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Understandably, exchanges have a difficult relationship with the OTC market. When you consider that 'Over the Counter' effectively means 'anywhere but on the exchange', you can see why. But exchanges are in a position to capture more business if, instead of lamenting this situation, they provide services that enable OTC business to be done on the exchange in the first place.
Another definition of OTC business might be 'business I won't do or can't do on the exchange'. So the challenge for exchanges is to find out the whys of the won't and the can't. And having understood those reasons, deal with the situation by offering a service that eliminates whatever obstacles there are.
The traditional OTC market is highly fragmented. Every transaction arises from a peer-to-peer conversation and the negotiation model is a discrete series of such conversations, culminating in a deal. It is time-consuming and it is inefficient. But in the absence of a central network that can bring all these conversations together into one place, with the maximum number of participants contributing, then participants cannot be blamed for sticking to the old model. If nobody has built a network with connections to the key liquidity providers and to the key users, there is little other choice. If you don't build it, they won't come, to coin a phrase.
It has been argued that, particularly with complex trades, the best way to conclude a trade is one-to-one negotiation. The complexity is too much for a simple electronic order book to follow. The evidence to support this view lies in the continued use of the floors in the US derivatives exchanges - while an increasing volume at the CME, CBOT and CBOE is being executed through their electronic books, a substantial amount of business is still executed on the open-outcry floor. I never thought I would say it but, as things stand today, I have to admit that the open outcry floor is a better 'network' for executing special trades than anything available electronically.
The 'call-around' market - particularly popular for options deals agreed over the phone - is the other putative solution to the problem. This is much more of a European phenomenon than a US one. With no trading floors in Europe, this is the best option available because all that is offered by the exchanges is a central limit order book and mile-wide quotes (if there are any quotes at all). Even the out-dated, out-moded, antediluvian open-outcry trading floor is better than that.
There is something of a vacuum here. The electronic central limit order book is not adequate to the needs of those participants executing the types of strategies or deals-in-size that are served by the OTC market. This is true in spite of the admirable efforts of the likes of Euronext.liffe, the CME and the LSE to enable execution of multi-legged strategies through their matching engines - these strategy tools work to a significant extent but they can never satisfy all the demand that exists at the OTC level. There is a point at which limit order book flow cannot meet the kind of block order flow that characterises the OTC market. The flows are fundamentally different in nature.
An electronic negotiation network is the right way to go - one that reproduces the benefits of the trading floor in terms of customised service but minimises its drawbacks in terms of inefficiency and cost. That network must be open to all professionals with an interest and the credentials to participate. It should ensure that every deal being negotiated is open to as many interested participants as possible (not just those on the floor or on the phone) and it should support the process of a competitive auction.
The conditions required for such a network is that the symbols being traded are fungible (so that what is being traded can be defined on-the-fly) and can be centrally-cleared (so that counter-party risk can be eliminated and access is as broad as possible). Nobody is better placed than an exchange to do this. If fungibility and central clearing are key conditions, then who better than an exchange to implement this model for the OTC market? Fungibility and central counterparty clearing virtually define what a modern exchange is.
The other requirement for this network is, well, a network: the connectivity and distribution that the major exchanges can offer. This is one of the major benefits to somebody offering an OTC product - it provides potential access to a global customer base, with price distribution, global access points, high service levels, reliability and performance. So the network - the connectivity and distribution infrastructure - is a fundamental part of what the exchange offers and is not easy to reproduce.
There are signs that exchanges are beginning to understand this and, as has generally been the case in the evolution of financial markets, it is the derivatives exchanges that are leading the way. It is educational to look at how they have done this.
The two exchanges to have made most progress in this direction have been the CME and Euronext.liffe. In each case, they have taken the lead from innovations that had been created by non-exchange protagonists. In mid 2005, Euronext.liffe acquired C-Screen from Cinnober. The whole C-Screen structure had been created by Cinnober: system, participants and all. Euronext.liffe could see how they could take it further. Liquidity Direct, an institutional options trading platform, was built and operated by a private consortium before the CME acquired it in 2004. In both cases, the exchange acquired the negotiation platform from outside and incorporated it into their network.
So far, neither of these initiatives has made that much of a splash and it is surely too early in the story to tell how well they will fare in the future. But the principle behind these moves is surely correct. It makes no sense to fragment the liquidity in the OTC markets around various IDB and/or sell-side hosted networks. The whole point of an exchange is to pool all the liquidity in one location, especially for trades where that liquidity is hard to find in the first place.
But to achieve this goal, one needs to understand the motivations of the principal participants in the OTC market. As we said above, there are two reasons people do not use the exchange's existing central limit order book infrastructure for OTC trades. Either they won't or they can't. For those in the former group, there may be a number of reasons - they don't want to pay the fees, they resent giving the exchange business out of sheer curmudgeonly behaviour, they prefer to control the process, they like the opacity of a private market.
I suggest that most of the people in this camp are on the sell-side. They will not change their minds about any of this unless their buy-side customers tell them to.
Which brings me to the can't category. I think most of the people in this group are buy-side customers. Their reasons look more compelling: inadequate depth, the exchange does not trade the thing I want to trade, my strategy is too complex. (There is another can't excuse: 'our market is different, you just don't understand it'. This is a can't excuse dressed up as a won't. The FX market long used this excuse but look at it now - it is an electronic marketplace.)
The exchanges have to move themselves closer to the demand side and address these legitimate can't excuses. The initiatives of Liquidity Direct and C-Screen are to be commended. So is the CME's alliance with Reuters to present their futures-style marketplace to the world of FX dealers in a form that the latter is comfortable with. That is the right approach: find out what people need and deliver it to them.
There are four elements to the strategy of offering OTC services that people will use:
- Understand the end-user needs and be willing to provide them with the requisite tools;
- Do not alienate the sell-side - these firms will remain an important source of liquidity and need to be partners all the way, but partners who recognise the new power that standardisation and connectivity has conferred on buy-side firms;
- Offer a negotiation model that protects anonymity but maximises exposure to interested parties; and
- Maximise flexibility of product definition: there is nothing in the world of fungible instruments that cannot be defined on-the-fly in today's trading technology. 'Too complex' is not an excuse.
The ability to deliver this is within the grasp of today's exchange technology personnel. The day will come when the kinds of algorithms that support today's explosion in DMA trading will also operate in this kind of negotiation market. It is perfectly possible to automate that business. If exchanges don't build the infrastructure, somebody else will.
