Is there a way to create better liquidity in the Derivatives Market?

Is there a way to create better liquidity in the Derivatives Market?

This post was written by Jack Neicho, Business Development Executive at Perfect Channel.

The Derivatives Market

A derivatives exchange is a central exchange where people can trade standardised agreements of a specific quantity and quality of a commodity or financial instrument at an agreed future date. The derivatives market can be divided into two segments:

  1. Over-the-Counter (OTC) traded derivatives – are customisable between two or more parties, and can be executed either directly or via brokers. All contracts started out as OTC agreements, but, when a product proves itself adaptable to benchmarking, exchanges ‘productise’ it, which creates a liquid market for a homogenous form of a derivatives product.
  2. Exchange traded derivatives – are generally widely traded but few in number in terms of highly liquid contracts and market participants.

The Derivative Markets role Derivatives have several key roles to play in the world economy. Firstly, they are used to protect the holder of the underlying asset from price volatility, otherwise known as hedging. Secondly, derivatives offer the opportunity for speculative trading either at a fundamental or a technical level. The three crucial attributes that a derivatives market must replicate to its users are as follows; efficient, safe and innovative. It is the responsibility of market participants and regulators to make certain these prerequisites are upheld in order to create a complete marketplace. Therefore, the main concern of all regulators and company stakeholders is to limit the systematic risk to the highest possible level. Balancing the needs of compliance and risk oversight is the need to promote liquidity. A continuous market requires liquidity (a ready supply of buyers and sellers) to generate the flexibility of entry and exit from a position.

Liquidity – is it as important in a discrete (auction based) exchange as it is in a continuous market?

Successfully and efficiently matching buyers and sellers is what will inevitably create a more liquid market. Combining a physical marketplace with an online one to create a new marketplace eco-system will create a completely new pool of buyers and sellers that might have not been able to participate in that original physical market. However, as we’ve stated before, when creating a new marketplace or moving a marketplace online it is crucial that marketplace design is thought through. Adapted from the Nobel Memorial Prize in Economic Sciences (2012) Alvin E Roth; a market must be:

  1. Thick (enough potential transactions at one time)
  2. Uncongested (enough time for offers to be made, accepted, rejected)
  3. Secure (secure to participate and to reveal relevant preferences)
  4. Easy to use (low friction and clarity of pricing).

The real benefits of moving a marketplace onto an online auction based trading system are as follows;

  • Lower cost than continuous exchange.
  • Can be run for a discrete period of time and therefore will not be so liquidity hungry.
  • Can respond better to the real world market constraints of location and quality.
  • Can be built hand in hand with a custom clearing service thus fulfilling G20 mandate.

Coupled with the ability to;

  • Proactively respond to market opportunities
  • Help sellers and buyers locate each other and achieve the correct price for the goods or services
  • Achieve a better price for the seller – price discovery which in turn stimulates liquidity
  • Digitise the existing trading process making it more efficient and transparent
  • Drive sales growth with a dedicated analytics engine
  • Optimize settlement
  • Reduce counterparty risk through clearing
  • Manage compliance through price discovery
  • Easily integrate to 3rd party solutions
  • Low TCO
  • Rapid ROI

Conclusion

Combining Alvin E Roth’s marketplace attributes with an auction based trading system could have significant benefits for a marketplace. An auction based trading system could allow for the creation of far better liquidity in the derivatives market, especially where clearing is harder to facilitate. An auction based system is put in place to create price discovery or optimise pricing in that given market by creating competitive tension between buyers and sellers, more effectively than merely having an online system. If all market participants from one segment of a derivatives market were to move onto an online based auction trading system it would be a perfect way of benchmarking in order to create market liquidity. Non-cleared OTC trades could be forced to move online to compete with exchange traded derivatives, an auction based trading system would suit this perfectly to create better market liquidity and increased price discovery.

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