December 06, 2011

Taking in OPRA can be hard work. I'm not talking about the music (although that can be tough to get through as well!), but the Options Price Reporting Authority (OPRA) feed of US options data.

The OPRA feed consumes more bandwidth than any other market data feed in the world and experiences peak traffic bursts--currently more than 5 million messages per second--that dwarf comparable rates of throughput in European options data feeds. That's not just because US options are traded more actively (which they are), but also because OPRA consolidates data from nine competing exchanges, whereas European exchange-traded derivatives are concentrated on their primary market platforms.

Should Europe experience more competition in on-exchange derivatives trading--and I'll explain why that will be the case later on--we will see requirements for a European consolidated options feed/s, similar to OPRA but a little bit easier to process in terms of message traffic. In other words, a European Operetta (a lighter version of OPRA).

Alternative trading venues for European derivatives, similar to the cash equities MTFs that propagated post-MiFID, have been touted in the past. Project Rainbow was a bank consortium-led initiative, similar to Turquoise (now part of the LSE Group), which was set up to compete with incumbent derivatives exchanges in Europe.

Although Rainbow had the backing of leading liquidity providers, the project didn't make it to market for many reasons, perhaps the most significant one being the vertical silo clearing model that until now has prevailed in European exchange-traded derivatives and provided cast iron protection for incumbents. Rainbow wasn't able to establish or access a clearing mechanism for the trading it had hoped to garner. [For an interesting lesson in how established clearing houses can foster trading competition without compromising the unified clearing model, see the ASX's agreement to provide clearing for Chi-X when they enter the Australian market later this month.]

Without access to an exchange's clearing silo, it is very difficult to shift liquidity. Even if your execution costs are extremely competitive, your trading members would see potential savings in trading fees cancelled out by a higher cost of capital (not being able to net margin across clearing providers).

Regulatory Push The driver for market structure reform in European derivatives is found in pending new regulations. The UK may have lost its battle to include exchange-traded derivatives in the scope of the European Markets Infrastructure Regulation (EMIR). However, the Markets in Financial Instruments Regulation (MiFIR), which was published in draft form on October 20, includes a range of measures under the heading "Title VI: Non-discriminatory clearing access for financial instruments," which should help stimulate competition in exchange-traded derivatives.

Title VI of the current MiFIR draft suggests the siloed vertical clearing model that currently exists will be opened up once and for all, not only by giving trading venues "non-discriminatory" access to CCPs, but also by giving CCPs "non-discriminatory" access to trade data feeds from each trading venue.

Should Title VI remain intact, it will completely remove the barrier-to-entry that scuppered Rainbow and will pave the way for more competition, either in the form of new entrants or existing exchanges competing head-to-head for derivatives market share. The outcome would be consistent with the move toward interoperability in the cash equity markets in Europe, where clearing houses are being forced to interoperate with each other in order to provide choice for trading venues.

In addition, Title VI of MiFIR also seeks to limit other competition-limiting practices, such as exclusive licensing agreements between index calculators and exchanges that trade index derivatives, which means we are likely to see a perfect storm brewing to shake up exchange-traded derivatives in Europe as never seen before.

Four years ago, MiFID helped to promote competition in European cash equities trading with the arrival of a series of new entrants (Chi-X, Turquoise, BATS Europe, Nasdaq OMX Europe, Arca Europe, Burgundy, QuoteMTF). These MTFs spurred an evolution in market structure characterized by the deployment of more scalable technologies, attractive commercial models (particularly for liquidity providers), and pan-European (or pan-Nordic in Burgundy's case) trading capabilities, enabling greater adoption of high-frequency strategies and prompting data volumes to spiral upward.

As new regulations promote competition in European exchange-traded derivatives, I'd expect to see a similar string of market forces: lower transaction costs, narrowed spreads, increased adoption of high-frequency trading strategies, higher trading velocity, possibly higher trading volumes (depending on market conditions), but undoubtedly higher data volumes.

As in fragmented equities markets, the key benefit of competition--namely, lower transaction cost--would be counterbalanced by a more challenging technical trading environment. To address those technical challenges, vendors will play a key role in supplying infrastructure (co-lo/proximity hosting, connectivity, etc.), trading and data solutions (smart order routing, order book aggregation, algo trading, TCA systems etc.) required to capitalize on fragmented liquidity.

The good news is that we've already adapted to similar market structure changes in US and European cash equities, and US exchange-traded derivatives, so the industry is in a much better position to adapt to the new market structure in European derivatives.

Obviously, there are still hurdles to overcome before trading in European exchange-traded derivatives becomes as competitive as the equities landscape. For example, one point of debate lies in choosing which closing price to use when settling equity derivatives contracts at expiry. While the MiFID review will see the arrival of post-trade consolidated tape providers for European equities, the primary market still serves as the benchmark pricing source for settling derivatives contracts at expiry, and there is nothing in the language of MiFIR or the MiFID review to suggest this would change.

It Ain't Over, but the Fat Lady Has Started to Sing We see competition, and ultimately fragmentation, as an inevitable evolution of market structure in European exchange-traded derivatives. And this fragmentation will look like a smaller version of what's happened in the cash equity markets globally over the last 10-15 years.

But to borrow a phrase from opera, "It ain't over till the fat lady sings." The draft publication of MiFIR means we have an idea of what the song is going to sound like, but we won't know for sure until the regulatory lyrics are finalized.

In the meantime, it's clear that alternative trading venues are champing at the bit to get a piece of the exchange-traded derivatives market. Turquoise has already announced plans to launch pan-European trading in single stock and index options and futures (pending regulatory approval), and Chi-X is seeking an alternative entry point into the market via its partnership with Russell Investment to create the Chi-X Europe Russell Index (Cheri) series, paving the way for trading proprietary index derivatives on its platform.

We think that opening up the exchange-traded derivatives market to further competition would be welcomed with open arms, not only from MTFs seeking to enter the market, but also by trading members looking for a more competitive landscape to drive down transaction costs.

However, one group unlikely to be in favor of these changes are the incumbent market operators. With the pending marriage of Europe's two largest derivatives exchanges as part of the NYSE-Deutsche Boerse tie-up, some have even speculated that the prospect of increased competition signalled by MiFIR may contribute to one or both parties getting "cold feet." While we don't see either party backing away from the proposed deal, we do believe elements of MiFIR will dictate the changes to the combined company that they are likely to recommend.

Whatever the future holds for European exchange-traded derivatives, it's clear that significant changes lie ahead. Trading firms looking to capitalize on these changes will need flexible trading and data infrastructures that can simplify connectivity to new liquidity sources, support redesigned trading workflows, and provide a common infrastructure for market data distribution. Building out that infrastructure yourself is costly and time consuming, which means managed vendor services will play a key role in helping the market adapt to the evolving market structure.

Rob Hegarty, is the global head of market structure, enterprise solutions, Thomson Reuters