What’s different about Curve?

The history of the derivatives markets is an annual of failed exchange launches.

Whether rival products or new exchange launches, it is notoriously hard to shift liquidity from an incumbent and it is into this litany of failure that the London Stock Exchange will launch its new rates platform.

Following FOW’s exclusive story yesterday that six global banks had signed up to support the London Stock Exchange’s new interest rates exchange, an official statement from the exchange this morning has revealed more details.

Two new details stand out.

First is that US options giant the Chicago Board Options Exchange is among the investors.

The second is that Michael Davie will serve as chairman of the exchange and in the new role of head of rates services across the LSE group.

Both indicate the ambition of the LSE for the new exchange but it is the latter that is perhaps the most significant for reasons outlined below.

Wresting liquidity

The Nikkei and the Bund are the most celebrated of the rare instances in the modern history of the derivatives markets in which liquidity in an established contract has been moved from one exchange to another.

These are the exceptions that prove the rule that it is nearly impossible to achieve a wholesale shift of liquidity.

Exchanges commonly launch look-a-like rivals to incumbent contracts with incentives and zero fees, but these alone are never enough to move liquidity.

Both the Nikkei and the Bund moved due to fundamental underlying conditions in market structure.

In the case of the Nikkei, it was draconian regulation by the Japanese that opened the opportunity for Singapore.

For the Bund, it was the advent of electronic trading and DTB’s embrace of the new technology in contrast to Liffe’s incumbent resistance.

Both were game-changers in the market rather than in the contract structure or approach of the exchange.

Portfolio margining

So what are the game-changers for CurveGlobal? Principally there are two inter-linked trends that the LSE will seek to ride.

The first is portfolio margining between swaps and exchange traded products. The offsets and efficiencies this offers in a capital constrained world are potentially huge for banks.

With SwapClear opening up its swaps portfolio to cross-margining, an unprecedented opportunity to test the benefits of portfolio margining will come in the first quarter.

If the savings and efficiencies are as great as has been suggested, the pendulum will swing strongly in Curve’s favour. We may well be entering a market environment in which the decision on where to trade is based on where you want to clear, rather than the status quo in which the market clears based on where it wants to trade.

A change of attitude within the banks?

One thing that held back Nasdaq NLX 1.0 was the reluctance of banks to really participate in the market. While many signed up at the start, few ever engaged with the market in any meaningful way.

Bill Templer, who has been heading up the launch of the exchange at the LSE, has learned the lessons and engaged with the banks early and predicated the launch on the agreement of a sizable number of the larger banks in the market coming on board.

With Bank of America Merrill Lynch, Barclays, Citi, Goldman Sachs, JP Morgan and Société Générale publically signing up to the exchange from launch one hurdle has been jumped. All have invested in the new launch, aligning their interests with the exchange.

Equally encouraging is the appointment of Michael Davie to chair the exchange and head up rates services at the LSE.

Davie is a swaps man through-and-through having run SwapClear since 2010 after 14 years at JP Morgan.

Curve will not succeed without the backing of the OTC desks within banks. They remain in many – but not all – investment banks the dominant influence on trading policy and where trades are directed.

With the backing of not just the banks but the OTC desks, Curve has another advantage above other recent attempts to take liquidity from an incumbent.

US reach

The third advantage is the participation of the CBOE. The deal is more than just a strategic investment for the US giant.

Ed Tilly, CEO of the CBOE, said that the firm will “leverage its trading and product development expertise” to develop new opportunities for curve.

CBOE therefore can open up Curve to the US market through its futures exchange as well as harnessing its volatility expertise to launch new contracts – expect a sterling volatility index in the coming years.

The elephants in the room

CurveGlobal certainly has advantages in the combination of portfolio margining, the backing of large banks and their OTC desks and direct access to the US market.

In this respect it looks stronger than previous attempts to take liquidity from ICE and Eurex. But what of the incumbent?

Jeff Sprecher and his team at the Intercontinental Exchange are unlikely to take the challenge lightly.

As outlined by FOW in July, ICE has a number of options to protect the franchise it bought in a multi-billion dollar deal in 2012.

Should it secure portfolio margining at SwapClear, which Mifid and the LSE’s commitment to open access guarantee it can if it wants to – it will eliminate many of the competitive advantages of CurveGlobal.

FOW understands it is in talks with LCH over open access and has a number of structures that can enable this, including the launch of a secondary trading platform that will effectively offer elective clearing without diminishing its liquidity pool.

Eurex too will fight back. Curve is launching products across the yield curve so threatens its bund, bobl, schatz franchise too.

The exchange was the first to market in Europe with its Prisma cross-margining methodology enabling portfolio margining between OTC and exchange-traded derivatives and has built open interest in its clearing house in Euro denominated swaps.

Whether the continued dominance of LCH in both sterling and euro products will be enough to move enough of the ETD market over to Curve is one of the many fascinating questions that will be answered in the coming months and years.

NLX will also be in a position to offer cross margining at SwapClear next year – long touted as its core advantage. It too is seeking to secure the backing of international banks and could soon announce it had secured the backing of some of the banks not signed up to Curve, and indeed some that have.

There are some notable absences from the LSE's list of banks. No German banks, neither Swiss giant UBS or Credit Suisse, no ABN or BNP Paribas. A flush but no full house. 

The perils of over incentivising

How Templer and his team bring the rest of the market on board will also be crucial to the long term success of the market.

Another lesson learned by NLX is the double edged sword of incentives.

Market makers and proprietary trading firms are eager to trade on the basis of incentives.

However, as FOW outlined in a recent whitepaper, they have the opposite effect on Commodity Trading Advisors and asset managers for whom the financial benefits of the trade are outweighed by the impact they have on the market.

FOW understands that Templer has been engaging with market makers and proprietary trading businesses extensively over the past two months but details of any incentives are yet to be announced.

He will need to tread the fine line between true incentives to trade and incentives that result in trading simply for the incentives.

Do the deal?

With a second quarter launch planned there is still time to do the deal that many in the market want – except ICE.

Rumours of a possible merger between NLX and Curve have been around since it was first revealed that the LSE was planning a new rates platform.

Talks did happen but it was clear that NLX owner Nasdaq and the LSE had vastly different views on the price of the exchange.

In 2016, once both have access to SwapClear, Curve and NLX will effectively offer the same products with the same Unique Selling Points, potentially backed by different banks.

This diminishes the chances of success for either market and so a deal between the two would strengthen the challenge to ICE.

No one has ever made money betting against Jeff Sprecher.

But his exchange group faces its biggest challenge in Europe to date with the launch of CurveGlobal.