A new chapter in the story of US interest rate derivatives began on March 21. NYSE Euronext, through its small exchange NYSE Liffe US, began offering Three Month Eurodollar Futures.

A full suite of futures on US Treasury bonds followed on Monday, March 28.

Although a bank-owned exchange, ELX Futures, has already shaved a few percentage points off CME Group’s 100% market share in listed US interest rate derivatives, many believe NYSE Liffe poses the most serious challenge yet to CME’s dominance.

By clearing its contracts through the newly minted New York Portfolio Clearing, a joint venture between NYSE Euronext and the Depository Trust and Clearing Corp, these corporate bedfellows are hoping that they can jump the age-old hurdles of attracting enough open interest and liquidity to make a viable long term market.

Leaving nothing to chance, NYSE secured market backing for NYSE Liffe US as long ago as October 2009 by selling some of the equity to five banks and high frequency trading firms: Citadel Securities, Getco, Goldman Sachs, Morgan Stanley and UBS.

Equity buy-in from big dealers and traders has been a successful formula for many multilateral trading facilities in the equity market, and for ICE Trust, the credit default swap clearing house that now enjoys a de facto monopoly.

On the first Monday of trading in the first five years of the Eurodollar curve, NYSE Liffe won volume of around 4,000 contracts, each worth $1m. By Wednesday, volume had topped 60,000, worth a total of $60bn.

That is still small compared with CME’s average daily volume in February of 2.69m Eurodollar contracts, but already represents a market share of 2.2%. Not bad for day three.

ELX Futures, which had a record month in February, hosted an average of 23,500 Eurodollar trades a day in the month, as well as 68,900 Treasury futures a day.

“We are very pleased with our first week’s performance,” says NYSE Liffe US’s CEO Tom Callahan. “The feedback from our customers has been encouraging, and we are extremely grateful for their early, strong support of our market.”  

Operationally, Callahan says, all systems at NYPC and at NYSE Liffe US had performed “exceptionally well”.

“Since go-live last Sunday night, we have had tight, two way markets all the way through five years with excellent depth and liquidity. We have many large clients still in the process of connecting to our market, so we are optimistic that our liquidity and market quality will continue to improve.”

Week two should be still more interesting, as it is then that NYSE Liffe should begin to benefit from its secret weapon – the possibility for clients to gain a benefit, in their margin payments on Treasury futures, for offsetting cash Treasury positions at Fixed Income Clearing Corp, DTCC’s bond arm.

The effect of this innovation is still untested, but it is certainly the talking point of the year in the world of US interest rate futures.

False start

Liffe previously tried to list a Eurodollar contract in 2004, but it never garnered the necessary liquidity, even though it was significantly cheaper to trade than CME’s.

This failure was a valuable learning experience, however. “We learned that we needed to be a registered US exchange and that you cannot just compete on price in the futures industry. We had to do something different,” says Callahan.

That something different is one-pot clearing, which allows clients who are netting members of FICC to have margin assessed across their portfolios of cash securities and futures.

“We are challenging CME in terms of capital efficiency at the clearing level, which is a place they have never been threatened before,” says Callahan. “NYPC delivers a margin environment where clients are able to recognise the economic value of hedges that exist in their portfolios between cash bonds and futures. This level of capital efficiency has never before been available. We think it creates a powerful motivation for customers to move their business.”

Until now, US interest rate futures have been cleared through CME Clearing (or, at ELX, the Options Clearing Corp) while cash bonds have gone to FICC.

ELX has been trying to persuade the Commodity Futures Trading Commission to compel CME to accept Exchange of Futures for Futures, a system that would allow traders to open a position at ELX and close it at CME. But despite some CFTC support for the idea, CME has not budged. ELX has also been cutting its fees. Meanwhile, the headlines have shifted from EFF to cross-margining.

According to John Coleman, managing director of RJ O’Brien’s fixed income division, cross-margining will provide a boost, particularly to basis traders. “Those who do arbitrage and speculation, with the cross-margining of cash and futures are definitely going to find benefit,” he says.

However, because RJ O’Brien, the largest independent futures broker in the US, mainly works for hedgers, its clients are more likely to benefit from staying at the CME, says Coleman.

“We handle accounts of people who are bona fide hedgers, who need to cross-margin Eurodollars and Treasuries with cleared interest rate swaps and OTC products,” says Coleman.

“Right now, I think we may see a bifurcation where the speculators and arbitrageurs prefer the ability to cross-margin with cash at NYPC and the bona fide hedgers and swap traders who prefer to cross-margin Eurodollars versus Libor-based interest rate swaps will stay at the CME.”

Merc hits back

CME appears to have recognised the threat posed by NYPC. It has responded by introducing a new membership class, intended to provide similar benefits to NYPC’s one-pot clearing.

Called the Financial Instruments Clearing Membership class and available by the end of June, it will offer margin payment reductions of up to 65% for those trading both Treasury bonds and CME’s corresponding futures.

Meanwhile, CME is also trying to move into clearing of over the counter interest rate swaps. Its service went live in October 2010. “We have just brought in two major new clearing members,” says Derek Sammann, CME’s managing director of interest rate and FX products in Chicago.

As regulatory reform, such as the US Dodd-Frank Act, makes centralised clearing of some OTC derivatives mandatory, more and more of the interest rate swap market is likely to move into clearing houses.

Although LCH.Clearnet’s SwapClear service has a huge head start in this market, CME hopes to soak up some of the flow, and ultimately to offer crossmargining between swaps and futures. NYSE Liffe, too, wants to crossmargin futures and swaps – this could be added within six to 12 months of launch.

For the moment, however, CME must compete on the basis of its existing interest rate futures system, with the FICM class to come by the summer.

Ironically, the bones of the system used by NYSE Liffe US were bought from the CME during its mergers with the Chicago Board of Trade, Nymex and Comex in 2007-8.

Further innovations to come

While Callahan agrees that basis traders will be the largest group of early adopters to start using NYSE Liffe US, he stresses that plans are in place to launch options by the third quarter of 2011, with OTC swaps to follow. Other products are likely to include futures on assets such as mortgages and repos.

As Walt Lukken, chief executive of New York Portfolio Clearing, puts it: “We will not try to walk before we can run, but getting cash securities, futures and later swaps in the same collateral pool is something we plan to do down the line.”

The NYPC risk specialists are developing the ability to process options using the one-pot margining methodology. They are building on Liffe Connect’s functionality, used for European short term interest rate options such as Euribor and Short Sterling.

Andy Nybo, principal and head of derivatives at Massachusetts-based research firm Tabb Group in New York, says: “While it is notoriously hard to create a marketplace, especially where there is an entrenched marketplace that enjoys the vast majority of liquidity like in the case of the CME, the two exchanges do seem to be pursuing a distinct and different client base.”

The NYSE Liffe US offering is squarely aimed at basis traders, brokers and clearing members, whereas CME wants to provide more efficient marketing capabilities in futures, says Nybo.

However, Sammann says testing on the FICM account class showed that it would be able to scale certain customers into a basis trading strategy. “Based on six months of beta testing, FICM allowed those CME customers an average of 40%-45% margin offsets,” he said.

Will traders move?

The most important question, however, is whether the benefits of cross-margining and consequent capital efficiencies offered by NYSE Liffe are enough to convince the largest users to switch business away from CME.

Ed Brown, executive vice-president of business development and research at Icap Electronic Broking in New York, believes the cross-margining solution planned by CME for its interest rate complex will not provide the benefits many believe it should, so that some will be tempted by NYSE Liffe.

“The CME’s new membership class allows it and the clearing house to get an intraday view of a client’s Treasury positions in the cash market and provides margin relief against that client’s futures positions, but there is no benefit to the clients’ cash position. So it is not really true one-pot margining,” he says.

In addition, notes Brown, to take advantage of the CME offering, clients have to shift their funds out of a segregated account and into the house account, thereby losing protection under Reg 4D. “It does come with a cost.”

Certainly, issues pertaining to the mechanics of the CME’s new margin offering have given pause.

Three days after the CME announced its new membership class on February 28, Standard & Poor’s put the exchange’s AA and A-1+ credit ratings on CreditWatch Negative – essentially, on review – over concerns about the innovation’s impact on risk management.

In response to this decision, the CME told FOW: “We disagree with S&P’s initial concerns that our FICM structure generates additional risk, and we look forward to resolving this with them. We are extremely confident in CME Clearing and the risk management methodology that has provided security to our customers for over 100 years.”

Nevertheless, CME will have some work to do to explain how the FICM measure affects risk at CME Clearing.

“From what little information the CME released regarding their FICM service, it appears to be simply a third party prime broker that stands between the clearing firm and clearing house. As S&P stated in their report, this looks like a step towards demutualisation of risk,” says Callahan.

The fundamental difference of what NYPC is offering, according to Lukken, is that because it is partnered with the FICC and has transparency into its entire portfolio, it will be able to take those assets into account when calculating margin, without compromising the integrity of the clearing house.

Brokers sceptical

Despite the hype about NYPC and the review of CME’s rating, some futures brokers contacted for this article were not ready to take their business to the new venue.

A spokesman for a large Chicago-based futures broker told FOW: “It all sounds great on paper, but if the open interest doesn’t move over, no one’s going. That is the bottom line. People don’t want to be in a situation where they are at a venue where there is no open interest and they are not able to get out of it.”

“Point blank,” the spokesman added, “certainly the NYSE is as worthy an opponent as you are likely to find, but I find it hard to believe that anyone is going to leave the CME, given their existing product base, without a very compelling reason.

I don’t think the difference will be cost of clearing.”

Despite predictions of failure from some corners and the litter of now defunct futures exchanges that have gone before it, Callahan is optimistic.

“It is one thing to describe the capital efficiencies, it is quite another when people see it for themselves,” he says. “When they see how the risk netting and capital relief actually work, they are going to get excited. And when they see how it impacts their balance sheet, they are going to get really excited.”

Lukken puts some numbers on it: “The reason that we believe we have catalyst to drive market share to this venture is that we’re going to be able to offer billions in savings, in addition to fees.”

Sammann at CME is not fazed. “When you look at the competitive landscape, I don’t think you can look at one attribute of a particular platform and say that is the differential,” he argues.

“It is a combination of liquidity, customer response, product breadth, services that provide efficiencies for the market trade. These are the overall fabric of what customers consider important and why they trade on a particular platform.”

Capital efficiency all the rage

While deliberations as to which exchange offers the best version of one-pot margining for different client groups will continue, there seems to be little contention as to whether it will be a good thing for the derivatives market. “I think it is going to become extremely critical to the industry as a whole,” says Coleman at RJ O’Brien.

The global financial crisis showed why controlling systemic risk by identifying it across multiple asset classes is not only beneficial, but necessary.

Moreover, the attempt to better control these risks and maintain liquidity, following the requirements of Basle III, will soon redefine global regulatory standards on capital adequacy.

Basle III’s coming implementation, say some industry participants, creates even more reason why new US derivatives exchange and clearing mechanisms aimed at capital efficiency should be given a fair chance to succeed.

“Since the financial crisis, capital is pretty expensive and there is going to be a great demand for capital with Basle III coming out,” says Lukken. “By bringing these collateral pools together, people are going to see the benefit of being able to manage their risk better.”

Furthermore, as the Federal Reserve is expected to end its programme of buying US Treasuries in mid-2011, some argue that the market will need a new pool of liquidity. “It is in everyone’s interest to keep as much liquidity in the Treasury market as we can,” says Coleman.

Farther down the road, some speculate as to whether NYSE Liffe US will eventually try to make an even bigger cross-margining pot.

Although NYSE Euronext’s planned merger with Deutsche Börse has numerous regulatory rivers to cross, the possibility of cross-Atlantic one-pot margining is now open for discussion. Lukken would not rule out the possibility, though he would not say whether the concept was on the drawing board.

While no one can dispute that the NYSE has deep enough pockets to cope with any bad weather in the early months of its new products’ life, all businesses have internal benchmarks to aim for, as a measure of success or failure.

For NYSE Liffe US, this benchmark is the direction of an arrow. “The measure of success will be if the graph showing open interest and volume is gradually but steadily heading upwards, that is what we are looking for,” says Callahan.

Says Brown at Icap: “In terms of liquidity, I think they have a fair chance.

But it is a challenging task to push open interest away from the incumbent venue.

Not impossible but a challenging task.”

Additional reporting by Tom Osborn  

Ready, steady, go for Treasuries

As FOi was going to press, NYSE Liffe US’s Treasury Futures had just been listed for trading on March 28.

CEO Tom Callahan says he is still more optimistic for this debut than for Eurodollar Futures, because it is Treasury products that “best optimise the capital efficiency of the New York Portfolio Clearing one pot margin methodology”.

“Treasury futures will also benefit from the NYPC automated delivery process, which will decrease risk to the system and to any customers making or taking physical delivery,” he adds, arguing that the bourse’s initial impact on competition had been welcomed by traders.

“Feedback from customers is that they are excited about these benefits, and they are excited to have a real, competitive choice in execution and clearing venues.

“As with our Eurodollar market, we will need to work with our customers to resolve initial connectivity issues.

As we get more and more customers in our market I expect our liquidity to grow quickly.” Tom Osborn