Exchanges, Dark Pools, and OTC Energy: The Next 5 Years

Summary
Unless dark pools solve their transparency problem, Exchanges in general and the CME in particular will be the beneficiaries of structural changes coming to energy options. A battle is about to begin for control of the energy options complex. On one side are regulated exchanges, and on the other side are dark pools. The winner will be decided by who chooses the best market structure for attracting transparent liquidity and then frames that structure with the appropriate technology.

Dark Pools Defined
A dark pool (or OTC market) is an off-exchange network where buyers and sellers of securities trade. These sources of liquidity transact business privately and are not obligated to disseminate their activity publicly. Counterparty risk is mitigated either by ISDA agreements or in the case of Clearport through submission to an accredited exchange after the trade is completed.[1] Because trades do not occur on an exchange, they must be mediated by brokers.

Brokers and Dark Pools
OTC brokers offer institutional traders single-price liquidity with minimal information leakage. They negotiate between counterparties without showing either client’s hand. Brokers are invaluable for price discovery when an asset is not continuously liquid, as in options and back month swaps. These intermediaries are essentially the “order matching engines” within the dark pool. Their competition for trades is regulated Exchanges.

Electronic Exchanges
Exchange trades must occur at a centralized location, whether it’s a trading floor or an electronic order matching engine. Electronic Exchanges excel in continuously liquid contracts where a broker is not needed for order matching or privacy.

The Difference
The major differences between dark pools and exchanges are: transparency, regulatory oversight, and transaction guarantees. Exchange trades are publicly transparent whereas for the most part, dark pools are not. Exchange governance is under CFTC purview, while dark pools are essentially self regulating with government involvement in the most extreme cases. Because counterparty risk is essentially collateralized, an exchange guarantees its trades, where as dark pools offer no guarantees.

A dark pool is as small as a single broker connecting two clients on a trade. They are the traders who provide liquidity and the brokers who facilitate the order matching. They are sources of deep, blind liquidity that provide one-price executions to investors that want to minimize leakage into the marketplace. This private block trading is the liquidity that drives institutional markets. Without it, the marketplace would surely suffer.

The Death of Dark Pools
Business, technological, and regulatory forces are pushing OTC Energy Derivatives 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.
If the market forces continue down this path, OTC participants can at best hold a shrinking percentage of energy volumes. More probable is that just like equities before them, the OTC market’s business will move slowly but surely onto regulated accredited exchanges. For the time being, Dark Pool trading is a sunset industry.

Industrial Darwinism
Exchanges are working furiously to figure out a way to transfer dark pool liquidity onto their platforms. They are getting closer. The key is market structure. Some are trying to force the OTC markets onto thei

The good news is that it doesn’t have to happen this way. The bad news is that it will take a retooling of the mind set and business structure of OTC brokers, market makers, and other dark pool facilitators. The only other alternatives for them are to take the money and run, or fight an ocean of change that is coming down the line and watch their business valuations disappear along with their growth prospects.
They are not Clearport or an exchange. But dark pools must evolve if they wish to remain relevant. More on this later.

The Core Issue is a Failure to Communicate
The first task is to identify the core issue that must be addressed. That issue can be summed up in one word: Transparency. A lack of transparency is what has investors freaked. The lack of transparency is what scares the Fed. It is the reason the regulators are up in arms. More transparency will allow for more objective portfolio valuation, more liquid pricing, and better regulatory accountability.

Revisiting the opening paragraph: Business models now demand open architecture and transparency. Technology enables transparency. (It just makes more sense to get a dollar from a million customers than to get a million dollars from one.) Finally, regulators need transparency t o solve the accountability problem. Exchanges realize that transparent pricing is their best marketing tool.

The obvious problem for OTC Brokers is how to operate more transparently without losing their market making community. There are several ways to solve this. What has to happen is that the marketmaking community must first realize that they are in the same boat as the brokers. The nature of electronic exchanges is to remove all forms of intermediation and replace it with continuously liquid ECNs.

Before we dive into the energy situation, let’s look at the state of Dark Pools in other markets. What is happening in Energy is happening everywhere. It is not a one industry issue. It is a fundamental rethinking in market structure and regulatory practices.

Subprime, the FX Markets and Dark Pools

The Subprime crisis is a very bad thing for dark pools. Here is why. There was no public accountability or valuation mechanism to keep the players honest with themselves or to let regulators do their jobs. This comes back to transparency. All you need to know about what went down in subprime can be found here:
http://www.businesspundit.com/sub-prime/

Subprime debt, CDOs and their cousins trade in off-exchange dark pools. A typical transaction takes place between a bank and a hedge fund with an ISDA to (allegedly) cover credit risk. What could not be known was, the systemic risk implied when too many people have the same positions in a product that no one was willing to objectively value. Add to this opaque market poor risk and bankroll management (i.e. too much leverage), and you have a recipe for disaster.

Logical conclusion? Clean the mess up and demand more transparency going forward. Bad news for libertarians and bad news for Dark Pool operators like banks whose credit was downgraded.

The FX story is ongoing, and a story worth watching. It may have a big impact on the banking industry itself. Banks are essentially dark pools of liquidity. If dark pools go away, then banks lose an important source of revenue. No longer will they be able to shoot fish in a barrel. The legacy infrastructure that was a synergistic asset will quickly become a drag on their profit margins.

In 2006, the CME and Reuters formed FXMarketSpace; a JV to create the world’s first centrally cleared FX exchange. Since then FXMarketSpace has performed below expectations. This is because the FX market is a last bastion of the banking industry. Banks are the principal providers of liquidity here, and want to protect their franchises. So they essentially boycotted the exchange and strangled much of its growth. But things are different now. Exchange volumes are picking up, banks with poor credit are using the exchange, and clients are more interested in credit risk than perfect execution.

The Subprime crisis has affected how everyone looks at counterparty risk. And it is our opinion that liquidity will be driven to the FX Exchange in search of creditworthiness. While banks are deleveraging and cleaning up their balance sheets, FX business will relocate. This will be the currency market’s version of what happened to energy after Enron went belly up. There will be a flight to diversified counterparty credit risk. FXMarketSpace’s time may have come. (Buy Exchange stocks and sell banking stocks?)

Beginning of the End or End of the Beginning?

So, it is not an energy broker issue. It is the result of a rethinking about risk. Once upon a time, clients took counterparty guarantees for granted and worried about execution risk. As the global credit bubble deflates, counterparty risk and transparency are all the rage. What can dark pools and OTC participants do in the coming environment? There is a market structure already out there that preserves the business model, satisfies the transparency issue and still mitigates credit risk. It is just a matter of time before someone smart executes it in Energy Options.

Footnote:
1. From the time a trade is executed to the time Clearport clears it, there is counterparty risk. ISDAs do not remove counterparty risk, but put a price on it depending on client credit ratings.

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