Hirander Misra is starting a new exchange. So is Alasdair Haynes. Neither of those plans should be that surprising to many people, since both played important roles in the meteoric rise and sustained popularity of Chi-X Europe, the first venue designed to take advantage of the sweeping changes brought in by MiFID. Automated Trader gets the low-down on the new Aquis and GMEX exchanges.
Initially, a pan-European MTF, Chi-X Europe immediately grabbed market share from established players and went on to become a dominant force in European equity trading. Scooped up by its rival BATS (which itself is now due to merge with Direct Edge), Chi-X Europe has since become a regulated market.
Hirander was instrumental in developing the company. He was its first full-time employee, and served as chief operating officer. Alasdair, after running ITG Europe, was brought in as CEO at the start of 2010 after a period of intense management turnover.
But both left the company to stake out new territory. So what are these two exchange leaders up to? They're going after very different markets, and in very different ways. Both say they have concepts that will shake up their respective sectors. One aims to overhaul the cost model, the other is trying to innovate on the product side. Automated Trader spoke to both about their new ventures.
Aquis: A leaf out of the telecom sector's playbook
Is it possible for a firm to entirely change the model that exchange fees are based on? Alasdair Haynes thinks so.
AT: How difficult is it to launch an exchange right now?
I would suggest to anybody in the future that it's not for the faint-hearted. The first thing, if you think you have a good idea, is you've to find a good way to fund it. I was adamant on day one that I wanted this to be non-conflicted, making it very different to other approaches from MTFs that have tended to be consortiums, often customer-led consortiums. I wanted something that did not have the customers involved. There is ultimately going to be a conflict somewhere down the road if the customers own your business and you're trying to build a very different model.
Alasdair Haynes, Aquis Exchange
We've done this deal with Warsaw Stock Exchange -- they're not a competitor, they're not a customer, but they clearly understand the exchange business. And then the rest of the funding has been done by high net worth individuals.
AT: Everyone claims to be new and different. Why is Aquis?
If we work, and obviously we believe it will, we think it will change the industry forever.
I knew when I left Chi-X that I wanted to stay in this space. I had some ideas of things we wanted to do, and I knew that we couldn't just start an MTF. A me-too was never going to work. And I think the trouble with many of these MTFs is being a me-too model. We were fortunate in that we managed to get a group of people with a proven track record, who have built, worked, and operated a successful trading platform, and who, with that track record, have been able to regroup and build a very advanced piece of technology.
Out of the hundreds of MTFs that have come to Europe the past few years, only a handful of them have truly succeeded and that is because most of them have very much been me-too models. This is completely different.
We're going to introduce a telecom-style utility model to the industry. And in other places, where this has happened and a subscription price has been introduced, you've seen a radical change to the industry. I unfortunately - and fortunately - am old enough to remember the way that British Telecom used to operate. My parents used to regularly shout at me get off the phone because it was costing too much money. And I look at my children now and I don't really care how long they're on the phone because it's an all-you-can-eat model. It's very efficient.
Since subscription packages were introduced, you've seen exponential growth in texts, exponential growth in the use of phone calls, exponential growth in downloading. And that is the same almost everywhere I've seen a subscription price introduced.
People's criticism of the equities market, particularly in Europe versus the United States, is we have a market that does about 25% of the turnover of that of the US, and yet we have the same GDP in Europe and a population that is actually slightly larger. Part of the answer is high costs and that the way to address this is with a new model. We think there isn't enough competition.
AT: How did the idea come about?
To be honest, it was when I was buying a phone for my 13-year-old son. That's when the penny dropped. I looked at the packages that were being offered in the particular shop and just went, 'Hang on a second. This is what an exchange is doing'. When I was operating Chi-X, I looked at how our costs were dependent upon message traffic in the same way that telephone costs are dependent upon the number of phone calls and the number of texts, the number of downloads. I don't really care what the underlying value of the stock is. And yet, exchanges today in Europe charge based on the value. You pay London Stock Exchange more for trading a share of Glaxo than you do for Vodafone, simply because one is at 17 pounds something and the other is at two pounds. That doesn't really make sense.
My costs operating as an exchange are down to message traffic, so why do we not charge based on message traffic, and why do we not do what the telecoms companies have done? If you're a small user and you're not using much, you shouldn't have to pay as much. And that's why I can go and buy my son a phone and where he has limited texts, limited downloads, a limited number of calls. On the other hand, I, as a heavy user of the phone, will have unlimited texts, unlimited downloads, unlimited calls. In other words I pay more bandwidth than he does, and therefore that is fair, transparent and open. And I think we can have the same form of impact in the exchange and the cash-equities space as we've seen in telecoms.
AT: A lot of venues have specific target groups. You seem to hope to attract different users based purely on your model.
The national exchanges naturally have liquidity from all areas. Most of the MTFs have been set up specifically for a certain group, for example, the retail market or the high frequency market… We're coming into this market saying, 'Actually it's open to all.'
Our pricing schedule is very simple. The start-up is 25 thousand messages a day. You pay £2,000 pounds a month. If you want more than 25 thousand messages a day you pay £10,000 a month and that's your cost however much you use - there is no cap. You can carry on trading as much as you like. That is a substantial saving. As we build liquidity, we've told people we would see additional price tiers coming in. At £50,000 we will cap it.
AT: How will you determine the tiers?
We have a forum that meets every six to eight weeks, about 20-25 different firms. The truth is, we don't know what the right message traffic number will be, because nobody's done and measured this. We're trying to work with the industry to give them a model which will ultimately change the way that all business is transacted in the execution cycle. And by that I mean I have a clear vision that in the future I would like to see, a day where a customer, whether it's a small, medium or large player, comes and says, 'I'm paying x euros or pounds or dollars a month, and with that, I get clearing, settlement, execution, data, and the ability to distribute that data'. And that's something that radically changes the industry for a fixed fee per month. And that will allow incredible growth to take place.
AT: The initial 'customer hurdle', how do you deal with that? Anyone in the industry has a dizzying array of choices…
We've said we want the barriers to entry to be as low as possible. There's always some pain to be taken by a customer to join. We're doing things which are very simple. That part of the business is not revolutionary. The revolution comes with the model rather than maybe some of the technology that we've got within the system.
AT: What's been the reaction in the industry so far?
We get questions. Ultimately the question I throw back at the industry is: Look, this is a unique situation. To get a group of people who have worked before, to get finance to not ask the industry for money, to have the technology to bring in a new model, I don't think anybody ever is going to come out again and offer the market the opportunity of a subscription price, and particularly at the starting point of an all-you-can-eat model at £10,000 a month. This is not huge money for the types of players that could be trading many millions of messages a day. As a private company, we will have a limited time to do this. And we have to get it right.
We also plan to have other income streams. After two to three years we will start looking at data, but we want data prices to be radically different from what they are now. And the third thing is we're selling software. Our exchange is like a shop window for anybody who wants matching engines.
AT: Doesn't that all set you up for a potential fight with the industry?
There is something wrong in a model where the same piece of data is charged for multiple times. Data is now a billion euro industry in Europe for the exchanges and it hurts trading.
We can change it. We need to make this more efficient. When an exchange owns 100% of the data, it is very valuable and there is little incentive to cut costs. But actually it's still incredibly valuable when they own 70%. We're obviously huge proponents of finding some kind of consolidated tape within Europe. We think that will help change. But that will only happen through competition. That's not going to happen with BATS Chi-X, with 25% of the market, with the national exchange having 70% of the market. People want us to succeed because it helps drive down the other prices. Data's one, but there are many hidden costs within the industry that could be made more efficient.
AT: Any thoughts about the latest spate of exchange technology issues?
Every single person who's involved in technology will know that the point of failure is only known after you found it. So, you know, I don't believe anybody who turns around and says they have mitigated all risks. The game is about understanding the risks you take and knowing about them and how you manage that.
There will continue always to be risks in the exchange and technology world. And that doesn't matter whether you're in trading, whether you're driving your car, in a plane or whatever it is. There's nobody out there who has a car that is so perfect that nothing has ever gone wrong. It just happens.
AT: And when things do go wrong?
This is something where I think the industry can improve a great deal. As and when something goes wrong, how do we communicate, how do we respond, what are the, the continuity plans?
Technology will have outages. But you want to minimise the risk to the customer and you want to find good alternative plans to make sure markets will happen efficiently.
Nobody is going to have perfect technology. There is no such thing as the perfect human who lives forever. There's no such thing as the car that doesn't break down. It doesn't happen. So therefore, what we have to do is work in an environment … where when you have a problem in one exchange, the market shifts to another very easily and efficiently. And we don't have that today.
If you have a technology glitch, it should hurt the exchange, not your customer.
If something does go wrong, what people really hate about the markets is, banned communication, not knowing where they are, not knowing what the alternative is and how to do it. And I think, if we work together as a collaborative group in the industry, then actually it's in everyone's interests.
GMEX: The challenge of preserving OTC flavour in an exchange format
What makes Hirander Misra so confident he can capture the essence of OTC trading on an exchange and steal a march on established players?
AT: What's GMEX all about?
What we've come up with is a brand new methodology with a US patent pending on it currently, that basically - as close as possible - aligns to the underlying OTC markets and therefore these products have the capacity to be very liquid as a result. GMEX is very focused on the transfer of OTC markets to on-exchange, in a way that reduces the strains on balance sheets across the industry from the buy side to the sell side, and encourages features as well as liquidity to come into the market and aid the growth. That's across a range of products but with an initial focus on fixed-income and currency products that are very
Hirander Misra, GMEX
different products than we've seen on exchanges before.
Then more broadly, we're looking at more correlated assets that lend themselves to trade. The futurisation of swaps is integral to what we're doing and what we'll launch, but beyond that there are also some other very interesting OTC variants on-exchange.
AT: What are you doing that's different?
If we take interest rate swaps as the big elephant in the room, it's $500-600 trillion open interest annually. Everyone's chasing that Holy Grail.
But the issue with all the current futures contracts is, that they're trying to put a square peg in a round hole. Because what they've said is, 'Let's take the swaps market and look at how we retro-fit that into a bond-style future', rather than, 'Let's look at how the market can conform to, then mirror the underlying market'. So they've looked at it in completely the opposite direction and what you've ended up with are bond futures that don't reflect the underlying market and therefore are not the right substitute.
You've got to look at the OTC market and how it's used. If you go to the underlying market and say, for argument's sake, that the open interest is $500 trillion across interest rate swaps. Two thirds to 70% of that isn't predicated on the underlying need - the underlying cash flows, the asset swap - because if we look at global debt insurance it doesn't add up to that. The vast majority of institutions use it for getting exposure up and down the interest rate curve. Plain vanilla swaps count for the vast majority. So where you need the underlying cash flows you need the swap. And it's going to be bespoke in most cases.
If we take that concept, you think: actually people want exposure to the whole curve. Therefore it's the different tenors that are the commodity and the exposure up and down those. It's not just the liquids, you know the twos, fives and tens we're talking about.
There are debt futures products out there. And you can argue the interests rates swap products on exchange are very much bond-style. But the problem with those is you've got a small number of tenors so you don't get exposure to the whole curve. You can't get exposure from 2 to 30 years which is what we're offering initially. And there's an argument in sterling and euros to go up to maybe 40 or 50 years and all the points in the curve.
But when you get the exposure to the equivalent points in the curve you can manage that as well because you can weight it accordingly to different tenors because the buy-side exposure isn't static. They need to manage that, and what you have with the bond-based contracts is you have expiries, IMM rolls, you have triple-witching out which also leads to a vast range of issues.
AT: How have buy-side players reacted to the concept?
We've been speaking to some very large asset managers. They've got a mandate now to reduce the balance sheet exposure to move from that onto futures products that are out there for as much as possible in terms of the portfolio. But they want that exposure in a way that closely aligns to the way that they do things in the OTC market. They don't want this square peg/round hole situation.
So the demand from the end users is there. But the product isn't. So by virtue of what we're doing, we've created it. We've created something called constant maturity futures. And with that, we've got all the different tenors from 2 to 30 years across the four major currencies initially.
We actually tie it back to the underlying interest rates swap market at the start of day and the end of day by way of a proprietary index we call the constant maturity index. We reflect the price as an interest rate swap rate rather than all the IRS futures out there, which reflect it as a price. The instrument allows the ability to trade the whole curve by using the discount factors at each tenor to calculate the present value of each trade at that point. This makes it an ideal buy-side instrument for hedging interest rate exposure across the entire curve.
AT: Apart from the buy-side, what about other users?
We've then gotten the extensive feedback across the different user types. The buy-side really like it, the banks really like it, there's some resistance amongst some of the larger swap banks, but you will get that. This is why they all keep plugging the IMM complex to some extent.
We're certainly in a situation now where some are breaking ranks. Because they get the way the market's going to move. Where there's resistance we've also gone to the buy-side who are now going to the prime brokers, who are these banks. Equally, it's very attractive to the electronic market making guys and futures players, because we tag the contracts by use of an index to the liquid underlying swap market with an exchange traded derivative construction.
The index is based on a number of contributors, not only banks but also end users, other players. We've created this methodology of constant maturity futures and a constant maturity index. Between the two of them, we then work through the P&L of doing an equivalent swap. And within a few cents it mirrors it (an OTC swap) exactly. It's as close as possible. Let's say it's a $1 million trade notional, you're speaking about three or four cents. It's basically nothing - it's like a rounding error.
AT: So this is much more about the product, not the cost?
In 2007, when we launched Chi-X, banks and others trading on an exchange group in Europe might have operating costs of $100 million a year. And they said, 'With a 90% reduction on cost we went down to $10 million on the exchange fees, excluding the clearing'. Now, if that $10 million becomes $9 million or $8 million, they really don't care because of the effort to get there, given the resource constraints.
With what we're doing, we don't need to compete on price. It's a new product. Yes, it needs to be on a level that's economic. The question is: In this environment, in a sustainable way, spending a minimal amount of cash up front but aligning your interests and market, how do you build liquidity?
So here's a take on this: what we've done with the index is say, yes the banks are important contributors to the makeup of any type of index like this because bank prices are out there.
But we're also saying, given the benchmark fury (over Libor), we'd like to encourage a wider set of contributors beyond the banks to contribute into the index. Through index surveillance - which is a bit like market surveillance - we want to insure that those contributions are within a certain range, are from sources that have a high degree of integrity, and we want to watch out for any outliers.
So we're encouraging the buy-side and electronic market makers to contribute curves to us. We've put them through a methodology and we will send out a consolidated index that reflects everything from the end users to the banks to those electronic market-makers.
We put this through various methodologies. We look at the standard deviation in most sense away from the norm and we throw out outliers and erroneous prices. If people are consistently offending, we'll remove them from the group of contributors.
AT: And you're also talking about a different commercial relationship with users?
We'll share a proportion of revenue that we're doing on the order book with those top contributors proportionately. You might have one bank saying, 'I'm much larger than he is or she is, I should be weighted greater and I should have more revenue'. We'll say fine, given a portion of what you're giving in we'll give you a portion of that revenue if you're consistently contributing good data.
But also, we'll have another equal pot for the volume you're doing on the order book and share that proportionally as well. So it almost creates a form of jump ball.
It creates a sustainable market because those who do more get more revenues back to them as well, because effectively you don't have to offer a rebate, but net you can still get revenues out of trading the book as well. So market players who want to provide liquidity really like that model. And this hasn't been done before.
We'll have 10% of the order book revenues up for grabs based on various criteria. Those who are ranked in the top 10 will be proportionally handed that 10%. And we can do that because we own the index and we own the exchange as well. And just to close a loop on that, we think we've come up with a better benchmark than ISDA fix.
AT: What's the timing looking like?
We anticipate getting FCA approval during the fourth quarter of this year.
We've got a number of letters of intent from key players - banks, the buy-side, the futures players, the electronic market markers. Then we're going to go through the formal testing period. We've got all the tick data from the index, running the index, the technology model around that. You've got to have this mock trading cycle. Everyone gets familiar with that. And then all that converges on launch, at which point the central clearing comes on during the first half of 2014.
AT: How do you see the overall derivatives industry changing, given all that's been happening with M&A and regulation?
The center of the universe for futures trading is somewhat shifting from Chicago towards London.
You've had ICE's acquisition of NYSE Liffe, and then you've got CME coming in as well. You've already got the likes of Eurex here in Europe as well. And equally it's mid-time zone, if we look at the US and Asia.
Certainly Chicago will remain an important centre, but equally we're seeing real competition emerging in London. And that's very exciting. We're going to see a lot of innovation on products. I would argue most of the exchanges haven't really innovated in this space. They've copied each other, and they've come up with similar products. If we look at it, with CME coming into Europe on currency futures and NASDAQ NLX live with existing fixed income futures, we've got a multitude of similar me-too products across the industry.
From what our potential members tell us, the appetite for me-too products is limited. The proof of the pudding is when there's approval and then it goes live. Obviously you've got strong players. But again it's using what they'd call the tried-and-tested product structures.
We saw that the exchanges, with very little exception, aren't really addressing the needs of the market. We see ourselves as a niche player right in the middle of that to address this. Some may argue that it's David and Goliath and in many ways it might be even harder than equities. But then in equities liquidity has been shifted before. There was a need and it was the right time. Here we truly believe we've come up with the right product set and the timing is perfect.