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Transatlantic Exchanges, Brokers Put Their Money on European Options Growth

December 17, 2007
By John Hintze

Several newly transatlantic exchanges have big plans in 2008 to more closely link their options markets, betting in part that Europeans will become as enamored of options contracts as their retail investor counterparts across the pond, who have driven that U.S. market's growth.

"We feel there's huge potential for development of the equity derivatives market in Europe, particularly by bringing current over-the-counter activity to the exchange and developing the flow coming from buy-side and retail investors," said Philippe Hajali, director of equity derivatives at Euronext.liffe, an NYSE Euronext subsidiary that comprises derivatives markets in Amsterdam, Brussels, London, Lisbon and Paris. "We think there is the potential to double or triple equity derivative volumes in Europe."

Of the recent cross-Atlantic merger activity, NYSE Euronext, the combination of NYSE Group and Euronext that was finalized in April, is furthest ahead in its integration efforts, and its goals extend well beyond options. Deutsche Borse more specifically targeted the options market in its agreement in May to purchase the International Securities Exchange (ISE) and connect it with its Eurex derivatives exchange.

Nasdaq too is on the cross-border options radar screen, with a complex deal to acquire OMX that involves obtaining Borse Dubai's shares of the Nordic exchange operator. Borse Dubai's bid had not been approved at press time, and Nasdaq declined to discuss exchange-integration plans.

NYSE Euronext is already seeking to accommodate large member firms by collocating their servers in the same facility as the Euronext.liffe trading engine to reduce data latency, a necessity for algorithmic trading. "We're going to provide 100 megabit pipes and people can be collocated in the same room as the Liffe trading engine to speed up trading." Hajali said. "So far, we have received over 80 applications for these new connectivity solutions, and over 20 of these applications are for collocation, which will go live early in 2008."

The exchange expects significant growth in 2008 stemming from algorithmic trading, especially from U.S. investors, said Hajali, adding that large "hedge funds and the big Chicago-based algo trading companies" are actively trading Euronext.liffe-listed contracts.

Ultimately, however, the goal is to reach beyond the biggest players, and there is already, substantial interest among European investors in the U.S. options market. Bruce Goldberg, chief marketing officer of ISE, said that 15 percent or more of U.S. options volume originates in Europe, executed via Wall Street trading desks or electronic accounts provided by mostly U.S. brokerages such as Greenwich, Conn.-based Interactive Brokers and, more recently, Chicago's optionsXpress.

Deutsche Borse's Big Bet

"A merger between ISE and Eurex will create an improved distribution system, to make various products on one exchange available to the other's clients," Goldberg said.

ISE, which typically ranks first or second in trading volume among the six U.S. options exchanges, may prove to be an enticing draw. Douglas Atkin, CEO of Majestic Research in New York, called that acquisition the "biggest bet" on growth in European options trading. "ISE had huge market share in the U.S. and that provides the ability to move share overseas," Atkin said.

Goldberg noted that a merger isn't required to create links and, in fact, ISE has discussed partnerships with other exchanges around the globe. That such links have yet to occur, however, highlights the complexities, which include the technical challenges of connecting exchanges as well as regulatory and cultural hurdles.

On the regulatory side, an exchange member on one continent must still become a member of the exchange's counterpart across the ocean, or clear trades through a member. Hajali said that NYSE Euronext has developed a link giving U.S. customers immediate access to Euronext.liffe's interest-rate and commodities derivative products.

In the first half of 2008, he added, the exchange plans to enable European brokerages that are members of both Euronext.liffe and NYSE Arca--currently 25--to trade products listed on each venue. "With a single entry, European investors will be able to trade on both Liffe and NYSE Arca," said Hajali, who noted that the plan has generated significant interest among European investors.

According to Steve Grob, director of derivatives at London-based Fidessa Group, "the next big battleground for all the options exchanges looks like it will be international." He noted that Fidessa sees "significant untapped potential" in investors interested in U.S. equity options trading, especially the retail market in Asia and institutional investors in Europe. However, he cautioned, there will be technical challenges such as adapting to the massive volumes of market data arising from myriad options contracts.

Also, said Grob, since options contracts in the U.S. are traded on multiple exchanges, smart-order routing has become essential to finding best execution. Apart from Fidessa's routing application, he added, there are few if any in Europe that can sweep all the U.S. options exchanges for the national best bid and offer and the depth of the market to suit their trading strategies and requirements.

NYSE Euronext's upgrade to its communications infrastructure aims to provide a conduit for options flow into the U.S. from Europe, allowing market participants to receive quotes and other trade-related data directly from the exchange. However, the exchange company will still need its independent software vendors to adapt their trading platforms to support the different way that options are traded in the U.S. "It's one thing to receive all the data, but you need intelligent applications to make sense of it," Grob said.

Fragmentation in Europe

Philippe Buhannic, president and CEO of New York-based TradingScreen, another large trading platform catering to institutional investors, foresees the options market in Europe growing "enormously." He noted that the U.S. model, in which contracts trade over multiple exchanges, will also likely move across the Atlantic. The EU's Markets in Financial Instruments Directive, effective Nov. 1, establishes best-execution requirements that are expected to cause market fragmentation similar to that of the U.S., prompting competition among execution venues, and option contracts to trade on multiple exchanges.

Fragmentation could encourage options trading growth in Europe, as it did in the U.S., where volume has grown by 30 percent annually for several years. Buhannic pointed out, however, that each European exchange has its own clearing system, while in the U.S. the Options Clearing Corp. clears trades across all the exchanges. Since derivative transactions can contain multiple options contracts as well as long equity positions that may be executed and hence cleared on different exchanges, cross-margining the transactions in Europe becomes all but impossible, creating an impediment to expansion.

Buhannic also noted that equity options in the U.S. are considered securities products, while options on futures contracts are treated as futures products--the former regulated by the Securities and Exchange Commission and the latter the Commodities Futures Trading Commission. In Europe, options and futures products fall under a single regulator. That creates complications for portfolios holding positions on exchanges in both continents. "How do we margin between a position on ISE and a position in Eurex?" said Buhannic.

It also creates a regulatory dilemma for European options investors, who in the U.S. will face two sets of rules and two methods to calculate margin requirements.

"There will be huge pressure for the regulators to evolve," said Buhannic, adding that the issue in the U.S. is whether there should be two regulators, while Europe will focus on a different question: Can products continue to be cleared on a single platform, or should there be multiple clearing venues?

The biggest obstacle for the European options market may be changing the mind-set of investors, especially retail ones, who have typically invested conservatively and avoided the financial markets. European institutions already trade large volumes of derivatives, particularly options on non-equity products. On the equity-option front, Euronext.liffe, the largest of 11 European options exchanges, executed a daily average of 955,000 contracts in October--less than half the recent volumes transacted by the four largest U.S. options exchanges.

One reason the European options exchanges foresee significant growth is their efforts to attract activity now conducted over the counter. To that end, Euronext.liffe launched Bclear in 2005, giving institutions and brokers the ability to customize listed transactions and clear them more efficiently. "Since October 2005, 150 million contracts have been registered on Bclear," said Hajali, adding that he expects that growth to continue.

U.S. Brokerages Abroad

European retail investors are increasingly buying structured financial products that their financial services firms construct using OTC and listed derivatives. But they are also investing more in equities, a trend that is perking their interest in equity options, in part as a hedging tool.

It helps that some of the most successful U.S. brokerages specializing in options have set up shop in Europe. "We're committed to growing the business in Europe," said Rumi Kuli, EVP of international business development at optionsXpress.

The electronic brokerage has registered in Amsterdam, enabling it to offer trading accounts across much of Europe. Kuli said that beyond improving access to overseas markets, the increased efficiency and liquidity stemming from transatlantic exchanges will eventually lower costs for all investors.

One European broker questioned whether retail investors will see cost savings from the mergers, since they must trade through exchange-member brokerages that will have to pay additional reporting and clearing fees. He said that institutional customers may want to take advantage of NYSE Arca's rebate for posting liquidity, but costs involving compliance, risk monitoring and adding dedicated telecom lines to become a direct member of the exchanges may be prohibitive. "Firms may still prefer to go through an international clearing broker that offers low-cost, direct access to U.S. markets, without the added costs of being a direct member to U.S. exchanges," he said.

Greenwich, Conn.-based Interactive Brokers (IB) has catered to European retail investors since 1995. Gerald Perez, managing director in London, said IB is bullish on Europeans investing in options, partly because the structured products they're buying carry much wider spreads than listed options. Perez said IB, a pioneer in connecting to exchanges worldwide, has seen steady growth in options trading in Europe, particularly in the last few years.

Perez noted that educating European investors about the options market is key. In addition to IB's educational efforts, a number of firms that focus on such education--many of them from the U.S.--have opened in Europe.

OptionsXpress, operating in Europe for about 18 months, has long emphasized education, providing customers with Web seminars, online content and books on trading options. Perhaps indicative of Europeans' growing interesting in the market, the firm's top executive in Europe had what appeared to be the misfortune of presenting a seminar in February at the London Business School when a rare blizzard hit. As it turned out, 187 participants trudged through seven inches of snow to attend the two and a half hour presentation.