The Use of Derivatives

This section is drawn from the Canadian Annual Derivatives Conference, presented by the Montreal Exchange in October of this year at Chateau Montebello in Quebec. The articles featured have one thing in common: they all touch on the rapid pace of change in the derivatives area. From the effects of e-commerce on futures markets, to single stock futures, to futures on sport (yes, futures on sport!), the world of futures is an explosion of change.
Derivatives: Futures Markets in an E-Commerce World
Can traditional futures exchanges survive in this new environment?
by Leo Melamed

It is no secret that the combined onslaught of globalization, Over-the-Counter (OTC) competition and technological advancement have put enormous pressure on traditional futures exchanges. Indeed, in some quarters there is a growing belief that the good days for traditional exchanges are behind them. It is thus imperative to examine the state of affairs and attempt a look ahead.

The world is in a major transformation. With growing demand for efficiency and speed of executions, an expanding universe of electronic communication networks (ECNs), and the advent of ever-bigger institutions of inordinate financial strength and awesome OTC capabilities and global reach, is there a role for traditional futures exchanges? Can the old-fashioned resources of futures markets viably compete in a world where the Internet has removed all borders from global transactions?

Tough question. Surprisingly, the answer is clearly in the affirmative, but just as clearly, it is qualified. To remain viable will require dramatic and speedy changes in the makeup of traditional exchanges.

I make the following three assumptions: First, that hedging activities in risk management will flow to the marketplace that is the most liquid. It is axiomatic that market users tend to shun markets that do not provide certain entry and exit. Second, that markets providing the widest distribution network on a global scale together with the most functional and efficient technology at the lowest cost will be the most attractive. Third, that market participants will gravitate to the marketplace that provides efficient and financially secure clearing and settlement procedures.

While there are other requirements for success in the e-commerce world, the foregoing three principles will dominate in determining which exchange, which marketplace, or which ECN will win the race in the 21st Century. Traditional futures exchanges have most of the necessary elements in place to succeed, but they are no longer alone. The OTC sector has come on strong, offering a wide range of derivative products to its natural customer base. Better than two-thirds of the $80 trillion outstanding derivative contracts were executed in an OTC venue. Swaps are today the instrument of choice when it comes to hedging of risk, and the world's biggest financial firms or banks have captured the lion's share of this expanding market. Indeed, less than a dozen world banks, mostly U.S., hold 95% of all reported derivatives transactions. Bottom line, with respect to liquidity, while traditional exchanges have a running start and still have much to offer, they no longer have a monopoly in this regard.

The second requirement--distribution and technological competence--is not favourable to futures exchanges. Most of the traditional exchanges are far behind modern-day technological demands. At many exchanges there still is no viable electronic system that can compete on a global scale whatsoever. If traditional exchanges are to stay alive they will have to quickly meet global technological demands. That requires huge sums of money, the kind of money that is usually available only within very large financial entities or the public sector. It is the very reason why nearly every traditional exchange is in the process of or considering de-mutualizing; abandoning their membership structure in favour of becoming a for-profit entity with an ability to go public or offer equity to a potential partner in return for technology.

The need for distribution is also the reason why many exchanges have created alliances and continue to create alliances with other exchanges, be it in equities or in derivatives. Global alliances, bilateral or multilateral, can theoretically serve as a means of quickly achieving a distribution network for marketing of products.

With respect to the third critical requirement--clearing and settlement capability--there is little doubt that traditional exchanges have the dominant advantage. To begin with, there are but a handful of major credible derivatives clearinghouses throughout the world. Regardless of which is the best with respect to this most critical component, existing exchanges have a commanding lead.

From this brief overview, it should be evident that the potential for traditional futures exchanges to succeed in the world of e-commerce, while daunting, is quite real. But time is of the essence. The competition is not sitting still. Traditional exchanges must act quickly to take advantage of their inherent capabilities. They must achieve a level of financial strength, technological capability, and market distribution for their products as demanded by the global marketplace. Those that don't will be history. Those that do will achieve a secure place in the e-commerce world of the 21st Century.

Leo Melamed is Chairman Emeritus and Senior Policy Advisor to the Chicago Mercantile Exchange.

Top 10 rules for a Derivatives Program
by Claude Lamoureux
1. It must be in writing.
2. It must be explainable on one page.
3. Each Board member must understand the program.
4. You need a very competent accounting group.
5. Accounting rules and methods must be clear.
6. Reporting must be simple and fast.
7. A good system support is needed.
8. Culture must encourage quick acknowledgment of error or loss.
9. Treat the external auditor as your partner.
10. And finally, to paraphrase Buffett: The program must be structured in such a way that a lesser mortal can run it... because one day one will run it.
Claude Lamoureux is President & Chief Executive Officer of the Ontario Teachers' Pension Plan Board.
Age of Opportunity
An exciting array of new derivatives products are just on the horizon.
by Patrick Young

When it comes to products, I think we are in a really golden age of opportunity. The number of products out there is truly fascinating. The one that is big-time on my radar screen is individual stock futures. In the past there has been the problem of high brokerage costs, but the Schwabification of the world has suddenly brought that down. When stockbrokers were in an environment where they could happily charge $200 for an equity transaction, they saw no reason to want to get involved in futures, which had much lower rates. Suddenly, with $29.95 maximum commissions seeming to be the order of the day in an online world, the prospect of dealing at futures commission seems to be somewhat attractive.

The issue of regulation has been blighting the development of this market. The difficulty south of this border is that the United States has essentially a dog's dinner of a system of regulation. It is an absolute complete and utter shambles and is going to be something that ultimately stifles their case. America is the marketplace that created several great opportunities for offshore (non-U.S.) markets to prosper. If they want to hand the individual equity futures business over to the rest of the world, then I think the rest of the world should just pick up that challis and just run with it, because it is certainly not a poisoned one.

Exchange traded funds
There is also going to be the whole business of exchange traded funds (ETFs), and this links us back very neatly to the single stock future issue. Nobody has really started talking about it yet, but just as we will see a panoply of good, liquid single stock futures, so you are going to see the next step in the ETF revolution. The next step is going to be an ETF that doesn't even own any of the underlying cash. It is going to own the futures, and use that to replicate the index that it is based on. There are going to be all sorts of opportunities in that area to create very significant niche marketplace indices with all sorts of wonderful payouts.

Sports futures
One of the areas I think is going to be a fascinating area for trading is one that the whole of North America's regulation seems to be largely against--the trading of sport. Futures on sport is going to be probably the biggest growth area in the financial business in the course of maybe two to five years from now. There are already a number of single marketplace market makers in the UK and Europe who simply cannot keep up with demand, yet they are single broker dealers, they make prices that you could drive a bus through and they have all the sort of counterparty credit risks that you have when you deal with one person. The exchange for sport is going to be reality. It is ultimately going to destroy American gambling with legislation, and is also going to provide the most amazing opportunity for futures-based product through spread trading.

Patrick Young is a professional trader, the author of Capital Market Revolution and editor of Applied Derivatives Trading, an Internet magazine.

The Forecasters
World outlook

"If the U.S. experiences a soft landing, Canada should do relatively well, with growth rates perhaps exceeding that of the U.S. If it is a hard landing in the U.S., then all bets are off. Canada tends to underperform the U.S. in hard landing scenarios."

Ted Carmichael, vice president and chief Canadian economist for J. P. Morgan Securities Canada Inc. U.S. economy

"Where are we going to go from here?...The current outlook for the S&P 500 is to reach 1500 by the end of this year. It closed Friday (October 13) at 1374, so that's a reasonably big jump, a good last two months of the end of the year. I think we have a reasonably good chance to do it. We'll probably know in about three weeks. If we get through the earnings situation and then see how excited or disappointed most of us are about the election, I think we'll be able to see where the market is going."

David Blitzer, managing director, chief investment strategist and director of quantitative services for Standard & Poor's

Oil prices
"There is one very fundamental difference between what has happened in the last year and a half and what happened in '73 and '79-80. The previous two oil shocks were basically caused by OPEC shutting off the tap. This time we see escalating crude prices with the tap wide open. And make no mistake about it. That tap has been wide open."

Jeffrey Rubin, chief economist and managing director of CIBC World Markets

Contex Group