When the Boston Options Exchange and London Stock Exchange’s EDX wanted a new matching engine, they turned to Sola, a system built by TMX Group. The result: TMX owns stakes in both exchanges. But as Tom Kloet, the Canadian exchange group’s CEO, tells Colin Packham, that is not the only winner in his hand. Canada’s options market has hardly begun and, with the regulators sympathetic, there is everything to play for. And Kloet even has a word of advice for the regulators on central clearing.

When the Boston Options Exchange and London Stock Exchange’s EDX wanted a new matching engine, they turned to Sola, a system built by TMX Group. The result: TMX owns stakes in both exchanges. But as Tom Kloet, the Canadian exchange group’s CEO, tells Colin Packham, that is not the only winner in his hand. Canada’s options market has hardly begun and, with the regulators sympathetic, there is everything to play for. And Kloet even has a word of advice for the regulators on central clearing.

FOW: How would you evaluate the size and maturity of the Canadian derivatives market?

Tom Kloet: Well, let’s take equity as a proxy. The value traded of our equity derivatives is about 40% of the value traded in the underlying cash markets. A number of major financial centres around the world typically have a value traded of equity derivatives of about 240% of the underlying markets. So we have a real opportunity to further develop this segment of the market.

How will you go about that?

We are focusing first on creating additional products. We have the main equity derivatives products like our equity futures composite index, and we have the recently announced e-mini and volatility index products coming on line. However, we are also working to develop the equity options market.

Why are you excited about options?

We operate the only regulated listed equity options market in Canada, and I would compare the market in Canada in terms of its depth and distribution with the period a couple years after the Chicago Board Options Exchange launched. There is room for significant growth.

How will you nurture the market?

There is some initial fieldwork to do to build the awareness of options and educate people to understand how having a good portfolio of options can augment a portfolio of cash equities.

So it starts with education, second would be an enhanced distribution model. We are strongly encouraging the continued growth of member firms that want to distribute options in the retail space. We do have some potential players coming, but we would like to see a continued expansion of the retail market.

Can you explain why there is limited distribution of your equity options, particularly to the retail sector?

There is a licensing issue in Canada in that we don’t have the functional equivalent of the US equivalent Series 7 exam, the system in the US market where financial intermediaries can offer options for sale. Such a structure does not exist, instead there is a separate battery of exams to start selling options in Canada, so that’s a barrier of entry.

What can you do to amend that situation?

We will call on the regulators to revisit the structure of the exams. Because we believe a stockbroker, in this day and age, should be in the position to sell the appropriate risk management instruments to mitigate the risk of the equity markets, especially as we have just experienced the type of volatility that can hit the equity markets. You want to be able to sell the right tools for protection of the downside, where a powerful tool like options can help. So we will be putting forth some ideas, because I would really like to see that.

Do you have such an open dialogue with the Canadian regulators?

I sit on the board of the industry SRO [self-regulatory organisation], IIROC, but I’m just one voice. But we have quite a good relationship with the regulators. They might not do everything we want. But I think the regulators do want to advance the capital markets, and we are working with them to give them an understanding about a deeper derivatives market.

There are ever more exchanges offering clearing for over-the-counter derivatives, including the much-maligned credit default swap market. Is this an area TMX Group is considering?

It is. TMX Group owns the only derivatives clearing house in the country, and a couple of years ago, we put forward new rules that allowed it to clear trades executed away from the exchange. This was the first step in this process.

We also have the product called Converge, where we are already clearing equity options traded off-market. We are therefore somewhat in the OTC clearing business.

The second step was to make the potential product scope deeper. For that reason, we rewrote the clearing software we use. We just implemented a new clearing system which we developed ourselves, called Sola Clearing. I don’t think many exchanges have rewritten their clearing systems, but we did and in a cost-effective way. We believe our clearing members are very happy with it.

What will the new system enable you to do?

There are a large number of improvements, but the main development is that this system will enable us to clear fixed income products, which aren’t necessarily the standardised fixed income contracts we offer already on the listed market.

Having implemented that, we are looking at the strategy to get into the OTC market. Our initial view is that the Canadian CDS market is fairly small, there really are just a limited number of names traded by a fairly limited number of counterparties. So we don’t initially see the key commercial opportunity for CDS clearing.

But we see an opportunity in fixed income repos and ultimately fixed income swaps. We would expect to build the functionality to clear these products, probably in that order, but we don’t have a timetable yet. We are talking to the market and the regulators.

What has been the initial reaction of the regulators?

I think they would like to see a clearing solution. There are some disciplines of derivatives clearing, such as margin deposits and daily settlement, that I think it’s fair to say the regulators are embracing.

Do you believe central counterparty clearing is here to stay for OTC derivatives?

The capital standards for banks have to encourage the clearing of OTC instruments through multilateral clearing houses, otherwise a bunch of these efforts around OTC clearing will not be successful.

There were some principles established under Basle II that went in the right direction, but they didn’t get all the way there.

Very simply put, what I think the public position should be, is that if you are a bank, your capital requirement is either reduced by placing an OTC trade in a multilateral clearing facility, or conversely the capital requirement is taxed or increased if you leave the OTC trade bilaterally cleared.

In other words, the end game will be based on how the bank’s regulatory capital is impacted by the creation of these OTC clearing mechanisms.

Absent putting in an incentive, merely offering these trades on a multilateral clearing facility will not work.

Do you think financial intermediaries want to reduce counterparty risk by clearing through a clearing house without financial incentives?

Yes to some extent. But the truth is that if I’m a triple-A counterparty and trading against an unrated fund, to a certain extent I enjoy a pricing advantage that would be removed by CCP clearing.

Are regulators around the world willing to introduce financial incentives to encourage CCP clearing?

Despite a lot of rhetoric, I have not seen a concrete proposal that says, “here is the reward or the penalty mechanism”. Absent a difference in the capital structure between a trade going into a multilateral clearing facility and one that doesn’t, I don’t think the current effort will succeed.

So, if you drive behaviour, you change the return on equity of a transaction significantly.

What do you make of some suggestions that all OTC trades should be mandatorily cleared by a clearing house?

Well it’s interesting that Tim Geithner [US Treasury secretary] suggested that all OTC trades should be cleared. I personally believe that not all OTC trades should go through a clearing house because some activity doesn’t belong there. But if a trade doesn’t belong in the clearing house, the capital requirements of such a trade should reflect that.

How will TMX Group develop its exchange technology?

The end vision is to build technology that links the cash and derivatives markets. So if I’m an investor that buys 100,000 shares of a stock, and I also want to buy 1,000 put options to protect that, I can do so through a single gateway, even if the two matching engines are separate.

If we can achieve that technological ambition, then we really have a meaningful technological synergy for our clients. That will be a couple of years coming, but I think that will be where we end up.

Can you explain how your deal with the London Stock Exchange’s derivatives exchange EDX came about?

EDX was looking at new matching engine software and they asked TMX Group for a customised copy of our Sola matching engine for EDX as well Borsa Italiana, and now Oslo too. We intend to deliver by the end of 2009. They will then take the software and the source codes and operate it.

I must say, that I don’t view TMX as a technology vendor, but if we have an opportunity to use technology as an asset, we would invest in the party we are dealing with.

So we talked to our friends at the LSE and decided that we would take some of the cash proceeds and reinvest that for ownership rights. We are now a 19.9% owner of EDX, and we will help participate in the development of the exchange, not just through technology.

We will give some ideas too, in terms of products and how we give value to our customers of both sides of the Atlantic.

I think EDX has the potential to build a suite of derivatives products that are extremely interesting across Europe.

How will your relationship with EDX differ from that that you have with the Boston Options Exchange?

We are the majority shareholder in BOX with a 54% stake, which makes it different. In the case of BOX, we operate the technology for the exchange, so while the data centre is located in the US for regulatory reasons, we remotely operate it. We earn fees for supplying that technology, so it’s a little different model.

But, in both cases, TMX Group would not be a partner if not for being a technology provider. In other words, we will use our technology to create interesting relationships and partnerships with exchanges.

Will you leverage your experiences with BOX and EDX to seek similar technology deals?

The short answer is yes. Part of the reason we believe Sola, (TMX Group’s derivative technology product) is so good is that it has been tested vigorously in the US equity options markets, which as you know is fiercely competitive. We will seek other opportunities which allow us to partner with exchanges in the future.