erivativesreview.com
Bridging The Gap Between Technology And
Content
Doctor Richard Sandor, father of financial futures, CEO of Environmental
Financial Products, recently appointed LIFFE board member and indeed,
amongst his many other august appointments, special advisor to
erivatives.com, gave the keynote address at the inaugural @Markets
conference in Boston in September 2000.
The presentation outlined how and why B2B markets and the derivatives
markets are converging, and his comments are as valid now as when they
were made back in Boston. Patrick Young attended the conference, and
here he gives a flavour of Sandor's remarks.
The address opened with a cartoon from the Orlando Sentinel of two
beggars. One is somewhat forlornly holding a sign saying "Will Work" and has
an empty hat in front of him while around the corner another is happily
brandishing a placard saying "Will Work For Food.com" and is quite literally
being submerged with dollar bills from passer by.
Doctor Sandor noted that the big division between open outcry and
electronic futures trading essentially amounted to the same dichotomy as
that being experienced by the beggars. Indeed, all markets, whether
organised spot markets, derivative markets or whatever, are going the same
way.
Sandor went on to note how throughout history, the development of
markets have uniformly followed a seven stage process:
1. Structural Change - Demand for Capital
2. Uniform Commodity/Security Standards
3. Legal Instruments Providing Evidence of Ownership (after all, we trade
warehouse receipts or evidence of ownership not the actual commodities as
such).
4. Informal Spot and Forward Markets
5. Emergence of Exchanges
6. Organized Futures and Options Markets
7. Proliferation of OTC Markets, Deconstruction
Sandor noted that this generic model applies to a variety of products, and
he opted to look at four specific examples:
1) The Dutch East India Company
The structural change driver for the Dutch East India Company was the
discovery of America. This huge opportunity had to be capitalised and led to
the development of the new world. Nevertheless, there were other
structural problems such as companies only holding a partnership form. The
emergence of the Limited Liability Company with evidence of ownership and
homogeneity helped create a solid basis for the promotion of the company
itself. Moreover, the emergence of the organized exchange in 1600 in
Amsterdam was a great boost to the capital raising process and indeed the
world's first modern futures contracts were launched on the Amsterdam
bourse in 1605 - futures on the Dutch East India Company no less!
2) Wheat
The informal movement of people westward from the US eastern seaboard in
the mid nineteenth century resulted in grain being gathered and shipped
back to the east coast. Meanwhile, standardised grain specifications were
developed by the CBOT. The Crimean war of 1853 resulted in the US
becoming an exporter of grain. Subsequently, futures contracts were
established (again at the CBOT) along with standardized warehouse
receipts and so on and so forth
3) Collateralised Mortgage Obligations (CMOs)
As the world plunged into the high inflation period which dogged much of the
1970s, interest rate volatility naturally exploded. There were forward
markets and subsequently Ginnie Mae futures before the OTC marketplace
developed. Ultimately, there was a high proliferation of CMOs - most
recently the standardization has been back in fashion with the Fannie Mae
agency futures contract.
4) Climate change
Here we have a physical commodity created by the US Clean Air Act to
mitigate acid rain. The catalyst was industrialization leading to heavy
industrial pollution. Later the CBOT established a spot auction process and
subsequently we have seen the proliferation of OTC markets etc.
What is purpose of going through all of these examples, asked Doctor
Sandor?
Well, for one thing, the four examples included a commodity, a fixed income
instrument "and a new age new world property right which is totally virtual"
These four models all have the same thing in common - whether we are
talking about wheat trading or Dutch East India Company shares - all were
"one state owned", i.e. the exchange was dominant, and owned the spot,
futures and derivatives markets...
As we progressed through the twentieth century, exchanges had the
derivatives market and the spot market was frequently left to other
people... Now what is happening is that the B2B world has really taken over
the franchise for spot markets. Moreover, the spot markets created in the
B2B world have been quite literally in every conceivable sector from
energy/utilities and motor vehicles through to agriculture/foodstuffs,
chemicals and pharmaceuticals. Then again the market for B2B has been
opened up because the computer is capable of having millions of people
compete in an auction process.
So we still don't have fully integrated derivatives and spot markets. Some
are web based, some are exchange oriented and there are huge differences
in the types of technology employed by the different types of markets.
So, what have the venture capitalists and B2B people brought to the party?
Well, it's the culture of speed, technology and management capability in an
ever-changing world. Their model is not governed by mutualisation, nor
governed by different classes of ownership. Above all, their model is not
driven by orientation but by profit... Where such models have already met
existing exchanges, e.g. in London at LIFFE, the model is one where
mutualisation just doesn't fit...
On the subject of trading algorithms, Doctor Sandor was quite intriguing. He
noted how first-in-first-out (FIFO) had become the largest and most popular
of the algorithms. But he also discussed how the more sophisticated
concept of distributed algorithms attempts to answer those black art issues
of how to truly "trap liquidity." Naturally, exchange matching engines are
becoming commoditised, and for hundreds of thousands of dollars we will
soon be able to get any matching engine. The next step will likely include
the creation of more sophisticated algorithms.
What exchanges have brought to the trading party is outside liquidity. What
they bring to futures and potentially spot markets is liquidity providers,
designated market makers and competing market makers...all models
beginning to happen within the B2B space.
So, where does value lie? What is value proposition? And how do the two
spaces of B2B and derivatives merge?
1) Liquidity: Bringing order flow is a key component in the existing futures'
exchanges armory. It may even be liquidity from those who are not
technically in the relevant B2B business but they can nonetheless bring a
tech liquidity component to trading any market.
2) Price discovery / information: Exchanges know about this and can not
merely sell their revenue streams but enhance their services to clients.
3) Existing futures exchanges tend to have a better grasp of the unique
intellectual product which can be created through hybrid products such as
indices or invented commodities. These are all things which will be captured
in an electronic world but which are not typical commodities. The major
commodities of the 21st century, Doctor Sandor noted, will be the
intellectual and human capital which produces fresh ideas, concepts and
other intellectual property.
4) Clearing: The last value proposition, yet one of the most important
especially where the existing markets' knowledge from leveraged
commodities is relevant.
If we look at the history of commodities, there has traditionally been one
owner of the spot market, and separate owners of the futures and OTC
space. The B2B folk have already captured one part - spot. Meanwhile,
futures markets maintain their franchise. Nevertheless, the venture
capitalists which brought the technology to a wide variety of heterogeneous
products in B2B land cannot be underestimated, although the exchanges are
now trying to catch up in B2B. The question is how the pie is divided. Who
owns clearing, pricing, liquidity and the intellectual products?
Reporting by Patrick Young
- who takes full responsibility for any omissions in Doctor Sandor's
information dense presentation. |
