January 30, 2006

From the Jan-Feb 2006 issue of Advanced Trading

U.S. exchanges aren't the only trading venues attempting to build the ultimate exchange (see cover story, page 30). The Toronto Stock Exchange (TSX) also is trying to increase profits and market share by adding new products. Rik Parkhill, president, TSX Markets, says the Toronto exchange - which trades predominantly equities - "would love to be in the derivatives business."

Canada represents 3 percent of the world's market capitalization, according to Jackie Chung, president of Competitive Metrics, a Canadian consultancy. Increasing that is a goal for the exchange, Chung says.

However, in 1999, the Canadian capital markets were restructured to create a more efficient and more liquid marketplace. As a result, the TSX became the country's center for cash equities, and the Montreal Exchange became the central exchange for derivatives. Consequently, a memorandum of understanding (MOU) exists between the TSX and the Montreal Exchange prohibiting the TSX from trading derivatives until March 2009.

Despite its inability to compete with the Montreal Exchange for another three years, the TSX has hired Robert Fotheringham as vice president of structured and derivative products "to develop a derivatives strategy," Parkhill says. "He will be looking at all of our options -acquisition, organic build - and looking at different types of derivatives products," Parkhill adds.

Hiring a derivatives strategist three years before the exchange is able to enter the derivatives market has sparked speculation that the TSX could be considering an acquisition of the Montreal Exchange. Parkhill declines to comment on talk of an acquisition or merger. However, he explains that building a new system and getting into a new business line like derivatives will take time. "It will probably take us that long to develop a system and get regulatory approvals," Parkhill says.

"My mandate is to create a plan for a platform," Fotheringham says. "An acquisition would be at a different level." Fotheringham also emphasizes that TSX Group CEO Richard Nesbitt has been clear in public comments that he plans to respect the agreement with the Montreal Exchange.

The plan to enter the derivatives space is in its infancy, Fotheringham continues. He relates that he is charged with creating a business plan and budget, which will be presented to management at the end of the first quarter. "I've been asked to research building a platform, buying a platform or leasing, and to put together a business plan and recommendation on how to proceed," Fotheringham says. He declines to specify which option looks most promising at this stage.

"We want to have something in place for 2009," Fotheringham adds. "We want to integrate what's already here and make sure things are seamless. We have a lot of work to do."

Fotheringham notes that the market is more mature than when the MOU was created. At that time, the market needed consolidation of the country's exchanges to create a central place for liquidity, he explains. "The markets have matured. Our model is stronger, the fact that we are a for-profit exchange now has made us focus on developing systems for the shareholder and the client," Fotheringham says.

"Going into 2009, it's in the best interest of our clients that we look beyond the agreement and enter into the derivatives space," Fotheringham says. "We've made a commitment that we'll be there."

TSX already has ventured into other product lines. It owns a 45 percent interest in Canada's electronic fixed-income platform, CanDeal, and acquired NGX, a natural gas and electricity trading operation from Sweden-based OM. In addition to researching the derivatives space, Fotheringham will look at all of the TSX platforms and products to determine if and how these markets should be integrated.

Why Derivatives?

Parkhill explains that derivatives are attractive for two reasons. First, "Trading volumes are growing at a faster rate in derivatives than in the cash markets, making the market very attractive," he says. Further, traders often hedge and offset cash positions using derivatives, Parkhill adds.

If the derivative and cash markets were integrated more tightly, the TSX could offer traders a one-stop shop - providing lower latency than if that trader had to complete a leg of a transaction on a different exchange, notes Parkhill. "The structure of trading and services is obviously around liquidity, speed of execution and order response times. If you can integrate the derivative and cash markets tightly, you can maximize what traders want," he says.

Fotheringham agrees that trading derivatives and stocks on one exchange will reduce latency. The time that it takes to move between markets will be eliminated, he asserts. It also will be more cost-effective, with fewer communications and technology costs, Fotheringham adds.

"It makes sense," observes Competitive Metric's Chung. "Why switch between different systems?" However, she warns, "The challenge of speed of trading is much greater in derivatives and options than for equities. It will be a major technology hurdle for TSX."

According to Chung, on the Montreal Exchange, it takes 3 seconds to execute a trade; Toronto currently is much slower. "Toronto has to invest enormously to make it commensurate with derivatives trading on the Montreal Exchange, and Toronto does have a large coffer to make this happen," she asserts. Chung contends that the Montreal Exchange's technology is superior to the TSX's technology. In fact, Montreal could emerge as a technology provider, she says, noting that it is the technology provider and part owner of the Boston Options Exchange. A TSX spokesman contends that the TSX executes trades in milliseconds.

Winners and Losers

When asked what this move will mean to the future of the Montreal Exchange, TSX's Fotheringham says, "It's tough to say what will happen to Montreal. Hopefully, competition will be good for the markets. Hopefully, at the end of the day, the client will win."

Chung isn't certain of the ramifications either. "I couldn't say who would emerge as the winner or if the two exchanges will join forces," she says. But one thing is clear: "Canada doesn't have room for two competitive derivatives exchanges."

On The Net

www.tsx.com
www.ngx.com
www.m-x.ca
www.candeal.ca

ABOUT THE AUTHOR