ThE FUTUrE oF CommodITy dErIvaTIvES - Futures and Options ...

The effect of regulatory
change on markets
Globalisation and
opportunities
Political and
commercial pressures
The Future
of Commodity
Derivatives
ISSUE 4 | 2011

welcome
Welcome to FOA InfoNet
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As 2011 draws to a close, we look back on another eventful year for the industry as it has
struggled to shelter from the onslaught of regulatory attack coming from both sides of the
Atlantic. The list of consultation documents and rules emerging from regulators in Brussels,
London and Washington, is huge and full of inconsistencies and unintended consequences.
Making sense of all this, and ensuring the industry’s voice is not drowned out by political
rhetoric, is at the top of the list of priorities for trade associations such as the FOA.
The rules around the implementation of Dodd-Frank in the US, for example, may largely be aimed at addressing
issues in the US market, but they clearly impact other markets beyond the States. Meanwhile, the review of MiFID
has gone much further than initially anticipated and, in some cases conflicts with work being undertaken under
the European Market Infrastructure Regulation (EMIR).
Of course, many of these developments have an impact on commodity markets, whether intentionally or not. For
commodities have been one of the key areas of regulatory concern, driven by political unease about high prices and
volatility in essential products. The answer, according to one school of thought, is to curb trading in these products,
particularly in financial instruments based on commodities, the ‘logic’ being that since trading in commodity
derivatives has grown in line with increased prices and volatility, the former must have driven the latter.
But, as the FOA commissioned research paper on the impact of speculative trading on commodity markets
suggests, the link may just as likely be the other way around – that higher prices and volatility have encouraged
greater participation in commodity derivatives. Certainly, the paper, summarised by its author Dan Corry at the last
InfoNet reported on in this publication, calls into question the assumption that speculation is bad and should
be restricted.
Others are of a similar view. In early December, the International Swaps and Derivatives Association (ISDA) and
the Securities Industry and Financial Markets Association (SIFMA) filed a legal challenge to the US Commodity
Futures Trading Commission (CFTC) rules that limit the positions that investors may own in certain commodities.
The associations argue that position limits may adversely affect commodities markets and participants, including
end-users, by reducing liquidity and increasing price volatility.
Where this action will lead to is not yet clear. But it certainly adds to the growing uncertainty around the future
for commodity derivatives.
Emma Davey, Director Membership and Member Services
davey@foa.co.uk
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3

the future of
commodity derivatives
Contents
5 InfoNet post-event report:
The future of commodity derivatives
20 All change: FOA InfoNet talks to Fidessa’s
Steve Grob about the changing market
structure for derivatives
22 Tabb report spotlights European equity
option flow into US and European market
potential
24 GHF takes risk management
to a new level with
Risk Informer
26 FOA news and events
Eurex Group_half page horizontal 26.04.2011 13:44 Uhr Seite 1
Safety,
efficiency,
diversity.
Just some of the things
we’re bringing to derivatives.
The InfoNet team
Emma Davey
Director, Membership and Member Services, FOA
davey@foa.co.uk
+44 (0)20 7090 1348
Bernadette Connolly
Corporate Events Manager, FOA
connollyb@foa.co.uk
+44 (0)20 7090 1334
David Setters
Contango Markets
david@contango.co.uk
+44 (0)7710 271291
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the International Securities Exchange (ISE),
Eurex Clearing, Eurex Bonds and Eurex Repo.
Eurex Group is part of Deutsche Börse Group.
Find out more at www.eurexgroup.com.
A report on the eighth FOA InfoNet:
The future of commodity derivatives
Moderator
Clive Furness
Managing Director,
Contango Markets Ltd
Emma Davey, FOA There are a number of
regulatory, legislative and political initiatives coming
at the commodities markets at the moment. These
have the potential to create quite an impact, adverse
or otherwise and we’re here to discuss what that
might be.
Our first speaker is Dan Corry, whose company
FTI Consulting has produced a report on speculative
trading and commodity markets together with a
review of the evidence and what impact that might
have. Dan will talk us through that report. (The
report is available on the FOA website, www.foa.co.uk)
Dan Corry The brief from the FOA was to produce
a review of papers on the impact of speculation in
commodity markets. There are a lot of these and
we agreed we weren’t going to review them all. We
picked a list of 20, which we discussed with the FOA
and some of the exchanges to check that we were
not missing something. It’s important to say that the
findings and the conclusions that we came to and
what I’m going to say about policy are what we think
and not what anybody else thinks.
The first thing you notice, reading through the
literature, is how much emotion goes through this
topic. Nobody really comes from a neutral position.
For obvious reasons, the price of commodities
matters a lot, particularly in developing countries, but
also in developed countries. You get a bifurcation – one
set of people feel that prices are determined by real or
fundamental factors, supply and demand, and another
set feel that prices are determined through financial
factors and futures markets. The latter set feels that’s
somehow illegitimate and I don’t think you’ll ever
persuade some of the public that isn’t the case.
But in academic literature, the interaction between
those two ways that prices get determined and how
they interact has been debated for many years and
I’m sure will continue to be. But in a sense that’s
where a lot of the complications come from.
The whole controversy starts by trying to define
speculation. People basically disagree about that.
The Commodities Future Trading Commission (CFTC)
defines a speculator as a trader who does not hedge,
but who trades with the objective of achieving profits
through successful anticipation of price movements.
It’s a simple definition, making clear as well that
speculation is lawful, very different from market
manipulation.
But these definitions are disputed. When is
speculation not speculation? When is it hedging?
How do you measure all that in the data, not least
when a lot of firms are doing both? So there are
complications from the outset.
As an economist you should always look at what
the data says. A lot of people have said that if
economists had focused a bit more on the long run
of history, they would have seen the financial crash
coming. I thought if they’d only focused on the
previous decade or so…
If you look at a fairly simple graph (see diagram 1,
page 6) since 1960, what is interesting is you see a lot
of volatility in prices, certainly in the 1970s and a bit
in the 1960s too. Then it comes to a halt and we get a
remarkable period of stability. Then, from 2000, and
particularly when you get into the 2006-2008 period,
you have incredible volatility.
Some people have asked if the strange period is in
fact that long period of stability as opposed to the
4 5
Speakers:
Dan Corry
Director, Economics,
FTI Consulting
Julie Winkler
Managing Director,
Research and Product
Development,
CME Group
Jonathan Parkman
Head of Agriculture,
Marex Spectron
Marc Cornelius
Policy and Regulation
IST – Compliance,
BP Oil International
Brett Hillis
Partner, Reed Smith
Caroline Davis
Managing Director,
Business Development,
Ffastfill
Louis Hems
Head of Customer
Relations, Gas and Coal,
EEX

the future of
commodity derivatives
periods of volatility at either end. But in the current
debate, most of the attention is on the last decade.
This graph just looks at the last decade (see
diagram 2, page 6). There is a massive spike in prices
and then the fall. I was working in government
when we had the great spike and it was the only
thing we were worrying about. We didn’t know that
it wouldn’t be long before we’d be worrying about
other things like Lehman’s. By the time we got our
act together to start thinking about it, prices had
collapsed and we had different problems.
So why might speculation be a good thing? You all
know that among economists the view is that it aids
price discovery and should allow information about
supply and demand, current and future expectations,
to be reflected in prices so that everybody is trading or
making supply and demand decisions on the basis of
correct prices. It also facilitates risk transfer, increases
liquidity etc, which is important for hedging.
On the other hand, the concern about speculation
is that it can amplify pricing trends. As Keynes
put it many years ago, rather than people trying
to determine future prices on the basis of their
expectations of supply and demand and the new
information they get, they’re actually just watching
what everybody else is doing and trying to guess
what they’re going to do and they’re moving with
them. Keynes’ example was the beauty contest
where you’re trying to guess who’s going to win; not
actually who is the most beautiful.
You can then argue that you get short-term bubbles
and the net result is that instead of prices being the
correct guide to both supply and demand responses,
they entice the wrong behaviour, which is not only
inefficient, but has feedback effects that keep prices
away from the correct equilibrium. That is why this,
for economists at least, is such an interesting issue.
It’s important to note just how hard it is to prove
things on speculation. So, it’s conceptually and
practically very hard to answer the question about
what impact speculation has on volatility and
price levels.
Why is that? One reason is because to start with
we have to know what the path of prices would
have been, if we hadn’t got speculation. That is an
extraordinarily difficult thing to work out because
the equilibrium price, which is the phrase that
economists would use, is determined by a multitude
1: Prices and GDP since the 1960s 3: Problems 500 of causation
Real prices (2000=100, 2000$)
400.0
350.0
300.0
250.0
200.0
150.0
100.0
50.0
0.0
1960 1970 1980 1990 2000 2010
Agriculture Base metals Energy World GDP
Agriculture Base metals Energy World GDP
2: Prices in the last decade
Real prices (2000=100, 2000$)
400.0
350.0
300.0
250.0
200.0
150.0
100.0
50.0
0.0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Agriculture Base metals Energy
Agriculture Base metals Energy
of things. And how can you measure those? How
can you take into account valid expectations of
future demand and supply, which may or may not
subsequently manifest themselves. Let’s say the price
moved because everyone had an expectation that
something is going to change on the supply side; it
didn’t actually happen, but it was certainly valid at
the time.
What you’d need to do is to measure all those
things, work out the path for your equilibrium price,
then look at what actually happened to the price.
The difference between them is what’s happening
on speculation. Although, there’s also an argument
about would all of that gap be speculation or would
some of it be something else?
This is a familiar problem in trying to look at
exchange rates. To economists it’s very difficult to
work out what the equilibrium exchange rate is and
how much overshooting or undershooting you’re
getting and how prolonged it is.
The other major problem in this area is causation.
It is endemic in this literature. When is correlation,
45
40
35
30
25
20
15
10
5
0
Real global GDP (trillions, 2000$)
4: Prices volatility with and without speculation
in fact, causation? It’s extraordinarily difficult to
prove. One good example of this is with commodity
index funds. People often look at a diagram like
Source: Bassam Fattouh, Oxford Institute of Energy, January 2010
this (see diagram 3) and say there’s a hell of a lot
more money in index funds. At the same time we’ve
also got a big rise in prices so, therefore, the case is
proven. Of course, the causation can quite reasonably
be argued to be exactly the opposite way round.
Economists try and guess at this through
econometrics – fancy statistical techniques. People
make good efforts at this, but it’s very hard to get
an actual causation. One set of tests tries to see if
one thing preceded the other. Then you might think
that shows that one caused the other, but it doesn’t
actually show that.
The other thing that economists have done over
the years is something called ‘Granger causality’.
It doesn’t really prove causation; it’s a statistical
test to show whether one series helps in forecasting
the movement of another series. Economists are
usually quite careful about this. They will write
that something ‘Granger caused’ something else;
they won’t actually say it caused something else.
So, it’s extraordinarily difficult to prove causation,
particularly using econometrics. You need to get into
the micro-issues to understand exactly what people
were doing and ask if there is any logical way which
could have caused that? But, equally, can you tell a
story where it didn’t?
You also have problems about having consistent
data, not only on financial variables, but on physical
inventories etc. There’s no particular reason to think,
a priori at least, that the way that prices are formed
and speculation futures prices interact with spot
prices is going to be the same in each product; we
could get a lot of differences.
The first thing I’d like to highlight is that our
review of the literature suggests that fundamentals
are the key driver of both spot and futures markets.
All the economic literature we’ve reviewed would
come to that conclusion. That’s important because
often the debate is about the margin, about how
much of a role speculation is playing, and that’s very
important. But it sometimes gets missed out that the
key things pushing prices are the fundamentals of
supply and demand.
The conclusion we came to is that it is clear that
speculation can at times exacerbate price movements
and thus introduce misleading price signals. You can
then get some reinforcing behaviour where people
follow herd behaviour. But most agree that it’s likely
to be short term and therefore there will not be
prolonged periods where people make supply and
demand decisions on prices that are at great variance
from the fundamentals. There are exceptions to
that and a particularly great argument about what
happened in the 2006 to 2008 period.
Another strong finding is the issue about when
you look at commodities with futures markets and
without them. What you find (see diagram 4) is that
you couldn’t guess in advance which one of these was
going to be traded and which are non-exchange traded.
I wouldn’t claim that it’s absolute proof of
anything and some people argue that these things
miss out the fact that different commodities, some
may not be traded, have close substitutes to things
that are traded. But there is powerful evidence that
suggests that something else is going on here.
Particularly in recent literature, the big thing
people do try to argue about is the massive increase
6 7
S&P GSCI SPOT PRICE COMMODITY INDEX
S&P GSCI SPOT PRICE COMMODITY INDEX
400
900
300
800
200
700
100
600
1400
1200
1000
800
500
400
300
200
100
1400 600
1200 400
1000 200
800
0
600
400
200
0
900
800
700
600
1970
1972
Molybdenum
Molybdenum
1970
1972
Total Long Commodity Assets SB
Total Long Commodity Assets SB
Cadmium
Cadmium
Non-exchange traded commodities
Rhodium
Ferrochrome
Cobalt
Tungsten
Manganese
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
Non-exchange traded commodities
Rhodium
Ferrochrome
Cobalt
Tungsten
Manganese
Rice
Rice
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
Iron ore
Iron ore
Steel
Steel
Ruthenium
Ruthenium
WTI
2000
2002
2004
2006
Jun-08
$300
$100
$250
$50
$200
$0
$150
S&PGSCI Spot Price Commodity Index $100
S&PGSCI Spot Price Commodity Index
Exchange traded commodities
WTI
Copper
Tin
Natural gas
Lead
1994
1996
1998
2000
2002
2004
2006
Exchange traded commodities
Copper
Tin
Natural gas
Lead
Source: Bassam Fattouh, Oxford Institute of Energy, January 2010
Nickel
Nickel
Silver
$50
$0
% change
since end 2001
Silver
Gold
Corn
Jun-08
Zinc
Aluminium
$300
$250
$200
$150
TOTAL LONG COMMODITY ASSETS
(BILLIONS OF DOLLAR)
% change
since end 2001
Gold
Corn
Zinc
Aluminium
TOTAL LONG COMMODITY ASSETS
(BILLIONS OF DOLLAR)

the future of
commodity derivatives
in financialisation recently and that this must be
having some effect on price behaviour. What it seems
to say is that there’s a possibility that it’s amplified
some behaviour.
There is a strong argument made in a recent paper
by Adair Turner and colleagues, which we didn’t
review – because it wasn’t published in time – on the
oil markets. It argues very strongly that oil markets
are going to be volatile anyway. Even if you had
no speculation, the interaction of different price
elasticities, income elasticities, supply bottlenecks
etc, means that price is going to be moving a lot. If
you do have a bit of herd behaviour and some things
that people think happen through index funds, you
can get a bit of amplification. But it’s very much
not proved that it has had that effect. When people
have looked at how people are behaving and making
decisions within index funds, it’s quite hard. In fact,
the Turner paper argues that it’s quite hard to argue
that that’s actually what’s been happening.
There’s a theoretical point about if speculators are
pushing prices one way, somebody’s taking the bet
the other way. The literature actually slightly steps
around that.
There’s another strand of the literature that argues
that prices have become much more correlated with
GDP and in some ways that must mean that instead
of fundamentals of supply and demand of that
commodity determining prices, something else is
going on. But most people think it’s not surprising
that a lot of commodity prices are correlated with
global GDP; it’s what you’d expect. You might find
it more surprising that in previous decades that
wasn’t happening. I don’t think that proves anything
either way.
The period that causes the most excitement is 2006
to 2008. We do have an issue here about whether
that was something peculiar about that period where
the whole world economy was convulsed with all
sorts of things going on. Economists find it difficult
to explain that period; they find it difficult to explain
in all sorts of markets. All the models broke down;
they didn’t predict what happened.
Was it something strange and are we going to
be back to some kind of normality or not? The
economist’s answer is that we’ll have to wait for
another decade of data. That’s not very helpful
when you’re a policymaker and it’s surprisingly
rare in these papers that they’ll stick their neck out
and say what percentage of price volatility is from
speculation. At the end of the paper where they’re
coming down in a qualitative way, they tend not
to stick numbers on. The highest number that we
came across in this review was for that key 2006-
2008 period with about 25 per cent of the volatility
attributed to speculation, particularly in 2008.
There are arguments that speculation can in fact
smooth volatility. It’s always been a theoretical
argument that that’s how markets should work. That
may explain that interesting period where we have
very steady prices between the 1970s and the 2000s.
There is some very old research where we had the
one natural experiment which we don’t often get in
this sector. Onions have been traded on and off in the
USA and looking at that market it does seem to show
that you get volatile prices when you have futures
trading going on and speculation.
People haven’t totally engaged with that in the
literature, partly because there have not been many
experiments like this. And I’m not sure we want
policymakers to give us any new similar experiments
by turning things on and off just so economists can
have a good go at the evidence.
Although it wasn’t really in our brief we wanted to
think about what this all means for policy. And the
overall thing is that policymakers have got to look
at the hopeful gains from any policy intervention
they might consider against the potential loss from
having less activity in futures markets. They need to
be quite clear what problem they’re trying to solve,
whether the instrument that they’re thinking of is
appropriate to solve that problem as opposed to some
other problem, whether the proposed policy can
achieve what’s hoped for, and of course whether it’s
operable and enforceable.
In addition there’s a danger, if you do think there
is too much speculation, on what the intervention
should be. Do you get distracted from the real issues,
the real fundamentals? There are many things
that cause prices to be volatile. They’re difficult for
governments because they’re obviously international
and in context they’re about trade and supply
barriers and all sorts of things. Politicians in different
countries and organisations slightly dodge those and
go straight to this speculation thing. You’ve got to
weigh these things up and think what you’re doing.
“Unless a regulator has really got
experience of commodities, then
you’re always going to be slightly
concerned about what’s going to
come out from them.”
Brett Hillis
Policymakers in my experience do make their
decisions on the best evidence, but this is an area
where there’s massive emotion; there’s a lot of
tendency to go for populism and that needs to be
resisted. One thing we did want to emphasize – and
nobody disagrees with this in the literature – is that
transparency is a good thing. Markets work best
where everyone is clear about what’s happening; as
much transparency as possible has to be a good thing.
You may think it confirms everything you ever
thought about economists, but what we have found
is that the literature can’t really decide on how
much speculation drives prices – which is not the
impression you would get if you were following this
in a fairly loose ‘reading the papers’ kind of way.
Policymakers have to be very careful about what they
do, and the onus is very much on those advocating
policy interventions to show they really would lead to
a better place, that the pros outweigh the cons, as it
is the other way the debate often seems to go.
ED Brett will now give us an update on some of the
regulatory issues in this area.
Brett Hillis There are three or four different
measures to look at and they don’t all fit together
particularly well. First of all there is the MiFID review
and in terms of commodities we’re looking at two
separate areas. First of all there are the ‘perimeter’
issues. That is things like cutting back on the
commodity exemptions, the provisions about third
country access to EU counterparts, professional
clients, eligible counterparts, requiring people to be
regulated abroad etc. That’s going to be a potentially
big issue for people who’ve been based abroad, but
who have been accessing the UK through the overseas
person’s restrictions. The addition of emissions
allowances to the scope of financial instruments is
another example.
Then you have the market issues, including
the addition of position reporting language, the
requirement for regulated markets, NTFs, OTFs etc to
establish position limits. Initial comment on that was
if it’s at the member state level that’s better because
we can rely upon the good sense of the UK exchanges
and authorities. But then there’s still a co-ordination
role for ESMA, which sounds like a licence to meddle.
We’ll have to wait and see where that goes.
We didn’t think that authorities in Europe were
quite so keen on pushing derivatives onto organised
facilities as in the US but the idea of having
organised trading facilities and potentially requiring
some of the derivatives that fall within the clearing
obligation in EMIR to be traded on OTFs or other
organised facilities is within MiFID, so there’s an
awful lot to look at there.
There is also the Market Abuse Directive review,
also due out in October and the potential extension
of the definition of inside information with respect to
commodity derivatives. That would make it a stronger
definition, which would mean you would not rely on
the concept of accepted market practices but it would
be more aligned with the securities market.
Then there is the bringing into scope of spot
emissions allowances, EMIR, of course, and OTC
clearing, which is winding its way through the
process.
The final thing to mention is REMIT, the Regulation
on Energy Market Integrity and Transparency,
which was adopted by European Parliament on
14 September. This is really a market abuse, data
collection, registration regime for people conducting
wholesale energy trading beyond the scope of MAD.
Of course, as ever, the devil is in the detail. It really
isn’t clear at the moment that there aren’t going to
be some gaps and overlaps with the measures that
are in place.
8 9

the future of
commodity derivatives
Clive Furness Let me open with a comment that
was made at a recent FOA InfoNet meeting by Mark
Fox-Andrews of ADM. Mark has been around the
commodity markets a long time and knows what he’s
talking about.
This is what Mark said in May. “I think hedging has
been made so difficult for hedgers now in terms of
the consequential volatility of all these fast market
traders, but actually I suspect it won’t be too long
before someone comes along, maybe even the Lloyds
Insurance Market – which let’s face it is what hedging
is supposed to be – who’ll come along with some
version of markets for hedgers, to get them out of
this arena just because it’s impossible.”
He went on to describe a customer he’d recently
seen, ”a perfectly reputable coffee hedger’ who, a
few weeks previously had seen the price go down 9
per cent and then end the day closing up 3 per cent
intraday. The resultant margin call was a staggering
sum but fortunately the markets then calmed down
a bit. But the hedger’s reaction was, ‘I can’t use these
markets any more; I can’t have faith that there’s
going to be any kind of logic as to how the prices are
going to move, especially in the smaller commodity
markets, which you know can be whipped around by
one hedge fund.”
Now, that may be emotion talking, but it’s
somebody who’s in the market and feels it quite
distinctly from their customer base. So, Jonathan,
is this something you’re experiencing? Are your
customers feeling this sort of pain?
Jonathan Parkman Absolutely. The pure
hedgers, the producers that we operate for, yes,
they’ve felt that; they’ve felt it the last two or three
years and it has been very difficult. An awful lot
of traders will say it’s been incredibly difficult as
well and there are plenty of hedge funds that are
experiencing a lot of pain at the moment; their
results are quite clear.
Yes, it has caused a tremendous amount of
difficulty. Away from the bigger picture, looking
at my specialist area of agricultural markets in a
little bit more detail, some of the problems that
we experience have to do with how the contracts
are written. They were originally written for fairly
small domestic arenas and then marketed as global
benchmarks. That has caused quite a lot of the
problems.
“Some of the problems we experience
have to do with how contracts are
written. They were originally written
for fairly small domestic arenas and
then marketed as global benchmarks.”
Jonathan Parkman
I’m as guilty as anybody. I’m not blaming the
exchanges here. I’m a broker and want to see much
more volume, so I actively market those contracts.
But we haven’t necessarily kept pace with re-writing
those contracts to make them suitable for the type of
instrument that we’d market as a global benchmark.
CF That’s interesting because it leads on to
another point. Should we be thinking about the way
in which derivative contracts are structured? Julie,
you’re in the product development space. What can
an exchange do? What are exchanges doing to try and
deal with effects of volatility in the product?
Julie Winkler It is difficult. Regarding Jonathan’s
point, people are attracted to the global benchmarks
because they want the liquidity. And it may not serve
the specific risk that that producer is facing, but it’s
the liquidity that’s enough of an attracting factor. And,
we certainly have seen extremely volatile markets.
Developing new products is extremely difficult.
Finding those new regional markets to develop and
to be global benchmarks is something we’d love to
be very easy to do, but, particularly in agricultural
markets, which have historically been physically
delivered contracts, it sometimes takes us two years
to develop a new physically delivered product.
The market can’t wait two years for that type of
development.
We are looking to other cash settled alternatives
that can be designed to supplement some of the
physical delivery vehicles that exist today. Much of it
is about opening up access to markets and allowing
people to offset their positions as quickly as they put
them on.
CF Louis, you represent markets that have
accepted index settlement, index pricing as part of
the way of doing business. Was that simply because
that was the only alternative? What’s happened to
make it different for the utility energy markets?
Louis Hems The power sector has been an
interesting example of that. In the past EEX has done
a lot of work doing day-ahead auctions, which create
a defined index price. That gives market participants
a lot of respect for any futures or derivatives that are
traded off that index. We spend a lot of time looking
at ways to make these indexes more robust and to
improve transparency.
For example, when you come in to trade power, not
everyone owns a power station and it’s very difficult
to know exactly what’s going on in the market.
One thing we’ve worked towards is opening up the
transparency, making those who own power stations
report on what’s going on with the power station.
We do that via a transparency website, which helps
facilitate the market. It’s all about making it a level
playing field for other traders.
CF So, it’s the flow of information from the
market to the exchange to ensure everybody’s got it
on an immediate basis?
LH Exactly. One problem you could have is if a
power station has a trip or something, you might
not hear about it for some time. Of course, this gives
the owner some advantages, so we’re really about
opening up the transparency.
CF What about the coal market? That’s
much more of a more traditional shipped physical
commodity.
LH We are listing financially settled coal and
using the main Argus indexes because these are the
ones the market has taken up. Our exposure to coal
isn’t huge; it’s something we’re looking to develop in
the future. It’s about using an index that people can
respect and trade off knowing that it’s robust.
CF Marc, do your traders express a preference
from a trading perspective as to what they like best?
Marc Cornelius Because of our almost unique
position of being producer, refiner, marketer, trader,
we see a lot of information; we also have a lot of
risk in that complex. And different instruments do
different things for us. We will use both the futures
and OTC markets to manage those risks and express
our market view.
What we’re seeing – as both Jonathan and
Julie mentioned – is around contract design and
market structure, particularly in oil with current
debate being around the benchmarks; are they
representative?
Brent is a great example of that. It was a contract
designed for the Brent physical market initially.
You’ve got this inverted pyramid of liquidity now
where at the bottom you’ve got ten players, maybe
in the physical space, who are able to take delivery
of cargoes of crude oil, and then the BFOE [Brent,
Forties, Oseberg, Ekofisk] market somewhere in
between with a slightly expanded set of players. Then
you have this vast futures liquidity as well.
CF Is that the tail wagging the dog?
MC One of the things we’ve seen is nonconvergence
between physicals and futures prices.
That goes to the very heart of contract design. In
theory, they should converge at some point. But
if you’re seeing consistent non-convergence, that
potentially points to a problem in contract design.
Platts are addressing that and ICE is gradually
picking up on it as well.
CF Contract design is extremely difficult. Every
exchange, at some point, experiences displacement
of the physical price against the futures. It happens
in commodity markets. Surely, commodity markets
are about physical things and if a limited supply is
displaced slightly, somebody can make some money
out of it. What’s wrong with that? Brett, moving back
to the comments on regulation, are regulators afraid
of commodities?
BH I’m not sure that they’re afraid of them,
but I suspect that they don’t quite understand
them. You have to remember within Europe, you’ve
got ESMA, which is really made up of securities
market regulators. They will naturally be thinking
in securities markets terms. Unless a regulator has
really got experience of commodities, then you’re
always going to be slightly concerned about what’s
going to come out from them.
JP Commodity markets can learn quite a
10 11

the future of
commodity derivatives
lot from equities markets in the way in which they
introduce regulation on positions and position limits.
There are certain rules which equities markets apply
to a certain percentage of ownership; it doesn’t
stop people owning it, but it makes the information
public.
Something that’s been spoken about a lot is that
an obvious weakness in the commodity markets is
lack of transparency. To bring in a declaration at
a certain level of how much individuals own is a
very important thing. Why is it anonymous in the
commodity markets when it’s not anonymous in the
securities markets? I don’t understand why we should
be special in that respect.
MC Owning what?
JP Oh, whatever you own; if you own futures,
declare the fact that you own futures.
MC How about physical?
JP Yes, declare that too, but you don’t have to
declare that to the futures markets.
MC My point would be that you can declare
so many millions of barrels of WTI in storage at
Cushing, for example, and that tells the market
exactly that; nothing else. It won’t tell you why those
barrels are being stored.
JP If you take the securities example, when you
own a certain meaningful percentage of a company,
you have to declare your interest. Why should we be
different in the commodities market?
CF This is exactly related to what Louis has just
said. I don’t think it’s mandated with EEX, but with
Nordpool, the second you have a station outage, you
are not allowed to trade anything until such time as
that’s posted on the exchange website and available
to the marketplace.
I’m playing devil’s advocate here, but I take
Jonathan’s point that if you are going to be involved
in these markets, then transparency is everything.
Regulators need to know everything. They’re only
finding out half the story if they don’t look at the
physical.
MC To come back on that, I’m a firm believer
in regulatory transparency. However, public
transparency is a very different beast. Greater
transparency should not be an end in itself. For
greater transparency to be effective, it has to
be meaningful. In the physical oil markets for
example, fundamental supply demand data will
“Not every risk out there needs to
be solved with an exchange traded
product. We’ve demonstrated that
over the last decade with the growth
of ClearPort and the innovation there
around new products.”
Julie Winkler
be meaningless if you don’t get OPEC members on
board.
I agree that position limits or position
transparency are ways to encourage and get a better
sense of dominance or people holding particular
positions. But if you say you need complete
transparency in the physical space, I think that will
be extremely challenging.
JP I’m concerned that the common target of
the politician has not actually been trade houses, but
it’s generally been speculators, whoever they may be.
I’m certainly in the camp that believes that that’s
unfair. We shouldn’t just be targeting the speculators
as the bad boys of everything that’s happened.
But where a trade house is concerned, you can
adjust your limits to appear different to speculators.
Currently in the CFTC report they’re treated
differently for those exchanges. We can adapt to treat
different forms of the market in different ways.
CF But aren’t there ways of getting around the
limits anyway? There are so many ‘me-too’ contracts
in the world, particularly in the energy space. You can
trade WTI in, what, five places now? You can trade
the original two and then you can trade lookalikes in
Dubai and elsewhere, all cash settled, none of which
come under the jurisdiction of the person that sets
the original price or the original limit; it’s a farce.
BH You’re always going to have an arms race
between the regulators and the market in a situation
like that. The regulators are wise to the fact that
there are lots of different venues and with MiFID
II, they’re basically talking about covering within
Europe any organised trading venue with position
limits.
Then you have questions about international
pressure and will the US or Europe put pressure on
other jurisdictions. Those questions will carry on
running for a long time potentially.
CF I’d like the guys from Trayport to address
an issue on the OTC energy markets here. Isn’t there
a danger that the lack of transparency in an OTC
market actually kills the development potential
for the product itself? The multiples you see in a
liquid commodity derivative traded on exchange
are significantly higher than those traded on OTC
markets. Isn’t there a danger that what happens
is the market loses something by not having that
transparency?
James Davies, Trayport The question is whether
or not the results of that have been better. In Europe
the marketplace has generally got more transparency
than the US, where it exists on a series of exchange
contracts. In the US you have a range of different gas
hubs, yet all of the gas is traded around Henry Hub.
Whereas, in Europe they have a number of different
gas points that have liquid contracts on them, where
you can sit in front of the screen and see a bid/offer
stack with a reasonable amount of depth on it and
you can execute a reasonable amount of volume
compared to the physical that you want to trade in
that marketplace. I think that’s quite an effective
contract.
The European energy market stands almost alone
among global markets as operating in a different
way with a combined order book of different
OTC derivatives that’s transparent to the entire
marketplace. A fair portion of that is cleared, so we’re
not talking about credit risk here. It represents a
reasonably good model.
We went over to see the CFTC and showed them
this model. They understand that there could be
a marketplace that was OTC and at the same time
transparent, open, easy to access and available to
everyone within that marketplace. It was a revelation
for them.
CF So, is basis risk actually becoming so much
of a factor now?
JD Looking at the trend mentioned earlier
“Greater transparency should not
be an end in itself. For greater
transparency to be effective, it
has to be meaningful.”
of a flat 20 years’ worth of volatility and at what’s
happened recently, we really don’t know what’s
happening. Where does market risk sit against credit
risk now? We know the game has changed but which
one’s more important?
JW Not every risk out there needs to be solved with
an exchange traded product. We’ve demonstrated
that over the last decade with the growth of
ClearPort and the innovation there around new
products. We’re rolling out 300-400 new products a
year just in the energy and metal space to address
what he’s talking about there. There are alternatives
and solutions and that’s the type of innovation the
industry needs.
CF Caroline, what role does technology play in
bringing new markets to new players? What are you
being asked for by your customers?
CD There’s a number of different things.
The changes to us are a double-edged sword. From
one point of view, we don’t want to be developing
products purely for the sake of developing them. A
lot of the changes that we’re seeing are preventing us
from innovating in other ways. But we also see that
changes and nuances in the commodity markets give
technology vendors the ability to innovate, to change
and to put their stamp on the markets with things
like the London Metal Exchange and other nonstandard
markets. We’ve been very successful in the
front office area in that respect.
The changes that we’ve seen in the back office of
the power markets has given us a chance to come out
with things that aren’t typical, standard products
and that allows us to address specific questions that
are out there in specific markets.
We do find that these products cause a lot of
challenges in terms of the technology, the underlying
code base, the flexibility that we need within the
architecture and it does mean that there is some reengineering
that needs to go on and some stretching
of the boundaries. But certainly with some of the
new technology that’s out there, we’re very interested
to see the markets continue to develop and to see
products that aren’t standardised.
CF In terms of non-standardised product,
though, surely that’s a very heavy development
commitment for you in that you’re building for a
specific company’s needs.
CD It is, and we have to be a little bit choosy
Marc Cornelius
12 13

the future of
commodity derivatives
as to what we actually develop to. We’ve seen, for
example, a lot of new venues coming up in Asia. We
haven’t written or provided access to them all. We
hope we’ve punted on the right ones; we’ll have to
wait and see.
It’s all very well us writing to an API, but if there
isn’t the volume there then customers aren’t going to
get into that market and they’re not going to clear it.
It’s very much a chicken and egg situation.
CF I wanted to cover clearing and the post
trade environment. We’re seeing quite significant
volumes developing in newer portfolio clearing, for
instance, in terms of linking cash and the derivative.
Should we be doing that in commodities too, given
the physical market and the futures market are so
inextricably linked? Shouldn’t we be trying to provide
better efficiency?
JW With all the regulatory changes it’ll come
down to capital efficiency. If product design and
clearing require that, that’s really what’s going to
drive things. People will need to bring business to
exchanges and clearing houses that provide them
that capital efficiency.
CF One thing that concerns me is the
mismatch of cash flows in the physical market and
the derivatives market. If the hedger I mentioned
earlier had had a hedge where the cash flows
matched on the physical and the future, that
wouldn’t have been as much of a problem. There
would’ve been volatility, but it would’ve been more
manageable.
Surely, we need to start designing products or
learning lessons from other markets, the LME for
example, that do that more efficiently.
JP This goes back to what we discussed at
the start, product design. I was talking about the
way in which we have to be careful in pushing
the investment community into the physical
market. But at the moment generally when the
agricultural markets become spot, there can be
short-term inconvenience; it rarely gets through to
the consumer or affects the amount of food that’s
available to people in the world. I wouldn’t say never,
but rarely.
If we regulate the markets to such an extent that
investors feel they can’t get sufficient exposure to a
market that they believe in, they will find products
which will actually get closer and closer to the
“Changes and nuances in the
commodity markets give technology
vendors the ability to innovate,
to change and put their stamp on
markets like the London
Metal Exchange.”
Caroline Davis
physical. That could have a much more serious
effect on food supplies around the world. So when
regulators deliberate over the next steps, they should
bear in mind that if there’s a genuine desire for
exposure to a particular group of commodities,
investors are innovative people and they will find a
way to get it. It’s much more dangerous if it’s in the
spot physical market or small agricultural markets.
It’s not necessarily so true in a much more liquid
market like oil.
CF But it’s been happening already. AIG used to
operate in the physical markets quite extensively.
JP Certainly hedge funds do operate in the
physical markets but the majority of what they do
is related. I wouldn’t pretend to know exactly what
AIG did, but I had some experience with it. A lot of
what they owned in the nearby was hedged in the
forward so you could argue that the net price effect
was a structural one, not an outright effect. That’s
generally the way it’s happened up till now.
Most hedge funds, in my experience in the
agricultural markets, prefer to operate with the
liquidity of a futures market rather than with the
illiquidity of a physical market. But that’ll change if
we over-regulate the futures markets.
ED Marc, which areas of the approaching
regulation will have an impact on commodities?
And which will have the biggest impact on how you
operate?
MC The review of MiFID has the potential to
impact some firms greater than others. If some of the
exemptions are changed or amended they may bring
into scope companies that are purely hedging risks as
a consequence of the underlying business.
Then there’s position limits. We already have them
in the US so it will be difficult for Europe to resist
following suit. The challenge will be in deciding
how far do you argue against them on principle or
do you actually focus on making sure they do not
have a disproportionate or damaging effect of your
business?
A further concern is the extension of pre- and posttrade
transparency requirements across asset classes
and the potential impacts these will have on market
liquidity. There is no guidance as to how those
requirements are going to be calibrated at Level 2.
That’s going to be an interesting debate for ESMA.
Regarding EMIR, 50 per cent of financial oil is
already cleared, 25 per cent is OTC cleared, and only
25 per cent of the market has remained un-cleared;
that’ll be subject to additional bilateral collateral
management. While the larger market participants
will probably be able to absorb these additional costs,
my concern is the impact this will have on small and
medium sized players in the market.
The Market Abuse Directive: I don’t think it’s going
to be too difficult, because I think it’s pretty much a
replication of the UK regime in a lot of ways. I think
it’ll be a big change for other member states.
And then there is REMIT – that makes me nervous.
Transparency is great, as long as it’s the right
transparency. For example, we are concerned that the
requirement to disclose unplanned outages will give,
at best, unnecessary and, at worst, misleading signals
to the market.
CF Caroline, from a post trade perspective,
what are your customers asking you to do to reflect
their concerns about the regulatory environment?
CD A lot of the changes that we’re making are
around the energy markets. There are a number of
new venues that we’re being asked to provide access
to. There’s reporting and other tools that we’re
being asked for, to help provide a different, more
transparent view of the data.
There’s a lot of demand to get that data sooner, so a
lot of the work we’ve been doing has been around the
risk; moving the margin notifications from the back
office forward in the process to the middle or front
office; being able to offer real-time Span margining
against your cleared position or your trade position
rather than waiting for T+1 when it’s all a bit too late.
Work on the risk management area is certainly going
to continue for the foreseeable future.
CF With respect to innovation, Ian Dudden
from LIFFE, would you talk to us about what you are
doing in Vietnamese coffee?
Ian Dudden This touches on the point made
earlier on the evolution of contract design and
whether or not contracts are always keeping pace
with developments in the underlying markets.
We’re responsible for running all the soft and
agricultural contracts in Europe. Many of these date
back longer than the energy contracts; 50 years
or so with coffee, for example. We went through a
major re-write of our coffee contract two or three
months ago to reflect change in the dynamics of the
underlying physical market; the shift of production
out to Asia to a very large extent instead of being in
East Africa.
What we’re now looking at, given also the impact
of ‘just in time’ stock deliveries and that sort of thing
and the tendency for the end users to rely on the
trade intermediaries to carry stock, is a pilot study on
whether or not we can facilitate more secure storage
at origin – in this case in Vietnam, specifically – and
whether or not we can allow pre-grading of coffee,
because for our contract anything that is being
delivered has to be graded by us in London before it
may be delivered.
This would mean, at a much earlier stage,
knowledge and awareness for owners as to the
true value of that coffee, whether it’s potentially
deliverable and, at what sort of discounts or
premiums against the market. That in turn also helps
from the point of view of bank financing. Bankers
typically apply much less of a haircut for financing
something that has a certain significant quality.
That’s something we’ve been working on for the
last couple of months in Ho Chi Minh City. We’ve
not yet concluded if we’re going to go live with it,
but it certainly has a great deal of support from
our customers.
14 15

the future of
commodity derivatives
CF You’re taking changes in the market into
account and doing something about it. Julie, what
sort of innovations are you bringing in around some
of your products?
JW We’ve seen a lot of interest in two things.
One is options and the other is how we can better
express views on volatility in a very direct way.
Obviously those two issues are related.
One thing we’ve seen work across asset classes and
most recently in commodities is the introduction of
weekly options. These are options that are a product
extension. They sit alongside all of our standard and
serial options, but they give the market participants
a much cheaper way to express their views on events
that are happening within the next week.
An interesting thing with those products is that
we’re seeing about 50 per cent of the activity take
place within 24 hours of the expiration. It’s providing
opportunities, for example, around key economic and
crop reports etc.
CF So, they’ve basically become binaries?
JW Yes, because they’re just so short-term
in nature. We’ve seen them in equities. Treasuries
were introduced in January; we’re already trading
10,000 contracts a day. Corn, beans and additional
agricultural products are being rolled out.
There’s a lot of interest in volatility products. It
remains to be seen whether those are truly going to
work in the agricultural space, but we have the Soya
Bean and the Corn Vix out now. We’re working on
the wheat one and the OTC market is actively trading
variance swaps, so I think that type of innovation is
there. Obviously you look at the growth of exchange
traded funds and everything that the providers are
doing in that space. It’s outstripping the growth
of fixed income for the first time ever. People want
access to commodities; they’ll find a product to do it.
CF Louis, what’s coming from you guys in
terms of new development?
LH There are two main areas: one is options,
as has been mentioned, because they’re not widely
used in the utility energy markets yet, but clearly you
would expect them to start to be used.
The other one is specific to the markets we operate
in and that’s the area of environmental products,
such as renewable power. Our partner, EPEX Spot
SE, has elaborated a first concept on a green power
product. You could have a certificate of origin or
“We spend a lot of time looking at
ways to make power indexes more
robust and to improve transparency.”
Louis Hems
proof of where the power comes from and you could
trade it as a different instrument. It’s a way of having
green products in the market that can be traded in a
different way to normal power.
CF Would that be fungible with other power
delivery points?
LH Of course limited transmission capacities
impose some restriction on the physical flow of
electricity. However, the green origin of the certificate
can be separated from the physical limitations. For
example, a buyer who is interested in supporting
renewable energies might not care where the green
energy was fed into the grid, as long as it fulfils the
standards of “green” energy.
CF And do you have to have a hierarchy for the
type of generation it’s come from? Whether it’s wind
or solar etc?
LH No, not yet. this is something that needs
to be defined together with market participants.
Obviously, if political policy is such that a decision is
made to use such efficient and flexible instruments
as a support mechanism for renewables, regulators
will need to decide which type of generation should
benefit from it.
CF We seem to have gone a long way tonight
towards realising that we need to educate a few
people; regulators, the people who trade basis risk,
the users of the market etc. It seems we are facing a
problem, potentially of the market’s own making.
We won’t work out tonight what the cause of
Like others in the BRIC economies, commodities are
a key part of Brazil’s market. BM&F Bovespa is at the
forefront of developing the right tools to expand the use
of derivatives locally and beyond, as the exchange’s Chief
Representative, EMEA, Sergio Gullo, explains
Twenty years ago, Brazil went through what the Eurozone is
experiencing now – instability of the banking system, speculation and
so on. It is a very young economy and since then has had to do a great
deal of work to address the impact of speculative money coming into
the system.
The OTC market in Brazil has been around for some time, but the
country’s producers don’t use these tools to speculate; they use them
to hedge. The banking system, especially Banco de Brazil, the Brazilian
state-owned bank, has specific products to educate producers to use
these tools. BM&F Bovespa has teamed up with Banco de Brazil to
assist in the education process.
The exchange is also working on new products. The partnership with
CME Group is of great value and has been very successful in building on
the success of the past. Brazil is a big producer and exporter of many
commodities but there is a cultural issue about how to take advantage
of this. There is huge potential to explore.
Part of that potential will be tapped in partnership with others,
like CME Group, and the rest will be met with local initiatives. The
exchange has a key objective to encourage the use of local markets by
producers for hedging purposes. For example, we have been working
on developing a Brazilian commodities index for a number of years. This
includes ethanol – one of four products being followed in the index, and
a key commodity in Brazil.
We recognise that such a product could also attract external
interest. However, there remain barriers to foreign investors adapting
to local regulations. Since 2008, volumes from international players
have dropped dramatically. They are beginning to grow again, but the
imposition of local taxes has not helped the process.
The players that have been in Brazil a long time know exactly how to
trade there. Our challenge is to educate the newcomers. That’s what
we’re doing now. We opened the office in London in 2009 and we are
determined to continue to support new players to get into Brazil.
The opportunities are there. We are working very hard to translate
these into business opportunities for the community; not only for the
Brazilian exchange, but in partnership with the authorities and with the
banks. Then it’s a question of time. We know there is a long queue of
players looking at the market, trying to understand how to operate and
allocate resources to Brazil. So, in the next five years, we’ll continue to
see this grow.
16 17

18
the future of
commodity derivatives
volatility is; it’s probably as individual as what each
one of us thinks it is.
But we have worked out there are gaps in
knowledge and understanding; there are things we
need to communicate. As a commodities industry, is
there a way we can bring that education together?
This isn’t about one exchange or one region; it’s
about everybody. Should we do what the OCC do in
the USA, which is pretty effective? You have one body
that does a large proportion of the options education.
Can we do that?
BH I wouldn’t have thought so. There are a
number of people you’ve got to educate, including
policymakers, and we’re talking about Europe, which
is so disparate anyway. I don’t think you can put
that on one body. The problem is that if there is a
gap in knowledge, it gets filled by these immediate
assumptions, which as we’ve heard are often
completely unfounded.
CF So, do politicians fill the gap?
BH Unfortunately they do. The industry must
lobby hard on all of these issues. It will take a lot of
work and a long time, though.
CF To wrap up, would you offer a few views
on what you think the developments will be. It can
be anything you think is relevant. Personally I think
water, as a product, is very interesting and there will
be some big opportunities in that.
JW I think volatility in a product that allows
you to express that in a clean, concise way. It will
take time but what we’ve been talking about all
night is how volatile these instruments are. And a
unique way to be able to express that is needed in the
marketplace.
JP There’ll be a shift from west to east towards
where the exchanges are located. Regulation will
become too extreme and it’ll deter people from
investing here. Already exchanges exist that we just
can’t get at, in Asia. And the shift towards economic
power will continue with the exchanges moving east.
MC You’ll see gravitation towards the new
producer countries like Brazil and India. From
our own perspective, we are seeing increased
opportunities in deepwater, biofuels and gas.
The drivers are emerging markets and developing
economies, where there is increasing demand
for energy.
CD From our point of view, one of the biggest
challenges is obviously regulation, which drives
innovation. But we need clarity; we can’t develop any
software if we don’t have clarity. A very small change
in the specification can lead to an enormous change
in the way we need to create, deploy and architect the
technology. We just need a clear picture of exactly
where the industry is going.
BH I foresee a huge amount of pain for some
people on the regulatory side. But I also see issues
with jurisdictions engaging in a kind of ‘resource
nationalism’ over certain commodities, especially
the rare earth commodities. I think there’ll be some
difficulties in that area.
LH One thing you’ll see is globalisation of
these markets. People will come into them from the
financial side and start trading utility energy. What
I really want to get across is that the regulation in
these markets needs to be tailor made to that market;
we don’t want to be here in two years’ time where a
small German municipality can’t trade on an energy
exchange because it doesn’t have the sophistication.
We really need to have appropriate levels of
regulation.
IDX Gala Dinner
In aid of Futures for Kids
Wednesday 27 June 2012
The Artillery Gardens
@ the HAC, London EC1
FIA and FOA are pleased to announce that
the IDX Gala Dinner will, once again, be held
in aid of Futures for Kids.
For information on all FOA events, including
sales and sponsorship, please contact:
Bernadette Connolly
connollyb@foa.com
+44 20 7090 1334
FIA/FOA International Derivatives Expo
26-27 June 2012
The Brewery, Chiswell Street
London EC1
Mark Your Diary!
The Futures Industry Association and the
Futures and Options Association are pleased to
present the fifth International Derivatives Expo.
Last year’s event boasted more than 40 exhibits
showcasing the latest in products and technology for
the derivatives industry, plus 30+ sessions with high-
profile speakers, information-packed workshops, and
endless networking opportunities.
Reserve Your Exhibit Stand or Sponsorship Now
Contact
Toni Vitale Chan, tvitale-chan@futuresindustry.org, 1.312.636.2919
or
Bernadette Connolly, connollyb@foa.co.uk, +44 [0]20.7090.1334
for information on becoming a sponsor or exhibitor.
www.idw.org.uk

SPECIAL FEATURE
All change
FOA InfoNet recently spoke with Fidessa’s Steve Grob about the changing market structure
for derivatives and the implications facing participants in the light of ongoing regulatory
reform discussions on both sides of the Atlantic.
The first development is the
well-documented move to drive
OTC trading onto exchange,
or at least centrally cleared
platforms. “One of the main
reasons OTC instruments exist
is to meet specific customer needs that cannot be
met by standard contracts offered by exchange-traded
markets,” says Grob. “While the outstanding notional
value of the OTC derivatives market is enormous, the
number of trades is relatively small. These two facts –
low volumes and non-standardisation – mean the idea
of trading them on an electronic central limit order
book (CLOB) seems fanciful.”
Moreover, he sees complications for trading venues
and market participants with respect to the concept
of SEFs (Swaps Execution Facility) in the USA and OTFs
(Organised Trading Facility) in Europe. “The terms
are not interchangeable,” he says. “A SEF is a specific
platform for trading swaps while an OTF is an asset
agnostic platform which allows discretion on behalf of
the operator as to who can participate and with what
instruments.”
The second main influencing factor will potentially
come about as a result of the Deutsche Börse/New
York Stock Exchange merger and the need to satisfy
EU competition authorities. The merged entity will
naturally seek to withhold access to its ‘vertical’ clearing
silo from third party trading venues listing ‘look alike’
contracts that compete with its own. However, it seems
certain that one concession the EU authorities will
want to see is that the new exchange opens up access to
its clearing so as to encourage competition.
“Most of the MTFs have ambitions in derivatives
and it’s highly likely that other primary exchanges
will create look-alikes too. That means there will be
competition in the world of exchange-traded derivatives
that we have never seen before,” says Grob. “And
even if the merger doesn’t go ahead there is just so
much political momentum from regulators towards
transparency, trading on exchange and competition
that some change looks inevitable.”
Of course, these changes in market structure will lead
to significant changes in the technology requirements
of market participants. First, he believes, there will be a
need for smart order routing (SOR) in derivatives which
takes into account the fact that you may be able to take
advantage of margin offsets and other ways of clearing
instruments in more cost-efficient ways.
“It will be the same but subtly different from the
SOR we’ve seen in equities,” says Grob. “The differences
come about because the regulators are trying to
overlay equity-centric regulation onto a derivatives
marketplace. The most fundamental of these
differences is instrument ownership.
“For example, a Turquoise FTSE futures contract is
not the same as a Liffe FTSE contract, whereas Vodafone
shares are identical whether they trade on the LSE,
Chi-X or OTC. And, even if they are designed to be
economically identical, they still cannot be the same
because one is owned by Turquoise and the other by
NYSE Liffe. It’s a bit like the difference between Heinz
baked beans and own brand equivalents,” he explains.
“I can buy Heinz beans anywhere but I can only buy
Sainsbury’s beans at Sainsbury’s. The degree of sameness
will be driven by the ability to access the open interest
and clearing pools of one from another, so you’re going
to need the ability to set up ‘virtual fungibility’.”
SOR can get complicated very quickly, he adds,
“especially when you look at exploiting the different
maker/taker rebates across different venues versus
the wholesale discounts that some other venues offer,
working out minimum legging risk, different clearing
rebates, margin offsets etc.”
All these issues will need to be addressed by the next
generation of derivatives smart routing technology and
from the point of view of providing, measuring and
proving overall execution quality.
On top of this, asserts Grob, the second big change is
that workflow is going to get increasingly complicated.
“You’ll be seeing a much closer correlation between
the exchange-traded and OTC derivatives worlds. In
the equities world, exchange-traded and OTC have
been intermingled since the markets began and that
structure is going to permeate the derivatives industry.
So as orders come, they will get split up and filled
in a variety of different ways, with each potentially
having a different clearing and settlement instruction
associated with it. The end customer, however, needs to
be insulated from this added complexity.”
The third change, according to Grob, is that as
a result of more venues offering derivatives, the
distinction between the asset classes will continue to
blur. Customers will want to trade in less asset-class
centric ways. Rather, they will move towards getting
exposure to an asset through whatever instrument they
might choose. “So, if I’m interested in Vodafone I might
want to trade the stock itself, CFDs, bonds, warrants,
OTC options, exchange-traded options, single stock
futures etc. I’ll want to blend different asset classes
around a specific investment objective in ways that I
haven’t been able to before.”
Grob believes Fidessa is well positioned to take
advantage of the changes in technology requirements
“Exchange-traded and OTC have
been intermingled since the markets
began and that structure is going to
permeate the derivatives industry.”
driven by the market reforms. “When we looked at
entering the derivatives space, seven years ago,” he
says, “Fidessa was an equity-centric firm, albeit a highly
successful one. We decided that rather than acquiring
an existing firm we’d go back to basics and engineer the
core product to be asset class agnostic. The end result of
all that is that the robust work flow for which Fidessa
is renowned is just as applicable to derivatives now as it
is to cash equities. And, the SOR and other algorithmic
capabilities that we’ve spent 10 years developing will
now come to the fore with derivatives as well.”
The crucial outcome for clients, says Grob, is that they
can begin to break down their trading into horizontal
layers rather than vertical silos and benefit from a much
more efficient spend on technology and use of capital.
According to Grob, the ability to bring this level of
sophistication to the new derivatives workflow was
very much a key factor behind its recent contract
with Citi to supply a global order management and
distributed low-latency execution platform along with
BlueBox, its integrated algorithmic trading engine. To
complete the package, risk management functionality,
comprehensive market data and a global order routing
service will also be provided.
Jerome Kemp, Managing Director & Global Head
of Exchange Traded Derivatives at Citi, described the
deal as “a game-changing and empowering move” for
his firm, adding that, after an extensive evaluation
process Citi “chose Fidessa for their sophisticated,
integrated workflow capabilities that operate across
multiple asset classes.”
Fidessa already has some 40 derivatives market
clients but, says Grob, “The Citi contract is significant
because it’s the largest, but not the first, deal we’ve
done that has been derivatives only rather than
derivatives as part of a multi-asset project. It’s also
important because they are using our algo and SOR
capabilities for derivatives markets.”
Grob believes that customers are beginning to
appreciate that they need the technology to meet the
demands of SOR, workflow, algorithmic trading and
the ability to deal with multi asset trading. “Building
your own platform is always an option,” he admits, “but
it’s a hugely expensive one, not helped by the fact that
the exchanges themselves are constantly upgrading
their APIs as they compete for each other’s’ liquidity.”
Fidessa supports over 160 exchanges worldwide and
each of these venues will issue an update probably twice
a year. “So, on average, we’re developing, testing and
commissioning nearly two per day. Spreading the cost
of this across a substantial client-base is the only way to
do it cost-effectively. And then there are the demands
for global market data that needs to be delivered in a
coordinated way through ticker plants that are spread
across the globe.”
Looking forward, Grob expects more companies to
take a long hard look at their technology platforms
to see if they are adequately prepared for the coming
changes to market structure. He also sees banks and
brokerage firms coming into more visible competition
with existing venues. “As people start creating SEFs and
OTFs they may start to compete with the pure exchangetraded
world,” he says. “We’ve been having more and
more discussions on venues, exchanges and ordermatching
with banks and brokers and more brokerage/
order routing, distribution related conversations with
exchanges. It’s hard to say exactly how far that ‘cross
over’ trend is going to go.”
20 21

SPECIAL FEATURE
Tabb report spotlights European equity option
flow into US and European market potential
Recent studies from The Options Industry Council
(OIC) highlight both the importance of European order
flow into the U.S. listed equity option markets and also
the potential that Europe holds for equity options in
general as key portfolio management tools.
The Tabb report on European Demand for U.S. Listed
Equity Options (September 2011) reports that there is
$1.3 trillion in US equity-related securities in Europe, 46
per cent of the total amount of US equities held outside
the US and the largest concentration worldwide. This
large holding drives order flow into the US equity
option markets, accounting for an estimated 10 per cent
of the US total. A 2006 survey estimated that 15-20 per
cent of US listed options volume originated in Europe.
Annual options trading volume in 2010 rose to 3.9
billion contracts, more than doubling from 2005’s 1.5
billion contracts (Figure 1), meaning that an estimated
10 per cent share originating from Europe today equals
an increase of 30-73 per cent in the number of contracts
traded compared with five years ago. Tabb found that
European order flow using latency sensitive algorithms
has often migrated to a US location, the better to
harness faster access speeds. Accordingly, this is no
longer classified as European order flow.
Tabb also puts some metrics around the quality of US
equity option markets (Figure 2). Average bid/ask spread
declined 10 per cent, while average bid/ask size rose 41
per cent. Liquidity, transparency and market depth were
cited as key attractions. Typical strategies used were
directional/hedging (71 per cent); premium overwriting
(41 per cent) and volatility (6 per cent). Firms identified
the areas of greatest growth potential for options as
ETFs (50 per cent), volatility products (38 per cent),
weekly expirations (38 per cent), index products (25 per
cent) and single stocks (13 per cent). Only 10 per cent of
European investors used low touch trading channels, in
contrast to 66 per cent in the US.
Focusing on customer location and type, the 29 major
firms interviewed by Tabb ranked the UK, Switzerland,
the Netherlands and Germany as the top four countries
of origin (in that order). Europe-based hedge funds
were identified as the single largest component of
European demand, accounting for 58 per cent. Private
wealth managers accounted for 18 per cent, prop
accounts 15 per cent and asset managers 5 per cent.
Firms were also asked what were the largest drivers for
European business flowing into the US listed equity
options markets. The themes pointed to the increased
acceptance of listed options as a risk management and
positioning tool: 43 per cent referenced an increased
use of listed instruments, 36 per cent greater adoption
and 29 per cent more risk management.
The report also highlighted specific challenges.
Competition between exchanges sharing the same
clearing house was seen as a plus, but users found
market structure complicated while at the same time
being hindered by internal workflow challenges.
Finally, it was interesting to see what market users
felt would help their marketing efforts: 43 per cent
mentioned education, 43 per cent research/ strategy,
29 per cent industry events and 14 per cent technology
documentation. Looking to the future, regulation
encouraging the move from an OTC to a centrally
cleared environment was seen as fully supportive of
listed option business.
The Tabb report points to the market potential of
Europe. In addition to the $1.3 trillion in US equity
related securities held in Europe, European asset
managers represent $18.4 trillion equivalent in AuM
(Figure 3) and are increasingly turning to derivatives for
risk management and positioning. In addition, high net
worth individuals – 3.1 million in Europe, accounting
for $10.2 trillion equivalent in total net worth assets
– are an important target market. Findings from two
other studies commissioned by OIC are relevant here. In
the Harris study (April 2010), US option investors were
found to have higher household incomes, be better
educated and more likely to use options to generate
income, manage risk and build customised strategies
for existing portfolios. The Bellomy study (May 2011),
found that financial advisers with larger books of
business were significantly more likely to use options.
Nearly half of US financial advisers had used equity
options in the last 12 months, with one third of option
users increasing their option usage over the past few
years, in response to clients asking for ways to avoid
losses and enhance returns.
There remains a clear need for continuing
information and education. Some of the OIC-sponsored
academic papers may interest those seeking to develop
the responsible use of options. Loosening Your Collar
(Szado & Schneeweis, University of Massachusetts)
Figure 1: US listed equity option
volumes 2001-2011
Annual options trading volumes
(millions of contracts)
Figure 3: European asset
managers: total AuM
European asset managers:
total assets under
management =$18.4 trillion
All amounts in $US billions
found that for the 11-year period to September 2009
a long protective collar strategy using 6-month put
purchases and consecutive 1-month call writes earned
superior returns compared to a simple buy-and-hold
strategy while reducing risk by almost 65 per cent. A
related theme is explored in 15 Years of Russell 2000 Buy-
Write (Kapadia & Szado, University of Massachusetts).
Using 15 years of data ending March 2011, it concludes
that a passive buy-write strategy of one month to
expiration calls on the Russell 2000 consistently
outperformed the index.
References
− Tabb report on European Demand for U.S. Listed Equity
Options
− Financial Advisor Engagement Study (‘Harris study’)
− Financial Advisor Benchmark Study (‘Bellomy study’)
− Collar Study for Fund Managers
− 15 Years of Russell 2000 Buy-Write
Go to www.OptionsEducation.org and search on the
relevant title for a free download. (Registration may be
required).
22 23
CAGR 2001
to 2011 19%
781 780
2001
2002
Belgium $0.6
Italy $1.0
908
2003
1,182
2004
Source: OCC, TABB Group estimates
Netherlands $0.7
1,504
2005
2,028
2,863
3,582 3,613
Source: European Fund and Asset Management Association, TABB, Group estimates
2006
2007
2008
2009
3,899
2010
4,597
2011e
Other European
countries
$4.1
Germany
$4.2
Figure 2: Quality of US equity option markets
Quality of US equity option markets
0.27
0.24
Source: TOG, TABB Group
France
$4.2
112.0
UK
$5.6
157.8
June 2010 June 2011
22.3 22.1

SPECIAL FEATURE
GHF takes risk management to
a new level with Risk Informer
“The futures and options
industry has always sought
to make things happen more
quickly. We moved from writing
out pink and blue slips to typing
trades into the TRS system and
so on, technology has moved progressively forward.
We’ve always wanted to take advantage of that and
this is another piece in the puzzle,” says Peter Lovell,
Chief Executive/Managing Director of GHF Financials
(GHF) as he describes the scenario behind his firm’s
implementation of Patsystems’ Risk Informer product.
Over the last three to four years there have been
increasing calls to adopt improved risk management
systems due to regulatory demands, but Lovell says GHF
has been driven as much by its own corporate ethos as
by broader industry trends.
“We constantly review new products and are keenly
interested in new technology. We have a saying within
the organisation, ‘We never say ‘no’, we say ‘not yet’.
Technology moves at such a pace that you just have to
keep up to date and make sure that what you’ve got is
constantly re-evaluated and re-engineered. With Risk
Informer it helped that I was aware that Patsystems
are also good at re-engineering themselves and their
technology.”
GHF is a fast expanding clearing and settlement
organisation offering access to the main international
futures markets and a range of services, including
bespoke clearing, order routing and market
connectivity. The company is currently awaiting a
US FCM licence application and over the past year
has announced new memberships and connectivity
to exchanges including SGX, HKMEx and the Tokyo
Financial Exchange (TFX) as it continues its drive to
become a global clearer. The requirement to review and
re-engineer is magnified many times through having
to deal with the 24 exchanges and 140 plus products,
currently cleared on behalf of trading clients in farflung
locations around the world.
“The procurement and implementation of Risk
Informer was partly a question of addressing our own
scale,” says Lovell. “The drivers were two-fold; as we
have expanded we have needed tools to consolidate
the information we’re seeing in one single place but
just as importantly we were seeking a way to calculate
implied initial and variation margins as close to realtime
as possible.”
The evaluation process involved a short internal
review to ensure the product was suitable, but this was
essentially an extension of ongoing reviews over many
years, during which a number of other products had
also been examined.
There was, however, one key feature which GHF
was looking for, as Lovell explains. “Risk Informer
had already gained traction in the marketplace with
some significant players, but the key difference for
us was that most of Patsystems’ customers were
taking data from the ‘cleared feeds’ of clearing
houses whereas we wanted to use ‘trade feeds’. It was
Patsystems’ willingness to go out of their way to work
on incorporating this into the product which was the
clincher for us.”
Although Patsystems’ front-end is used for access to
some Far Eastern markets – through a licence with a
clearing firm – Trading Technologies (TT) and Stellar
are GHF’s main front-end suppliers. This provided an
interesting situation with companies normally seen
as competing being asked to work with one another to
provide the solution GHF required.
“The greatest obstacle was unfamiliarity from all
the parties with this scenario. We weren’t trying to
use competing parties as a foil, we were just trying to
get where we wanted to go. It was quite a challenge
changing from taking a cleared feed to a live feed so
there were some frustrations, but we had to realise it
did involve a high degree of complexity. So there was
an element of diplomacy, but once our needs were
understood I have to say that all the companies were
very helpful in moving things along,” comments Lovell.
The key feature was to have live transactions fed
into Risk Informer from TT and Stellar as soon as they
occurred rather than waiting for the cleared side.
“The key to me was margin,” says Lovell, explaining
the reason behind the change of focus from the
‘cleared feeds’. “Because we have very strict pre-trade
risk management processes, which start with ‘know
your client’ and how much money they leave with us
etc, we use initial margin as a plank in pre-trade risk
management. We then have a whole lot of internal
processes which allow certain amounts of intra-day
leverage in addition to the product itself.
“We were already looking at margin as a key indicator
but we were struggling to calculate it frequently
enough. Our view is that the effect of a client’s trading
losses may hurt us but, because of the way we manage
the pre-trade and post-trade risk, this is quite visible.
What we are always fearful of, typically with a client
with multiple sub accounts, is ending up with some
sort of concentration risk. We’d see that very quickly
through the margin, not necessarily through the P&L,
which is an important tool but one that doesn’t tell the
whole story.”
“We can see what our real underlying
market risk is on the trade side
as near to real time as possible
and on a consolidated basis.”
At the outset Risk Informer’s capability was to take
in a snapshot of the prices and calculate margins once
every three minutes but Lovell says that with Risk
Informer they have been able to “tune this up” to once
every minute, so the user has access to a P&L versus the
position and the implied margin at the same time.
Another important factor was the ability to drill
down into the data and ‘cut and dice’ it from multiple
points of view. “Now, I can split it down all the way to
individual sub-accounts so users can see per exchange,
per clearing house, per product and also what our
exposure is against the clearing house and what it is
versus the customer. You can select your view and it will
process to that view,” explains Lovell.
This also provides the ability to determine who sees
what and it can then be distributed to various parties
externally and internally.
“Because as an organisation we believe that risk
management begins with knowing your client and not
just how much money they give you, if we can give a
picture to the client of what is going on – a trimmed
down view, perhaps – then we always like to,” he
says. “And because you can set the hierarchies and
determine who sees what, it is highly distributable
not just to clients, but to staff as well. This ‘multiple
visibility’ means that every member of staff can be
part of risk management.”
To demonstrate just how rigorous the process has
become Lovell goes on to explain how GHF still uses
the other tools. “We haven’t got rid of any of them, as
we don’t believe that one system is going to tell us the
whole story. For our cleared side we use Sungard’s Ubix
product but it is a clunky manual process to run an
intra-day implied margin calculation, which we run
roughly once an hour. We still do that to check that
Risk Informer doesn’t have a problem. TT and Stellar
are combined into Risk Informer for the P&L and then
on the margin side we’ve got Risk Informer checking
calculations every minute and we still check that on an
hourly basis with Ubix.
“We have procedures throughout the day whereby
we make a visual comparison between what’s coming
through from the trade side through TT and Stellar
with what’s in Risk Informer to make sure that they’re
in line and comparing those to our cleared side. We use
all these tools to see if anything is breaking down. The
experience in the team is to spot when they are slightly
out of line and then pinpoint exactly why.”
One last advantage of Risk Informer, explains Lovell,
is that it makes GHF much more platform neutral on
the trade side. “Clients typically use different platforms
for different reasons. With this set-up, the front-end
suppliers can actually compete in the area where you’d
expect them to be competing. We can say to our clients,
‘You use the one you want, we’ll be able to see the
consolidated risk anyway’.”
The whole project took just short of a year from the
original evaluation to going fully live and in keeping
with the ‘constant re-engineering’ theme, regular
dialogue with Patsystems continues on bespoke
development. Lovell clearly believes the time and effort
has been well-spent, concluding, “The biggest benefit
is we can see what our real underlying market risk
is on the trade side as near to real time as possible
and on a consolidated basis. It moves the whole risk
management process up to a new level.”
24 25

NEWS and events
FOA News
Regulatory activities
Copies of the following responses can be found at www.foa.co.uk
Recent responses to regulatory consultation papers:
Regulator Consultation Date submitted
FSA
ESMA
BBA/FOA joint response to FSA’s guidance consultation
on the Transaction Reporting User Pack
Guidelines on systems and controls in a highly automated
trading environment for trading platforms, investment
firms and competent authorities
November 2011
October 2011
BIS BIS letter – capital charges on CCP exposure October 2011
26
In addition, the FOA has submitted a response to the FSA’s guidance consultation entitled Proposed Guidance on the
Practice of Payment for Order Flow and to the Questionnaire from DG COMP which ‘tests’ with market participants
the proposed merger remedies from NYSE and DBAG. The final decision on the merger from DG COMP is expected
by 23 January 2012.
FOA responds to EU proposal for a financial
transaction tax September 2011
Joint Associations letter to UK Chancellor
George Osborne reacting to the European
Commission’s proposal for an EU-wide financial
transaction tax October 2011
FOA enhances regulatory team November 2011
The FOA has enhanced its regulatory resources with
the appointment of Blake Stephenson as Manager,
Regulation and the promotion of Simon Andrews to
Director of Commodities. Both report to Kathleen
Traynor, Executive Director, Regulation.
FOA Members
The FOA is pleased to welcome the following new
members:
Nasdaq OMX
Linklaters
Kinetic Partners
Orrick, Herrington & Sutcliffe
Alpari
Forex.com UK Ltd
MCX Stock Exchange
FOA Events Calendar
The City Debate
22 February 2012, The Mansion House
Topic: Is the City Fit For the Future?
Since 1996, the FOA’s annual City Debate has become
established as one of the City’s more entertaining and
intellectually stimulating debating forums. It provides
the City’s international financial services community
with the opportunity to address topical issues which
have the potential to affect the current and future
development of the industry. The event comprises a
black-tie dinner followed by university-style debate,
featuring leading business and political figures.
IDX: International Derivatives Exhibition
26-27 June 2012
Organised in conjunction with the Futures Industry
Association.
IDX Gala Dinner: In aid of Futures for Kids
Wednesday 27 June 2012 – The Artillery Gardens
@ the HAC, London EC1
FIA and FOA are pleased to announce
that the IDX Gala Dinner will, once
again, be held in aid of Futures for Kids.
For information on all FOA events, including sales and
sponsorship, please contact: Bernadette Connolly,
connollyb@foa.com, +44 20 7090 1334

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