OTC and Exchanges: Convergence Deferred
Zwick, Steve, Modern Trader
Five years ago, the promise of commoditization and real-time processing created an expectation of a renaissance in listed product development. Alas, only a handful of products were developed, and they were underwhelming. But the expected convergence of OTC and exchange markets is gearing up now.
Richard Olsen and his partner Michael Stumm built the Oanda trading platform in part to show it was doable, and in part because they truly seem to believe that if you get more people participating in open, transparent and liquid markets, you'll end up with the kind of fair and stable financial system that markets are supposed to deliver.
Contrast that with the over-thecounter (OTC) world, where a few well-educated, but not particularly diverse, minds are determining the prices on which trillions of dollars worth of global instruments are based.
A cynic would blame the top-tier banks that run everything and keep the markets closed and clunky to bloat the bid-offer spreads that generate their profits.
Someone less jaded might argue that closedness and clunkiness are necessary traits of the OTC beast, which is no beast at all, but rather a sort of financial market Miles Davis or Kurt Cobain - a cantankerous and temperamental genius, whose idiosyncrasies we willfully tolerate to enjoy the benefits of their work.
Olsen says their value has been greatly exaggerated.
"If you have one group of people who all read the same newspapers and all go to the same restaurants agreeing on a price," he says, "you get a price that can go to completely unreasonable levels, and eventually the bubble will burst, and that's what's happening now."
The price he's referring to, of course, is that of credit default swaps (CDS) and other credit-default instruments, but the analysis can be applied to all markets dominated by OTC transactions.
His point touches on several fascinating debates, chief among them being whether broader participation in the pricing of such instruments would have prevented, or at least minimized, the current credit debacle.
"I don't think you can say the whole credit crisis would have been averted if people were trading credit products on-exchange," says Eurex Product Strategy boss Brendan Bradley. "Only a small percentage of credit instruments are suitable for exchange trading now, and most of the structured instruments out there never will be."
Rick Redding, the Chicago Mercantile Exchange's director of products and services, agrees, but adds that time has a way of commoditizing some fairly obtuse instruments.
"Weather derivatives are a case in point," he says. "These were pure OTC instruments'until we launched our futures contracts, and now both products are doing well."
Credit default products have been launched by exchanges from Frankfurt to Chicago, beginning in March with Eurex's launch of Itraxx Europe credit default index futures and its sub-index, Itraxx HiVol, as well as Itraxx Crossover.
So far, however, all have failed to attract significant volume and the HiVol hasn't traded at all despite that OTC traders themselves are more and more using credit default indexes like Itraxx to benchmark their risk.
Common wisdom says the big banks have simply not used their credit books to support the products because they fear a successful exchange-traded index would lead to exchange-traded single-name products - and single-name products generate the fattest margins.
Bradley, however, says it's more likely that investment banks have just moved on to greener pastures, and points out they also make their margins in second- and third-generation products such as index tranches and Constant Proportion Debt Obligations (CPDOs), which involve swapping baskets of high-risk and AAA debt with complex guarantees with issuers in the event something goes sideways.
Redding adds the day will come for credit default futures as more and more hired guns leave the big banks and join the buy side. …