Just 25 years ago, the idea of a burgeoning derivatives market in Eastern Europe would have been unbelievable. In the late 1980s, as Liffe blossomed in London and DTB geared up to launch in Germany, stock markets in the Central and Eastern Europe were mothballed behind the iron curtain.
The Communist-era temporarily interrupted a long history of trading the region. Trading in currencies and bills in Central and Eastern Europe can be traced back to the 13th century and over the next three hundred years as many as 15 regional mercantile exchanges opened across the region. What is now the Warsaw Stock Exchange opened as the Warsaw Mercantile Exchange in 1817, the first stock exchange in Prague opened in 1861 and in Budapest in 1864.
Aside from temporary closures during the First World War, the region’s bourses traded up to the outbreak of the Second World War. However, they were all shuttered during the Communist era only to reopen after the fall of the Berlin Wall. The Budapest Stock Exchange was relaunched in 1990, Warsaw re-opened its doors in 1991 and the Prague Stock Exchange began trading again two years later.
Derivative launches soon followed the reopening of the bourses. Trading in futures began on the Budapest Stock Exchange in 1996 with the launch of currency and interest rate future and in Warsaw in 1998 with the advent of the WIG20 Index. Today those two exchanges continue to dominate derivative trading in CEE, with Warsaw comfortably leading the field.
“The Warsaw Exchange is the only place there is any liquidity,” says Douglass Welch, director, Emerging & Western European Equity Derivatives at Unicredit Bank. “It is far ahead of the other markets in terms of its marketing approach and has attracted a healthy number of sophisticated retail investors.”
Others agree. “Practically speaking, beyond Warsaw and Moscow, there is very little on the radar of clients,” says Philippe Carré, global head of connectivity at Sungard. “The equities markets in some of these countries are strong and that bodes well for the future growth of derivatives in the region but there is little in terms of derivatives at the moment.”
Crisis economics
The Warsaw Stock Exchange is the region’s success story. According to data from FOWintelligence.com, over 11.5m contracts were traded on the exchange between January and
September this year, with the majority traded in its flagship WIG20 Index contract.
Trading on the Warsaw Stock Exchange represents a 60% share of total volume traded across the regions four derivative exchanges, including the Power Exchange, a subsidiary of the Prague Stock Exchange. The Budapest Stock Exchange is next in the pecking order with 6.7m contracts traded in the year-to-date, followed by the minnow in Prague. 9,000 contracts have been traded on the Prague Stock Exchange and its power subsidiary to date with the lion’s share of those trades on the Power Exchange.
The financial crisis hit the region hard and the strong growth that derivative volumes on the Warsaw and Budapest stock exchanges had enjoyed was checked. Trading volumes in derivatives on the Budapest Stock Exchange fell from 18.8m in 2007 to 13.9m in 2008 and 11.8m in 2009. On the Warsaw Stock Exchange, volume growth slowed from the 25% a year it had enjoyed from 2006-2008 to 5% in 2009.
Need for innovation
Despite its place at the top of the podium in the region, WSE still faces some substantial challenges going forward. One criticism levelled at it by some traders is that it has, so far, failed to attract institutional investors, whose presence would bring much needed stability and liquidity to the exchange.
“The trouble with having only retail investors as participants is that their liquidity can be fickle and if panicked, can disappear, which can be damaging to the market,” says Welch. “Attracting institutional investors will be important to its long-term future.”
The asset classes of derivatives traded in the region also remains limited to simple structures and market participants complain that little innovation has occurred in recent years. Index futures and options dominate the market at present, with futures by far the most liquid.
However, single-stock futures and options also now starting to gain a solid footing post-crisis, something the WSE with its strong equities franchise has benefited from.
“Futures and options are the basic building blocks of the market; they are commonly used as investment management tools, not pure speculation” says Welch. “There are plenty of opportunities in less liquid bespoke securities but cost can be an issue. A lot of bespoke products are more so expensive, targeting a specific need, thus to bring them to market is not practical as there is no broad market demand.
“In highly volatile markets, as they are right now, people are more risk averse - the futures market is growing but there is little product development or innovation. The high volatility has caused Option volume growth to stagnate temporarily”
Things are slowly changing, however. Carré notes that education is needed in the region but adds that the process is gathering pace. “You are starting to see a lot more seminars and learning events take place in the region on things like how to trade options,” he says.
Thilo Derenbach, deputy managing director of REGIS-TR, the European Trade Repository, agrees. “The complexity of OTC derivative products used is lower than in the UK, for example,” he says. “The product complexity is still evolving.”
He also notes, however, that the potential of the derivatives markets in CEE should not be underestimated. “The CEE markets have great potential,” he says. “These markets are full of very well educated ambitious people who want to make these markets work.”
Perhaps some of this education is paying dividends already. Chris Marczak, president of UNISystems Research, says he is seeing growth in the liquidity of options. “Besides the increasing popularity of structured products in CEE region generally, another notable development is option market growth. Option liquidity on the WSE has increased significantly due to additional engagement of market makers.
“As recent global market volatility during this crisis will result in growing demand for option products, it is noteworthy that some exchanges are already moving in the right direction,” he says.
Regulatory uncertainty
But for all the optimism surrounding the future of derivatives in CEE, the most important influencing factor on the market’s continued development could be regulation. Welch is critical of the regulatory regime in Poland because of a lack of clarity over trading laws and guidelines for asset managers on what use of derivatives is acceptable.
“For all the market’s positives, it is hampered by poorly understood regulations,” he says. “They are unclear and that can have a negative effect on the market’s growth. The regulator really needs to clearly communicate Best Practice Guidelines for the use of derivatives. The vagueness of the regulations are not conducive to the market and are hampering its development in some ways.”
Some, however, note that the Polish regulator is not entirely to blame. “Regulatory changes are taking a long time to happen in Poland but while it is easy to blame the regulator, it may also be the case that some of the incumbent players are suspicious of newcomers and can make things difficult,” says Carré.
“Some of the local players have done very well out of the market and there are some powerful vested interests there as a result.”
Any problematic national regulatory issues will soon be transcended, however, by two market changing regulatory initiatives set to come into force over the next 12-18 months. After several months of negotiations between the EU’s 27 member countries and a great deal of wrangling, the European Markets and Infrastructure Regulation (Emir) is set to be introduced in the middle of next year while the Markets in Financial Instruments Regulation and updated Legislation is expected to be enforced from 2014.
There will be consequences for the CEE region specifically, says Judith Hardt, secretary general of the Federation of European Stock Exchanges (FESE).
“We expect that as a result of greater certainty and transparency, a portion of the OTC derivatives market will have to pass by CCPs and reported to trade repositories; it is important these systems and platforms are robust enough to deal with the expected greater volumes,” she says.
Conflicting regulations
Not all welcome the EU-wide directives, however. Marta Smolarz, attorney at law based in the Warsaw office of European law firm Noerr, agrees that the implementation of these new laws will mean big changes for the markets.
But she believes the new regulations will have a detrimental effect on trading in the region. “I believe some investors will back out because of the increased regulations,” she says.
“In Poland specifically, their rules are incomplete and incomprehensive. With the EU changes coming in on top, the national regulator will have to implement them around its own regime. So much regulation could put investors off. It is just hard to interpret them all.”
Derenbach agrees. “The regulatory changes, particularly in the field of OTC derivatives, could inhibit the development of the segment in the CEE region,” he says.
“There will be additional regulatory costs so market participants may simply seek more standardised products going forward.”
Marczak says that there is a need for regulatory harmony in the region with new rules being enforced elsewhere. “Regulations in CEE are more restrictive in terms of licensing individuals and companies managing funds in comparison to the US,” he says.
“At the same time they allow very controversial practices such as selling option products carrying enormous risk over-the-counter to individuals and companies that do not have sufficient understanding of the risks involved. More liberal regulations of licensing seem to be necessary change required to make this market vital and more competitive.”
Welch adds that, however the Polish authorities implement Emir, better guidelines are the needed catalyst for investors in Poland. He says resolution of this regulatory challenge will offset any economic cyclicality in the region. In some ways, more agitation to clarify the regulations may be the secret wish of the Regulator - only when participants truly understand the market/instruments which the regulations are intended to govern and the inherent costs of the status quo, will the pressure for change then be great enough.
“The regulator does needs to clarify the regulations on what constitutes “prudent use” of derivatives for Fund Managers and Asset Mangers,” he says. “They should follow global benchmarks on this so Managers know what the situation is. The regulatory policies surrounding the bourse offset the short term optimism in the correlation between regional economic growth and increased trading volumes.”
Exchange consolidation
The smaller regional exchanges in CEE, however, will also have one eye on their own future given the global trend towards consolidation among exchanges in recent years. There are big question marks over the extent to which smaller exchange can stand alone in the new world order.
The consensus in the market seems to be that, because the region is not necessarily on the radar of big global players, the local players will remain independent for now. But most also expect alliances to be formed either between a number of exchanges regionally or with bigger global players.
“These players do sit off the radar to a certain extent and their big advantage is their geographical specialities,” says Carré. “But we are seeing alliances already. Warsaw has a tie up with NYSE Euronext and that is the type of trend we will see alongside other regional alliances.”
An example of this later trend is the CEE Stock Exchange Group which, lead by the Vienna exchange in Austria and comprising of an alliance of Budapest, Ljubljana, Prague and Vienna. As a group, it boasts 1,800 traders from a total of 180 national and international banks and brokers on the four exchanges and has recently converted its trading system for derivatives contracts from the Nasdaq-OMX’s OM-Click to the Eurex system.
Marczak believes this type of arrangement is the way forward but also warns that the process will not be a speedy one. “I believe that existing trading platforms may eventually evolve and merge into larger ones, however, as in the case of exchange mergers, this process may be lengthy.
“Depending on the structure of future global exchanges smaller platforms may fit in that future system providing trading opportunities for niche and local products in the same way as large supermarket chains coexist with smaller local chains and shops.”
The rapid growth of derivative trading over the past two decades as the CEE region emerged from Communist rule is testament to the potential of the region. So too is the resilience of the ETD market in the face of the global economic downturn. However, if derivative trading in CEE is to truly thrive, regulations will need to be harmonised and exchanges will need to innovate.