Exchanges/volatility

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Debating what the future holds for futures can result in some pretty confusing conversations. It can also mean some wild price swings. Since August 8, shares in futures exchanges including Nymex, Intercontinental Exchange, and the Chicago Mercantile Exchange have suffered double-digit percentage drops, compared with a 3 per cent fall in the S&P 500.

That might seem odd. In the same period, the Vix index – a measure of volatility in US equities – has increased by 18 per cent, while commodities have also been choppy. Volatility ought to be good for derivatives exchanges, which traders use to try to hedge their exposure. And indeed, in July and August, exchanges hosted record volumes.

But while the fallout from the problems in credit markets has pumped up demand for derivatives for now, there are unpleasant side effects. Sentinel Management Group’s meltdown was a wake-up call from one of the less prominent corners of the market. Sentinel was a provider of supposedly safe cash management services to futures brokers. The fear was that its problems could spread across the market and eventually leave the exchanges’ in-house clearing businesses dealing with hung trades.

For now, that risk looks minimal – Deutsche Bank estimates that funds parked with Sentinel amount to 1 per cent of total futures market capital. The other, perhaps more serious, threat comes from the “de-risking” process underlying current volatility. If a swathe of investment funds unwinds and investors lose their taste for leverage-fuelled speculation, demand for contracts to hedge positions will fall accordingly.

It is too early to tell how big a threat that is. But the exchange sector was trading on forward price/earnings multiples of 40 and upwards before the latest turbulence. Far from being odd, taking some money off the table – the stocks still trade at multiples in the high 30s – looks sensible.

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