Spring 2007 Conference on Developments in Financial Markets

Financial markets are undergoing dramatic change as they consolidate, introduce new trading technologies, and develop new products. How will the competitive landscape be affected? What are the regulatory implications of these developments? Are there clearing and settlement risks in the OTC derivatives markets as the volume of activity grows? These and other issues were discussed at the 20th annual conference of the Financial Markets Research Center held at Vanderbilt University on April 12 and 13, 2007.

Hans Stoll, Director of the Center, welcomed the participants and introduced the first speaker, Reuben Jeffery, Chairman of the Commodity Futures Trading Commission. Chairman Jeffery spoke on the unparalleled growth and change in the industry regulated by the CFTC. Trading on futures exchanges is now primarily electronic, the ownership of exchanges has changed dramatically requiring a change in governance, new product applications to the CFTC are at an all-time high, futures traders are increasingly institutional investors, and futures markets are global. Globalization, in particular, poses regulatory issues that require cooperation and coordination with foreign counterparts. Chairman Jeffery emphasized the role of the CFTC in fostering competition and innovation so that futures markets can most effectively fulfill their price discovery and risk management functions.

After a short question and answer period, Professor Stoll introduced the panel on the topic, “The Changing Landscape in Futures and Options Markets.” Ed Joyce, President and Chief Operating Officer of the Chicago Board Options Exchange, commented on several developments at the CBOE – the benefits of the demutualization currently under way, the success of the CBOE’s hybrid market that mixes screen based and open outcry trading, the effect of the penny increment pilot for 13 options, the growth of volatility options, the introduction of the CBOE Stock Exchange which expects to attract stock volume related to option trading, and the advent of portfolio margining for customers. Andreas Preuss, Chief Executive Officer of the Eurex, spoke on developments at the highly successful European exchange. He noted the Eurex’s three-pronged strategy – global expansion of access to Eurex, diversification of the product range, and fast, reliable electronic trading technology. He noted that the Eurex would be reducing the message delay from 29 milliseconds to 9 milliseconds (which raised the question, “how long is a millisecond). Speaking next was Jeffrey Sprecher, Chief Executive Officer of the IntercontinentalExchange (ICE). Mr. Sprecher commented on the rapid transformation of the ICE since its founding in 2000. In that time ICE acquired the International Petroleum Exchange in London and the New York Board of Trade. It relies on electronic trading technology to service its exchange and OTC trading business. He did not comment on the ICE’s current offer to merge with the Chicago Board of Trade, which competes with an offer by the CME. He noted that the ICE is a uniquely global exchange and that cooperation between US regulators (the CFTC) and British regulators (the FSA) in overseeing the ICE is good. The final speaker in this panel, John Damgard, President of the Futures Industry Association, commented on trends in the futures industry, such as the dominance of electronic trading, the globalization of markets, and the need at the regulatory agencies for finance skill.

After a coffee break, the next panel, chaired by Rick Kilcollin, co-founder of Sanborn Kilcollin and former CEO of the Chicago Mercantile Exchange, dealt with new product innovation. The first speaker was David Downey, CEO of OneChicago, the entity established to trade single stock futures. Although not new (they were approved in 2000), single stock futures are still behaving like a new product with relatively low volume. Downey noted the benefits of single stock futures both as a substitute for long position in the underlying stock and as a less costly way to establish a short position. He ascribed their lack of success to the failure of hedge funds and other institutional investors to switch away from their reliance on their prime broker. Downey argued that long or short positions established via a prime broker were more costly than if established with single stock futures. Speaking next was Brad Hogatt, Chief Investment Officer of GuaranteedWeather and a former academic meteorologist. Hogatt described the growth of weather derivatives, the major participants, and the primary contract settlement parameter (temperature). He noted that weather is correlated with a variety of economic activities, such as agriculture, tourism, and power use, and hence weather derivatives can serve as a useful hedging vehicle. He also commented on the analytic tools available to help predict weather at least in the short run (and hence make profits). The final speaker in this panel was John Labuszewski, Managing Director for Research and Product Development at the Chicago Mercantile Exchange. He described the new product development process and the factors that have in recent years spurred product development. These include the demutualization of exchanges and their resultant profit orientation, the less restrictive new product approval process at the CFTC, and the advent of electronic trading which lowers the cost of trying out a new product.

After a break for lunch, the conference resumed with a panel, “Changes in Equities Markets,” chaired by Jim Cochrane, former Senior Vice President for Research and Planning at the NYSE. The first speaker, Reena Aggarwal, Professor at Georgetown University, spoke on “Changes in equities markets: Trends in ownership, value, and governance.” She described the demutualization process and the healthy stock market performance of exchanges going public, and she noted the new regulatory and governance issues that arise when exchanges are for-profit entities. Paul Bennett, Chief Economist of the newly formed NYSE Euronext, spoke on several developments. He noted that the NYSE, Euronext, and Arca would operate as separate subsidiaries at least for the time being. The NYSE hybrid market is increasingly electronic with a large fraction of the trades completed automatically and only some of the larger orders going to the floor market. Speaking next was Steve Swanson, CEO of Automated Trading Desk, an electronic trading firm currently responsible for about 6% of aggregate trading volume. The firm specializes in high speed, algorithmic trading and order routing. Swanson, who had feared snafus in the implementation of Rule NMS, the SEC mandated rules on trade-throughs, noted that NMS appeared to be working satisfactorily. Frank Hatheway, Chief Economist of Nasdaq, described the newly revamped PORTAL trading system which, under SEC Rule 144A, facilitates secondary market trading in private placed securities among qualified institutional buyers (QIBs). Erik Sirri, Director of Market Regulation at the SEC, commented on various regulatory issues. He noted that a credit derivative swap, although not a security directly subject to SEC oversight, could be subject to insider trading regulations if the swap were based on the underlying security. Trading of foreign securities unregistered in the U.S. is an issue that should be dealt with. Easier screen based access to such securities for institutional investors and brokers should be considered in view of the fact that trading of foreign securities currently occurs anyway. On the question of shareholder voting and short selling, he noted there were problems of over-voting, under-voting, empty voting, and broker voting, all of which were compounded by a lack of good record keeping.

Thursday’s final session, “Clearing and Settlement of Derivatives Contracts,” was chaired by Richard Lindsey, President of the Callcott Group and formerly President of Bear Stearns Securities Corp. Lindsey noted that the explosive growth of OTC derivatives had caused some back office problems that were in process of being corrected. The first speaker Michael Cahill, President of the Options Clearing Corporation, described current developments at the OCC, which clears exchange traded derivatives. Peter Axilrod, Managing Director at the Depositary Trust and Clearing Corporation (DTCC), next described the development of standardized clearing arrangements for OTC credit derivatives. The Trade Information Warehouse of the DTCC maintains the basic record of swap contracts, processes events and messages, and calculates payments due from one side to the other. Unlike clearing houses for exchange traded derivatives, swap contracts are not guaranteed by the DTCC. Pat Parkinson, Deputy Director of the Division of Research and Statistics at the Federal Reserve Board, reported on the latest study of OTC derivatives clearing put out in March 2007 by the Committee on Payments and Settlement Systems of the Bank for International Settlements. He noted that considerable progress had been made to correct the backlog in documentation of credit derivatives and to improve OTC clearing arrangements in general. Further improvement is needed to correct confirmation backlogs in derivatives other than credit derivatives and to deal with the potential market disruptions when credit derivatives close out.

The first session on Friday morning, chaired by Peter Layton, newly appointed Chairman of the Boston Stock Exchange, examined the topic of short selling. Stewart Mayhew, Assistant Chief Economist at the SEC, summarized the results of an SEC study (carried out with Amy Edwards, Tim McCormick and Allan Zebedee) of a sample of 1000 stocks exempted from short sale restrictions. The removal of short selling restrictions increased the volume of short selling (not the short interest) but had no effect on stock prices or on volatility. Mayhew noted that short sale rules were not very restrictive; hence their removal would not be expected to have a large effect. The second paper in this panel, presented by Ekkehart Boehmer (and co-authored with Charles Jones and Xiaoyan Zhang), was entitled “Which Shorts Are Informed.” Based on proprietary NYSE trading data for the period 2000 to 2004 which identified short sales, the authors found that short selling predicts subsequent returns. Large institutional short sales tended to predict larger price declines than other short sales.

The last session of the conference, chaired by Michael Bickford, Senior Vice President of the American Stock Exchange, dealt with options trading around ex-dividend days. The paper,  “Failure to Exercise Call Options: An Anomaly and a Trading Game,” was presented by Bob Whaley, Professor of Finance at the Owen School and Co-director of the FMRC, (and was co-authored with Veronika Pool and Hans Stoll). Deep in the money call options should be exercised before the underlying stock goes ex-dividend to avoid a drop in the value of the option. Failure to exercise such long call positions hurts the call buyer and benefits the call seller who is not assigned. Whaley showed that call buyers lost in excess of $280 million (net of transaction costs) from failure to exercise in the years 1996 – 2005. The trading game, played primarily by market makers that have low transaction costs, involves taking large short call positions (hedged by identical long call positions) to increase the chance of not being assigned and hence profiting from the longs’ failure to exercise. Option volume on the day before ex-dividend days is extraordinarily large. Eric Noll, Global Head of Strategic Relationships at Susquehanna International Group, discussed the paper.  He commented that transaction costs, taxes, and monitoring costs could explain much of the failure to exercise calls, and he felt it to be a legitimate function of low cost trading firms to profit from this failure.