TRADING IN AN ELECTRONIC WORLD-LESSONS FROM LIFFE

Introductio

Market structures in the developed world are evolving quickly. I will review what I consider to be some of the key trends apparent in the derivatives industry historically. Then I will discuss the processes that I consider to be changing today's market structure into the marketplaces of tomorrow. These processes will be as important in the case of the forex markets as they are in other markets and this will let me make the connection with what CFETS is trying to achieve for the yuan. It will become clear that CFETS should not merely try to adapt market structures as found in the today's fully developed world to the Chinese case. I call this the "moving target effect" because it is far better to anticipate what global markets will look like tomorrow in those developed currencies before choosing a direction for developing your yuan markets further.

Introduction to Euronext.liffe

Euronext is a single commercial organisation but is organised internally into Strategic Business Units (SBUs). Each SBU has its own senior managers who attempt to control the SBU costs and grow the SBU revenues independently of each other but within the overall central Euronext budget framework.

The Derivatives SBU is called Euronext.liffe and is itself split into two divisions. The first is where I work and is a futures and options exchange through which our customers can trade a large range of products. On the equity side we offer mostly European equity options and are especially active on the UK, French, Dutch, Belgian and Portuguese markets. Equity futures are also traded. On the interest rate side we offer ￡，CHF and ￥denominated short term interest rate products as well as some ￡,＄and ￥bond and swap products. There are also a few FX products traded.

The second related part of Euronext.liffe provides other exchanges with technology and has already sold the LIFFE CONNECT¨E[1]ÈQ trading engine to well known futures exchanges such as TIFFE and CBoT. Often these technology sales are associated with agreements to cooperate on the product side of the business where I again become involved.

At Euronext.liffe our aim is to serve our customers by making local markets global and driving down the costs of accessing multiple markets. We are in the process of creating a single market for derivatives by bringing all derivatives products together on the same trading platform, LIFFE CONNECT, to make cross-border trading cheaper and easier. As well as selling our systems to other exchanges we have created our own global derivatives exchange powered by LIFFE CONNECT. This exchange is connected to well over six hundred trading outlets in 26 countries and each of these is in turn connected to many more individual traders. This exchange therefore offers each customer the chance to trade with many other customers creating a huge pool of liquidity with an average of 2.7m contracts traded every day in 2003 across a range of 256 listed products.

I've already said we are in the process of creating a single market for derivatives by bringing all derivatives products together on the same trading platform. I'd now like to go through a little history to give you more of an idea of how rapid yet complex this process has been. In 1998/99 the LIFFE market on the London trading floor adopted LIFFE CONNECT. When in 2000 the Amsterdam, Brussels and Paris stock exchanges merged to form The Euronext Group each of these exchanges also traded derivative products. In 2001 Euronext bought LIFFE for ¡￡E[1]555m (892m) and shortly afterwards it was decided that all derivatives exchanges across the group should be part of the same SBU and migrate to using the same platform, namely LIFFE CONNECT. Meanwhile in 2002 the Euronext Group absorbed the Portuguese exchange BVLP. The migration of Belgian and French derivatives markets to LIFFE CONNECT was completed earlier this year (2003) and the migration of Portuguese and Dutch derivatives will take place in 2004.

I would like to show you the volumes we are achieving in Euribor. Euribor is a short term interest rate future on the Euro that therefore didn't exist five years ago.

As you can see in September we traded over 12 million contracts and as each contract is valued at 1 million notional that's a turnover of 12 trillion euro.

The volume growth trend is quite obvious in the futures themselves but is even more extreme when options on Euribor futures are considered.

Overview of historical trends in derivatives

The first historical trend I would like to mention has been the increasing standardisation within the derivatives industry.

Standardisation has many aspects but this trend is really all about improving the efficiency of each deal.

The International Swaps and Derivatives Association (ISDA) has transformed the organisation of these markets by creating standard contract terms and the documentation overhead and other operational risks have consequently been slashed per contract. The important role of ISDA has been generally recognised and many observers believe that the growth seen in these markets over the past two decades would have been impossible without ISDA. Please be aware however that as a consequence of the very considerable growth in the value of contracts remaining open, the documentation overhead and other operational risks have again become significant in total. To this extent ISDA are a victim of their own success and continue to look for further way to improve overall efficiency.

ISDA has recently endorsed the FpML standard, which will accelerate the electronic trading trend. FpML is intended to automate the flow of information on derivatives and is already doing so1. Ultimately, it will allow for the electronic integration of a range of services, from electronic trading and confirmations to portfolio specification for risk analysis. The rival FIX protocol which began as an equity standard is also expanding into derivatives.

Derivatives have an unfair reputation of being difficult to understand and difficult to manage from a risk perspective. Whilst not all derivatives are easy to use there is now a very efficient inter-dealer OTC derivatives market and because of standardisation both at an ISDA level and at a market quotation convention2 level a typical inter-bank deal is extremely simple to describe. Newer products tend to select most of their quotation conventions from the universe of pre-existing conventions and only adapt changes or additions to these where absolutely necessary.

If market conventions of the type described above did not exist then market makers would be unable to trade quickly and efficiently over the phone within their own community. Also customers and arbitrageurs would find it less convenient to trade across a range of different derivative products. It is apparent from the growing use of electronic protocols in the OTC markets that they are sufficiently standardised to be traded electronically. For example spot FX which used to trade over the phone is now principally an electronically matched market in the developed world.

Of course futures and options exchanges only list certain standard products so in this sense we are ahead of the interbank trend. However the range of value dates in particular has been historically more restricted via a less flexible choice of market conventions On-Exchange than OTC. Given that futures exchanges have themselves become electronic there is every reason to believe that more value dates can be listed than in the past and I believe there will be little practical difference between the OTC and the On-Exchange markets in a few years time. We also bring quite naturally much reduced operational risks even as compared to ISDA and have had straight through processing of trades for many years now.

Another historical trend worth highlighting has been the increasing product sophistication in derivatives.

When a new type of derivative marketplace emerges the banks that are among the first to offer the new products can often make very attractive profit margins. This is because of reduced competition from other potential market makers and the deeper understanding of the product these first-to-market banks achieve from their extended experience. There is also a definite advantage to having been one of these banks as customers will have become familiar with dealing through them rather than newly arriving competitors so these first-to-market banks can perhaps maintain their bigger margins for longer. Examples of relatively novel derivatives include Credit Default Swaps, Inflation Swaps and various kinds of correlation or switch options.

Thus one significant driver for the trend to increasing product sophistication is the fact that banks themselves are continually trying to offer new derivatives to get that first mover advantage. The process is also of course linked to customer demand and their increasing use and understanding of derivatives.

As the growth in volume and breadth of derivatives has continued there has been a parallel historical trend towards an increased understanding of credit line management.

Banks have always been in the business of assessing creditworthiness as this is what they have to do whenever they lend money. However in the past the process has been very qualitative and large banks may not have even been fully aware of their exposure to large counterparties as all their open positions across all their dealing and lending operations have not been monitored centrally.

The situation today is radically different with a far more unified approach to credit risk and counterparty risk in most banks. Risk management has become an important function within all banks and with this has come a clearer understanding of how quickly various risks can build up. This is especially true in the inter bank market and has historically led to an increasing use of automatic systems to check credit lines pre-trade. There is also an increased understanding of the value of "tear ups" and "assignments" where trading to exit a contract is the aim rather than merely overlaying it with an offsetting contract that leaves residual credit risks.

Credit risk itself has been limited by the increasing use of collateralisation in the cash markets i.e. various kinds of repo. Large banks will these days seek to manage risks from their largest or most highly-leveraged counterparties by a daily cash settlement of positions whenever possible. Indeed many banks will only establish trading relationships with certain customers if they can collect margin to cover replacement risk in the case of default.

The interbank market as a whole has become so aware of credit and operational risks that entirely new entities such as CLS Bank and LCH Swaps-Clear have been created in recent years. Of course futures and options exchanges have used central counterparties for decades so once again we are ahead of the trend.

Another increasing trend has been that towards greater customer sophistication.

This greater sophistication is at least partly in response to the bigger margins banks always try to achieve in newer and more exotic products. These days customers can in principle acquire equally sophisticated pricing software to banks so they are more likely to be able to see the margins that banks are trying to keep. Thus to some extent newer markets are maturing more rapidly and the first-to-market advantage is being eroded.

Customers have become familiar with the idea that constantly dealing through the same banks rather than taking seriously late comers to new product areas is a mistake. Each customer will try and use a sensible number of bank counterparties that balances the need to obtain market maker quotes among competing banks with the need to maintain the trading relationship and manage the open positions with each individual bank. Banks on the other hand have learnt that it is easier to keep a customer's most valuable business if they offer a broad spectrum of products for them to trade.

Finally, I would like to point out how easy it is to forget that even basic valuation tools such as Excel that are vital to the banking industry today have not been around forever. In fact the role of IT is key in all these trends and it is no surprise that the emergence of derivatives and the emergence of desktop PCs occurred at around the same time.

The outcome of trends in today's markets

Let us consider a typical bank. It is under continual pressure to improve its use of capital and offer a full service to customers as already discussed. This drives them towards OTC derivatives, either as true market making banks or as distribution channels for the core 'money-centre' banks. The bank makes money from the bid/ask spread directly or from spreading around the interbank bid/ask but in either case more customer volume means more revenue at least in principle.

The IT revolution has allowed and will continue to allow banks to grow their distribution channels to encompass more and more customers. Thus the level of competition increases and this is another driver for banks to search for newer products in order to get the first mover advantage.

Standing still is not an option in this kind of situation and banks must continually renew themselves in order to survive. For example banks will try and control staff costs as competition steadily increases. A very natural way to do this is to automate the distribution of additional product types rather than paying for a sales force. Thus the use of electronic distribution is a self reinforcing trend. Unfortunately customer loyalty can only be won in this new environment by offering the most convenient platform. A moments reflection will show that a customers are likely to want multi-bank distribution platforms where they can see the prices from several competing banks cheaply and conveniently. Such central electronic market place begins to look a lot like the exchange traded world.

Exchanges are in some sense similar to banks in that more customer volume means more revenue through the exchange fees that are levied. Exchanges have of course also become electronic and this has led to a growth in the activity of independent traders who behave very much like bank market makers. Likewise the IT revolution has allowed and will continue to allow exchanges to grow their distribution channels to encompass more and more customers. The competitive pressures mean that exchange are becoming more aggressive - Ultimately there is no reason to have more than one or two exchanges globally and I believe this will come about through the occasional extinction of some exchanges under pressure from others or more likely through mergers and acquisitions activity.

In a sense an electronic exchange is like a super efficient bank in that it can create revenue from volume without applying any risk capital at all. To my mind On-Exchange traded and the OTC derivatives sectors appear to be converging and this is a direct result of the IT revolution. Already market making banks are servicing largely the same customers as the derivatives exchanges and both are reaching out directly to their desktops. This will increasingly be the case as more interbank phone markets move to electronic and distribution networks of banks and exchanges continue to grow.

The ultimate end point of this process is likely to be the fragmentation of banks with all types of customers having direct access to each other via a single system/exchange.

Conclusion

Let us take a look at how these trends are playing out in the field of forex which in recent years has seen the spot market move from being phone-based to electronic. This has lead to considerable consolidation with less competitive banks exiting the forex market as risk takers. As few banks are able to bear the necessary IT costs there has been a concentration of market making and volume to those few banks. It is generally believed this trend will continue. Meanwhile we have seen the rise of EBS market share especially in euro trading which is closely analogous to the rise of EUREX in the futures industry. At the CME there are now significantly increased volumes of electronically exchange traded FX futures and options as a result of the electronic spot market.

As the Information Technology revolution continues to unfold in banking the structure of the FX industry in the "west" is changing radically. If I am correct there may be a natural tendency towards centralisation via competitive pressures and a reduction in the importance of bank-tied market makers.

CFETS is already a centralised electronic system and thus is close to the right answer. What I believe is required for CFETS to remain relevant in the longer term is that you:- a) Broaden your yuan denominated product range to include derivatives; b) Open up your markets to non bank-tied market makers; and c) Realise that ultimately the customer is international so CFETS will have to compete or cooperate on an international level.