Exchanges once saw 'disruptive' hedge funds as bad for business. Now that they're after profit themselves, hedge funds make good customers, especially as new exchanges spin off from the digital revolution It should come as no surprise (but it often does) to learn that hedge funds drive up to 30% of some exchanges' business. The surprise is these apparently arcane investment vehicles command such large volumes on established exchanges.Not all exchanges benefit from this attention, but the major US and European exchanges have certainly attracted large order flows from hedge funds - both in cash markets and derivatives.The key questions now being addressed by exchange managers, therefore, are: what attracts such business? Is it desirable? And how can they encourage more of it?It is not so long ago that most exchanges (even derivatives exchanges) tried not to encourage hedge fund business. They were viewed as disruptive, volatile influences on more routine business. However, a number of studies, including a University of London study of hedge fund activities on the London Commodity Exchange, concluded there was no evidence that hedge fund activity encouraged perceptible increases in price volatility.With this awareness, and the more recent shift of exchanges into shareholder-owned, for-profit corporations, exchanges now consider hedge fund business to be desirable.Why come to market?What attracts such business to exchanges? At its simplest level, three factors (in no significant order) are important: liquidity, depth and the right contracts. Starting with the last, and stating the obvious: distressed debt funds will not be active on an equity index market; long/short funds will not be active in commodities, volume arbitrage funds will not be active on cash equity markets, and so on. The availability of a suitable range of contracts is therefore important. Traditionally, the monopoly specialisation of individual exchanges around certain contract groups meant there was no user choice in the matter. This is gradually changing as exchanges start competitive listing. Eurex's liquidity on Nokia options, for example, is greater than that on Nokia's `home' exchange in Helsinki.While exchanges ran floor-based, open outcry trading, contract competition was next to impossible. But the gradual shift to electronic trading, plus reduction in regulatory constraints on listing/quoting, means exchanges are now competing for similar contracts. In the US, for example, five exchanges currently compete for individual equity options business, with two waiting in the wings.Inevitably, therefore, the mere listing of a suitable contract is no longer sufficient to attract hedge fund business - other factors apply. Liquidity is key among these. Liquidity, however, is a function of both volume and depth.A $1bn hedge fund will not be interested in contracts where the market struggles to accept $1m order tickets without distortions during entry/exit. Slippage can easily erode short-term profitable opportunities. So trading targets are limited to markets where sufficient volume is sustained consistently to allow entry/exit relatively efficiently. But the bigger the hedge fund, the more this problem applies, which is why larger hedge funds tend to allocate less of their risk capital to, for example, most commodities, smaller equity markets and some of the more exotic index products. But liquidity is not just about absolute levels of trading volumes. Market depth is important, too, and best defined in terms of the size of order you can trade without incurring a large negative price reaction. Brokers know, for example, that you can trade 20,000 bund futures contracts on Eurex without causing undue disruption in the market. But try getting 20,000 options on British Telecom away on any given day!One of the core tasks of an intermediary therefore, particularly prime brokers, is to advise on where the investment should be best placed and what kind of slippage might be expected.Interestingly, despite the popular attention paid to the shift to online trading, a useful and lucrative role is still fulfilled by so-called voice brokers, specialist firms whose services are used to `work' large orders. Client A wants 20,000 six-month, out-of-the-money BT options. The broker knows this will skew the market if placed onto the screens without filters. Voice brokers are asked to find a single, fixed-price counterparty for the order. Once lined up, the deal is executed on the trading system and cleared in the normal way.Efficient executionWhy is this kind of execution efficiency important? Two reasons: hedge funds by definition do not run buy-and-hold funds. Mutual funds hold individual investments for several years; the fine tuning of buying/selling prices is therefore not as important when looking at long-term investment and yield plays. But hedge funds buying for short-term gains of 20% over a few weeks, for example, will be severely disadvantaged by entry and exit slippages of 5% per trade. Secondly, many hedge fund mangers trade for more than one fund/account. Investment-weighted allocations of a 20,000 order at a single price are much simpler to make than allocations of orders that have been executed in different sizes at 10-15 different prices. Exchanges per se cannot do much about liquidity and depth, other than encouraging the right environment for them to develop by marketing and attracting new members/users. Although a contentious argument has been running between US and European exchanges about so-called payments for order flow, where exchanges reward members for bringing large volume to the exchanges. Exchanges, when they were owned by their members, gave fee rebates to their members in proportion to the volume they transacted on the exchange. Over the years, clients became aware of such rebates and expected similar treatment from their brokers. As exchanges have become for-profit, shareholders expect a dividend return with fee rebate redirected into dividends. The consequence of this is that intermediaries do not display loyalty to any exchange other than for its ability to handle the transaction cheaply and efficiently with a minimum of regulatory interference.The process of exchange demutualisation has only been in effect for a few years. Major exchanges have therefore not yet found product diversification particularly feasible. The Chicago futures exchanges - Petri dishes for modern hedge funds - remain split along certain commodity and financial futures lines. The CBOT commands long bond liquidity and the CME the short end. In Europe, Eurex has the long end and Euronext Liffe the short end. The London Metal Exchange dominates the metal markets, Nymex dominates crude oil, and so on.Young challengersNew exchanges are challenging this. Some, like the International Securities Exchange (ISE) in the US, are targeting established high-volume business such as US equity options. In three years, ISE has captured 30% of US equity options business by offering an efficient electronic trading system to compete with CBOE's floor. Other new ventures are pushing into new markets: until the US energy crisis of 2001, the InterContinental Exchange had successfully developed an important US gas and power market autonomously.In general, development of new exchanges offering new contracts has been limited - established exchanges employ new business development teams specifically to seek new contract opportunities and with the trading and clearing infrastructure already in place, barriers to entry remain quite high.Exchanges understand that although new contract development is an important expansion route into new markets, it may not be the most relevant attraction for established hedge funds. The increasing sophistication of hedge funds means intra-exchange arbitrage potential is substantial. Nowhere is this more apparent than, for example, the long/short funds or the volatility arbitrage funds. Both such strategies rely on: • ability to trade pairs or combinations of offsetting contracts quickly, efficiently and in size and;• ability to net positions for clearing purposes. This also is one of the reasons for the growth of equity index trading among hedge funds. A cogent investment strategy can be sustained trading baskets versus the index. The expansion of sub-indices gives such strategies even more focus, but again the hedge fund will need to be assured that the exchange can sustain the efficient liquidity on both the index leg and the constituents' trading.From efficient arbitrage strategies, it is only a short step to netting and clearing. One of the key trends which became much more tangible in 2003 was the development of the clearing role as an umbrella activity for several exchanges. Hedge funds - and all market users - are increasingly conscious about the efficient use of capital in relation to trading exposure. The leverage aspect of derivatives remains a major attraction - using $500,000 to create an exposure on $10m is enticing - but risky because of the market risk. Using the same ratios but with a reduced market exposure in a long/short or arbitrage strategy is more interesting. The role of Sharpe ratios reflect this focus. The traditional problem with this approach among established exchanges, however, is that the locals have often identified the arbitrage first and hit it. This is the essence of interest rate ladder or strip trading, or the crack spread in oil. But a broader arbitarge - say the old Liffe Eurodollar versus the CME Eurodollar failed to attract sufficient volume on the Liffe side due to: • lack of consistent liquidity and;• no mutual offset, that is the trade had to be unwound rather than settled out. The excess costs created by the unwind and the running of two separate margin positions through two clearing houses with no risk offset was not capital-efficient and the Liffe Eurodollar contract failed.The consolidation of clearing is of major importance to the industry, in particular hedge funds. Currently, prime brokers calculate the OTC mark-to-market valuation of a hedge fund's position and marry that to their listed initial and variation margin positions. This is done to produce a single risk value between the intermediary and the fund. This value can lack transparency and is coloured by the prime broker's subjective valuation of the quality of credit of their counterparty, so that questions remain: does the prime broker agree with the fund's trading strategy? Is the prime broker comfortable that it is in possession of all the risk information associated with the fund it is servicing? These subjective elements usually have a negative outcome on leverage, thereby limiting the fund's ability to trade.prime brokers marginalisedWith the exchanges/clearing houses now competing for volume (as evidenced by clearing houses expanding the number of asset classes they are prepared to clear) and clearing houses investigating more sophisticated margin algorithms for purposes of providing greater risk offsets, thereby increasing potential leverage in a controlled fashion, the clearing houses begin to fulfill a component of the role of prime broker - providing uniform standard margin calculations. This is good for everybody, as it provides transparency, clarity and consistency of approach that in turn provides the platform for increased leverage in a fiscally controlled fashion, which allows for increased anonymous trading through exchanges where the credit component is known. The intermediary service provider to the hedge fund is now less concerned with the credit quality of the fund's counterparty (it is the clearing house) and can concentrate on managing its relationship with the fund.The moves by the industry that have led to a transfer of bilateral trading to the central counterparty (CCP) environment must be augmented by a consolidation of CCP environments. While we all want to foster competition, risk aggregation through fewer CCP's will result in greater trading potential, higher volumes and increased profitability delivered in a controlled risk and regulatory framework that will reduce the LTCM type of risk and deliver to users and exchanges the value that will increase volume.Finally, provision of exchange IT has become an important issue for hedge funds. Instant and improved market transparency is a function of IT. Compared even with five years ago, there are now few exchanges where professionals do not have access to instant data on price, volume and depth. This enables extraordinary levels of entry and exit planning, with order entry and routing software lined up ready to hit trigger prices instantly and automatically. Most exchanges, however, have wisely decided that their core trading systems need not also support sophisticated front ends that are all things to all users. But the independent software vendor community has been quick to step in here and provide both connectivity and functionality that add value to the execution process without impeding its efficiency.Key PointsExchanges are now courting hedge funds, whose business is no longer seen as disruptive to established marketsLiquidity, depth and volume are the main factors that attract hedge funds to exchangesNew exchanges and electronic trading facilities are causing clearing houses to compete for business, ultimately increasing leverageAs clearing houses provide uniform standard margin calculations, prime brokers can concentrate more on managing their relationships with hedge funds...
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