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The art of designing markets. Part V

Release date: 05 Sep 2018 | Eurex Exchange, Eurex Clearing

The art of designing markets. Part V

Trading outside the public order book

Market design recognizes that well-functioning markets are more than the confluence of supply and demand. They depend on detailed rules. Market designers try to understand the rules and procedures as well as the workings and requirements of particular markets well enough to fix problems or to build completely new markets when they seem promising.

This is the fifth article in a series of topics related to the market design of electronic market places. The first article discussed the most common execution models in electronic derivatives markets, the second covered the various components of an order-generating process that define its arrival time, giving us an overview of the three steps market participants need to generate and submit an order to an exchange. The third reflected on the electronic exchange connectivity options for indirect exchange participants such as institutional and retail investors and the fourth examined these options for direct exchange participants i.e. the members of the exchange. This article looks at market segments in Eurex products that are organized outside Eurex by phone.

 
 

Randolf Roth, Member of Eurex Frankfurt Executive Board, responsible for market design

While discussing the electronic paths to a fully electronic exchange like Eurex in the last four articles, I already mentioned that there are market segments in Eurex products which are organized outside Eurex by phone. Today I would like to shed a bit of light onto this.

Historically not only in the US but also in Europe the trading of exchange derivatives took place on a trading floor. In the early nineties, two relatively small exchanges at the time, Frankfurt-based DTB and Zurich-based SOFFEX, challenged this. Both were fully electronic. As they gained momentum over time they not only grew the overall business but also grabbed market share from LIFFE, at the time the biggest European derivatives exchange by far. In 1998, DTB & SOFFEX merged to become Eurex and shortly after – and within only a couple of months – Eurex managed to shift completely the then most actively traded derivative contracts in Europe: the derivatives on German government debt. As a result of this dramatic loss LIFFE decided quickly to also go fully electronic and then to shut down the trading floor.

Throughout this period of drastic market structure changes, not all product segments moved completely into a fully electronic environment; a new market structure had been established in parallel: The so-called “European Call-Around market”. One driver for this was that exchange technology/functionality and the available on-screen liquidity could not address sufficiently all participants needs for executing very large or complex orders. Another driver was the availability of talent from the floor days with good market skills and relations, but little or no interest in moving into electronic trading.

The “Call-Around Market” – organization and players

The “Call-Around Market” is organized by various brokerage firms, which “broker” deals between banks on the one side and market makers on the other via phone. Market structure-wise it is very similar to the markets organized by the Inter-Dealer Brokers (IDBs) in OTC products such as Swaps. This “Call-Around Market” still exists today for orders that are either too large or too complex to be addressed in the public order book. The majority of the respective volume is in options, where all Eurex options are traded, not only in the order book but also with a substantial share in the “Call-Around Market”. When looking at futures, the “Call-Around Market” is of particular relevance for illiquid futures while in liquid futures it is especially used when open positions are rolled into a new expiry. This generally happens shortly before the expiry date of the current futures contract (usually referred to as “front month”) is reached.

Nonetheless most of these arranged orders in options and futures find their way into Eurex as Eurex provides a block trade service called T7 Entry System (TES), where participants offer these pre-arranged orders and ultimately conclude the trade. This is only permissible for transactions above certain minimum sizes that have to be above the regulatory required transparency thresholds. This is necessary as transactions organized in the “Call Around-Market” by their nature do not provide pre-trade transparency, as the price formation process happens outside of the exchange. In contrast, pre-trade transparency is regulatorily required for any normal size trading activity.

Various segments of previously voice-traded instruments are moving toward a more electronic trading style. Eurex believes that this trend will gain momentum with MIFID II transparency and best execution requirements acting as a catalyst. In the next article, I will talk about how Eurex is addressing this development.

 

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