Exchanges, Brokers and Bright Pools

Business, technological, and regulatory forces are pushing the OTC Energy Marketplace onto electronic exchanges. CME’s buyout of NMX, congress’s growing concern over speculators, and new order entry platforms are examples of the pressure being placed upon the OTC.

When the dust settles, OTC participants can at best hold a shrinking percentage of the energy market volumes. More probable though is that just like in equities before them, the OTC market’s business will move slowly but surely onto regulated accredited exchanges.

First, swaps brokers will be disintermediated. Then, OTC options brokers and their clients. What many traders may not realize is that independent market-making types will also be phased out. None will be needed in an LMM type centralized liquidity pool.

Arising from these seemingly depressing realities is a tremendous business opportunity for savvy brokers to grow their businesses. There are actually two different paths that an OTC broker may go down to survive. They must either: evolve into electronic brokers, or create more transparent dark pools.

Electronic Brokers

For those seeking to evolve with the changes coming, this makes the most sense. The Broker must first build a web site with Globex connectivity embedded. He must then broadcast liquid transparent prices (from multiple marketmakers) on the site for trading. He should also add market commentary, automated order entry and other content.

The value proposition to the market-making community is the fresh retail business. That is why they will do it. FCMs charge over twenty dollars per contract executed at the retail level (open an account at RJO if you don’t believe me). That is why an OTC broker should do it.

The broker who most efficiently combines transparent prices with marketing materials and good technology stands to become an OptionsXpress, ThinkorSwim or Lightspeedtrading in energy options.

There is hard work involved on this path. Business structure, client relationships, technology, IB relationships and marketing all are big factors in this concept. But the payoff is big. A business that successfully does this will morph from a company worth 1.5x revenues and a 25% profit margin to a company worth 12x earnings and a 50% profit margin. More likely the broker gets bought out in 2 years by a firm like the ones listed above.

Bright Pools

The other way to survive in the new environment is create a 3rd type of market structure, a Bright Pool. Imagine a dark pool where prices are transparent to all, regulatory oversight is present (even welcomed), and participant credit risk is mitigated.

It would first help to truly define what a dark pool is. For our purpose, dark pools are off-exchange sites where trades can occur and then be submitted somewhere for clearing. Dark pools are where the trade takes place. They can clear anywhere. It just so happens that OTC Energy clears mostly at Clearport. Therefore, OTC brokers themselves are dark pools.

To become a Bright Pool, Brokers must address the business, technological and regulatory issues facing the OTC industry. He must open his business architecture and broadcast price action globally without restriction. He must become a transparent provider of services to satisfy regulators. In clear terms he must:

1. Shine a light on the activity- post prices and markets on an easily accessible platform for all to see. It doesn’t have to be in real time, but it has to be reliable and public.
2. Create a Global virtual trading pit- use tech to create a hybrid platform that combines real time execution with broker assistance. Have complex structures trade with a brokers help. Have market maker
3. Broadcast it everywhere- make it web based so anyone can get on it at any time

More interestingly, OTC brokers with Clearport clients are the definition of a dark pool.

For more information, contact Vincent Lanci at (212) 223-1000.