The Hybrid Dark Pools Puzzle

[Reprinted with permission from Markets Media Online.]

The Over-the-Counter Markets must evolve into a hybridized exchange model to satisfy the regulatory and business issues they are currently facing. They must provide regulators a window into their business and a way to gauge risks on both counterparty and settlement basis.

Successfully done, this will not only satisfy regulators and market participants, but transform the current OTC business model from a sunset industry to one of accelerated growth. Key to their success is clearing fungibility, market structure, and appropriate technology. The energy markets offer examples of one path to a successful evolution for OTC participants.

What OTC Venues Offer

The OTC Markets problems are many and well known. Among them are: counterparty risk, subjective portfolio valuations, and systemic market risk. But the OTC execution model offers value despite the outcries of its detractors.

One-price liquidity, minimal information leakage, and structured deal pricing are some reasons for the persistence of OTC trading and good reasons why regulated exchanges have yet to co-opt their liquidity pools.

• One-Price Liquidity: An institutional investor may value the time he must spend tallying the various partial fills he gets more than the 2 cents he paid over the exchange advertised price. Equally important, it minimizes information leakage which could hinder the fill.
• Information Leakage: the longer a large order rests in the market, the more potential for competitors to move the price away from the clients order price. Good OTC brokers use discretion and one-price liquidity to minimize this problem.
• Structured Deals: institutional clients do not want a la carte pricing for trades involving multiple instruments as in Options. Electronic platforms do not offer this effectively yet.

The Problems Exchanges Face

The government, the public, and much of the investment community are up in arms about the Over-The-Counter markets. So what is taking so long? In much or the OTC world, the liquidity pool and clearing are fragmented. Additionally, banks are the main liquidity providers of the OTC markets and are not too excited to give up those franchises. A prime example is the CME-Reuters FXMarketspace venture that failed in part due to the lack of bank participation.

What must they do? They must leverage their inherent advantages: mitigating counterparty and settlement risk, while removing the perceived advantages that the OTC enjoys. If they can do this without fragmenting their sources of liquidity, they will succeed. Marketmakers and gatekeepers must be incentivized to participate without compromising market integrity. Regulators must work closely with exchanges and understand the complexities of the dilemma. When it comes to marketplace liquidity, five million “one-lot” orders on an exchange can be as bad as three banks trading five million contracts in a dark pool.

Market Structure and Technology

There is one market that is successfully transferring OTC volumes to accredited exchanges while preserving its liquidity pool. It is the Energy market. Energy is enjoying secular growth while keeping its OTC volumes. Both major exchanges, The CME and The Intercontinental Exchange (ICE) are successfully replicating their OTC business onto regulated electronic platforms. Two major factors in determining their success are Market Structure and Technology. The CME has focused so far on Market Structure, while until recently ICE focused on Technology. Both have been successful.

The CME inherited the Clearport product from its Nymex acquisition. Clearport is the clearing mechanism that Nymex smartly advanced post Enron’s collapse as an alternative to bilateral credit. It addresses the OTC from a Market Structure approach. Its main advantage is its removal of counterparty replacement risk.

The CME’s Clearport product is slowly but surely replicating the whole of the OTC bilateral market onto an accredited regulated platform. But the CME is going further. Wherever it can, it seeks to replicate benefits of OTC trading in its futures business, while enabling fungibility on its clearing side. Block trading in futures negates the OTC one-price liquidity advantage, while CME readies its own front end for Clearport products. Despite having top tier technology, the front end screens will come last when it comes to OTC Energy. They are being careful not to fragment the energy market liquidity.

ICE on the other hand, leveraged its technology to create an ECN type screen where price was transparent but counterparty privacy was preserved until after the trade. This was especially effective since all its trades were bilateral initially. Now ICE owns its own clearing house and has effectively gone from an unregulated dark pool to an Exempt Commercial Market. Their early model sought to disintermediate the OTC broker with electronics, and they were quite successful in the Natural Gas Swaps market. Now ICE sees the limitations of a disruptive approach and is embracing FCMs as gatekeepers to volume growth. Additionally, they have implemented YJ Trader, an Instant Messaging technology that tries to mimic the current flow of options business, rather than disrupt it.

The Hybrid Exchange Model

Hallmarks of an OTC market successfully evolving into a regulated trading venue are varied. CME used a cooperative model, while ICE used a disruptive one. What is and will be consistent across the board are fungibility of products, centralized clearing, and adaptive market structures using appropriate technology to model information flow.

Those OTC dark pools that do not become a part of regulated exchanges will most likely themselves become exchanges.

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About the Author:
Vince Lanci, co-founder of FMX Connect, a successful commodity portal for professional brokers, traders, and retail investors, has 19 years of experience as a commodity options trader. He is currently managing partner at Echobay Partners Ltd, a private investment and trading firm. His involvement with FMX Connect came into play when Echobay recently bought a stake in the firm.

Prior to this he was portfolio manager at CiSEnergy, LP a profitable derivative fund out of New York. He founded and was president of Berard Capital Management, a commodity market making firm from1993- 2004. He began his career as a Commodity Derivatives trader on the floors of the Nymex, Comex, and Nybot exchanges working for Cooper Neff and Associates.

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