade details –and in some cases also open orders – to reflect all of a memberfirm’s market activity, and software vendors are responding withthe necessary tools to receive and analyze these consolidatedfeeds: SunGard’s Global Execution Server is an example.4We count 70+ derivatives exchanges globally that attractsignificant levels of business, and a global broker needsconnectivity to most or all of them.David Morganmarketing director, trading and clientconnectivity, SunGard’s capital markets business
www.sungard.com/360trading 7DMA, algos and HFTIncreasing levels of technological sophistication amongderivatives market users have fuelled the growth of DMA tradingin recent years. More and more investors and traders nowdevelop and execute their own strategies (often built into ‘blackbox’ automated trading engines), and simply want the means tosend orders to market as rapidly as possible. The main demandson brokers are then for extended capabilities in the tradingworkstations and other software tools that they provide to theirclients: strategy trading is discussed on the following page, andthe use of algorithmic trading to improve execution quality is alsomore and more prevalent.Increasingly, brokers differentiate themselves in their marketingvia the breadth and innovation offered in their algo suites, whichoften include traditional equity-market staples – TWAP, VWAP etc.– as well as derivatives-specific exotics. Growth in the use of theseimpact-management algos is, however, still hampered by thedifficulty of performing accurate and meaningful transaction costanalysis in derivatives markets. Leading brokers are working hardto address this gap, as good TCA tools could act as a realdifferentiator for them.There is also demand for wider access to exchanges. Despitethe market concentration in certain segments discussed above,we count 70+ derivatives exchanges globally that attractsignificant levels of business, and a global broker needsconnectivity to most or all of them: the technical complexitiesand costs involved in this are of course a major factor drivingthe rise of managed service usage.Alongside the DMA growth, we have seen the large-scaleapplication of high frequency trading techniques in thederivatives markets: often the HFT firms are themselves market-making exchange members, but in other cases they usebrokerage services, and may then demand specific low-latencytechnology support. These firms now make much of the runningin major markets: in the US, the CFTC has noted that HFT playersparticipate in more than half of the trading volume in liquidfutures contracts, and has made proposals to require registrationand to pre-test algorithms. The exchanges recognize the value ofthe HFT business in terms of liquidity provision and of coursedirect revenues, and continue to expand and promote theircolocation facilities and related services.Strategy tradingThe continuing growth here is fed by wide availability of thenecessary automated tools to support the trading of complexstrategies. Exchanges have perhaps failed to capitalize fully onthe potential for listed strategies: their offerings in recent yearshave remained relatively static and undifferentiated. But this mayreflect a lack of demand for standardized products: there hasbeen no lack of creativity in the range of multi-legged strategiesthat individual trading firms have built, and in many cases thesecould not have been put together by any individual exchange,as they span multiple derivatives markets and also involvecash-market and FX transactions as part of complex hedges.The leading software products that support strategy creation andexecution today offer all the flexibility and market connectivitythat most users require, so we can expect yet more imaginationto be employed in exploiting the potential of these tools.Exploiting market fragmentationAs noted earlier, derivatives markets have as yet seen almostnone of the fragmentation that has revolutionized equity marketsin North America, and more recently in Europe after MiFID. Theone major exception is of course the US equity options market,where the usual proprietary-contract ‘rules’ have not applied andwe see a structure very much like the underlying cash market,with the same accompanying technologies of smart routing andliquidity-seeking algorithms in wide use.Elsewhere, there are early signs of change. In Europe we seeNasdaq OMX, Turquoise Derivatives and the BATS Chi-Xcombine making moves to compete directly against Eurex andNYSE Liffe, but the creation of a few non-fungible derivativescontracts is still a long way from what these firms haveachieved through open competition in equity markets. Thereare radical proposals in the EU’s MiFIR that require openaccess to clearing for trading venues and competitionbetween multiple CCPs, but the exchanges are arguingforcefully against these moves. They state that proprietarycontracts cannot be fungible across multiple trading venues,and that shared clearing is therefore not practicable; they alsoargue that interoperable derivatives clearing is not possible,which implies separate contracts for each CCP. We can expectmuch further debate and lobbying on this issue.There is also significant activity in the fast-growing Asian financialcenters, with new exchanges in mainland China, Hong Kong andSingapore. Apart from the Chinese markets’ naturally strongposition in commodity derivatives, it is too early to tell how muchimpact the Asians will have in competing for global businessagainst the established US and European markets. The HongKong Exchanges’ acquisition of the London Metal Exchange willimpact on the inter-region dynamic, given the relevance of theLME’s contracts in the Chinese market, and the SingaporeExchange is aggressively extending its Pan-Asian reach inderivatives trading.Where from here?The continuing trends described above show that much is still influx, and there is a lot to play for in the fast-changing competitiveenvironment. There is potential for the central market structuresto alter radically under the two major influences of globalization-driven mergers and new regulations, and this could in turnimpact significantly on the priorities and strategies of brokeragefirms. As noted above, in attempting to manage the rapid paceof market and technology changes, FCMs are likely toconcentrate increasingly on their core business competencesand to outsource large elements of technology management.Given the increasing range of possibilities that will be out there,everyone involved in the listed derivatives markets will have tomake hard choices about direction, but (at least for those withstrong stomachs!) the ride will continue to be an exciting one.5