Adrian Farnham’s outlook on the current state
of European exchange traded derivatives is bleak. The chief
executive of London Stock Exchange owned Turquoise Derivatives,
which last month took over the LSE’s EDX
derivatives platform, sees it as a closed shop dominated by the
duopoly of NYSE Liffe and Eurex.
The two exchanges are, he believes, closing off competition
that could bring down costs for the end user through their
market dominance, control or planned control of clearing and
ownership of the intellectual property of indices on which
index derivatives are based.
He is not alone in his concerns over competition in the
sector. As FOW reported last month, the proposed merger of
Deutche Börse and NYSE Euronext, and with that the
possible merger of Liffe and Eurex, has reopened the debate on
competition in the European derivatives space. The
EU is currently considering the antitrust issues associated
with the deal and last month, UK Treasury Secretary Mark Hoban
MP, said at a seminar that it was "odd" that exchanges can own
the intellectual property to highly liquid instruments.
Advocates of the status quo claim, with some justice, that
liquidity is king in derivatives trading, and that fragmenting
liquidity pools will be of detriment to the end user.
Derivatives exchanges, for that reason, tend towards a natural
monopoly and this is of no detriment to end users, indeed, it
creates a healthier marketplace, the argument goes.
New world order
However, Turquoise Derivatives has launched not only to
develop EDX but to call for a new world order in exchange
traded derivatives: a procompetition, fungible model where
markets compete on price, efficiency and customer service,
where contracts can be opened on one market and closed on
another and clearing is structured on an interoperable
On the face of it, it is easy to be cynical. Of course a new
exchange would call for fungibility and a pro-competition model
is obviously a better one for a platform starting out with a
tiny market share. However, Farnham says his message is more
than just a bid to get off the ground.
"What we understand is that the timing right now is positive
for this idea of introducing competition in exchange traded
derivatives," he says.
"We currently have a positive regulatory background for this
change with its push towards more transparency and more central
clearing. That environment works well with the Turquoise
philosophy. We have been created to deliver liquid, transparent
and displayed public markets. The regulatory market is
encouraging towards that.
"We very much think that our customers want competition in
the market. The structure in Europe today is two very large
derivatives market in Liffe and Eurex, which may end up in one
even larger market. The market structure is such that there is
a lack of competition pressure in derivatives. Take the
licences on index products, for example. It is three to four
times more expensive in Europe to trade exclusive index
products than non index products. For us that is an opportunity
FTSE 100 futures
This month Turquoise Derivatives will attempt to create that
competition with the commencement of trading in FTSE 100 Index
futures contracts. Launching FTSE 100 Index Futures is a direct
challenge to NYSE Liffe, whose London market has a liquid
contract on the index.
In March, the month before Turquoise announced the plans to
launch the contract, 4.89m FTSE 100 Futures were traded at
Liffe, as well as 2.08m European-style options on the index.
Liffe also had 25,500 FTSE 100 Dividend Index Futures traded
and 18,800 FTSE 250 Index Futures.
These instruments collectively form about 15% of the volume
in equity and index derivatives across Liffe’s
European markets, which totalled 45.9m contracts in March.
Eurex’s equity derivatives market is even bigger,
with 130m contracts in March, of which 78m were futures and
options on the Euro Stoxx 50 Index.
A life in opposition
For Turquoise, however, taking on the giants is its raison
d’etre. The Multilateral Trading Facility was
launched in 2008 in the wake of the Mifid regulations that
opened up equity trading to competition.
"We were frustrated with the way the exchange landscape was
evolving," says Farnham. "There was still a model in which
there was one big venue per country and little opportunity for
new entrants to break through. Clearing was expensive, trading
was expensive. There was a perception that the market could
have better trading systems and we launched to realise that
"From a trading perspective Turquoise along with the other
MTFs (Chi-X and Bats) was able to deliver a truly European
marketplace with new low latency technology and a compelling
At the time of the launch, banks were trying to solve the
problem of how to introduce competition in
Europe. Turquoise, which was then owned by nine investment
banks, worked with the DTCC to create a European subsidiary,
Farnham says that at the time, US securities were being
processed for $0.01 where in Europe it was twenty times that
"By bringing EuroCCP over to Europe, we were able to create
a whole new pricing framework on a totally different scale to
what had existed before," he says.
Despite launching on the day that Lehman Brothers collapsed,
the early signs were positive and Turquoise soon hit its target
market share in the first year of 5% and the exchange rapidly
became the largest mid point dark book "a position that we
expect to grow further".
However, it struggled to get above the 5% level in lit
trading and lost significant ground to fellow MTF Chi-X. In
March 2009, liquidity provision agreements with its founding
banks ran out and Turquoise’s market share
Still loss making, the MTF was sold to the LSE in 2009. For
the LSE, the deal marked more than the acquisition of a rival.
It was the beginning of its push into derivatives. Since it
missed out on the acquisition of Liffe in 2002, a rare mistake
by the former chief executive Clara Furse, LSE had been written
off in terms of its potential in derivatives.
When Xavier Rolet assumed the helm in 2009 he soon made a
move into derivatives a priority at the exchange. The LSE had
been operating EDX, a small derivatives platform specialising
in Scandinavian and, later, Russian equity products, since
The exchange had mustered a niche in its Scandinavian equity
derivatives but this was dependent upon a deal with OMX. When
Nasdaq acquired OMX in 2008, the deal was soon terminated and
EDX was left floundering. Attempts to launch similar products
to what it had been trading with OMX failed and, despite
successes in the Russian equities market, there was no clear
path for growth for the exchange.
"The reality was that EDX was a small derivatives business
with the scope to grow and had the people, process and
technology," says Farnham.
"I had a conversation with Xavier [Rolet] and we discussed
how Turquoise has always wanted to move into derivatives and
EDX was a good asset. Between Turquoise and the LSE we had a
large part of trading in the underlying in the LSE data
"In addition, the LSE has the ability to work closely with
FTSE and and other index providers to help us develop a new
index product and a clearing relationship with CC&G and
LCH.Clearnet that will allow us to offer an innovative and open
clearing model. We had the network of HFTs on Turquoise and the
partnership with the banks. Putting the two together would
enable us to take on Liffe and Eurex."
"A big task"
Taking on the two most liquid derivative exchanges in Europe
will not be an easy job especially by going head to head,
fighting for liquidity on one product. Many have failed where
Turquoise chooses to tread. For example, Eurex ultimately
failed in its attempt to take on the Chicago Board of Trade in
US Treasury bond futures in 2003, in one of many examples of
Indeed, ask anyone in the industry to name a time where a
contract has successfully been won from one exchange and you
will get the same answer: futures on German bunds which Eurex
took from Liffe in 1997 in a matter of months due to the advent
of electronic trading.
Farnham is under no illusions as to the scale of the
challenge. "Introducing competition in exchange traded
derivatives will be a big task. The LSE and Turquoise see this
as something we will need to be committed to for a number of
years. The opportunity is substantial and so the commitment
needs to back that up. We are not expecting overnight success,"
Unlike in electronic trading in 1997 when Eurex wrenched the
bunds from Liffe, there is no silver bullet for Turquoise as it
launches its assault on the market status quo. Regulation
opened up competition in equity trading but derivatives is a
different game. Turquoise has a range of weapons in its arsenal
but they constitute more silver shrapnel than silver
No silver bullet
It will launch its FTSE 100 futures with a maker/taker
market model, the first such instance of this in the European
derivatives market. Under the model, the exchange will pay
liquidity providers for their dealings on the market. A rebate
of 5p a contract for passive flow and 20p a contract for
This compares with a standard 25p charge on alternative
platforms. Turquoise will also be the first to cap charges for
OTC block trades in index futures. It says its per-contract
clearing costs will be a third lower than
Another area in which it claims it has the upper edge is in
technology. The exchange will be using its SOLA technology,
which according to Farnham is "extremely low latency".
The technology offers average response time of 690
microseconds (orders) and 870 microseconds (bulk quotes), the
company says. In addition, SOLA technology is right next door
to Turquoise trading technology and the LSE cash trading
technology. Anyone who is connected to the LSE or Turquoise
will get a free cross connect to Turquoise Derivatives.
Having the underlying right next to the derivatives will be
the "best possible place" to make prices in UK and pan-European
derivatives, says Farnham. Combined with maker/tariff the
proposition is "compelling offering for liquidity providers",
Clearing will be provided through CC&G clearing
services, with LCH.Clearnet as CCP, a move that, at least for
the time being, has ended speculation that Turquoise will with
the LSE, build its own clearing house.
Remoulding the landscape
All this might offer an edge over Liffe but will it be
enough to wrest control of the FTSE 100 futures contract?
Farnham believes that the game is changing and it is the
pro-competition participants in the market that will win
"LSE is the most interoperable market in Europe. What we are
doing is developing that model. Bats Chi-X Europe might be
entering the market and others might be coming in as well. What
we have agreed is that the Turquoise open interest will be
available for margin offset against any other venue that
chooses to work in the same open and competitive way that we
do," he says.
"If Bats Chi-X Europe creates a derivatives platform and
chooses to use LCH.Clearnet, we will create an ecosystem where
if customers have off-setting positions with Turquoise on one
side and another pro-competition trading venue on the other,
there will be margin offset within that ecosystem. We think
that is a much better model for customers compared to the
narrow, walled-in vertical silo model that exists today.
"We understand that derivatives are different [to equities]
and the challenge is even more difficult but we believe that
the environment is now supportive of change and that our
offering is compelling. Our gamble is that the benefits are
compelling enough to switch liquidity. We appreciate the scale
of the task and we are in it for the long run."
A gamble it is but there is a sense in the market that the
tide is turning in favour of competition within the derivatives
industry. Last month, Michael Spencer, chief executive of
inter-dealer broker Icap, called for increased competition in
the exchange traded derivatives sector. An article in the
Financial News quoted Spencer as describing the regulatory
failure to address alleged monopolistic behaviour among
derivatives exchanges as "incredible".
"Customers don’t want monopolies, but the
existing models of derivatives exchanges are monopolistic.
It’s incredible that this issue
hasn’t attracted the attention of the antitrust
authorities before," Spencer said.
Spencer’s comments came as the EU begins its
investigation into a possible merger between Deutsche
Börse and NYSE Euronext. Last month, speaking at the Cass
Business School, Joaquin Almunia, the EU Antitrust Commissioner
advocated a message of the creation of competition within
stability. Stability was important, he said, but there must be
competition as well. The two are not mutually exclusive.
Farnham says: "The current regulatory push is about safety.
However, we believe that once regulators understand the
implications of this push, they will want to balance that with
some pro-competition elements within the regulations.
"Safety and security must be the priority but we think that
the politicians and the regulators will want to ensure that
while they create a safer market they don’t create
a market that is closed to competition."
According to Farnham the long-term vision of Turquoise is to
create a market similar to the US equity options market where
there are a number of competing venues and an infrastructure
that enables a choice of clearing venue and margin offset.
"That is the healthiest model and the model we are trying to
create in Europe. We believe that Europe will get there
eventually," he says.
Back to reality
For the time being however, Turquoise must compete in the
current world. Early moves to change the game have proved
unsuccessful. Turquoise asked for a licence to trade Stoxx
futures, a request that was rebuffed. Also, in the run up to
the launch of the FTSE 100 futures, Turquoise approached Liffe
to explore ways of creating fungibility and/or margin offset
between the two markets on correlated contracts.
Liffe, understandably perhaps, refused. However, that
refusal has encouraged rather than deterred Farnham. "Our
proposition would have given more customer benefit and the
customer should be looking at why it is that these markets are
not providing their customers with this kind of benefit. We
asked for it. We didn’t get it so we are competing
head-to-head," he says acknowledging that "in the short term"
he is playing a binary, zero sum game.
Despite the challenges, Farnham is bullish about the
prospects for Turquoise Derivatives. "Two or three years ago,
there were people who said that there would never be change in
the equities market but now the new entrants have 30-40% market
share. We are the leading dark pools trading venue. That has
already happened, it is not going to go back.
"We think that the trading opportunities from the
co-location of cash and derivatives within the LSE data centre
plus the new maker/taker tariff that pays for the provision of
liquidity will lead to attractive bids and offers on the
screen. Our job is to convince customers to look at the prices
on the screen and slowly build open interest until we get to
the tipping point."
Whether that tipping point can be reached and what it will
be remains to be seen and many in the market were sceptical
about the chances of success for the new entrant.
However, the success of MTFs in gaining market share in
equities cannot be ignored. While derivatives is a different
beast, moves by EU regulators to open up derivatives markets to
competition may provide a significant boost for Turquoise.
In addition, the success of Turquoise Derivatives is not
dependant on the success of the FTSE 100 futures contract. The
group still trades the burgeoning Russian derivative contracts
on the RIOB index, "an unpolished gem", according to
In addition, the platform has plans to launch options and
futures on singles stocks in both the UK and Europe as well as
creating a bluechip pan- European index. Farnham says it will
also look at various other asset classes including fixed
income, government bonds and ETFs.
When, as is widely expected, Bats Chi-X enters the
derivatives market following their merger, a move anticipated
for next year, the pro-competition school may gain some
traction. For Turquoise that will be a long wait and a test of
Launching with a direct challenge to Liffe, rather than with
a unique product is a bold move and one that Farnham may live
regret. However, the provision of a cheaper alternative to the
incumbents will be welcomed by the market and if Farnham can
pull it off, whether with the FTSE futures or with subsequent
launches, he might perhaps succeed in his mission to change the
European derivatives landscape for good.