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Electronic Derivatives Trading for Idiots

You don't have to be an idiot to be confused by all the efforts to move derivatives trading on-line. Banks, interdealer brokers, exchanges and new Internet companies are all urging clients to give up telephone, fax and e-mail in favor of a bewildering variety of electronic trading interfaces. In the following pages, we summarize all the e-commerce initiatives affecting the derivatives market.

Alternative Trading Systems Fight For Turf

Asset by asset, the Internet is filling up with rival trading systems.


If you're looking for evidence that the financial world—to say nothing of the U.S. economy as a whole—is in the midst of a technological revolution, keep reading. Last summer, we examined six pioneering firms that were in the process of establishing alternative trading systems (ATSs) on the Internet ("The E-Players,” August 1999). Now, a mere eight months later, that list has exploded to more than 25, with new entrants popping up at a staggering pace.

But while derivatives dealers are hooking up and pairing off faster than swingers at a key party, the ATS boom thus far has produced precious little in the way of actual trades. Like many dot-com ventures, new ATSs are following a hype-and-hope strategy. Some market observers aren't surprised at the paltry results to date.

The ATS
boom thus far has produced precious little in the way of actual trades.

"The markets that make the most sense for Internet-based electronic trading are the ones that are regionally dispersed and have enough liquidity and enough players and enough little different pieces such that a computer really does help—like the U.S. municipal bond market,” says Peter Vinella, senior consultant at Peter Vinella & Associates. "But if you look at over-the-counter derivatives, where there's maybe 200 people in the entire world who are active in any given market, electronic functionality makes no difference. The telephone actually helps, because part of doing the deal is the sales process. I look at all of these startups as a curiosity in time, as opposed to a long-term trend.”

The Tower Group, a Needham, Mass.-based research firm and consultancy, is slightly more optimistic. "Although investors will profit from the advantages of multiple providers, access to inexpensive analytics, and market transparency, they must overcome their sensitivities to placing large transactions online,” the consultancy wrote in a December 1999 report on CFOWeb, a promising ATS. "In addition, the scope of financial products initially offered by providers includes complex swaps and currencies, where traditional brokers and banks have valued expertise, discouraging investors from online investing. Tower Group believes that these corporate treasurers will adopt the CFOWeb.com technology slowly before committing to its use on a large scale.”

Not exactly a gold rush prediction. Yet ATSs continue to develop, and banks and brokers continue to foot the bill. Vinella believes fear is the main motivation. "All these dealers are investing in BrokerTec and TradeWeb [an Internet-based bond-trading facility] because they're afraid that if they don't invest and it kicks off, they'll lose their business. But the fact is, none of these things are going to make any money.”

Such naysaying hasn't slowed the ATS stampede one bit. What follows is a lay of the land in the increasingly crowded world of ATSs, organized by asset class.

Interest rates

BrokerTec Global (www.brokertec.com) threw its hat into the fixed-income derivatives field early. Its shareholder lists reads like of who's who of global investment banks: ABN Amro, Banco Santander, Barclays Capital, Credit Suisse First Boston, Deutsche Bank Securities, Dresdner Bank, Goldman Sachs, Lehman Brothers, Merrill Lynch, Morgan Stanley Dean Witter, Salomon Smith Barney and Warburg Dillon Read.

BrokerTec's goal: to create a global derivatives trading system that links together the underlying cash products in order to reduce margin, clearing and settlement costs for its shareholders. Scheduled to launch sometime during the summer, it plans to offer a one-stop shop for everything in the fixed-income world, from U.S. and European government and corporate bonds and mortgages to repos, swaps and other derivatives, on a single trading screen. OM, the Swedish software giant, was tapped in February to build BrokerTec's global trading platform, while the London Clearing House will clear all euro-denominated government debt—and would be the logical choice to clear the bond futures BrokerTec plans to launch down the road.

CFOWeb
will give dealers access to players for an annual price tag of $300,000 PER ASSET CLASS.

CFOWeb (www.cfoweb.com) is taking a different tack. Created by Palo Alto-based Integral Development Corp. in 1999, the site will serve as a derivatives trading portal for CFOs, corporate treasurers and fund managers. The site will offer interest rate and currency derivatives, foreign exchange, loans and deposits, and the pricing and modeling of fixed-income instruments—threatening to disintermediate the dealer-corporate business like never before.

But CFOWeb isn't making an end run around dealers altogether. The site is in negotiations with several major dealers to join in as exclusive partners. ABN Amro, Bank of America, Standard Chartered and AIG have already signed on, and others are rumored to be close to striking a deal as well. The arrangements will give dealers access to a growing list of players—more than 500 companies and 1,600 financial professionals thus far. Pricing for providers is approximately $300,000 per year per asset class, while CFOs can join the basic site for free and subscribe to premium services for a fee. The site's products will include interest rate swaps, currency swaps, interest rate caps and floors, forward rate agreements, spot and forward foreign exchange, foreign exchange options, loans and deposits, government bonds and various cash instruments.

In addition to brokering trades electronically, the site will offer a number of other services, such as presenting real-time market data; generating zero curves and implied volatility surfaces; saving trades to a portfolio; managing trading work flow; transmitting trades to interested counterparties for pricing, trading, confirmation and settlement; performing portfolio analysis; marking to market; cash management; risk management, including value-at-risk, scenario analysis and market-rate sensitivity analysis; and back-office functions, including settlements, confirmations, payments and rate resetting.

DerivativesNet (www.blackbird.net), based in Charlotte, N.C., has been gestating since 1996, when two former swaps traders at JP Morgan decided to start the world's first Internet-technology-based on-line derivatives trading facility. When the system launches (it recently received a $29 million investment from Internet Capital Group), Blackbird will cover interest rate swaps, interest rate basis swaps and forward rate agreements in many currencies for many terms and structures. DerivativesNet hopes to better its competition by providing enhanced liquidity and information, greater flexibility and control, credit prescreening and real-time negotiation. The company is sticking to its plan of serving only dealers, but with so many dealer-based initiatives crowding the field, DerivativesNet may end up lost in the shuffle.

Electronic Brokerage System (www.ebsp.com) was quietly launched in November 1993 and has kept a remarkably low profile since. Like BrokerTec, EBS is a consortium of major investment banks, including ABN Amro, Bank of America, Barclays Bank, Chase, Citibank, Commerzbank, Credit Suisse First Boston, HSBC, JP Morgan, Lehman Brothers, National Westminster Bank, S-E Banken and United Bank of Switzerland. Within a few short months, EBS, based in London, had unseated Reuters as the predominant spot foreign exchange order-matching system. In 1998, the group began trading forward rate agreements, and offers FXNet, an automated bilateral netting service.

eSpeed (www.espeed.com) is an electronic trading platform launched by the giant bond broker Cantor Fitzgerald in March 1999. The system covers a wide range of global fixed-income securities, including government securities denominated in U.S. dollars, euros, yen, British pounds, Canadian dollars and emerging-market currencies, as well as securities of U.S. agencies, municipal securities, eurobonds, corporate bonds and other global fixed-income securities. The system also provides access to the Cantor Exchange, which began trading futures contracts on U.S. Treasuries last year and plans to roll out futures on U.S. agency securities soon. Cantor claims that eSpeed processes some $150 billion worth of financial instruments each day, transacted by more than 500 firms worldwide, including the 25 largest fixed-income players.

Yet another entrant to the field, Icor, was announced in February. Formed by Jeff Larsen, former head of capital markets at Chase, and Neil Chriss, author of Black-Scholes and Beyond: Modern Option Pricing, and a former vice president and portfolio manager at Goldman Sachs, Icor announced cryptically that it plans to become the "leading on-line business-to-business broker” by trading "sophisticated financial products.” The Icor Brokering System, developed in conjunction with IBM, will offer brokerage at reduced costs with total anonymity and increased efficiency for the entire trading operation. Icor has announced that it will seek patent protection for its ideas.

Credit Derivatives

Creditex (www.creditex.com), based in New York, is an Internet transactional and informational system for the global over-the-counter credit derivatives market created by two former Deutsche Bank traders. The trading platform, launched last month, focuses on single-name credit-default swaps, allowing users to see a full range of bids and offers, and assisting in the documentation process as well. The site also provides historical information and news. During its first two weeks, more than 500 trades had been posted, with a value of more than $10 billion.

Within a few
short months, EBS unseated Reuters as the predominant spot foreign exchange order-matching system.

Since U.S. commercial banks held a reported $234 billion in credit derivatives as of last September—up 47 percent from the previous December—creditex is hoping to tap into an explosively growing market. Its investors, which include JP Morgan, Morgan Stanley Dean Witter, Capital Reinsurance, the Bank of Montreal and Pacific Life Reinsurance, hope so as well.

CreditTrade (www.credittrade.com), based in London, is a bit more ambitious. The site, which opened for business in June 1999, provides a trading platform for all manner of credit derivatives, including credit default swaps, total-return swaps, loan trading, basket trades, spread options, asset swaps, synthetic loans, credit-indexed swaps, credit spread forwards and credit-linked notes. Traders view posts of live bids and offers and, if interested, use the site's mail facility to correspond with the counterparty anonymously. The site also boasts a document exchange, where traders can post, send and receive supporting documentation. Anonymity is ensured until both parties agree to a trade and want to exchange names and contact information. Deals are then completed via telephone.

Meanwhile, a group of private investors is in the process of forming yet another credit derivatives site. The new company will focus on selling credit protection, primarily in the form of credit derivatives. It intends to act as a principal rather than a broker, and is building an electronic platform to achieve this goal.

Foreign Exchange

EBS dominates the interbank spot foreign exchange markets, while scores of new Internet startups cater to the retail spot markets. But the midlevel markets have received short shrift on the Internet to date. Mark Gallant, CEO of Warren, N.J.-based Gain Capital (www.gaincapital.com), hopes to change that. Last month, the firm was set to begin trading foreign exchange products in an effort to become the Charles Schwab of the foreign exchange market, catering to small- to medium-sized players such as hedge funds, commodity trading advisers and big-time individual investors.

Gain Capital
hopes to become the Charles Schwab of the foreign exchange market.

Among the benefits Galant promises: real-time execution from live two-way quotes; spreads of five basis points or less on all major currencies; no commission or transaction fees; 24-hour trading capability; an initial account size of only $5,000; and a bevy of real-time charting tools and other analytics. Galant has staffed up with professional traders from the Street, and at press time planned to begin trading on the six main U.S. dollar currency pairs with two 12-hour shifts of four traders each, plus a head trader. Sometime after launch, the firm plans to switch to three shifts and add the major crosses and, eventually, additional currencies.

Last month, meanwhile, three powerhouses threw their hats into the foreign exchange ring, when Deutsche Bank, Citibank and Warburg Dillon Read announced the creation of Volbroker.com (www.volbroker.com). (See "FX Options Go Electronic,” Page 24.) The site will allow these dealers—and, ostensibly, future partners as well—to post bids and offers on foreign exchange derivatives and execute trades on-line. It also promises option-pricing tools and a great deal of middle-office functionality.

Energy

Dozens of small energy ATSs have popped up already. But lately, the big boys have gotten involved as well. Last October, Houston energy giant Enron launched EnronOnline (www.enronline.com), catering to the gas, power, plastic and pulp markets. Then, in January, it opened the system to European clients as well. But that's only part of EnronOnline's plans. When fully operational, the site will cover commodities such as gas, power and crude oil, as well as weather derivatives, emissions allowances and petrochemicals. Enron says its auction-based site offers real-time, competitive prices, global coverage, multicommodity and multicurrency transactions, and security, and that it will remain free to Enron customers. Traders using the site can see the products available and their contractual terms, the bids and offers, and the trading volumes of the products. When a customer submits a bid or offer, the transaction is completed within one second, and the transaction is electronically validated, checking the counterparties' credit limits, the volume of the transaction and the price.

NordPool, the Nordic Power Exchange (www.nordpool.com), bills itself as the world's first international commodity exchange for electrical power. It trades in standardized physical (Elspot) and financial (Eltermin) contracts, offers clearing services to Nordic participants, and provides customer support in Sweden, Finland, Norway and Denmark.

Altrade Power (www.altra.com), created by a consortium including Altra Energy Technologies, Amerex and Prebon Energy, went live last October. The on-line electronic power trading system attracted more than 210 users on its first day of trading. Altrade Power offers real-time, market-wide price discovery and trading anonymity—as well as transaction liquidity. In fact, Altrade Power traded some $24 million in contracts in its first two days alone. The system, boasts its backers, gives traders the personal attention provided by traditional voice brokers as well as the speed and market coverage of electronic trading systems.

Altra also operates Altrade, a real-time, anonymous on-line trading facility for natural gas, crude oil and natural gas liquids, and supplies energy transaction management systems that help customers with risk management, physical delivery and financial settlement.

SwapNet, in conjunction with European derivatives broker Garban-Intercapital, began trading oil swaps in Singapore last October for some 50 counterparties, primarily in Southeast Asia. SwapNet tapped U.K.-based XMTL to provide the web hosting and architecture for the site. XMTL has guaranteed 99.5 percent connectivity and constant customer support, allowing for 24/7 trading from anywhere in the world. The system is like other on-line financial auction sites, allowing bids and offers to be made anonymously and for trades to be concluded in real time. Settlement is handled by Citibank via a direct Internet link. Garban-Intercapital, meanwhile, provides a "hybrid” broker function, advising customers and, when asked, entering orders into SwapNet trading screens. The SwapNet system includes front- and back-office and credit management software.

When fully
operational, Enrononline will cover gas, power and crude oil, as well as weather derivatives, emissions allowances and petrochemicals.

Sometime this year, Eurex, in conjunction with its parent Deutsche Borse (soon to be known as Euroboard) will launch an electronic communications network called the European Energy Exchange to trade physically settled electricity futures and, eventually, spot electricity as well. The EEX is squaring off against the Leipzig Power Exchange, which was scheduled to begin trading last month. EEX hopes Eurex's reputation, as well as its clearing and settlement functionality, will woo traders away from the LPE in short order.

The Automated Power Exchange (www.energy-exchange.com) is an Internet-based electricity trading exchange that began trading in the California market in March 1999. The APX is a certified power scheduling coordinator between the California Independent System Operator and electricity generators, retailers and end-users active in the California markets. Market participants include utilities, energy retailers, aggregators, power aggregators, power marketers, generators and municipalities. The Houston Street Exchange, meanwhile, launched an on-line electricity trading system for wholesale energy traders last July. The system initially covered the New England, Pennsylvania–New Jersey–Maryland and New York state markets, with plans to expand nationally in the future.

Just last month, seven banks and energy firms announced that they were creating a new on-line energy and metals market called the IntercontinentalExchange. BP Amoco, Deutsche Bank, Goldman Sachs, Morgan Stanley Dean Witter, Royal Dutch/Shell Group, Societe Generale Investment Banking and Totalfina Elf Group have agreed to create the new entity by year's end. That came a week after the New York Mercantile Exchange rejected a proposal by Goldman Sachs and Morgan Stanley to create a similar exchange.

Meanwhile, both Natsource and the Cantor Exchange have created on-line emissions trading facilities. Natsource's system (www.natsource.com) trades SO2 and NOx contracts, augmenting its voice broking system, while Cantor (www.emissionstrading.com) trades these products as well as greenhouse gas reduction andother environmental credits.

With players like these getting onboard, things are likely to change quickly in the hotly contested on-line energy markets.

Weather

New York-based TradeWeather Inc. (www. tradeweather.com) launched the first weather derivatives trading site last fall. The site, which focuses on temperature and precipitation contracts, features automated order placement and execution, personalized portfolio tracking, real-time quotes 24/7, historical data, market news, pricing models and discounted weather forecasts. The site's goal: to become a one-stop shop for weather derivatives—especially in the increasingly commoditized vanilla markets such as heating and cooling degree-day contracts.

Tradeweather's Focus
is on the comoditized vanilla markets such as heating and cooling degree-day contracts.

But hot on its heels is I-Wex (www.I-wex.com), a London-based consortium formed by Liffe, Intelligent Financial Systems and WIRE that planned to launch full Internet trading by March 1. (Like most ATSs, it missed its targeted launch date.) The site promises to be an on-line marketplace where global buyers and sellers can meet and strike deals through the standard auction-type system. The site also offers bulletin boards and news, on-line pricing models and various weather data services. I-Wex's parentage is impressive, as are its public supporters, who include Richard Sandor, the oft-deified derivatives visionary.

While those two battle it out for the institutional market, RainDay (www.rainday.com), put forth by Manhasset, N.Y.-based Worldwide Weather Insurance Agency Inc., hopes to capture the as-yet-nonexistent retail market. The site promises to safeguard people's wedding photos, as well as film shoots, sporting events and other weather-sensitive commercial ventures, by offering short-term protection against fog, lightning and cloud cover. The drawbacks: the contracts are costly and could be likened to gaming in some states.

Hedge Funds

The traditionally secretive world of hedge funds could withstand the democratizing forces of the Internet for only so long. In the last six months, two web sites have been launched that not only provide copious hedge fund data and information, but also allow users to trade on-line. HedgeWorld (www.hedgeworld.com) was first out of the gate when it hit the ether last October. Through the Hedge Trust Exchange, it offers an order-matching system to bring together buyers and sellers of non-U.S.-domiciled hedge funds. In addition, the site provides access to the Tremont Advisers TASS+ database, which tracks performance and other information for more than 2,200 hedge funds managed by some 1,500 fund managers.

Not to be outdone, HedgeFund.net (www.hedgefund.net) has also created a hedge fund trading facility, which it bills as the hedge fund version of Schwab's One Source, a system that lets investors trade in and out of mutual funds on-line. Investors will be able to open accounts through an as-yet-unnamed international bank, and the accounts will be monetized by cash or limited partnership interests in specific funds. The site also offers investors free access to, and lots of information about, more than 1,200 hedge funds. It provides detailed fund screeners based on 33 investment strategies and sub-strategies, and ranks funds based on 10 separate criteria.

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