derivatives market development

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Derivatives Market

DevelopmentKey Success Factors in Building a New Derivatives Market

A White P aper from Alberta Market Solutions Ltd. (October 2003 )

OVERVIEW AND SCOPE

Table of Contents

Overview and Scope.1Market Environment.....3Legal and Regulatory.....9Participants...11Market Development.........14

What Next?.......21

Alberta Market Solutions Ltd. provides

technology and business intelligence to capitalmarkets, challenging conventional wisdom with

new insights and perspectives based onresearch and direct experience.

This document contains views and informationdeveloped by Alberta Market Solutions Ltd. If youshare it with someone else, kindly give us credit andspell our name correctly.

While all reasonable care has beentaken in thepreparation of this document, no liability isaccepted by the author(s) for any errors, omissionsor misstatements it may contain, or for any loss ordamage, howsoever occasioned, to any personrelying on any statement or omission in thisdocument.Copyright 2001-2002 Beddis Services Ltd.Copyright 2003-2005 Alberta Market Solutions Ltd.

Any questions regarding this document or othersshould be forwarded to the following:Alberta Market Solutions Ltd.Calgary: +1.403.246.5104Vancouver: + 1.604.603.0880e-mail: [email protected]

Introduction

This paper describes the major factorsinfluencing the viability of a new derivativesmarket. It is targeted primarily at emergingmarkets or markets that do not yet have a

derivatives market infrastructure and isintended as a guide to understanding themajor factors determining the appropriatenessand likelihood of success in developing a newderivatives market.

Most of the discussion here relates to theestablishment of exchange-traded derivativesin a formal, regulated environment. This doesnot mean that the issues raised do not applyto over-the-counter (OTC) markets. But sinceOTC markets are each unique in their ownway, it is harder to draw generalized

conclusions about how a particular issueaffects them one would need to look at thespecific OTC market under consideration andsee what observations are applicable. This,incidentally, illustrates one of the advantagesof an exchange-traded derivatives market: thefact that they trade standardised productsopens access to a much broader range ofusers (the other big advantage is that tradesare nearly always cleared through a centralcounter-party which greatly reduces risk ofdefault, compared to an OTC market.).

Many, if not most, new derivatives marketswill be interested in launching commodity-based contracts even if their initial inclinationis to focus on equity derivatives1. However,

1Until the invention of Eurodollar futures at the CME

and Treasury Bond futures at the CBOT, virtually allderivatives were commodity based and futuresexchanges evolved their equity derivatives on the back

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2003-2005 Copyright Alberta Market Solutions Ltd.


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Derivatives Market Development (White Paper)

each commodity class (metals, agricultural,energy etc.) has unique characteristics and,even within a class, there can be considerablediversity. So a proper analysis of the issuesfacing the launch of a commodity derivativescontract belongs in a more detailed

presentation than this one. Some of the keyissues specific to commodities are covered onpage 18, Commodities.

Many market operators are already tradingequities and so the issues faced in launchingequity derivatives will be of particular interestto them. Equity derivatives pose their owndistinct set problems and many of these areoutlined in this paper (see pages 6, 7, 10 and14).

The main objective of this paper is to identify

the winning conditions for a successfulderivatives market. What characteristics needto be in place and what pitfalls should beavoided when a market operator sets out tocreate a new derivatives market?

Derivatives

For completeness, let us define what we meanby a derivative. As the name suggests, it is afinancial instrument whose value is derivedfrom something else either another financialinstrument or an index or measurement ofsome kind (e.g. the weather). But describing it

in these terms does not really uniquely defineit after all, symbol MSFT on NASDAQderives its value from a set of investorsbeliefs and sentiments about fundamentals,technical trends, hot tips etc. but it is not aderivative. Better to look at it this way: while aconventional spot market (e.g., a stockmarket) trades assets, a derivatives markettrades promises. A spot market always dealsin the delivery of physical products or assetsand each transaction results in a change ofownership. In contrast, a derivatives contract

only deals in the sale and purchase of apromise a promise to deliver somethingor pay something, given certain conditions. A

of their commodity experience. Recent history hasreversed this: Eurex the worlds biggest derivativesexchange started as an equity and debt derivativesexchanges and only later added commodity derivatives.Now, the Eurex model looks more likely to be emulatedby most nascent markets.

derivatives contract might result in physicaldelivery or it might not the deliverymechanism is not the defining characteristic,indeed the delivery may well be handled bythe spot market infrastructure.

Because it is a contract, full payment for theunderlying contract value does not need to bemade up front when a derivative is traded.Instead, the market merely demands somesecurity against potential price fluctuations(i.e., margin for futures positions and shortoption positions) or payment of a premium inthe case of an options holder. This is whatgives such great scope for leverage and this iswhy derivatives are popular with speculatorsseeking disproportionately high returns.

There are fundamentally two types of

derivatives: futures and options. Other sub-types exist within these two broad categories forwards, for example, are like futuresexcept that cash settlement always occurs atthe time of the original delivery date ratherthan at the time the position is closed out.There are also different types of options: theirexercise style can vary (American stylemeans the holder can exercise any time;European means the holder can onlyexercise on the expiry date2) and exoticoptions can have unusual conditions attachedto their value such as barrier options which

are only exercisable if the underlying assetreaches a certain price level. But exotics onlyexist in the OTC markets: no exchange hasyet launched trading of exotic options andthey have limited popularity.

Exchange-traded derivatives offer severaladvantages over OTC derivatives: They arestandardised, meaning that their contractterms are consistent from one instrument toanother this introduces fungibility into whatwould otherwise be a free-for-all. Exchangetraded derivatives are more likely to haveguarantees of liquidity through the provisionof market makers and to have minimalcounter-party risk since trades are generallynovated through a central clearing counter-

2There are others too such as the little-known Japanese

style which can only be exercised on a Thursday!


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party. They are subject to investor-protectingregulation.

All of these benefits have their flip-sideshowever which the OTC market is able toexploit: the absence of standardisation meansthat the OTC market offers flexibility; theabsence of exchange provided liquidity meanstrading costs are lower and most professionalsprobably appreciate that the lighter regulationthat exists in the OTC market. Nevertheless,from the perspective of the non-professionalin particular, exchange-traded derivatives dooffer meaningful advantages. Non-professionals would most likely not usederivatives at all if they were not exchange-traded. As a result, OTC derivatives marketsare almost exclusively used by professionalsand institutions3.

An observation on B2B markets

It is worth noting parenthetically that manyB2B markets are effectively derivativesmarkets in nature. With the exception of spotforex, it is hard to think of a fungiblecontinuous auction market where the trading,clearing and settlement models resemble theconventional securities market and itsassociated CSDs. But many of the potentialB2B markets strongly resemble the derivativesmodel. (In this context, B2B means B2B

exchanges where buyers and sellers tradeagreed, well-defined contracts in contrast tothe broader world of B2B e-commercewhich can include almost any commercialtransaction conducted via an electronicnetwork).

B2B markets mainly deal in forwards, notfutures. Futures are a more advanced formof forwards in the sense that, in a formalcentrally cleared futures market, the ordinaryphysical contract (to trade something fordelivery at later date at a fixed price) is

converted into something that has someadditional, rather special, characteristics. Afutures contract is fungible, it containsminimal counter-party risk and its cash flowcan be immediately realised at any time. None

3The one exception to this would be the forex market

where banks offer retail and small business customersderivatives products which are effectively traded O TC.

of these things are necessarily true offorwards.

The B2B market comprises the ordinary dailydealings of buyers and producers. Theparticipants in most B2B markets will tend tothink of their market as consisting of physicalsales-and-purchase contracts. Many of themwould be surprised to learn that thesecontracts have a technical label, namelyforwards.

Users of derivatives perceive theirmarketplace differently. Their physical marketand the derivatives markets are just differentaspects of their overall risk profile. They havearrived at this state because there is anexchange, clearing and banking infrastructurewhich provides all the standards and

procedures to allow this to happen: fungiblecontract definition, novation, standardiseddaily settlement procedures, margining,exchange-for-physical etc. Futures just do notexist outside that exchange infrastructure.

Hence, almost by definition, continuously-traded fungible B2B markets consist offorwards. Of course things are not so neatlycompartmentalised; many B2B markets areused by practitioners who have long beenusers of derivatives markets. But the point tonote is that the futures contract is an

evolutionary product that has nearly alwaysdeveloped from an existing physical forwardsmarket.

Many exchanges, even those in less developedmarkets, may contain infrastructure, whichcan be adapted to create a fungible B2Bmarket. So it is feasible that a derivativesmarket may develop via that route, especiallyin very high volume markets such as energy.

MARKET ENVIRONMENT

A successful derivatives market requires the

right overall environment in order to flourish.Some financial authorities suffer from a Me-too syndrome, which assumes that, in orderto take their place in the ranks of markets-to-be-taken-seriously, they must have aderivatives market. But it is important tostudy each case to see whether the conditionsare right in some cases it may be better towait.



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The major environmental elementsdetermining success are discussed here.

Traditional barriers

Until very recently, the potential for a start-upderivatives exchange was hampered by a

number of factors, unrelated to whether ornot there was investor demand for the tradingof derivatives. These factors include:

a) Outright hostility from politicians,regulators, the media etc. due to thepoor reputation of derivatives, whichhave often been blamed for marketcrashes, excessive speculation,bankruptcies etc.

b) Lack of product knowledge amongstboth investors and professionals(brokers, exchange personnel andfund managers), which limited thecapability and demand for productdevelopment.

c) Inadequate competition in thesecurities industry:

To brokers who wereunfamiliar with the product,derivatives tradingsometimes appearedunattractive. They believedthat the status quo straight

commissions based on thevalue of the underlyingsecurity earned themhigher returns than would bethe case with low-costderivatives trading. Forexample, the commission onan index futures contractwhich gave a client $100,000dollars of equity exposurewould be many times lowerthan would be the

commission on trading$100,000 worth of the samebasket of securities thatconstitute the index. Asimilar problem arose whenbrokers compared theirearnings from margin tradingto those available fromderivatives.

The local exchange oftenpossessed an effectivemonopoly which had one oftwo effects: either theywould not bother to developthe derivatives market (why

should they?) or they woulddevelop it, but out of a senseof obligation and hence withlimited enthusiasm.

d) An absence of affordable, efficientelectronic trading platforms. Thiswas exacerbated by a misguided beliefthat open-outcry trading was moresuitable for derivatives (when in factopen-outcry was quite hard toimplement in a start-up market).Nowadays, nobody would argue in

favour of an open-outcry model for anew derivatives market.

While some of these factors probably stillprevail to varying degrees in emergingmarkets, lessons have been learned and it islikely that most of todays newer marketswould suffer from these problems to a lesserdegree simply due to better education andawareness in the worlds capital markets. Aswill be argued later, most emerging marketsshould be capable of successfully developing aderivatives market in stock indexes andcommodities.

Liquidity

Without liquidity in the underlying marketthere is little hope of there being liquidity inany related derivatives. Liquidity in theunderlying market implies there is interest inthe asset itself and therefore a demand forinvestors to use derivatives to hedge theirexposure to that asset4. Without that demand,a derivatives market would rely solely onspeculators who are scarcely ever able to

sustain a market on their own.

4There are rare exceptions to this rule. For example,

the relative success achieved in OTC markets withweather derivatives is not based on any identifiableunderlying spot market but this is rather a special case.The demand for hedging the risk which arises fromweather conditions has always existed but it couldnever be t raded. So there is a kind of implicit underlyingliquidity.



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Moreover, without that liquidity, potentialmarket makers and other suppliers of liquidityin the derivatives market would be unable tohedge effectively. Successful derivativesmarkets need this virtuous cycle of hedgers inthe underlying market laying off their risk in

the derivatives market by trading withprofessionals who in turn hedge theirderivatives risk in the underlying market.Speculators then provide the means to narrowbid/ offer spreads by joining a market, whichalready has natural users.

Large, high profile underlying markets doexist which are still insufficiently liquid tosupport a derivatives market. Perhaps thebest example of this is the property market.Attempts have been made in the past to createproperty price indexes which are suitable for

derivatives trading but all these attempts havefailed. The problem is that the propertymarket is essentially illiquid despite the factthat it is large, important and closelymonitored by diverse segments of thepopulation5.

It is not easy to state a measurable, objectivetest for adequate liquidity but in thiscontext, three factors need to be looked at:trade volume, size of bid/ offer spread andmarket depth. If any one of these isdeficient, then that is a mark of illiquidity

since a low score on any one of these suggeststhat the market is weak from the standpointof supporting a derivatives market.

The other problems of designing a successfulderivatives contract are discussed later.

Derivatives markets addressinefficiencies

A successful modern6 derivatives exchangesworks properly when it manages to addressinefficiencies in the underlying market.

5However, recent attempts have been to create and

trade property benchmarks, the initiative has beenlaunched by investment banks who support the marketas market-makers. It will be interesting to see if this cancreate a liquid market, based around those benchmarks.6Traditionally, derivatives exchanges were formed by

user associations with a common interest in comingtogether to trade in a convenient physical meeting place.This physical need does not really exist today.

These inefficiencies can take many forms.For example:

Counter-party risk in the physical market. Aproducer who is keen to sell forward a certainquantity of its commodity may be unable tofind a buyer with satisfactory credit standing.Under a centrally cleared exchangeenvironment, this is not a problem if theproducer sells a futures contract.

Counter-party inflexibility. The same producer if he had not used the futures market mayhave difficulty getting out of the deliveryobligation if he decided he did not wish todeliver. He may not be able to persuade thebuyer to cancel the contract on reasonableterms. In a liquid futures market, he cansimply buy back the position at a fair

market price.Complex ity of trade ex ecution. Some underlyingmarkets are simply not capable of providingefficient execution. The most commonexample is index futures. In most markets, aninvestor who wishes to track a benchmarkindex may find it impossible to immediatelybuy or sell the full set of constituent indexstocks in the right proportion. An indexfutures contract satisfies this requirement verywell7.

Stifling trading rules. Many markets have trading

rules that limit investors ability to act. Themost common example is a ban or restrictionon short selling. A futures or an optionscontract can be used to take short positionswhen this is prohibited, or hard to do, in themain underlying market.

E xcessive taxes. If the underlying market issubject to taxation that increases the cost oftrading, a derivatives market can providesome relief (see page 5, Transactions Tax es &Fees for an example).

Barriers to trade. If exchange controls or othertrade barriers are erected for example by agovernment wanting to protect its owncommodity producers a derivativesexchange within that protected territory canflourish where it might otherwise not i.e. the

7But note the competition from exchange traded

funds.



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protectionism allows an island of liquidity forlocals barred from using overseas exchanges.This is one of the most common reasons forcommodity exchanges to flourish in emergingmarkets. The original Eurodollar contract atCME was created because foreign exchange

transactions were subject to excessiveconstraints under European law at the time.

N o options tools available. This seems simpleand obvious but in those markets where thereexists a demand for hedging with options, it isunlikely that any institution other than anexchange will be able to provide an adequateoptions service if banks have not already doneso. Banks may not provide options servicessimply because they lack the skills and/ or thecapital to do it8.

A start-up exchange needs to be sure that itsderivatives market addresses some of theseinefficiencies. If it does not, then it isquestionable whether the market will be asuccess.

However, it is important to note that evenwhere these inefficiencies exist, there has tobe some latent demand for a solution to theproblems raised by those inefficiencies.

Attitude to derivatives

One of the biggest obstacles to success in a

new derivatives market is vested commercialinterests who oppose the introduction ofderivatives. These are covered in more detaillater.

But there are always other elements whooppose derivatives on principle. There are anumber of clichs such as the tail-wagging-the-dog the allegation that derivativesdisrupt the underlying market. There areclaims that they increase volatility andencourage needless speculation. The mostdramatic example of this was the collapse of

Barings Bank which was widely blamed onderivatives (and even caused one Asianmarket to effectively pull the plug on its

8To provide an options market making service to

clients, a bank needs traders who understand optionspricing, risk managers who understand how to monitordynamic exposure to price volatility and adequate capitalto support potential losses arising from unforeseenmarket events, counterparty default etc.

planned futures market). Yet Barings was justa case of fraud, an unusual one admittedly (inthe sense that the perpetrator gained nothingfinancially) but it was just that fraud; it hadnothing to do with derivatives per se andcould just as easily have happened with

stocks, bonds, forex or any other tradableentity9.

A start-up exchange needs to be aware of thisopposition and be prepared to fight it withfacts. The facts support the contention thatderivatives are a good thing. Many studieshave indicated that derivatives have either abenign or positive influence on the underlyingmarket. So part of the process of creating anew derivatives market is to assess the level offear-based opposition and preparearguments to counter it.

Existing competition

Many markets already have surrogatederivative products, which are effectivelycompetitors to a nascent futures or optionsmarket. This point is really an extension of thearguments on page 4,L iquidity, namely that aderivatives market must address inefficiencieswhich are not met by existing products orservices - but it is worth dwelling on somespecific examples because they can be quitecommonplace, even in emerging markets.

Warrants and other structured products

Structured products are securities issued by athird-party financial institution that aredesigned to offer investors specific riskexposure to an individual stock, sector orother underlying asset. When they give theholder the right to acquire or sell a security ata particular price within a particulartimeframe, they are called warrants. Anestablished warrants market can be a veryeffective competitor to an options marketbecause warrants provide the same kind of

leverage but are traded just like stocks.

Warrants are nearly always classified assecurities and only secondarily as derivatives.

9Barings was also unusual in that it was the only

financial crisis involving exchange-traded derivatives.In just about every other case, if derivatives wereinvolved, it has been OTC derivatives, not exchange-traded.



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Most markets regulate derivatives differentlyfrom securities, requiring higher tests of clientsuitability, for example. One of the effects ofthis is that, to trade futures and options, aclient generally needs to open a separatetrading account and sign new forms asserting

that he or she understands the risks. Butgenerally there is no need for a regularsecurities client to open a new account with abroker in order to trade warrants: this giveswarrants a competitive advantage overoptions.

For those markets that have no derivatives atall, the introduction of warrants can be auseful stepping stone to introduce investors tothe concept of leverage and risk managementthrough derivatives (see 5.1.1.3 for morecomment on the benefits and pitfalls of this

approach).

In more developed markets, convertiblebonds and warrants with complex payoffs aresometimes introduced to provide a widerrange of risk management instruments toinvestors. But such products will tend only tothrive in markets that already enjoy broad-based and high levels of liquidity.

There is no structured product equivalent towarrants which compete with futures,however, and so the introduction of an index

futures contract ought to face lesscompetition from listed structured products.Instead competition to futures comes fromanother source:

Margin trading

A strong tradition of margin-trading canprovide an effective competitor to bothfutures and options. When margin tradingoperates efficiently (as it does, for example, insome Asian markets), it provides the same riskprofile as a futures contract.

A similar effect is achieved in markets with along settlement window such as those thatoperated in London, India and elsewhere untila few years ago. Because settlement onlyoccurs at the end of the cycle, these marketsbehave like mini futures markets on individualstocks.

However, since margin trading is generally notavailable on baskets of stocks, an index

futures contract stands a good chance ofsuccess if it genuinely introduces an ability togain exposure to a basket underlying a popularbenchmark. (But things are changing: indeveloped markets almost everywhere, wehave seen the hugely successful introduction

and aggressive growth of Exchange TradedFunds (ETFs) listed securities whichactually contain the underlying stocksthemselves. These will introduce newcompetition to the start-up futures markets.If ETFs are traded on margin, they givesomething very close to the risk profile of afutures contract and could providecompetition to index futures. Emergingmarkets may well see a flourishing ETFmarket before they even get the chance tointroduce index futures10.)

Foreign competition

In some markets, a foreign competitor mayalready have dominated trading in the mostattractive derivatives contracts. Singapore haslong enjoyed success with its Nikkei indexfutures and repeated it with its Taiwan indexfutures. Many other markets have since triedto emulate Singapore, some have beensuccessful but most have not.

In the Singapore case, the exchange tookadvantage of the home country being slow to

develop its own market. This suggests that itmay be legitimate for a home market to createa futures market solely to pre-empt foreigncompetition, regardless of the likelihood ofsuccess.

However, even if a foreign exchange operatorhas already created a competing derivativescontract, there are always significant homeadvantages not the least of which is thatlocal investors are more likely to access ahome market than an overseas market. As aresult, despite the fact that Singapore has been

trading a Nikkei contract successfully formany years, there is a thriving Nikkei contract

10Interestingly, the introduction of ETFs in the US,

where futures already existed, generated additionalliquidity in both products but the reasons for this are, inour opinion, due to certain attributes of the US marketthat would not necessarily prevail in emerging markets.Incidentally, the first exchange to trade ETFs was theToronto Stock Exchange.



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in Osaka (driven in large part, ironically, byarbitrage between Osaka and Singapore!)

So foreign competition need not be a seriousimpediment. There are many examples ofattempts to set up competing contracts fromoffshore bases but very few indeed have beensuccessful.

Summary

In all these cases, the common competitivefactor is that investors may already haveproducts that partially provide the types oftools that derivatives provide - riskmanagement, leverage, portfolio managementor speculation11.

The above examples are mostly from theequity sector but the same principles applyelsewhere. The most common example isforex futures. One would think that thesewould be ideal candidates for all kinds ofderivatives contracts, given the immenseliquidity which underpins just about any forexmarket - yet forex derivatives are rarely asuccess. The problem seems to be either thatthe banks already adequately satisfy demandor that the banks are not motivated to supporta market that might eat into their margins.Perhaps both.

Other structural impediments

Trading rules

In addition to needing liquidity in itsunderlying market, a successful derivativesmarket also needs continuity. So if tradingpractices in the underlying spot market aresubject to interference, this can affect theconfidence of the derivatives market. If tradehalts due to major market movements arecommon or individual stocks are frequentlysubject to suspension thus interfering with thecalculation or hedging of the index, then thiscan seriously affect the success of the market.

Similar problems can occur in commodityderivatives markets if the governmentimposes things like price controls. In the caseof options, if there is any possibility at all ofthe underlying asset being suspended from

11Speculators are vital to ensuring ongoing liquidity and

so it is important that the new derivatives market offersthem something they do not already have.

trading, then this can create havoc at the timeof expiration and this is something to bestudiously avoided.

The reason that continuity is important is thatderivatives markets rely on up-to-date priceinformation to operate. If there is noinformation available about the state ofunderlying market, then the derivativesmarkets operate less well. It is true that, insome circumstances, a suspension of theunderlying can help the derivatives marketbecause the derivatives provide an outlet fortrading that is otherwise unavailable. But thismay only be a short-term benefit in the longrun, if suspensions or halts are too frequent,the inability of professionals and marketmakers to hedge in the underlying market willdrive them away from the derivatives market

and this is unhealthy.

Those markets which practice pricemovement limits or circuit breakers (e.g.halting trading if the index moves 15% up ordown during the day) tend also to be marketswhere interference of this nature is the normand thus it is likely that price limits will beimposed on the derivatives markets too. Sosuch limits tend to be bad for the derivativesmarket.

In addition to this, many other underlying

market factors can affect the derivativesmarket: unreliable settlement procedures,excessively high minimum bid/ offer spreads,awkward board lot sizes etc.

These are all inefficiencies that can work infavour of the derivatives market or against it depending on how drastic they are. So itwould be important to know which ofinefficiencies are good for the market andwhich are bad. Perhaps this is a useful way ofcharacterising it in a summary form:

To the extent that a planned derivativesmarket can avoid using the underlying market(as may be the case with many stock indexfutures contracts), it can exploit inefficienciesto its advantage but if it must use theunderlying market (e.g. stock options) thenthese inefficiencies work against the interestsof the derivatives market.



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Corporate Events

Complex share splits, mergers and re-capitalisations can negatively affect optionsvaluations and index calculations. Anenvironment where these are commonplace isnot conducive to a successful equityderivatives market. Although such anenvironment suggests high volatility, which isgood for derivatives markets since it increasesthe need for risk management tools (as longas volatility is not too high), the administrativecomplexity of handling these events detractsfrom the efficiency of the derivatives market.

Domination by a small number of stocks

It may be difficult to introduce an indexfuture into a market dominated by one stockor by a very small number of stocks

especially if there is a margin trading. In thiscase, the liquidity may be so efficientlyfocused on those stocks that the introductionof a futures contract has no competitiveappeal. In such markets, the benchmarkindex will in all likelihood be dominated bythose few stocks, limiting the usefulness of aseparate, tradable benchmark index.

In these cases, an options market may havemore appeal to investors since optionsprovide a unique form of risk managementnot available via futures. Again, however, if a

warrants market has already been established,the case for options may be weaker.

High interest rate environment

High or volatile interest rates create demandfor risk management using debt derivativesmarket and are thus good for an emergingdebt derivatives market.

But such an environment is very bad forequity derivatives. Apart from the fact thathigh interest rates tend to coincide with bearmarkets (and derivatives trading often declines

once a bear market has been established), thethreat of high overnight rates can send anequity derivatives market into turmoil. This isbecause most arbitrage and market-making isfunded by borrowing overnight funds a highinterest cost will force traders to liquidatenon-cash positions which creates a downwardspiral effect in the stock market. More to thepoint: it discourages such traders from ever

returning to the market even after the crisis isover because they fear that high interest rateswill return.

Transaction taxes and fees

If there is a transaction tax payable on

underlying transactions (e.g. stocks), this willhave a detrimental effect on derivativestrading (particularly options) unless the rate isexceptionally low. The same applies toexchange trading and/ or clearing fees. Thereason for this is that the percentage eats intothe very thin margins that are available tomarket makers.

On the other hand, an unusually hightransaction tax can be a benefit to aderivatives market if it allows the introductionof products which track the underlying asset

values without incurring the tax. (Such asituation allowed OM to launch in Swedenwhat was until recently the only trulysuccessful single stock futures contract evertraded the contract died when thegovernment abandoned the tax).

Other local or cultural factors

It is hard to generalise here but it is worthexploring areas where local customs may havean impact on the derivatives market inaddition to the moral ones such as a cultural

aversion to gambling.For example, in some societies, local clericshave the authority to declare a public holidaywithout giving notice. If this happens on anexpiry day, it creates confusion in the optionsmarket in particular since option pricingassumes a fixed expiration day.

A similar effect can arise where outsidefactors regularly halt commercial activity (e.g.hurricanes or other extreme conditions).

LEGAL AND REGULATORY

Probably the first thing that needs to belooked at before determining whether tocommit resources to developing a derivativesmarket is the legal and regulatoryenvironment. The potential for the lawand/ or regulators to scupper initiatives shouldnot be under-estimated.



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Legality of derivatives

In many places, derivatives tradingcontravenes the laws particularly thoserelated to gambling. If the laws need to bechanged there needs to be a political will to doso. This obviously can be very time-consuming and complicated if it requiresconvincing influential authority figures.

Clearinghouse privileges

Even if derivatives are legal, creating thedesired contract structure can be complicated.The act of novation in a clearinghouse doesnot, on its own, necessarily afford theclearinghouse the protection it needs tooperate effectively. Clearinghouses need to beable to avoid ranking as regular creditors inthe event of a bankruptcy (and thus forced to

hand over margin funds which may be neededto protect their own exposure). Thissometimes requires a change of law.

Agent vs. principal

Similarly, in some legal systems, the questionof whether a broker acts as agent or principalin a derivatives transaction has a crucialimpact on the integrity of the clearingoperation (if the broker acts as agent, then aninvestor may have a claim against the clearinghouse). Such problems do not arise sofrequently in a regular CSD environmentbecause there is no contractual relationship(i.e. no promise to perform) between theinvestor and the CSD.

It is worth noting that proprietary traders arean essential component of derivatives marketsin that they are the providers of liquidity whenend-user investor supply and demand isinadequate (which is generally the case withderivatives products, particularly options).Any regulations or laws banning orunreasonably inhibiting such trading will be

detrimental to the markets chances ofsuccess.

Securities borrowing and lending

It is a little recognised fact that stockborrowing and lending (SBL) underpins thewhole equity derivatives market in the sameway that REPOs underpin the debt market.

Without it there can be no short-selling12andwithout short selling, derivatives traderscannot properly hedge (this is because shortsales are a hedge for long derivativespositions). While it is probably true that aderivatives market can work without stock

borrowing, particularly if it is limited tofutures only, its chances of success and itsvalue as a service to the investor issignificantly enhanced by there being a liquidSBL market.

Stock borrowing and lending is still illegal insome jurisdictions. But it should be noted thatthis is not just a legal question even if SBL islegal, there may not be adequate expertise orinfrastructure to support SBL and it may takesome time to develop.

GeneralEach society will have its own legal quirkswhich needs to be looked into, the abovebeing the more prominent and commonexamples. Suffice to say that legal costsshould be high up in the list of budgetedexpenditures.

Regulatory issues

A characteristic of most capital marketsregulators is this: if your proposal is new thenyou will be barred from implementing it until

such time as the regulator has decided how toregulate it. This is not a criticism ofregulators, whose job is to ensure thatinvestors are protected and who cannot dothis if they have not evaluated a new proposalproperly. But the result is that even if some ofthe problems listed below do not exist, theregulators may find a way to make them exist.

Licensing requirements

All brokers need to be licensed to engage inwhatever activity they are doing. If thetrading of derivatives is new, the regulator will

first need to establish its policy on licensing

12Because when you sell short, you are selling

something you do not have. Having sold short, you stillhave to meet a delivery obligation for example onT+2. If you dont own the stock, the only way to meetthat obligation is to borrow it from somebody with apromise that you will give it back to them later (e.g.when you buy back the short position at a later date).So if you cannot borrow, you cannot sell short.



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and then impose its requirements on theintermediaries. Indeed this will extend toclients of those intermediaries and proprietarytraders so that all market users will need tomake preparations to participate in themarket.

At the very least, for intermediaries this willinvolve a qualification system for investmentadvisors, involving examinations and othersuitability assessments. This will also extendto the clients of those advisors so that clientswill be required to sign paperwork assertingthat they have read the warnings andunderstand the risks.

This means that the exchange will need todevelop training courses and training materialsand prepare users intermediaries and

investors - well in advance of the marketlaunch.

Trading and clearing rules

Most of the regulatory requirements manifestthemselves in the trading and clearing rules.The rules cannot be completed until all thelegal and regulatory research and negotiationhas been completed. If the derivatives marketis being created by the operator of an existingexchange and clearinghouse, the task ofadding derivatives rules is simplified sincethere are many areas particularly in the

trading rules which can be common to bothmarkets. Nevertheless, the scale of this taskshould not be underestimated and it would bean unusual market operator that could draft,review and finish its new derivatives rules -with regulator approval in less than 12months.

Foreign participation

Some regimes bar or severely limit foreignparticipation in their capital markets. It iscommonplace to hear allegations of hedge

funds and the like manipulating markets byusing derivatives, especially in smaller, less-diversified markets and thus the foreigner-banis often applied even more severely inderivatives markets than in other marketsegments.

For options, a refusal to allow foreignparticipation will probably greatly reduceefficiency. Options market maker skills, while

not necessarily the rocket science they aresometimes alleged to be, are still hard toacquire and most markets have to start byusing foreign firms. This is not just aquestion of having the financial skills butincreasingly it is a matter of technical skills in

building efficient interfaces between theoption pricing and risk management frontoffice tools and the derivatives trading system.If foreign ownership is banned then thisobviously makes it harder for these skills to bemade available.

Limits on foreign participation may notmatter quite as much in the case of futuresmarkets where local participation cangenerally be relied upon to provide liquidity at least for the more prominent benchmarks.But even for futures, a market is likely to

achieve much greater success if overseasinvestors can use the derivatives markets fortheir own risk management needs and forstrategy trading using arbitrage and other risk-based techniques, which can add considerableliquidity to a market.

PARTICIPANTS

Participants represent an essential factor inensuring some initial success and growing themarket over the long term. Both the qualityand quantity of participation are important.

Brokers

It is necessary to assess whether the brokersare prepared and whether there are enoughbrokers to serve the market properly.Derivatives market planners always take therisk that nobody will participate and it is hardto obtain enough meaningful up-frontcommitment to avoid the chicken-and-eggsyndrome of there being no market withoutthe players and no players without a market.It is nearly always a case of build it and theywill come.

Each market is of course different but oneshould look out for the following attributesamongst the broker community:

Prior experience of derivatives atsome level

An understanding of the need tomarket new products to clients



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A positive attitude towards theproduct

This last point seems a little nebulous andunhelpful but a negative broker attitude tonew products is not unusual. It needs to be

recognised that, even today, brokers areessential to the success of a new derivativesmarket and this is probably especially true inemerging markets. While it is true thatbrokers can be forced to provide services ifthere is enough demand from enthusiasticinvestors, the main conduit to persuadeinvestors to use the market will, for now,continue to be the broker sales channels.

This is a problem because, to some brokers,the commercial attractions of having theirclients trade derivatives compared to trading

equities are just not there. They perceive thatcommissions are higher on stocks and that itis easier to spin stories about stocks thanabout derivatives. Particularly amongst olderbrokers, there is also the fear that they do notreally understand the product and thereforeneither will their clients. While it is true thatthe advent of on-line trading via the Internetis changing this picture, it remains a fact that alarge proportion of exchange trading stillinvolves person-to-person communicationand things will remain that way for the timebeing.

Once the on-line method has been fullyaccepted, the attitudes of the brokers maycome to matter much less since investors willdecide what they want to trade and they willderive their inspiration about tradingstrategies from the general market place ratherthan from individual salesmen. At that time,the development strategy may well changebut, until then, the brokers are vital.

The lesson here is that brokers need to benurtured, encouraged and maybe even

coerced into supporting the market.

Investors and users

A truly successful derivatives market will haveprofessional traders, retail investors andinstitutions all contributing in reasonableproportions and ideally, the types of brokersone targets when trying to secure participationwill be ones who can provide a mix of all

three types of user. In practice, this rarelyhappens and the market tends to bedominated by one group or another.

Critical mass

There should be a critical mass of users. This

means there needs to be a variety ofunconnected participants. Proprietary tradersin particular can sometimes cluster within oneor two dominant institutions (banks, veryoften) and this is not a situation that favoursgrowth in the market.

So if the market structure is one that does nothave reasonably diverse participation bypeople with reasonably different potentialmarket views, then this lowers the likelihoodof success for new derivatives contracts.

Having said this, any market that enjoys goodliquidity in its underlying market even if it isnot from diverse sources - has the potential toenjoy good liquidity in related derivativesmarkets, provided a sufficient number of theconditions outlined in this document are met.

Speculators

Options markets often though perhaps notalways thrive in a culture where there arefew outlets for speculative trading. Forexample, the Scandinavian and Germanmarkets both experienced high levels of

options activity by retail investors: bothsocieties are not really renowned for theirrecklessness on the casino floor and yet themarket penetration of options contracts wasmuch higher there than in most othercountries.

There is no hard evidence to support anycorrelation between a societys appetite forgambling and the success of its derivativesmarkets. But it can be shown that even wheregambling is not a particularly popular pastime,derivatives markets can succeed.

Vested interests

In any circumstances, the people who benefitfrom the status quo will oppose change. Thisplatitude is the major factor in preventinginnovation in the capital markets. One onlyhas to look at the failure of the forex marketsto evolve into a transparent exchange model:this must be entirely due to the fact that all



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the major market makers in forex want aslittle transparency as possible.

And this prevails whenever a new derivativesmarket is introduced. A very good exampleof this is the warrant market (described inmore detail elsewhere in this paper). Warrantsare structured products that are generally calloptions (although there are put options too)over stocks or indices. They are issued by thetrading desks of large investment banks whoare the guarantors of performance and listedon the exchange. The issuers can control thatmarket because they are the only effectivemarket makers, especially where short-sellingis prohibited. They have a monopoly onmarket making and that monopoly can bevery profitable indeed. Very often, they donot want to risk damaging their franchise by

supporting an options market that, if it weresuccessful, might remove the high marginsthey enjoy from issuing and trading warrants.

This less of a problem when contemplating afutures-only market. Futures markets maywell be welcomed more enthusiastically by thepowerful financial institutions who will see itas an additional potential revenue streamthanks to things like index arbitrage.

So where a strong structured products marketexists, it is important to be aware of how the

participants in that market may not providemuch support for a fledgling derivativesmarket. Dominant institutions want toprevent the development of an exchange-traded environment for other reasons too: forexample there may be a thriving OTC optionsand equity swaps market which theinvestment banks may fear would be damagedby a transparent exchange.

There is some irony in this anti-competitivestance of the financial community because itcommonly happens that the introduction of

an exchange-traded product actually enhancesthe liquidity of the OTC market and thestructured products market by providing moreavenues for hedging. But users often viewsuch arguments as more academic than actualand prefer the comfort of the status quo.

Data vendors

Without good price distribution, it can behard to convey price information to optionsmarket users. This is partly because of thesheer proliferation of prices - there are somany option series available.

But it is also due to the confusion thatsometimes surrounds the ticker symbols foroptions. Because options trading began toflourish at a time when bandwidth wasexpensive, a kind of confusing shorthand hasbeen used to identify symbols whendisseminating prices and this has not alwayspromoted good user-friendly practices. Astart-up exchange would do well to seriouslystudy its price dissemination policy and ensurethat it has the support of the primary datavendors in distributing prices.

Also, price feeds should be given away forfree or at least sold very cheap in a marketsearly stages so as not to discourage thevendors from carrying them.

Market makers

This point was made earlier but it belongs inthis section too. For options markets, marketmaker skills are essential. The marketoperators need to ensure that there areenough skilled people in the trading

community to do the job. If necessary,powerful incentives should be offered at theoutset to encourage market makers to committo the market. Without them, an optionsmarket cannot function.

Note that this is much less of a problem withfutures since the nature of the product is suchthat market makers are not always necessary.However, some new futures contracts canbenefit from a futures market maker systemand so the possibility should not be ignored.The use of market makers for futures

contracts has increased in recent years; thegood thing about futures market making isthat it does not necessarily require a heavyinvestment in systems and people skills tocarry it out except where the underlyingmarket is seriously illiquid (making hedgingdifficult).



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An account of the most important conditionsrequired to support market making is given inAMSLs white paper, Improving Liquidity.

MARKET DEVELOPMENT

Product design

Throwing spaghetti at the wall and seeingwhat sticks. This is how many people havecharacterised the approach to productdevelopment in the worlds derivativesexchanges.

For a start-up exchange, the safest approach isobviously to introduce standard products thathave been tried and successfully testedelsewhere. There are very few products thatsatisfy this standard: index futures and indexoptions and debt and commodity futuresappear to have the highest success rate.

Equity derivatives

Equities tend to be the most actively tradedand closely followed financial instruments inmost markets both emerging and developed.For this reason, they are obvious primecandidates for derivatives contracts.

Futures

Stock index futures tend to be the mostpopular and most successful equity derivativesand it is most likely that a properly designed

index future on a benchmark index willsucceed, provided the overall market is activeand there is no existing competing contractavailable locally. The design of the index itselfand the way in which settlement is calculatedupon expiry can have important implicationsfor the success of the contract. Thesettlement method needs to be one whichminimises the potential for marketmanipulation.

Also the multiplier is important: theunderlying value of the index needs to be high

enough to make it attractive to largeinstitutions but not so large that it shuts outthe small investor. The multiplier is used tocalculate the value of the underlying contract.For example, the multiplier for the S&P500futures at the CME is $250 per point so, whenthe S&P500 stands at 1000, one futurescontract is equal to $250,000. Every onepoint change is equal to $250 profit or loss.

This is excellent for institutions who need todeal in size and are looking for liquidity inlarge chunks rather than having to fight theirway through a quagmire of small orders. But itis way too much for many retail investors: theinitial margin - the amount needed to open a

position can be as much as $25,000 or more.

Some markets have dealt with this dilemma byintroducing a second mini- futures contractand have had some success with this theCME introduced a $50 multiplier for theS&P500 thus offering a contract one-fifth thesize of the main one. But this situation cameabout in the first place because of increases inmarket capitalisation in the years since thecontract was first launched. Starting out witha mini-contract may not be necessary or wisesince it runs the risk of the mini- becoming a

maxi- if the index rises a great deal over time(or becoming a midget- if the index falls a lot).

In cases where the index is dominated by onestock13, care needs to be taken to avoid theindex becoming nothing more than an indexon that stock. The commonest solution is toapply weighting to the stocks to avoid thatdomination and to avoid duplication of cross-holdings. Some indexes are based on freefloat rather than on the total number ofshares in issue, although this sometimes mightmake the concentration worse. Most markets

now have indexes compiled for them byspecialists such as Morgan Stanley (in a jointventure with Capital International), Standard& Poors, Salomon Smith Barney, theFinancial Times etc. A start-up market willideally want to use an index that already hassome recognition and acceptance

However, some agencies charge for the use oftheir trademark and for this reason it may bedesirable for the exchange to create its ownindex. Tailor-made indices have been createdby exchanges in some markets e.g. ThePhiladelphia Stock Exchange created severalindices for different market sectors purely forthe purpose of trading options and were quitesuccessful. Some of these (like SOX thesemi-conductor index) actually became

13Like Finland, where Nokia has at times represented

80% of the entire market capitalisation.



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benchmarks in their own right even thoughthat was not necessarily the original intention.

Index compilation is an art and a sciencewhich requires a good understanding of whereinvestors are focused now or where they maybecome focused in the future14.

Some exchanges may want to introduceindices on overseas markets equities or otherproducts and trade derivatives on those butthe success rate for this has been quite poor.

Single Share Futures

There has been much discussion about theintroduction of single share futures, whichhave been launched successfully in the UK(the most successful being futures on foreignsecurities) and, so far, with less success in the

US. However, other markets which have triedto introduce these have had little or nosuccess with the major exception of OM inSweden when transaction taxes on ordinaryshares were excessively high. Once the taxwas withdrawn, the contract died. In HongKong, share futures were introduced at a timewhen the minimum cost of a round-trip(taking into account exchange fees, taxes andminimum bid/ offer spreads) for shares couldbe more than 100 basis points, share futuresfailed totally even though they cost as little as10 basis points for a round-trip. It is likely

that the availability of margin trading in liquidstocks made share futures an unnecessaryalternative.

However, the current fashion is for thetrading of share futures to be expanded andmost markets are now experimenting withtheir own versions. The ideal conditions forsuccess seem to be those where trading in theunderlying stock is difficult to do for somereason but investor demand neverthelessexists. This certainly seems to be the case withthe USF products launched with considerablesuccess at Euronext-LIFFE.

14Note the systems implication here: implementation

of trading on a home-grown index will require systemcomponents which can calculate and disseminate indexvalues on a real time basis.

Difference between futures and options

The main difference between futures and options is in their riskprofiles. A future is a straight up-and-down exposure to the directionof the underlying. If the underlying rises by $1, the long gains $1 andthe short loses $1. The risk is linear and both long and short face

precisely the same type of risk.An options risk is skew. The buyer of a call option (for example),buys the right to buy the underlying for a certain price in a certaintime frame. Once he has bought the option, the payoff from thatoption will vary according to market direction and market volatility.A $1 rise in the market may cause the option value to rise by less than$1 or more than $1 (if volatility increases).Also the profiles of the buyer and seller of an option are notequivalent. An option holder (the buyer) has limited risk his risk islimited to the cost of the premium he paid to acquire the option. Thewriter (seller) has unlimited risk and his maximum gain is thepremium received.A speculator enters into a futures contract to maximise his exposure

to the underlying asset and is willing to risk losses if the marketmoves against him. A speculator buys an option contract toparticipate in gains from the market moving upwards (if he buys acall, downwards if he buys a put) but does not want to bear any riskbeyond the cost of the premium paid.

Why do people sometimes confuse the two?

With futures, you pay no premium, you merely pay margin to coverthe downside risk. If the market goes in your favour and you closeout, you get to keep all the profits. If it goes against you lose anunpredictable amount of money.With options, you pay a premium but no margin. The premium is asunk cost and will be deducted from your final profits, you pay nomore margin along the way and if the market goes in your favour and

you close out, you get to keep all the profits less the cost of thepremium (which you have paid upfront). If it goes against, you lose apredictable amount of money the premium.The main similarity between futures and options is that they bothprovide leveraged exposure to the underlying price. The maindifference is that with options you pay an insurance premium to limityour potential losses. But it is the leverage aspect that appeals tospeculators and since both are leveraged instruments, mostspeculators will compare them from this perspective. This isprobably the main reason that they are confused with each other.They both allow you to speculate on market rises and falls whilecommitting capital to only a portion of the cost of the underlyingasset. This is in contrast to stock trading, where you (normally) pay

the full price of the asset unless you are trading on margin. In fact,the risk profile and cash flows when buying stocks on margin isessentially identical to the risk profile of buying stock futures.Note that the writers of options have a completely different riskprofile for which there is no equivalent in futures trading. When youthink about the role of option writers and the risks they bear andmanage, it can be seen that the two products are really quitedistinct.



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Options

Option contracts can be much harder todevelop than futures since they involveconcepts which are quite alien to manyinvestors despite awareness of options beingsignificantly higher than ever before. Indexoptions tend to have a better chance ofsuccess than other kinds of options, partlybecause they are cash settled and theunderlying is less subject to deliverycomplications than, for example, single stockoptions. A benchmark stock index also has agreater population of natural users who canmore clearly see the benefits of tradingoptions on an index.

For single stock options, care needs to betaken to select stocks that are suitable (seediscussion earlier in 2.5.2. about avoiding toomany corporate events). It is a good policyfor an exchange to announce in advance theconditions under which an option class will bede-listed (e.g. continuous absence of tradingfor more than 90 days) so as to avoidaccusations of discriminating against certainstocks.

Warrants

It is questionable whether warrants should beincluded here because they are tradable undera cash market environment; they do not need

a derivatives trading and clearinginfrastructure. But they are derivatives andthey are important products so, forcompleteness, they must be considered.

Warrants have become very popular inmarkets around the world due to the fact thatthey provide investors with an easilyaccessible instrument for taking on leveragedexposure. They tend to be most popular withretail investors. For a market that has noexisting derivatives products, they are anattractive way of introducing derivatives to

investors.

It should be noted that one effect of having asuccessful warrants market may be to dilutethe demand for a traded options market; thisis not always the case but it can happen.Warrants do not provide the same degree offlexibility that options traded on a formal

options exchange provide and so the warrantis, in many respects, an inferior product.

For example, one important differencebetween warrants and options is that warrantsare generally difficult or impossible to sellshort. This is because they are issued inlimited quantities and there is ofteninsufficient free float available for lending(see 3.1.3 for an account of why lending is animportant pre-requisite for short-selling).However, most users want to buy optionsrather than write them given that theleverage effect is achieved by taking longpositions so this difference may not be assignificant as it appears, except that it limitsthe ability of professional traders to makecompetitive markets in warrants.

Another drawback is that the availability ofcalls, puts, strike prices and expiration datesavailable are determined by the issuers. Inoptions markets, these are handledautomatically so as to ensure ongoingavailability of relevant options contracts.

Finally, there is higher counter-party risk forwarrants than is the case with centrally clearedoptions because the delivery obligation resideswith the issuer, rather than the centralcounter-party in a clearing organisation.

But warrants do have their place and so it is

wise to adopt a managed programme ofimplementation which reflects the long termobjectives of the market operator, who maywant to have thriving warrants and optionsmarkets.

The introduction of warrants involves a rangeof legal, regulatory and market practice issues,particularly the question of financial strengthof the issuer and ensuring ongoing liquidity inthe warrant itself. Both issues have to beaddressed by adopting an effective set of rulesthat allow for close monitoring of the issuinginstitution. The guarantor of performance forthese products is the issuing institution, notthe central clearing house that guaranteesoptions performance. So that institutionneeds to be robust.

Also, there is no market making function forwarrants, unless the exchange provides aplatform. The candidate best placed to make



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markets in warrants is the warrant issuer itself this introduces potential conflicts andcomplexities that need to be resolved bytransparent and effective regulation.

Exchange-traded funds

Exchange Traded Funds (ETFs) are nottypically regarded as derivatives but, becausethey provide an alternative to index futures, itis worth noting a few points about them. Anumber of different legal structures are usedto create them but, from the end-users pointof view, all ETFs are essentially the same: ameans of trading a basket of securities underone stock exchange symbol. Instead ofbuying all the securities individually, astructure is created whereby an institutionholds the securities on the investors behalf.Each unit represents a basket of securities andinvestors can buy or sell many units at a time,as with regular shares.

The most popular ETFs are those based onbenchmark indices i.e. the same indices as themost popular index futures are based on.Both ETFs and index futures give investorsthe same profile. However, there are anumber of substantial differences between thetwo products:

Dividends are paid into the ETFstructure so that the investor actually

realises the dividend income from theunderlying stocks in the basket.Futures do not pay dividends.

Index Futures have an expiry date onwhich the final profit or loss on theposition is paid out. An investor whowants to retain exposure to the indexmust roll the position over, whichcosts money. An ETF does notexpire.

Futures can be bought or sold on

margin, meaning that the exposurecan often be created at a much lowercapital outlay than with ETFs which,as securities, are generally subject tomuch tougher margin rules. Thereason for this lies in the complexhistory of securities industryregulation.

The value of individual futurescontracts are generally many timeshigher than those for ETFs whichmakes it possible, using the futuresmarket, to trade a much largerquantity of underlying exposure in a

single trade. To trade the equivalentexposure using ETFs requires anappropriate amount of market depthin the ETF. (Of course, market rulescan be changed so that this differenceis eliminated but, in establishedmarkets, that is sometimes easier saidthan done). For this reason, largeinstitutions use the futures markets toestablish large positions more quickly- which they subsequently switch intothe underlying market having

established their entry (or exit) price. It is generally easy to enter a short

position using futures and hard to doso with ETFs (because of shortselling restrictions that prevail inmost markets and the need to borrowthe security - which may not beavailable at short notice)

It is apparent from this that futures are ashort-term trading tool while ETFs areappropriate for longer-term position taking.The main benefit of index futures is that theyare cheaper to trade in the short term andtherefore attract liquidity, especially fromspeculators and those who need to enter orexit from a large position reasonably quickly.

But it is interesting to note that lower costsand ease of trading are not really inherentcharacteristics of futures themselves: with thepossible exception of short selling constraintsarising from the need to borrow the security,all the characteristics of futures and ETFs areman-made, and so any respective

advantages or disadvantages could, in theory,be neutralised by changing thosecharacteristics (e.g. by reducing the cost ofmargin trading for ETFs).

On balance, however, a developing marketshould probably support both products andallow local conditions to dictate whether oneor the other or both will thrive.



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Index Arbitrage

It is possible to trade the basis of indexfutures contracts i.e. the difference betweenthe underlying index value and the value ofthe index futures contract. In theory, thedifference should be equal to the carrying(interest) cost of the basket of securitiesbetween now and the expiry date. Butsometimes that difference gets distorted,creating an artificially high, low or evennegative basis. Index arbitrage is used toexploit that distortion by trading the indexagainst the underlying. This accounts for asubstantial amount of futures and securitiestrading activity in developed markets. ETFshave made such strategies even easier toexecute, to the benefit of both markets.However, the benefits are most likely to

accrue to those markets that are already highlyliquid.

Fixed income

In some markets, Fixed Income derivativesare dominant (e.g. Canada). This tends to betrue where a large amount of Governmentdebt is in issue and/ or there has nothistorically been a strong equity culture (e.g.Germany, until quite recently). A successfulfixed income derivatives market will alsorequire the presence of a reasonable variety of

institutions that are engaged in moneymanagement dominance by one or twogroups will not make for a liquid market.

The typical fixed income derivatives contractsare futures over a long term governmentbenchmark bond contract together with ashort-dated (90-day) interest rate futurescontract, whose settlement price is based on afixing rate assessed by a group of banksand/ or the monetary authority. The fixingrate assessment method needs to be one thatis broadly accepted by the financial

community and it needs to be clearly acceptedthat this is not subject to manipulation.

Various intermediate classifications of bondcan be used as the underlying for fixedincome contracts and the alternatives willreally be determined by the local marketconditions.

The general comments made above about thelikelihood of success with equity optionscontracts applies to fixed income also.Interestingly, there is no apparent evidencethat institutions are significantly more inclinedto trade options than retail investors and so

the institutional bias of the fixed incomemarkets does not mean that fixed incomeoptions are any more or less likely to besuccessful than equity options.

Commodities

The first derivatives contracts were oncommodities and they are still ideally suited tothe creation of futures and options contracts.The good thing about commodities is thatmost countries have a local commodity whichis of particular importance to the localcommunity whether it be rice, gold, palm oilor sheep which can attract trading interesteven if there already exists an internationalbenchmark. For example, the fact that theCBOT in Chicago is the worlds largestagricultural derivatives exchange has notprevented Winnipeg in Canada from carvingout space of its own with its contracts in thesame time zone and geographicalneighbourhood.

The scope is particularly good for perishablecommodities that cannot be inexpensively

shipped long distances and therefore cannotbe benchmarked to international prices.Tariffs and other forms of protectionism alsoaffect the influence of foreign benchmarkprices and thus provides a climate ofindependent pricing which can support acommodity derivatives market.

In an equities market, most investors whowant to know where the market stands willgenerally look not to the futures market but tothe underlying price data, expressed in theform of the stock price or a stock index. But

in commodities markets, the futures marketitself often becomes the barometer thatinvestors look to for price discovery. Asuccessful commodity derivatives market cantherefore be at the heart of the market andmay eventually be used as the benchmark forsetting spot prices as well as futures prices,creating a very important role for theexchange. This role can even become truly



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international in scope. For example, considerthe metals traded at the London MetalExchange (LME): even a Japanese buyer ofcopper would contract to buy from a Chileanproducer using LME reference pricing, asreported from the exchange in London.

For these reasons, new derivatives exchangesought to give serious consideration tocommodities. Having said this, there aremore failures than successes and so it isimportant to identify a commodity for whichnatural local interest exists. A contract thatexists purely to attract speculative interest willprobably not last long such contracts tendto be quickly closed down by regulators evenif they are successful.

One of the main issues for commodity

contracts is the method of delivery onexpiration should the contract be physicallydelivered or settled in cash based on asettlement price? Physical hedgers andregulators customarily prefer the former,market operators and speculators prefer thelatter. This can sometimes lead to contentionand much consultation and effort needs to bespent in determining which method will beused. The dangers of price manipulation areoften greater in a cash-settled market than in aphysically-delivered market.

It should also be noted that the creation of anindex is not necessarily limited to equities;cash-settled commodity indexes can also becreated and there have been some cases whereresultant derivatives contracts have tradedsuccessfully.

General

Perhaps the keywords for designing a newderivatives contract are: Simple & Relevant.The concept needs to be easy to state and forinvestors to understand and it needs to berelevant to the natural risk management needs

of the investor.

Derivatives are supposed to be all about riskmanagement and the importance of thisshould not be overlooked: an asset whichdoes not exhibit much medium term volatilityis not likely to attract enough liquidity for aderivatives contract (another reason whyproperty futures never succeeded).

On the other hand, excessive volatility is not agood thing either. The clearinghouse needs tobe reasonably confident that there will not beserious price spikes. Some exchanges dealwith this by imposing price movement limits but these are of limited use in preventing

chronic volatility and an excessively volatilecontract often stops trading altogether.Electricity prices have been subject to excessvolatility and this has created problems inestablishing a market in electricity products.

Infrastructure

Clearing

It is sensible to allow the clearinghouse someindependence from the exchange, even if theexchange owns the clearinghouse.

First, clearing house personnel need to befocussed on risk management and the bestinterests of all market participants withoutundue interference from exchange operatorsand governing brokers. The clearinghousemay need to take steps which may not be seenas being in the best interests of the executivesof the exchange or the member firms.

Secondly, if a clearing house does suffer amajor default which results in its having to useits own assets, it is not desirable that theexchanges assets should be exposed in this

way and so it should be under a separateownership structure. In this regard, the desireof the exchange to protect its assets has theeffect of creating a natural independence onthe part of the clearinghouse.

It is also preferable to use an existing clearinginstitution for clearing new derivatives ratherthan setting up a new one this makes iteasier for members who will generally preferto be members of as few organisations aspossible. It also lowers costs for membersand eliminates one of the set-up risks

namely that people may prefer not tosubscribe for membership of a newclearinghouse15.

15However, the received wisdom that a single clearing

house is always better than multiple clearing houses isquestionable. First, competition between clearinghouses can be a good thing since it can promote

innovation without compromising standards (assumingthat the regulators are monitoring the quality of the risk



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Intermediary infrastructure

It has already been pointed out that brokersand traders form an important part of asuccessful derivatives market. In order to playtheir roles effectively, they require specialtools tools which they may not previouslyhave needed in a market consisting solely ofcash instruments.

In particular, they need front-office and back-office software which is suited to the specificneeds of derivatives trading, clearing andsettlement. Some of the additional featuresrequired for derivatives:

Front Office (mainly for market makers andproprietary traders)

Derivatives pricing tools

Risk management software tomonitor position risk

Automated submission of quotes thatcan interface with the above and withthe exchange

Back Office

Client Portfolio software able to storederivatives positions

Margin calculation for client positions

Exercise/ assignment and allocationprocessing tools

Interface between derivativesprocessing and underlying marketprocessing (e.g. margin duringdelivery)

It is important to ensure that these tools areavailable to intermediaries in advance oflaunching the market. Many of these productsare offered on an ASP model, which can bethe most efficient way of ensuring their

availability since this can lower the cost forthe brokers and shorten the time-line for

management). Second, monolithic clearing houses arenot the only way to net and reduce risk crossmargining between clearing houses can achieve the samething. Look at it this way: Which is worse? TheClearing House For Planet Earth going under onceevery 100 years or 1 small clearing house going underevery 10 years?

becoming acquainted with the product,especially if accompanied by a properlyplanned education program.

Promotion

This is a dimension that a traditional market

operator may not have encountered before.Marketing

Marketing is a vital and most easilyunderestimated success factor in the creationof a new derivatives environment. Withoutgood marketing, a new market cannot achievesuccess. The marketing needs to be targetedat all levels of participant:

Intermediaries. Brokers and other providers offinancial services need to be sold on the ideathat derivatives will help their business.

Investors. They need to understand how andwhy these tools can help them in theirinvestment objectives. The message needs togo to both retail investors and institutions although they may use the tools in differentways.

General Public. Even those who are notinvestors should ideally understand whatderivatives are and how they work. This isparticularly the case when the media andpoliticians, who thrive on a little controversyfrom time to time, launch their inevitablechallenges to the idea of a derivativesexchange. The general public need to beinformed of the facts and the studies whichhave shown the beneficial effects ofderivatives in other markets i.e. their tendencyto:

reduce volatility,

reduce the likelihood of catastrophicfinancial events;

increase the liquidity of the

underlying market;

assist commodity producers andconsumers to manage their businessplanning and financial planning andgenerally remove uncertainty; and

provide useful financial tools whichhelp all investors manage financialrisk.



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Sometimes this marketing effort needs skillsthat do not naturally arise in an exchangeenvironment and the organisation needs to bebold in how it recruits people to take on themarketing role. The types of people whoenjoy working in a regulatory environment

(such as prevails in the traditional stockexchange) will probably not have the skills orinclinations to be effective in marketingderivatives.

Education

The Marketing effort can only be effective if itis accompanied by a responsible and effectiveeducation program. The education programneeds to be aimed at professionals andinvestors. As mentioned above, regulatorswill probably require that brokers pass anexamination before being allowed to marketderivatives to clients.

Training courses can also be a useful sourceof revenue for a derivatives exchange. In factit is not unknown, in the early stages of a newmarket, for exchanges to make more moneyfrom selling training courses than from actualtrading! (Of course there is a commercialargument for giving away courses for free inthe hope of encouraging participation).

Academia

A good relationship with local academics canbe useful for two purposes: first, academicscan be marshalled to provide support inmaking the argument described above (5.3.1)about the benefits of derivatives. Businessschools tend to be enthusiastic supporters ofderivatives and open markets and academicsare generally respected by the public.Secondly, educational institutions can providematerial and resources for running trainingcourses16.

Academics also value the opportunity to carry

out research studies on local marketbehaviour and the effect of derivatives in the

16It should be noted, however, that academics generally

do not necessarily make good trainers for public courseson derivatives. Some of them may believe thateverybody shares their enthusiasm for things likederiving the Black Scholes formula from first principlesand this is definitely not the case. It may sometimes bebetter to use professional trainers.

local market something which can work toeverybodys benefit.

WHAT NEXT?

Determining viability

Having looked at all these factors, how should

a market operator approach the task ofdeciding on its derivatives plan?

In terms of priority, it is recommended thatthe following issues be addressed, more orless in sequence. The broad headings thatneed to be addressed are those described inthis paper; the specific issues to be looked atwill vary from market to market.

Legal and Regulatory

Are derivatives legal? If not, can the law bechanged and will it take an acceptable amountof time to change?

Is there political support for the introductionof derivatives?

Intermediaries

Is there a constituency of intermediaries whowill promote and encourage use of themarket?

Do those intermediaries have access to therequisite skills to service a derivativesexchange, clearing house and customer base?

Underlying instruments

Is there an investor class that actually valuesthe ability to manage risk in the underlyinginstruments that are being proposed?

Funding

The creation of a derivatives market requiresinvestment in people and systems. Is thereadequate funding to create the necessaryinfrastructure?

If there is serious doubt about any of these

issues, then consideration should be given todelaying the project until such time as thosedoubts can be eradicated.

Project team requirements

If all of these questions can be answered inthe positive, then the process of building amarket can commence. The development



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project will contain the followingresponsibility groupings:

Product development: What will be tradedand how those products will be traded andcleared.

Technology:Requirements capture, projectmanagement and implementation.

Legal and Regulatory: Conversion ofoperational policy into rigorously definedRules and Procedures, liaison with regulatorsand government on matters in need ofresolution.

Marketing and Education: Developingeducation and promotional materials andoperating and administering courses.

Clearly, these roles need to be played by

people with the requisite skills and experience.While derivatives experience will beimportant, it is only one component and themajority of the personnel involved in theproject will not need in-depth derivativesskills, as long as the t

derivatives market development

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