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OnExchange.com
Plug-and-Play Exchanges For Hire

TThe mania for business-to-business companies calmed down a bit when the stock market tanked in April. But B2B development efforts are still in high gear. In virtually every industry, companies are getting together on-line to trade raw materials like bandwidth, paper and chemicals at a stunning rate.

Now, Waltham, Mass.-based OnExchange is trying to capitalize on the craze. For a fee, the company will provide you with a readymade, plug-and-play B2B exchange. And it'll create a customized derivatives marketplace based on the underlying cash products as well.

Richard Jaycobs, CEO of OnExchange, came up with the idea for his turnkey exchange product in January 1999, and refined the idea in subsequent discussions with Philip McBride Johnson, former chairman of the Commodity Futures Trading Commission and currently a regulatory attorney in Washington, D.C.. Jaycobs, a former managing director at Finex and chief technology officer at Tudor Investment Corp., believed that none of the electronic derivatives trading efforts to that point offered a complete solution. "Phil and I agreed that electronic markets were going to be little more than service bureaus and wire connections,” he says. "If someone were able to build an exchange that had all the necessary components so that any marketplace that decided to form itself could simply snap into it, that would be a really valuable proposition.”

The idea: to build plug-and-play exchanges for clients in various industries, and create full-service derivatives marketplaces on top of the underlying cash markets. The target audience: everyone from Internet markets trading paper pulp to credit derivatives and traditional futures dealers.

How, exactly, will OnExchange spread derivatives enlightenment to the commodity-trading masses? It's already applied to the CFTC for regulatory approval to become a bona fide futures exchange, and it expects a green light sometime early next year. Once that happens, OnExchange will oversee the futures-trading operations for its clients—and advise market participants on how derivatives can be used for risk management.

OnExchange hopes to occupy the space where over-the-counter and exchange-listed trading meet. It will support regulated and unregulated derivatives trading to suit the preferences and customs of the underlying cash markets.

The product

OnExchange offers three basic types of services. First and foremost: technology, for companies looking to set up B2B exchanges or to migrate existing financial and commodity markets to Internet-based trading and clearing platforms.

The key to OnExchange's system is its universality. OnExchange's generic system is designed to be adaptable enough to add new financial products virtually as they're created. "After talking to a number of market users,” says Jaycobs, "we feel we can match and process everything from credit derivatives, energy, foreign exchange and agriculture to every other kind of widget. And our product-authoring tool can offer any product on the fly in our system. That is a killer piece of functionality.”

OnExchange's core technology platform is more than a trade-matching engine—it promises to offer full-fledged straight-through processing from trade matching to clearing and settlement. David Scheinberg, former vice president for electronic trading at the New York Mercantile Exchange, built Nymex's Access trading system and was the architect for OnExchange's offering as well. One of its biggest STP features: pre-trade credit vetting. When customer A hits customer B's bid, the system first makes sure their credit relationship is acceptable, whether on a bilateral or multilateral basis. If either party doesn't fit, the system immediately looks for the next valid match.

The system also offers real-time risk management. At the moment, it supports value-at-risk and Span, the industry-standard risk management system in the futures business. OnExchange also allows clients to plug in their own proprietary risk management systems.

The second arm of OnExchange's product offerings is regulatory. When it receives CFTC approval, OnExchange will supervise the futures-trading activities of its client exchanges. The result: regulatory certainty, at least for the futures products it's responsible for. "Once you decide you want to list, say, widget futures,” Jaycobs says, "we will list those products on our exchange, and do a revenue-sharing arrangement with you. The interface is linked to your cash market dealing—we integrate our interface directly into the widget market's interface. And all of the clearing and settlement is handled just as it would be on a bricks-and-mortar exchange.”

The final piece of OnExchange's product offerings is consultative: the company helps its clients understand risk management and integrate it into their daily operations. "We're offering the expertise of people who know derivatives to companies that may understand the cash side of their business but not the value of derivatives and how to use them as a risk management product,” says Jaycobs. "If a client is, say, a paper-trading exchange, we'll send in a team to do risk management profiles and walk them through the ways paper derivatives can increase their cash market volumes and so on.”

Will it fly?

Only one in 10 futures contracts survives at exchanges. But is that because of a lack of demand for futures contracts, or the inability of traditional futures exchanges to offer a wide array of novel contracts? Jaycobs thinks the latter is the case. "The bricks-and-mortar open-outcry environment is a difficult one in which to create new liquid markets,” he says. "For example, electricity trades like crazy, but the Nymex's electricity futures contracts haven't taken off. We think that's because the OTC market is much more flexible in offering products that reflect the underlying power markets.”

OnExchange's contracts, by contrast, will reflect the cash markets as accurately as some of the more standardized OTC products. "It's going to be harder and harder to tell the difference between a custom derivative in a particular market and a generic futures contract,” says Jaycobs. "As time goes on, you're going to see a merging of the two. There will be a lot of electricity futures contracts that look like forwards or swaps. They may be considered futures contracts because they go through a clearinghouse and permit offset, but they may not resemble futures traded at, say, Nymex at all.”

That middle ground, Jaycobs says, is where everyone will be moving in the future. To get there, OnExchange has been busy securing financing—it's rounded up $10 million to date—and ramping up its staff to 40. That number, says Jaycobs, could double after platform deployments start in November. Pending CFTC approval, regulated contracts could begin trading in the first quarter of next year. Trading in unregulated forwards and swaps could be launched in the fall. Right now, prospective customers include participants in the energy, chemicals, forest products, electronic components and agriculture industries.

Can OnExchange succeed as a creator of derivatives markets? Jaycobs is optimistic. "We're going to create an infrastructure where there are going to be 15 contracts for a given commodity, each of which resembles the underlying cash market, none of which is ‘the market.' The lines of demarcation between OTC and exchange-traded are blurring, and we think the real business is going to the middle.”

— Robert Hunter
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