An Alternative to the OTC Market?

Euronext LIFFE makes a bid to win back business with new listing facility

Stuart Fieldhouse

Exchanges, particularly in Europe, compete with each other for business, just like in any other financial sector. Euronext LIFFE's latest product, Bclear, was launched a year ago to cope with a different threat, however, that of the OTC derivatives market. It is an effort to repatriate a lot of the 'exchange look-alike' business that had haemorrhaged out to the OTC market. According to Ade Cordell, Head of Equity Derivatives at Euronext LIFFE, "If it's exchange look-alike, then surely it belongs on an exchange in the first place."

A lot of banks have been carrying out trades that they would freely admit belong on an exchange, but otherreasons have dictated they turn to the OTC market, including price, coverage (e.g. exposure to a particular sector or stock), and the inherently discrete nature of the OTC market. Cordell and his team set out to offer the benefits of the OTC market, but with an exchange listing. "We decided we'd cover the top 300 blue chips in Europe, regardless of country, on day one," he says. "You don't have to worry about different rules and regulations, because it's all under our rulebook, and our pricing structure."

Euronext also wanted to make sure that not only was it offering the cheapest trade of its kind on these options, but went the extra mile by capping the fees as well. This move was intended to appeal to those traders that had turned to the OTC as a cost-effective alternative. It addressed the privacy issue by giving the market the option of keeping a trade private. Traders could still have full transparency if they needed it. "It's a relatively simple message," Cordell says.

Bclear is also deviating from the typical exchange-style maturity – e.g. the third Friday in a month – Bclear users are being given the option of nominating their own settlement date. Cash settlement or physical delivery, American or European option style, all can be determined by the client, providing almost as much flexibility as a trader would be able to procure in the OTC market. "What we've got here at the end of the day is a service that marries OTC-style flexibility with the benefits of trading on the exchange," says Cordell. "If you think about a typical trade in the OTC world, yes, you've got all the flexibility you like, but what about the processing of that?"

OTC trades do admittedly suffer from extensive time lags when it comes down to confirmations, something that might concern investors in hedge funds for example. By contrast, an exchange like Euronext LIFFE can settle in T+1.

Broad appeal

The launch of Bcllear is likely to appeal to a wide range of firms, ranging from the banks and brokerages that are existing members of the exchange, through to asset managers and hedge funds in particular. Cordell reports that presentations to hedge funds have been particularly well-received, and a number of major names have switched from OTC trades to Bclear. "We've seen take-up from that community pretty much from day one," he says.

Euronext LIFFE is currently marketing heavily to the hedge fund community, partly because it will help to push the exchange's member firms to act as they respond to the requirements of hedge fund clients. One element behind the rapid move away from exchange-style OTCs has been the increasing emphasis on transparency and accurate pricing from institutional investors. Another aspect has been the more prosaic issue of disposing of volumes of paperwork: a T+1 settlement with an electronic record, as well as independent daily mark-to-market and lower fees. In short, it is much more user-friendly than previous offerings from the exchange, and appeals particularly to small and medium-sized hedge fund operations with limited operational resources.

Word of mouth is also helping to spread awareness of the service in the hedge fund community. Although Bclear was originally designed as an offering to the market in general, it has been hedge funds in particular that have played a role in making the system an early success, more so than was expected. Natalie Withers, Head of Operations at Cheyne Capital, has seen clear benefits from the use of Bclear. Already a user of Euronext LIFFE for listed derivatives, Cheyne found it easy to move over to using Bclear once it became convinced of its advantages. "The main reason we started using it was because it allowed us to get our trades confirmed on a timely basis," Withers says. "B-clear provides an automated service, which helps us to avoid a backlog of trades."

With increased focus by US regulators on unconfirmed backlogs, such a facility is a mjor boon for large-scale hedge fund managers. Flexibility and pricing were also factors in Cheyne's decision. Withers pronounces herself happy with the European stock coverage offered by Bclear, and would consider other geographical areas were they to be offered on the system. It seems as if the Euronext LIFFE team has developed a formula that appeals to the hedge funds space in particular.

The post-Bclear world

In the post-Bclear world, Euronext LIFFE has been able to dramatically increase its geographical coverage of major European stocks beyond its normal core markets. Following only a year in business, it has found a lot of the volume has been generated by the buy-side community (e.g. single stock futures, stock options, etc). Certain trades like periodic trades, or dividend arbitrage trades, not necessarily generated by hedge funds, have also been migrating onto Bclear.

The service now offers 352 stocks, which Euronext LIFFE expects to continue to grow going forwards. Euronext LIFFE updates the list on a quarterly basis with additional stocks based on what the market wants. "We will look at a scenario where a particular hedge fund will request a specific underlying, and we'll bundle it up with other requests, so that in each quarter there will be 25-30 new ones made available," says Cordell. This helps to screen the interest of an investor in a specific stock. Cordell and his team are now looking at potentially bringing variance futures onto Bclear, in an effort to capture a share of the variance swap market. Plans are also afoot to extend coverage to North America and Asia, again using the same principles that have proved successful with the European market.

Hedge funds will typically already be trading listed stocks, so will be able to make the move onto Bclear straight away. No new systems are required: it is simply a case of making a phone call. Cordell himself has been impressed with the speed at which hedge funds have been able to make the decision to use Bclear, but sees this as part and parcel of the more dynamic nature of the industry.