Increase in new derivatives exchanges
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Ali Curi: Markets ConversatION is an ION podcast where we discuss topics of importance to capital market participants with product owners, subject matter experts, and industry leaders.

Stephen Bruel: So the exchanges have been busy, but so have the users. And so this is very much a global discussion. And so when you look at the retail participation and the exchange traded derivatives, it's been fascinating to watch. And just one example is that the number of equity index options traded on Indian exchanges was up 153 percent between 2022 and 2023.

Ali Curi: Hi everyone. And welcome to Markets ConversatION. I'm Ali Curi on today's episode, Bruce Roberts from ION Markets and Stephen Bruel from Coalition Greenwich will discuss the changing landscape of new derivatives exchanges. We'll explore how the market is changing with current exchanges moving into new products and new exchanges coming to the market.

We'll discuss the benefits to the market and its participants, and what are some keys to success for new exchanges. Bruce and Stephen will wrap up the discussion by exploring how established exchanges and clearinghouses play a pivotal role in transforming the dynamics of the derivatives market. 

Let's get started.

Bruce Roberts, welcome back to the podcast. 

Bruce Roberts: Hi, Ali. Great to be back. 

Ali Curi: And also joining us as a friend of the podcast, Stephen Bruel with Coalition Greenwich. Hi, Stephen. Welcome back. 

Stephen Bruel: Thank you, thank you for having me. 

Ali Curi: We're happy to have you back. 

Bruce, you're a regular on the podcast, but for our new listeners, can you briefly share with us your background and your role at ION?

Bruce Roberts: Thank you. So I'm based in London and I'm part of the global cleared derivatives management team at ION Markets and also focus on business development. And I've worked in financial services for more than 25 years. 

Ali Curi: Thank you, Bruce. 

And Stephen, please tell us about Coalition Greenwich and your role there at CG.

Stephen Bruel: Sure. Coalition Greenwich is a benchmarking and research organization focused on financial services. Specifically, I look after derivatives and foreign exchange as part of our market structure and technology team. 

Ali Curi: Well, Stephen, let's continue with you. For those who may not know, would you explain what is the purpose of a derivatives exchange?

Stephen Bruel: Sure. I mean, I guess to start like the primary function of the derivatives market itself is essentially to facilitate the transfer of risk among market participants by offering a mechanism for like liquidity and price discovery. And what we see, the exchanges and the clearing houses are trusted intermediaries between those different institution types that want to access the derivatives market. So the exchange needs to be designed to sort of optimize the efficiency and the risk sharing between market participants. And so if we think back, maybe to 2008 in the global financial crisis. I think a lot of us remember there is a class of instruments that are listed and cleared.

Those generally behaved pretty well during the global financial crisis. Then there is a class of instruments that are uncleared and bilateral. Those did not quite behave as well. And so there's a big regulatory push to get as many derivatives transactions through sort of the exchange and clearing model as possible. And then maybe just give you a little bit of a sense of sort of the overall influence and size, futures volume is in the tens of billions of contracts per year. So this is a very big and very important market for the industry. 

Ali Curi: And Bruce, to add to that, from a strategic perspective, what are market participants focused on?

Bruce Roberts: So as Stephen outlined, the creation of exchanges establishes a market for the transaction of financial products in a regulated marketplace. And just as producers need access to global markets to sell their physical goods, they too need access to global derivatives markets to hedge risk in times of volatility or uncertainty.

So market participants, such as farm producers, as an example, who are growing wheat, coffee, cotton, or other agricultural products sold around the world, know in a regulated market that they can hedge price volatility in markets to protect their businesses and profitability. So that being one of the primary reasons for markets being there.

The other, being derivatives exchanges, provide access to a central, transparent point of global price discovery. And it also can provide a deep liquidity pool by bringing ready buyers and sellers that make it possible to enter and exit positions with ease. So these are a few of the key areas that market participants look for.

Stephen Bruel: Yeah. Right. So when Bruce talked about this idea of sort of the trusted intermediary, and it's also needs to be, I guess, a trusted process. And so the regulators do spend a lot of time looking at these markets. Again, I sort of implied that there were some challenges, you know, during the global financial crisis.

And so the way the regulation sort of manifest themselves in the day to day lives of say a bank, is the idea that they need to be thinking about capital efficiency and operational efficiency. So when you ask about individual market participants, our research indicates really their top two areas of investment, derivatives are becoming a more capital intensive business, so they want to become more capital efficient in how they trade them. Derivatives tended, especially the bilateral, tended to be a little bit more operationally difficult to manage. So you need to have a good sense of your overall workflow because a good workflow can actually help with your capital efficiency and the profitability of the organization.

So again, we see capital and operational efficiency as key strategic initiatives for market participants. 

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Ali Curi: And let's talk a minute about the exchange space. How is that changing the CCP exchange space? Are there a lot of new entrants? What are the incumbents doing? 

Bruce Roberts: So it's a great question. And I think as Stephen alluded to the last real seismic shift in the derivatives markets occurred with the movement of OTC rates and credit products post the financial markets crisis.

And that was really driven by the Dodd Frank Act in 2010 and the CFTC, or the Commodity Futures Trading Commission implementing a new set of clearing requirements for standardized over the counter interest rate and credit default swap instruments to be traded on exchange. And post that, in the last kind of five years or so, we're seeing a significant increase in new products being traded in the sustainable energy transition, such as cobalt and lithium that are crucial components for battery manufacturing, but also cryptocurrency such as Bitcoin futures.

So traditionally, the number of exchanges and clearinghouses has been pretty static over the years, but we're also starting to observe changes with the new exchanges entering the market over the course of these last few years. There are different drivers for those different exchanges and clearinghouses, but if you look at the energy transition as one that's happening globally, you start to observe the need to increase liquidity and access to capital and risk management to fund this transition.

And as Stephen alluded to, operational efficiency and capital efficiency are keys to enabling that, and the markets help provide that. 

Stephen Bruel: And if I can add to that for a moment, because so the exchanges have been busy, as Bruce just talked about, but so have the users. And so this is very much a global discussion.

And so when you look at the retail participation in the exchange traded derivatives, it's been fascinating to watch. And just one example is that the number of equity index options traded on Indian exchanges was up 153 percent between 2022 and 2023. You know, so that's just an India story, but really what we're seeing is a greater participation by retail in this.

And again, ultimately those transactions flow to the clearinghouses. The other thing we see from the clearinghouses is this idea that, you know, we keep talking about workflow and operational efficiency. And so that manifests itself in the CCPs as they start to buy software and fintech providers. And so we've seen a couple of different clearinghouses buy tools that are workflow tools that are operational tools in order to help their clients sort of think about it, not just as a listing in trading and clearing venue, but also as a software vendor that is sort of help that is thinking about the entire process from pre trade, trade to post trade.

So again, there is a trend to trade and clear more and more items electronically. All that means that the clearinghouses are essentially very, very busy organizations these days. 

Ali Curi: So with all that said, how are the new and existing exchanges benefiting the wider economy and the market? 

Bruce Roberts: So for the economy and market as a whole, the derivatives markets provide a key service.

So this extends not only to farm producers who buy, but also are used by many other sectors in the economy, such as mining, energy, and financial firms. So market participants are not only interested in the price discovery and managing liquidity risk, but also leverage to the operational efficiency of the exchange and clearing houses to also manage high volumes, periods of volatility.

So collateral requirements are another, and the ability to use collateral offsets to net margin requirements are a key consideration for firms trying to hedge their risks in uncertain or volatile periods. And finally, the cost charged by exchanges and clearinghouses will always be a concern to market participants.

And this brings into focus why the technology provided by exchanges and clearinghouses, our prime focus, to offer front to back solutions that streamline operations but also help manage risk and compliance and optimize costs. So innovation is such an important part of what the derivatives markets have achieved and continue to play a role in and that benefit the wider economy and market.

Stephen Bruel: And I think this really, this is a risk management discussion as we've been talking about. If you own a lot of bonds of a certain corporation and you're a little bit worried, but you don't want to sell the bond, you can buy a credit default swap and that can help mitigate some of that risk. You're never going to potentially entirely eliminate risk.

But these are strategies that can help you eliminate risk and essentially help you, whether you're a portfolio manager, whether you're a corporate, really helps you manage sort of the finances and the financials of your organization with a bit more precision than otherwise would be available.

Ali Curi: And Stephen, for new exchanges starting out, what are some threats and what are some opportunities to be successful?

Stephen Bruel: First of all, oftentimes, stealing share from incumbents can be difficult. It can also be difficult to create liquidity in a new product from scratch. So I guess the key there is to think about what are the unmet market needs. And so I think when Bruce was talking about sustainability and the climate transition, there are a lot of unmet needs in that space.

And so there are areas of opportunity for people to understand if you're a natural end user, a power plant might be a definition of a natural end user versus a hedge fund, which might more speculate. How do you marry? How do you get those two organizations that theoretically might not interact? How do you get them to interact in a trusted environment where they feel like they can trade with each other, even if they've never met before?

So I think for new exchanges, it's identifying the unmet market need, and then thinking about what your differentiation is. Now, that's all easy to say, but there's also a lot of, you know, very kind of meat and potatoes things that need to happen. You need to make sure you've got the regulatory approvals.

You need to make sure you're getting clearing members. You need to make sure that you've got the right liquidity that you can help your clients ultimately be able to effectively trade and process all of these transactions. So it's really a multifaceted story where first the product that you're listing and trading and clearing has to meet a market need, but then you also have to make sure you have all that infrastructure broadly defined like regulatory approval, like the right technology in order to allow people to effectively transact on your system.

Ali Curi: Thank you, Stephen. Those are some great points. Bruce, in your work with new exchanges as a product vendor, what came up as the three most important requirements that a newly formed exchange needs to consider when they're working with a new technology product vendor?

Bruce Roberts: So we recently worked with a Canada based platform who introduced a centrally cleared, physically delivered futures contract and derivatives for energy, metals, and carbon markets.

And these new instruments aim to provide better price discovery and improve risk management. But the exchange is building an advanced risk management tool tailored to the needs of retail investors. And I reference this as due to the financial markets being more versatile, interconnected, and complex than ever.

None more so than derivatives where profound technological developments and automation democratize access to a market that was once the preserve of the professional investors. The boom in demand from retail investors for financial products has fueled exponential growth for brokers, clearing houses and exchanges and the incumbents now face competition from these new participants.

So I kind of provide that backdrop that with new exchanges and clearing houses coming into the market, the three areas that I believe are really key to being successful are one, being tech savvy and being able to provide a seamless operation to minimize risk and scale for new entrants onto the exchange are going to be critical.

And what does that actually mean? Well, I would suggest the start has to be partnering with product companies who have built easy-to-use trading and order management platforms with the connectivity backbone to route orders and low latency and high volume easily to your venue through connectivity. The second would be to limit your scope at the start and launching a select set of products that allow you to create the liquidity and depth in the market to attract the volume and the participants.

The third is if you're a new exchange and clearing house, not encumbered with legacy systems or fragmented data, you have a distinct advantage. So the ability to move to real time and be positioned in the advent of markets moving 24 by 7 will give you optionality. And a strategic decision would be to build in house or to partner with existing firms who've developed the technology to connect to a new exchange front to back and who have supported exchange matching engines today.

And finally, I would highlight resiliency and recoverability. The ability to meet regulatory and government requirements is going to be an ongoing requirement. 

Ali Curi: And Stephen, in your research and discussion with market structures, what came up as the three most important requirements a newly formed exchange needs to consider when they're expanding into new products or setting up for the first time?

Stephen Bruel: I think Bruce covered quite a lot of it and so maybe just to sort of reiterate some of the points you made, I think, you know, this idea of the process and the value proposition where we sort of identified what are the key issues that folks have, capital intensive business can be an operationally difficult business if you don't have the right investments.

Do you solve those problems or do you make them worse? And so if you have a solution that can, for example, is more capital and collateral efficient, there's going to be a demand in the marketplace for that because we do see a lot of the frictional costs of trading going up as the regulations continue.

Whether we're talking about Basel III, whether we're talking about SA-CCR, there's a huge regulatory focus on capital and derivatives, as I said, are capital intensive. And that workflow question can't be understated. Price discovery, execution, post trade workflow, scenario tools, all the technology that Bruce was talking about, that's vital to make sure that when people are connecting, that they're not connecting to systems where they have to download PDFs potentially.

So the idea of a seamless workflow is very important. And as I said before, stealing share from an incumbent from a standing start can be difficult. So the question is, what is your differentiation? What is your value add over the existing solutions out there? If you're starting with a product where there isn't a huge market yet. You know, that's still difficult to do, but if you're trying to take share from an existing incumbent, you need some point of differentiation, potentially around capital, margin, operations, global reach, whatever the case may be, but you need that point of differentiation in order to attract that liquidity that's so important. 

Ali Curi: Great. Thank you for that. For the following question, I want to get both of your takes and Bruce, we'll start with you. What is the one big thing you hope listeners will take away from this episode? 

Bruce Roberts: I would hope that listeners will take away from today that derivatives markets have proven to be resilient to financial crises in the past, cyber attacks, and societal changes through the innovation of new products and technologies over a number of decades.

And that's why we see the markets continue to expand and new interests coming in, as Stephen highlighted. We cannot take these for granted as change is constant, and as this happens, we need to ensure that all parts of the industry remain well governed and possess the capabilities to respond to the next market event, and that includes, from my perspective, the CFTC,

as well as the futures industry association on top of the exchanges, clearing houses, clearing members and product firms to support key technologies in the industry. But Stephen, what are your thoughts? 

Stephen Bruel: Yeah, I think the only thing I'd add to that is this idea that like the derivatives market is constantly changing.

What I think that the innovation that we're seeing is also really important to note and to reiterate that this is an operationally complex capital intensive business with a lot of nuances and sort of difficult processes. But there are technologies out there that help solve them. So I understand, you know, some of the challenges in operating in this environment, but there are a lot of innovative companies that are creating a lot of innovative solutions.

Whether you're talking about creating markets that don't exist, whether you're talking about workflow automation, whether you're talking about capital efficiency, there's a lot of innovation happening in this market. So you have to pay attention, figure out what's going on and understand what the solutions landscape looks like cause it's a pretty good landscape out there. 

Ali Curi: Great. Thank you, Stephen. Now we're going to change gears a little bit. Bruce, I've asked you career advice questions in previous episodes. My question for you today is what is a specific habit or routine that has contributed to your success? 

Bruce Roberts: So great question, Ali. It's probably mindset, in terms of routine. So some days you may not be sure you're winning or losing, but my approach is to have the mindset or routine and thinking about just getting one thing done. And it's more or less the attitude that I'm going to focus on just leaving what you've done a little bit better than where you found it.

And I think you can also step back and apply this to your career or life and whatever you choose to do, just leave what you've worked on a bit better for others in the future. 

Ali Curi: And Stephen, same question. What is a specific habit or routine that has contributed to your success? 

Stephen Bruel: I think for me, and I think for a lot of people, it's just managing your career in the way that you want.

And that sounds rudimentary, and that doesn't mean knocking on your manager's door every day, asking for a raise and a promotion. It just means setting yourself up for success and thinking about sort of what's out there in the future and how you want to get there and making sure you're managing your career, you're managing your interactions.

And you are putting yourself in a position to succeed, not just day over day, but month over month and year over year as well. 

Ali Curi: Well, thank you. I think that is some great advice to close our episode with. 

Bruce Roberts, Stephen Bruel, thank you both for joining us again on the podcast. I look forward to our next time.

Stephen Bruel: Thank you very much. 

Bruce Roberts: Thank you, Ali. 

Ali Curi: And that's our episode for today. You can follow ION Markets on X and on LinkedIn. Thank you for joining us.