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FEDERATION OF EURO-ASIAN STOCK EXCHANGES SEMI ANNUAL REPORT MAY 2005 COMPUTERSHARE MARKETS TECHNOLOGY Peter Brew Director, Business Development DERIVING THE FUTURE Although the FEAS five year strategic plan is wisely focused upon harmonization of rules, cooperation, and promotion of the region’s exchanges, in this article I invite you to think about another aspect, namely the development of derivatives markets for your exchange. Perhaps this is something you are already considering, perhaps not. Regardless, I suggest that derivatives will play a role in your markets sometime in the future and I hope this article will encourage you to think through the issues. FEAS members have the great advantage of being able to study the development of derivative markets in other countries and learn from that experience and benefit from the maturing of technology. Firstly I want to show you that there are real benefits in introducing a futures market: your economy should function more smoothly, efficiently and effectively. Then I will discuss some of the issues that you need to consider in preparing for a derivatives market, such as the how you develop the contracts, what trading technology to use, clearing and settlement issues and market surveillance. Much of what I write comes from Computershare’s long experience with the FEAS countries. Our role in helping to develop derivatives markets in the region goes back more than ten years. We first installed a futures trading system for currencies for the Moscow Interbank Currency Exchange (MICEX) in 1994, and in 1996 they took delivery of the SMARTS surveillance system. We have subsequently installed futures and options trading systems in Kazakhstan in 1996, Istanbul in 1999 and Budapest in 2000. The same software will operate the new derivatives market in Turkey, TurkDEX which began operation just this year. Elsewhere in Europe we have implemented systems for interest rate swaps for Icap plc, the world’s largest inter-dealer broker, and a warrant trading system the SWX Swiss Exchanges in 2005. Computershare continues to provide advice and the most advanced software systems to the region and I would be happy to hear from you if this article interests you. History of derivatives trading Although futures trading can be traced back a long way, financial futures have a surprisingly recent history. The many anecdotes about the development of derivatives range from agricultural markets in China 6000 years ago, to 17th century Japanese rice markets, and even King Philip II of Spain who arguably used futures on gold and silver arriving from Latin America to finance his European wars. PAGE 12 FEAS members have the great advantage of being able to study the development of derivative markets in other countries and learn from that experience and benefit from the maturing of technology. But for our purposes the history of derivative trading can be neatly divided between the years before and after the demise of the gold-standard for currencies in 1971. Before 1971 derivatives were nearly entirely about agricultural products. In 1972 the first currency futures were introduced. The growth of these financial futures has been exponential ever since. Another milestone occurred in the USA only in1982 when options on agricultural products and the idea of cash settlement instead of physical delivery were authorised for the first time. This innovation enabled the development of a range of new types of contracts for which physical settlement would have been impossible (such as index futures). In this decade we have even seen the development of weather derivatives and most recently futures on economic announcements such as indexes of inflation. In order to understand why there has been such growth, we need to understand the role that derivatives play in an economy. The role of derivatives First let’s consider some common derivatives that are used by businesses. Then we’ll look at the benefit to the economy as a whole. Fundamentally businesses use derivatives to hedge (or reduce) the risk of prices changing. Here are some typical examples: • A farmer wants to guarantee the price he will receive for his produce before he buys the seeds or food for his animals. If he waits until he has grown the produce before selling it (as has traditionally been done), there is a risk that the price might be so low that he ends up selling his produce for much less than it cost him to produce. So instead he enters into a futures contract on the commodity he is producing to fix the price before buying this seed or animal food. • A small manufacturing company receives a large order for their products from another country and the client wants to pay in his currency. The company will then need to convert it to their own currency in order to pay their staff but they won’t receive money for twelve months and they are worried that the currency may be devalued before then. So they enter into a currency futures contract to agree the conversion rate. In other words, they set the price now of the other currency in the company’s own currency. • A construction company is being asked to price the development of a new apartment block in the city and needs to give the developer a fixed price. They know that in six months time they’ll need to buy a certain amount of steel for the building. If they give a price to the developer now and then when they buy the steel six months later they find the price has gone up, the construction company may find that it cannot complete the building since their costs exceed the income they will receive from the developer, which would be catastrophic for everyone. So instead they buy a steel futures contract to fix the price of the steel they will want to buy, now. • A company considering investing in a new product line knows that it will need to borrow some money from the bank in the future in order to develop the product. It estimates the market for the new product and the costs for producing it including the cost of the interest on the loan to the bank. However if interest rates rise then it may not be cost effective to develop the new product. So they enter into several futures contracts to sell the governments treasury bills at six month intervals to fix the price of their interest payments now. If interest rates go up then they have pre-sold their treasury bills for above market rates and use the profit to pay their extra interest on their own loan. • A pension fund has made some good returns on the local stock market but does not yet want to take the profits into cash because it will forgo dividends. But the fund is worried that the stocks may fall in value. So they enter into a futures contract to sell the index in six months time to fix the value of their profit now. Through these examples we see that futures contracts encourage investment by businesses, by providing a level of certainty about future prices. In the case of the farmer or the construction company the future price of the commodity is determined and fixed for them. For the manufacturing company the future price of the client’s currency is fixed, for the company considering developing a new product the future price of money (interest rates) is fixed, and for the pension fund the future price of stocks is fixed. If you read the article by Takasbank in this FEAS year book you will see that it is precisely these four futures products that operate in Turkey. If we now generalize from the examples, we can understand the three fundamental purposes of derivative markets. The first is to allow businesses to reduce risk and give it to people who want to take on risk – the speculators. The second is to facilitate operating capital – short term loans for immediate purchases. For example the farmer will find it easier to get a loan from a bank to buy his seed based on the guaranteed price he has agreed in the future contract. Thirdly derivatives provide information to decision makers about future events by discovering the future price based on an examination of all possible information available today. It seems clear then that an economy with a derivatives market will be more efficient because capital can be applied with less risk of loss. The economy will also function more smoothly because prices are less prone to wild fluctuations.
FEDERATION OF EURO-ASIAN STOCK EXCHANGES SEMI ANNUAL REPORT MAY 2005 We might add that from an exchanges perspective, a derivatives market provides additional revenue from new products and if as a result, stock prices are smoothed, this should encourage increased investment in the stock market too. It’s probably also true that some over-thecounter (OTC) trading of derivatives is already happening in your country or at least by businesses in your country on another country’s market. Standardizing these contracts and bringing them on to the exchange can save costs for the businesses in your economy, and bring liquidity to the futures market, which will reduce risk for all participants, since liquidity enables someone to enter and exit a market at a fair price. Implementation issues A “Getting Started” guide for an exchange starting your own futures market is of course overly simplistic. However here are some of the more important things to consider which I will discuss in turn: • Contract development; • Trading System; • Clearing and Settlement; • Margins, performance bonds and guarantee funds; • Surveillance. The first step of course is to identify the needs of your market and develop futures contracts for these needs. The four basic futures contracts described in the article by Takasbank in this semi annual report is a good place to start but there is a wealth of information freely available on the internet concerning contracts used around the world. Reproducing a contract used in another country or developing a contract to be used throughout FEAS should be considered. The fungibility (interchangeability) of such contracts will increase liquidity, lower costs and ease understanding by foreign investors. The software technology used for trading is of course an important consideration. Ideally derivatives and cash instruments should be traded in the same system. The advantages of doing this include: • avoiding the duplication of maintenance costs, hardware and operations staff to have two separate systems; • the ability to simultaneously manage the derivative and underlying cash market (e.g. adding users, executing corporate actions, suspending trading, surveillance); • Traders have a single screen for trading all markets and a single API to which to connect their systems, reducing their costs; and • Investors have the ability to trade a derivative and underlying simultaneously without legging risk. Computershare’s X-stream trading system can do precisely these things. X-stream can trade equities, futures, swaps, options, warrants, ETFs, foreign exchange, and multileg strategy orders all on a single system. In addition X-streams flexibility enables you to change contract specifications or introduce new products as soon as your analysis CONTACT INFORMATION indicates that they are necessary. As a proven system in use all over the world, X-stream contains the latest functions and up-to-date know how on derivative markets giving you confidence for the future. Perhaps the most important issue is establishing the clearing and settlement system (CSD) which gives the financial security that supports the market. Some aspects of clearing and settlement are more complex than cash markets. For example the fact that settlement risk exists every day until contract expiry. As a consequence funds must be transferred between counterparties every day until expiry. These transfers are variously known as margin calls or performance bonds and the clearing house must decide what levels of bonds are required when the contracts are marked to market (valued), and what forms of collateral can be used to fulfill the obligations (cash, bonds etc). One advantage of using the same clearing house for cash and derivatives markets is enabling what is called “cross margining”. This is where a broker’s obligations in cash and derivative markets can be offset against each other. This reduces the amount of collateral that a broker requires to have locked up in guarantee funds and so makes transactions cheaper for the market. Computershare’s Equator system is the ideal choice for a CSD. The internationally recognized SWIFT standard messaging for connectivity to banking payment systems and a direct connection to the trading system (such as X-stream) are critically important when you make a decision about a choice of CSD system. Registry functions and full Delivery versus Payment (DvP are fundamental to a fully functioning CSD like Equator). Market surveillance is the last area I want to consider. Surveillance here means monitoring market abuse by traders to ensure a fair and efficient futures market (I am not referring to the monitoring of risk positions within the CSD). A fair market is one where all participants face a transparent set of trading rules which are effectively enforced. The SMARTS Surveillance System that Computershare supplies, enables an exchange to promote this goal by providing the ability to monitor and investigate all trading in real-time. Using superior data management facilities, SMARTS builds an understanding of the normal market behavior so that alert algorithms can be created to identify abnormal behavior. These help detect market behavior which may have an adverse effect on market integrity and thus, a rapid response from surveillance departments is easily achieved. A particularly new area of research is to monitor trading behavior across cash markets and derivative markets. For example monitoring the spot market and the futures market for a commodity, or trading in stocks in the benchmark index and the futures product on the index. SMARTS is the only product in the world capable of doing this. Summary I hope that this article contains some food for thought. Derivative markets and in particular futures markets have a great deal to offer an exchange and the businesses and the economy you serve. Their primary purpose is to allow businesses to reduce risk and give them the confidence to invest but the net result is an economy that is more efficient and that functions more smoothly. Once you have decided that you want to begin a futures market and considered issues like the contracts you want to deliver and the regulations and mechanisms for your market, Computershare has the knowledge and the technology for clearing, settlement, surveillance and trading that will solve your technical needs. Technology and know-how that will ensure your success - today and tomorrow. ABOUT COMPUTERSHARE MARKETS TECHNOLOGY Computershare Markets Technology provides the most advanced and innovative solutions for exchanges, clearing & settlement houses and surveillance organizations who want to ensure they are the leaders of tomorrow. Our advanced financial markets systems are flexible, scalable and use the latest, proven and open technology to ensure reliability, performance and accessibility. Our vision is to enable markets and exchanges to swiftly realize the efficiencies, enhanced accuracy and added functionality achievable through process automation and technological efficiency. Computershare’s products power more than 40 of the world’s national financial markets and central market surveillance and regulation organizations in more than 30 countries, more than any other software provider. Major exchanges operating the systems include the SWX Swiss Exchange, Istanbul Stock Exchange, Moscow Interbank Currency Exchange, New Zealand Exchange, and the world’s largest inter-dealer broker, ICAP plc. Established in 1992 and headquartered in Sydney, Australia, Computershare Markets Technology has offices in Sydney, London, New York, Chicago, Calgary, Zurich and Dubai. For more information, visit: http://marketstechnology.computershare.com Contact Name Mr. Peter Brew E-mail marketstechnology@computershare.com Website http://marketstechnology.computershare.com PAGE 13
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