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In a new research report, TABB Group says that high-frequency trading and capital-constrained dealers failed to support the plan from the London Stock Exchange (LSE) to introduce contracts for difference (CFD) trading on its order book. According to TABB, this listing failure represents a lost opportunity by regulators and dealers to unite and demonstrate to the financial markets industry that an over-the-counter (OTC) derivative product can be moved to an exchange.
“As the dust begins to settle on the global financial crisis, the LSE’s April ‘postponement’ seems to have had more to do with the overall marketplace panic peculiar to the times and not any ill-preparedness on the part of the exchange,” writes Adam Sussman, director of research at TABB, and co-author with Will Rhode, a London-based financial journalist. He adds that, “with normalcy in the markets beginning its return, it is clear that the status quo remains and the dynamics that originally made the listing of a CFD on an exchange like the LSE a good idea are just as valid today.”
The TABB research note closely examines the details of the LSE proposal for exchange-traded CFDs and the current OTC workflow in order to try and understand why the industry could not come together at this time to bring the proposal to fruition. In doing so, Sussman and Rhode discuss prime financing partners (PFPs), the give-up process and its role in high-frequency trading strategies, stamp-tax exemptions, the new disclosure rules and potential new participants the exchange-traded product could attract into the market.
The LSE’s decision to indefinitely postpone their plan highlights many intrinsic difficulties investors face converting an OTC product into exchange-traded instruments. To succeed, explains Sussman, you need a critical mass of support from liquidity providers and investors and regulatory approval. “Meeting demands of these constituencies, each with different requirements and often competing objectives, is a difficult juggling act.”
The authors explain that the LSE was effectively turning itself into a quasi-futures market due to the hybrid nature of CFDs, which share characteristics of both cash equity and equity derivatives. The product, they claim, was a natural fit to the LSE’s core business and had the potential to expand its reach into a new market, recapturing lost market share in its core business. The listing also had potential to open up the CFD market to Undertakings for Collective Investments in Transferable Securities (UCITS) funds and long-only institutional managers who have not been involved in the CFD market.
The LSE plan also could have affected high-frequency trading because a high proportion of the industry’s current £720 billion estimated CFD volume comes from high-frequency trading strategies. Demand for CFDs depends on the give-up process and stamp exemption. As Rhode explains, with its initial offering the LSE secured stamp exemption but couldn’t promise the give-up process.
Although it is often dealers’ greed or the solipsism of an exchange that is blamed for a failed listing, the truth is often that there are some components of an OTC derivative that simply do not translate into an transparent, real-time, time-stamped execution environment, Sussman says, as many OTC derivatives depend on nuanced contract details that are not easily translated into the certainty of an “execution.” The way in which high-frequency trading employs the give-up process is a classic example of this.
While any exchange-traded proposal is a potential threat to the OTC dealers, the LSE attempted to utilise the cash balances and equity inventory of the dealers in a manner consistent with the operation of the OTC desk. For the banks where OTC trading desks handled CFDs, the potential lay in the efficiencies an exchange-traded product would deliver. A centrally cleared, exchange-listed CFD contract represented a potential convergence between execution, equity finance and clearing operations within investment banks.
According to TABB Group, although annual prime brokerage IT spend is expected to decline by as much as 40% through 2010, apparently the modest outlay required for the CFD expenditures, from £150,000 to £2 million, proved too much for banks to overcome.
The biggest losers from the listing failure must be the investment banks themselves,” says Sussman. “Some of them could be accused of short-sightedness for their role in not bringing the product into fruition. Although the prime broker divisions will preserve their hefty margins in the OTC market, they will fail to see an expansion in the product’s appeal, as well as the attendant increase in volumes and liquidity.”
In the final analysis, he adds, “The devil is in the details. Just as there are nuances of the OTC CFD market that seem unable to be ported over to the exchange model, regulators and exchanges worldwide may learn the same is true for many of the OTC derivatives now under discussion. Although part of the appeal of an exchange-traded listing, including centralised clearing, is to enhance transparency, increase the number of participants and thus generate additional liquidity, there is no guarantee the listing will succeed.”
The 18-page report with six charts can be downloaded by TABB Group Research Alliance clients and pre-qualified media at https://www.tabbgroup.com/Login.aspx. For an executive summary or to purchase the report, please visit http://www.tabbgroup.com, or write to info@tabbgroup.com.
