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March 14, 2013 2:39 pm

Derivatives industry takes reality check

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Derivatives markets have enjoyed a boom period for the past 30 years but futures exchanges, broker-dealers and institutional investors face a new worry – growth.

The globalisation of financial markets, with corporations and investors seeking to offset their risks with hedges such as swaps or interest rate futures, has been a boon for both over-the-counter derivatives and their listed counterparts.

In the past decade alone, the amount of OTC derivatives by outstanding notional value has doubled to $640tn.

But last year provided a reality check for the industry with volumes slumping as continued global low interest rates, little economic growth and greater stability in the eurozone curbed investor appetite for trading.

The number of listed derivatives contracts fell 15 per cent to 21bn, the first reversal in eight years, according to the World Federation of Exchanges, a trade association.

Whether those longer-term trends will return amid a far-reaching global regulatory overhaul of derivatives markets has been the chief topic among delegates at the industry’s largest annual conference, hosted by the Futures Industry Association in Boca Raton, Florida.

“We should all be clear that the loss of volumes caused by the deleveraging of our end users, our customers, will not be compensated in the short term,” Andreas Preuss, chief executive of Eurex, the derivatives exchange owned by Deutsche Börse, told delegates.

The industry’s search for growth in a world of near-zero interest rates and tighter rules on bank capital has been complicated by sweeping incoming regulation.

Authorities want to move more of the vast OTC market on to electronic trading venues with more deals processed through clearing houses.

A clearing house stands between two parties in a deal, guaranteeing the trade in the event of a default.

However, the new regulations have been beset by delays and the low volumes have complicated banks’ and brokers’ search for a new commercial model.

“If we are going to assume we are going to have super-low interest rates in the short to medium term, maybe the business models need to change and customers need to understand that,” said Steve Grob, director of group strategy at Fidessa, a UK trading technology company.

If we are going to assume we are going to have super-low interest rates in the short to medium term, maybe the business models need to change and customers need to understand that

- Steve Grob, Fidessa

Some clarity has emerged in recent months. Mandatory clearing for the most active traders of swaps in the US began on Monday, marking the first stage of the final implementation of the key rules.

Some are seizing their chances. IntercontinentalExchange chose to make its bid for NYSE Euronext in part because money was cheap. Others are launching new products that turn swaps into futures.

“There’s still a lot of work to be done but conceptually we have started turning the page,” said Walt Lukken, president of the FIA.

Others are more circumspect, pointing out that the laws governing the electronic trading platforms for the regulated trading and clearing of swaps, known as swap execution facilities, have yet to be agreed by the Commodity Futures Trading Commission, the main US regulator for the industry.

Banks are now for the first time putting a number on what the impact of the rules may be.

At its recent investor day, JPMorgan estimated that the effect of the regulations – including mandatory clearing, Sef trading, and new margin rules but excluding the Volcker rule – would cut turnover from its own markets business by $1bn to $2bn.

While the bank expected about $300m-$500m would be clawed back by new services in OTC clearing and collateral management, Deutsche Bank said: “This amounts to a 5-10 per cent markets revenue loss.”

As a result, the industry is watching closely how the convergence of OTC and exchange-traded derivatives plays out.

Among the early signals is likely to be a new product by CME Group, the world’s largest futures exchange.

Last December it launched a futures contract that is delivered as an off-exchange swap, offering investors the lower cost of the former but the economic benefit of the latter.

The first rollover of the so-called “futurised swap contract” takes place on Monday.

While the industry remains focused on innovation, some suggest fundamentals will prevail and volumes are bound to come back as interest rates inevitably rise.

Jeff Sprecher, head of the ICE, said markets were already reacting to even minor positive comments from central banks.

“You’ve got to believe that in a zero interest rate environment that money is flowing into places where it wouldn’t otherwise flow if there were normal interest rates,” he told delegates. “I think as interest rates rise, we’re going to discover where all that money went . . . and people will have to hedge or get out of those transactions.

“I suspect it will be pretty good for listed exchanges.”

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