A consolidating world

Record trading volume and the move towards for-profit

The growth numbers were big last year and these latest trends will only fuel growth, records and rivalries. The Chicago Mercantile Exchange (CME) surpassed the billion mark for total contracts traded in 2005, an increase of more than 200 million from 2004. Meanwhile the Chicago Board of Trade (CBOT) traded a quarter of a billion contracts in 2005, about 175 million more than 2004. And that's only Chicago. The European derivatives exchange Eurex traded 1.2 billion contracts in 2005, after having traded just above the billion mark in 2003 and 2004. The New York Mercantile Exchange (Nymex) traded 204 million contracts in 2005, about 40 million more than 2004 and Euronext.liffe had 414 million contacts traded in 2005, about 30 million more than 2004.

ONE-STOP-SHOPS

Exchanges are racing to become one-stop-shops, offering multiple asset classes, including clearing services, OTC contracts and the creation of OTC look-alikes.

"Exchange's trying to become onestop-shops is definitely a trend that is taking place not only in the United States, but also in Europe," says Max Butti, product manager at Euronext.liffe. "The recent attempt to consolidate all securities and derivatives trading under one roof is due to the obvious benefits for the end-users.

A big part of the one-stop-shop notion is clearing ability through an exchange. Euronext.liffe in October launched Bclear, its new "on-exchange" cleared service for the wholesale equity derivatives market. Bclear is a Webbased, on-exchange administration and clearing service that provides a simple way to register and process wholesale trades through Euronext.liffe to clearing at LCH.Cleamet Ltd, reducing the counter-party credit, legal and operational risks associated with off-exchange deals.

Bclear can handle the registration of both standard exchange and flexible trades in futures and options covering 12 countries and pan-European indexes and more than 300 underlying European securities from 15 markets. Since the launch of Bclear in October 2005, 6 million contracts have been traded, and 46% of Bclear volume is in flexible contracts.

But will one-slop-shop exchanges be good for the end user or only the exchange? "It benefits everyone," says Kelly Loeffler, VP of investor and public relations for the Intercontinental Exchange (ICE). "The efficiency, speed and access is better for the customer. And the exchanges, while profiting from their IPO's, have developed robust, viable business models that produce growth for the industry."

Joe Raia, SVP of marketing at Nymex, says the efficiencies of one-stop shopping are massive for customers and it is necessary for an exchange to expand services and update technology to stay competitive. Nymex has been looking into Europe and Asia to expand its global reach and added 25 new European swap futures contracts on its electronic matching engine Clearport in February. This doubles the number of contracts in this area at Nymex.

OTC: NYMEX VS. ICE

The implosion of Enron created the need for the added certainty of third party clearing in the OTC energy world. Cleared OTC energy contracts provide participants with access to centralized clearing and settlement arrangements. The introduction of cleared OTC contracts has reduced bilateral credit risk and the amount of capital market participants are required to post on each OTC trade.

Both Nymex and the ICE attempted to fill this void by launching OTC clearing - or in the case of Nymex, OTC look-alikes - in 2002, and in terms of volume they are running almost neck and neck. Their business models are very different, however, and that has some important implications for how their clearing systems operate. ICE is essentially an electronic trading platform that operates through the Internet. Most trading at Nymex still takes place on the exchange floor while the OTC clearing business is conducted through ClearPort, which has the capability to support trading, but at present only a tiny number of transactions brought through ClearPort are actually matched on that system.

"Since we've introduced ClearPort into the European marketplace in 2002 the interest in clearing in the European marketplace for these types of contracts has grown tremendously," Raia says. He adds the new contracts bring a better sense of risk mitigation into the marketplace. "They clear as regulated futures contracts, which nobody else is doing right now with these types of contracts," he says.

Nymex's ClearPort Clearing provides traders an interface where transactions are posted, margin requirements are calculated and the transactions are processed by the clearinghouse in the same manner as the Nymex futures contracts. Commonly traded, financially settled contracts for Henry Hub natural gas, natural gas basis, refined products, refined products spreads, crude oil, crude oil spreads and electricity that are available for trading on Nymex's ClearPort. Trading also can be done off of the exchange and submitted for clearing through ClearPort as an exchange of futures for physicals (EFP) or exchange of futures for swaps (EFS) transaction.

The crude oil swaps contracts include swaps based in whole or in part on the ICE Brent futures contract and the gasoil-related contracts include gasoil 0.2 vs. ICE gasoil swap futures.

"With ClearPort we've bridged the gap between the OTC market, which historically traded as a bilateral eustomer-against-customer type of arrangement, vs. now clearing them here at the exchange, as fully regulated futures contracts, with protection on margin and protection against default. You have no counterparty risk," Raia says.

Before 2002 Nymex didn't have a link to the OTC market. Since May 2002 Nymex has listed more than 200 OTC contracts that clear at Nymex as futures contracts.

Nymex's total cleared volume for 2005 through ClearPort was 35.4 million and was at 11.5 million as of the end of February for 2006. In 2005, volume in ICE's cleared OTC contracts totaled 47.4 million contracts, more than 161.8% of the 18.1 million cleared contracts traded in ICE's electronic OTC markets in 2004. ICE provides its cleared OTC products through established clearing firms on the ICE platform and in cooperation withLCH.Clearnet.

About a week after the Nymex's announcement, the ICE announced plans to introduce more than 50 additional cleared contracts in its OTC markets during the first half of 2006.

Raia says the line between exchangelisted and OTC contracts is being blurred. Through clearing arrangements, institutional traders are able to receive margin offsets between exchange traded and OTC transactions.

Rick Redding, managing director, products and services at the CME, says, "Exchange products and OTC products are complimentary to each other and as the OTC market experiences growth, so do the exchanges and vice versa."

At Euronext.liffe customers can take standard contracts and trade their lookalikes, which are generally traded on the OTC market, in an exchange environment. "The most interesting advance in respect to look-alike contracts is that we allow customers to trade flexible contracts and custom-make their own derivative contracts and then use the exchange to register them and transform them from OTC contracts into exchange listed," Butti says.

CONSOLIDATION

The biggest story in Europe besides who, if anyone, will buy the London Stock Exchange (LSE), is whether or not Deutsche Borse (DB) will join forces with Euronext. The onagain, off- again merger has broken down over the ultimate clearing structure and where to headquarter a combined exchange.

Euronext runs the Paris, Amsterdam, Brussels and Lisbon stock markets. BD owns Eurex, the world's leading derivatives exchange, jointly with the Swiss stock exchange. DB and Euronext held preliminary talks but they foiled to agree to any terms. If they joined forces they could overtake the LSE as Europe's largest marketplace for securities trading.

Meanwhile, the CME and New York Stock Exchange (NYSE) may have entered the market just as LSE may decide to go it alone. In February the NYSE finally received approval for its merger with electronic rival Archipelago Holdings Inc., a $9 billion deal that will transform the exchange into a for-profit company to give them, already the world's largest stock exchange, new high-tech trading capabilities and an estimated 49% of the market in stock trading.

"Exchanges are becoming more active in consolidating flows into one single trading environment," Butti says. "The question becomes why would you trade your futures and options somewhere else when you can get all the benefits from one integrated registration environment, one rule-book, one clearing house with the obvious benefits of cross margining and margin offsets."

Exchange IPO's are an ongoing trend. The Chicago Board Options Exchange (CBOE) announced its intention to operate as a for-profit organization in January, though its actual demutualization and eventual IPO are a ways off and dependent on it resolving the question of CBOT exercise rights. CBOE entered into an equity-stake partnership with the electronic micro exchange, HedgeStreet.

Also, Nymex was preparing for a shareholder vote on March 13 on a proposed $160 million investment by private equity firm General Atlantic. The amount represents a 10% stake, but is contingent on Nymex carrying out an initial public offering this year.

The Nasdaq Stock Market Inc. recently unveiled a plan to compete with NYSE. It plans to create new listing standards for its companies to better compete for prestigious corporations.

Niclas Lilja, VP of corporate communications at the Helsinki Stock Exchange (OMX) says, "Our major effort in promoting cross border sales is our creation of the Nordic Exchange, consisting of the exchanges we own in Stockholm, Helsinki, Copenhagen, Vilnius, Riga and Tallinn. As an integrated marketplace for listing, trading and clearing of securities as well as information services, the Nordic Exchange offers ease of access to more than 80% of the exchange trading in the Nordic and Baltic countries." The goal of the Nordic Exchange is to attract more interest and investment in the whole region.

But Loeffler says the ICE's acquisition of the International Petroleum Exchange, now known as ICE Futures, in 2001 is one of the few examples in recent years, prior to the NYSE-Arca deal. "Consolidation is an evolutionary process and while rumors of potential combinations persist, these don't always play out," Loeffler says.

ELECTRONIC MARKETS FUEL GROWTH

While the focus is on exchanges moving to for-profit status, some exchanges still need to improve their technology.

"You can't become a global exchange with just having one entry point to an exchange, you need multiple venues to help the market move forward," says Raia. Nymex's board, who has been chided by industry insiders for being well behind the curve, finally voted to offer side-by-side open outcry and electronic trading of its benchmark, physically settled energy futures contracts, which is expected to launch in the second quarter of 2006.

Nymex's decision came only weeks after ICE launched an electronicallytraded West Texas Intermediate (WTI) crude oil futures contract in competition with Nymex's WTI contract.

At the CBOT 65% of total trading volume was conducted electronically in 2005 and a further advance is expected this year as its board will soon vote on listing its agricultural complex electronically during the trading day. At the rival CME, electronic trading already accounts for more than 70% of its contract volume.

"For markets, the transition to the screen equals immediate globalization," Loeffler says. Raia agrees, "You can't have a global presence without superior technology."