Anish Puaar
June 9th, 2014
The attempt by Nasdaq OMX to launch a derivatives market in Europe is a year old and it has been trumpeting its progress in building liquidity. However, data seen by Financial News shows that the majority of its trading in Euribor contracts is taking place in two narrow time windows each day in a way that allows firms to collect a share of the £50,000-a-week cash incentive that Nasdaq OMX pays to encourage trading. Outside these two windows, trading volumes are drastically lower.
It’s a demonstration of the challenge faced by any trading venue trying to crash into a new market: no one wants to be the first to move on to a new trading venue because it has low liquidity – but liquidity won’t build until banks and traders move over.
It also illustrates the difficulty in designing an incentive scheme to break this cycle. NLX’s first incentive scheme led to a burst of liquidity once a day. The scheme was changed to try to spread liquidity, but this only resulted in two bursts a day instead of one.
NLX declined to say how much it has paid out in trading incentives or which companies have collected them. It added that it does not discuss the trading of individual participants.
Charlotte Crosswell, chief executive of NLX, said: “What’s important to remember is why we created this platform in the first place, which was to bring choice and competition to the market. And as we continue to advance and gain traction, we are working to build the highest-quality market possible.
“The revised marketmaking programme introduced on June 2 will help ensure that we have the tightest possible bid and offer during the course of the trading day and multiple price levels actively quoted in each market with significant volume available at all levels.
“We continue to monitor the effectiveness of our incentives and will evolve these accordingly to grow the market.”
Since NLX was founded in 2011, Nasdaq has invested more than £40 million into the venture, according to UK company filings. NLX’s launch marked the first significant attempt from a start-up trading venue to break the duopoly held by Liffe, the London-based derivatives market recently acquired by IntercontinentalExchange, and Eurex, owned by Deutsche Börse, in the trading of futures based on European interest rates.
It’s a big target. In the first quarter of this year, trading of European interest rate derivatives garnered over $140 million in revenues for Liffe and Eurex combined, according to their first-quarter financial statements. But starting a new trading venue isn’t easy. In the equities arena, Europe’s 2007 Markets in Financial Instruments Directive encouraged start-ups to challenge domestic stock exchanges. Several new venues emerged but many have since failed to gain enough traction and were forced to close, including one from Nasdaq OMX called Neuro.
With any new market, building an initial base of liquidity is always the toughest challenge. Popular ways to build up liquidity on new markets involve incentives such as offering market participants equity stakes in the venture – a tactic used by alternative equity market Chi-X Europe when it launched in 2007 – or reduced trading fees, a tactic commonly used by Eurex to build up activity in new or illiquid contracts.
NLX has opted to offer cash incentives to those members that trade more than a certain number of contracts a week.
Crosswell said: “We believe incentive schemes are an important part of starting a new market. It is incredibly hard to get a market off the ground otherwise. Many markets offer equity stakes as incentives but when we were consulting the market before launching NLX, there did not seem to be much appetite for this.”
It is not alone. Cash incentives also form part of CME Group’s efforts to build trading on its European derivatives exchange, which offers foreign exchange and energy products. CME said on May 30 that it would split a monthly bonus pool of $50,000 between the four most active participants for FX contracts on CME Europe as part of a short-term liquidity creation scheme, as long as monthly volumes exceed 40,000 contracts.
At NLX, the first scheme launched on August 19, 2013 offered £100,000 a month to be split between members trading more than a certain number of long or short-term contracts. Incentives were split between members on a pro-rata basis in line with the number of contracts traded, subject to the rule that no member could take more than £30,000 of the incentive.
By February, Euribor volumes were building, with some contracts trading more than 10,000 times per day, although this was still a fraction of the volumes traded on Liffe. However, data seen by Financial News shows that during February, 54% of trading in Euribor contracts was transacted between 07.00 and 08.00.
Butterfly spread trades
The majority of trades executed during the hours with the most trading activity are known as butterfly spread trades – low-risk and low-volatility strategies, with each trade made up of four contracts. Volatility is low during those hours so anyone trading has minimal risk of loss.
Nasdaq OMX changed the incentive scheme in February.
Under the new scheme, a total of £50,000 is available each week, split equally between a morning and an afternoon scheme running between 07.00 and 12.00 and 12.00 and market close. The incentives are split between qualifying members on a pro-rata basis and subject to a 30% cap.
Data seen by Financial News shows that the new scheme, offering a higher overall amount of cash incentive, has simply split the concentrated trading into two slices. The data shows that last month, 69% of trading in Euribor contracts was done between the hours of 07.00 and 08.00 or 12.00 and 13.00.
Trading on NLX does not appear to be correlated with macroeconomic events that normally drive trading in interest rate futures and the recent market share gains have not coincided with an increase in open interest, or the value of contracts outstanding. During May, open interest on Euribor contracts on NLX has fluctuated between 28,024 and 28,932 contracts, according to its own figures. On Liffe, open interest in Euribor futures ranged between 3,654,644 and 3,822,447 during the same period.
The nature of the activity has raised questions on whether some NLX members that qualify for the scheme are trading contracts between each other with the primary aim of receiving cash incentives.
Patrick Young, an exchanges consultant and former chief executive of Romanian exchange Sibex, said: “The breakdown of the trading data reveals vast numbers of butterfly trades, which have little economic value in Euribor given the current low-interest rate environment. Indeed, the spreads themselves barely move. Many people have drawn the conclusion that these trades represent a volume mirage of marketmaker to marketmaker transactions as they seek to achieve their targets under the NLX liquidity programme.”
NLX declined to say how much it had paid out in trading incentives or which companies had collected them. It said it did not discuss the trading of individual participants.
Hirander Misra, chief executive and co-founder of Global Markets Exchange Group, a derivatives market seeking approval to launch this year, said: “For any new market, building liquidity is a challenge. However, experience has shown that pure cash incentives tend to attract proprietary trading firms rather than real money flow. The key is designing incentives that attract an even distribution of volume throughout the day.”
Crosswell said: “We are constantly trying to evolve our incentive schemes to ensure trading is spread out during the day but it can take some time to get this right. We think the right way to build a derivatives market is to ensure people have access, attract volume and then let liquidity and open interest build on the back of this.”
Part of this effort includes the introduction of a marketmaking scheme from June 2, which Crosswell describes as the “building blocks” for NLX’s next phase of liquidity growth. Rather than rewarding cash incentives based on the number of contracts traded, the designated marketmakers will have to provide liquidity for a set proportion of the trading day, with price and size constraints. Those that qualify receive an execution fee rebate and a monthly stipend to “contribute towards the direct costs associated with providing the marketmaker service”.
According to Andrew Chart, senior director, origination and structuring, prime clearing services at Newedge Group and an NLX board member: “You could argue that volume may have skewed towards a particular type of participant, but recent numbers suggest that this is being rebalanced and addressed and that there is more different flow coming in.”
Chart said he expected more buyside flow on NLX following the recent volume growth: “Some mandates prevent certain funds from joining markets that aren’t considered mature. The 15% Euribor market share is a significant milestone and might take some of the shackles off the buyside and allow them to participate.” Crosswell believes NLX’s long-term success will ultimately be driven by reforms to the over-the-counter derivatives market, which will complement its existing core value proposition.
