The Development of Organized Derivatives Exchanges in

Laurent Hublet
The Development of Organized
Derivatives Exchanges in
Emerging Countries
The Case of MexDer in Mexico
Mémoire présenté en vue de l’obtention du grade d’Ingénieur de
Gestion – Solvay Business School (ULB)
Université Libre de Bruxelles
Directeur : Prof A Farber
Assesseurs : Prof. A Chapelle
Prof. J Lévy
Note finale : 18/20
It is my greatest honour to thank all the persons without whom I could not have conducted
this research. Although it is unfortunately impossible to cite them all, I would like to thank in
particular Mrs Jacqueline Hernandez, Mr Jorge Alegría and Mr Rodolfo Liaño at MexDer, Mr
John Ross at the Boston Consulting Group, Mr Chris Allen at the Bank of America, Mr Jos
Schmitt at Capital Market Company, Mr Jose Jorge Ramirez at ING Americas and Prof. Claudia
Nelly Berrones at Instituto Tecnologico y de Estudios Superiores de Monterrey.
I am also highly grateful to Prof. Jacques Lévy for his very helpful advice and comments,
to Prof. André Farber for his indefectible support and to Mrs Nava Sokolovsky (Oxford
University).
To my parents for their help in good and hard times
To my friends in Belgium and in Mexico,
2
Executive Summary .................................................................................................................... 5
Abbreviations .............................................................................................................................. 9
Introduction............................................................................................................................... 10
1. The market ........................................................................................................................ 10
1.1 A clarification.................................................................................................................. 10
1.2 Transaction on a market................................................................................................... 11
1.3 Market and Exchange are not synonymous ...................................................................... 12
2. Trading mechanism and exchange ......................................................................................... 12
2.1 Market participants .......................................................................................................... 13
2.2 The place ......................................................................................................................... 14
2.3 The rules.......................................................................................................................... 16
Section 1 - Financial markets in Mexico .................................................................................... 18
Chapter 1 - A Brief History of Mexico’s Financial Markets....................................................... 18
1975 - 1994: Towards globalization....................................................................................... 18
1994 – 1996: The Tequila Crisis and its aftermath ................................................................. 19
1997 – Present : An improvement of the financial stability .................................................... 22
Chapter 2: Debt and money markets ......................................................................................... 25
2.1
Improving the supply of debt ..................................................................................... 25
2.2
Strengthening the demand ......................................................................................... 29
Chapter 3 : Stock markets.......................................................................................................... 33
Chapter 4 : Derivatives markets................................................................................................. 37
Seventies and eighties: the enfancy........................................................................................ 37
1990 - 1995 : unsustainable growth ....................................................................................... 37
1995 - present: the rise of exchange-traded IR derivatives ..................................................... 38
MexDer in Mexico’s financial context ................................................................................... 39
Section 2: MexDer in the international context .......................................................................... 44
Chapter 5 : Over-the-counter versus exchange-traded ................................................................ 44
5.1
The global situation.................................................................................................... 44
5.2
OTC vs EXT in Mexico ............................................................................................. 45
Chapter 6: Trades on Organized Exchanges............................................................................... 49
6.1
Global trends ............................................................................................................. 49
6.2
Trades by Exchanges ................................................................................................. 51
6.3
Exchanges classified by type of product ..................................................................... 52
6.4
Trades on MexDer ..................................................................................................... 56
Chapter 7 : Recent trends in Derivatives exchanges ................................................................... 59
7.1
Electronic trading....................................................................................................... 59
7.2
Globalization and consolidation ................................................................................. 61
7.3
Demutualization......................................................................................................... 64
7.4
Conclusions from the international evolution ............................................................. 66
Chapter 8 : The adaptation of MexDer....................................................................................... 68
8.1
Progressive reforms on the sell side............................................................................ 68
8.2
Expanding market participants on the buy-side .......................................................... 73
Section 3 : Financial analysis..................................................................................................... 77
Growth at glance: Accounting versus activity ........................................................................ 78
Chapter 9: Financing ................................................................................................................. 80
3
9.1
The patrimony of the Clearinghouse........................................................................... 80
9.2
The patrimony of MexDer.......................................................................................... 82
9.3
Cash flows from Asigna............................................................................................. 82
9.4
Cash-flows from MexDer........................................................................................... 83
9.6
Conclusions on financing ........................................................................................... 86
Chapter 10 : Profitability ........................................................................................................... 88
10.1 Commercial Profitability............................................................................................ 88
10.2 Industrial profitability ................................................................................................ 94
10.3 Financial Leverage..................................................................................................... 96
10.4 Equity profitability..................................................................................................... 97
Chapter 11: Financial strength ................................................................................................... 98
11.1 Liquidity .................................................................................................................... 98
11.2 Solvency .................................................................................................................. 101
Chapter 12 - Valuation ............................................................................................................ 104
12.1 Expected Return....................................................................................................... 104
12.2 Estimated value........................................................................................................ 105
12.3 Sensitivity analysis................................................................................................... 107
Conclusion .............................................................................................................................. 108
1. Strengths ......................................................................................................................... 108
2. Weaknesses ..................................................................................................................... 108
3. Opportunities................................................................................................................... 109
4. Threats ............................................................................................................................ 110
Bibliography ........................................................................................................................... 112
Reference books .................................................................................................................. 112
Scientific Literature............................................................................................................. 112
Dissertations........................................................................................................................ 115
Press.................................................................................................................................... 115
Reports & presentations....................................................................................................... 116
Annual Reports.................................................................................................................... 118
Audited Financial Statements .............................................................................................. 118
Analysts Reports ................................................................................................................. 118
Interviews............................................................................................................................ 119
Appendix 1 – Micro-structural theories ................................................................................... 120
1. A review of the microstructure literature.............................................................................. 120
1.1 Definition ...................................................................................................................... 120
1.2 The Pioneers .................................................................................................................. 120
1.3 Inventory-based models ................................................................................................. 122
1.4 Information-based models............................................................................................. 122
1.5 Conclusions from the literature ...................................................................................... 125
2. Studies on microstructure of Emerging Derivatives Exchanges........................................ 125
Appendix 2 – Product mix MexDer ......................................................................................... 127
Appendix 3 – Engrapados........................................................................................................ 129
Appendix 4 - Margin calculation by Asigna............................................................................. 131
Appendix 5 - Examples of Extreme Events............................................................................. 132
Appendix 6 – Beta Calculation ................................................................................................ 134
4
Executive Summary
Using the example of Mexico, this dissertation aims at understanding how an organized derivatives
exchange can be developed in an emerging economy to answering the question: why has the Mexican
Derivatives Exchange (MexDer) become one of the world’s most active trading places for financial futures and
options only eight years after its start? A multidisciplinary approach combining macro-economics, microstructural, strategic and financial aspects has been chosen in order to encompass the richness of the concept of
“derivatives exchange”. Following preliminary insights from the theoretical literature on this topic, we describe
in section 1 the macro-economic context in which the Mexican derivatives exchange was developed. Section 2
focuses on the evolution of the derivatives exchanges industry and on the strategic environment which affected
MexDer’s history. Section 3 provides a financial analysis of the Mexican exchange with regard to a sample of
eleven other derivatives and universal exchanges in order to assess its past achievements and its future
viability. We conclude by explaining the elements which are likely to foster, or contrarily to prevent, the future
growth of the exchange.
Following a thorough liberalization of its financial sector, Mexico suffered a major financial crisis at
the end of 1994, referred to as the “Tequila Crisis”. Foreign investments in capital markets rapidly abandoned
the country and financial authorities became aware of the necessity to develop internal debt and stock markets.
Financial markets recovered thanks to a cautious monetary policy after the crisis (stabilization of inflation) and
to improvements in the banking sector, which became increasingly concentrated in foreign hands, but at the
same time, lost some of its importance as a capital intermediary.
As far as money and debt markets were concerned, reforms were aimed at improving supply through a
more efficient primary market and a more liquid secondary market. They also targeted the demand-side,
particularly through the liberalization of the pension system. As a consequence, pension funds (Afores) have
become important participants in capital markets. We strongly believe that MexDer could only have developed
thanks to improvements in the cash debt market, although, conversely the launch of the derivatives exchange
was part of the reform and contributed to enhancing the liquidity in this cash market.
By contrast, stock markets did not undergo as positive an evolution as did the debt markets and to this
day, Mexico lags behind many emerging economies as far as stock market significance is concerned. On the
demand-side, this underdevelopment can be explained by an unfavourable legal framework that prevented
pension funds from investing in equities as well as by the concentration of wealth in the country. On the supply
side, it can be explained by the competition from US exchanges, in which many Mexican companies decided to
be listed after the “Tequila Crisis”, as well as by corporate governance shortages and microstructural features of
the stock exchange.
The derivatives exchange was developed in this environment of financial reforms, with the aim of
reinforcing capital markets, and particularly the debt market. It received the support of the authorities although
5
it was developed by financial firms. Its most original feature was the architecture of its clearinghouse Asigna,
which was legally independent from the exchange and funded by four major Mexican banks. Nonetheless,
MexDer did not mark the start of financial derivatives in Mexico, which were already traded in the over-thecounter market and in US exchanges.
As MexDer developed in a market that was not in its early stages as far as derivatives were concerned,
it was immediately confronted by the global environment. Worldwide, derivatives have grown faster than OTC
over the last decade, but OTC remains dominant in term of notional amounts traded. Activity in IR derivatives
has been especially buoyant in Mexico. Although official figures suggest that activity in the organized market
outpaced that of the over-the-counter, we conclude from a brief qualitative assessment that this is not the case
and that OTC still dominates in all categories of derivatives instruments.
Exchanges should now be classified according to their pools of liquidity, i.e. the star-product(s) in
which they are specialized. Using the BIS terminology, we have classified financial derivatives exchanges as
follows: short-term IR derivatives markets, long-term IR derivatives markets, stock-index derivatives market
and, individual-stock derivatives markets (this latter category being much less concentrated). Along with
BM&F in Brazil, MexDer is the only exchange located in an emerging economy which clearly belongs to the
first category. Activity is highly focused on interbank-rate futures, although the concentration of operations
indicates that this is more due to the size of trades than to the number of participants.
Based on the literature and following the analysis of interviews, we determined three major strategic
changes that have affected the derivatives exchange industry over the last decade:
1. The shift towards electronic trading, which was initiated by European exchanges (such as OM or
Belfox) and where US exchanges are still lagging behind.
2. A wave of consolidation, which also started in Europe, transformed the exchanges from national to
international players and increased the concentration of the industry.
3. A radical transformation of corporate governance structures, with exchanges turning progressively
from non-profit mutual companies to listed firms. Exchanges in emerging countries are less advanced
in this demutualization process, especially in Latin America.
As a consequence, exchanges are now forced to compete in the field of their strategic business model and we
suggest a mapping based on two dimensions:
-
The proportion of revenues extracted from derivatives instruments to distinguish between pure
derivatives versus universal exchanges.
-
The proportion of revenues extracted from transactions to distinguish between vertically integrated
exchanges versus focused exchanges.
Nevertheless, it is hard to place MexDer in this framework. The progressive adaptation of the Mexican
exchange to these changes in the industry should instead be divided into four stages:
6
1. At the start, it was a mutual structure with an open outcry platform and few members. This business model
was at odds with international standards and liquidity was almost inexistent. As a consequence, the
exchange was at the verge of bankruptcy in March 2001.
2. Major reforms were implemented in a very short time, including: a) a switch to electronic trading, b) a
take-over by the stock exchange (BMV) c) a demutualization of the exchange, and d) the introduction of
market makers. We determine that the two last aspects had the greatest impact on liquidity.
3. 2002 to 2004 was the euphoria period. Activity in the exchange was buoyant and consolidated by :
a. Product innovation through the development of “engrapados” (series of futures contracts with
consecutive maturities) to compete with the swaps proposed in the OTC. The success of this technique
is confirmed by the decrease in market velocity in MexDer and the fact that this indicator is now at the
lowest level worldwide for the Mexican exchange.
b. The expansion of market participants to the new important players in the debt market: pension funds
and international customers.
c. The launching of an option trading platform provided by the Spanish exchanges BME which then
became a minority shareholder, representing a unique case among emerging derivatives exchanges.
4. 2005 was characterized by a drop in market activity of more than 50% due to a change in taxation, which
highlighted the overly dependence on a single product and thus MexDer’s fragility.
Nevertheless, MexDer has achieved similar or even better levels of strategic competitiveness compared to the
most successful derivatives exchanges located in emerging economies, with two areas that require further
growth: the underdevelopment of equity derivatives and the increase in foreign participation through
independent software vendors (such as GL Trade).
In the last section, we assess how this adaptation to local and international conditions was translated into
financial results. Seeing as the incorporation of clearing activities has a major impact on the financial structure
but also provides a better insight into the actual situation in Mexico, we consider MexDer and its clearinghouse
Asigna as a single entity. Nonetheless, we distinguish between the funding of the clearinghouse and the
exchange because they differ considerably and fulfil different needs. It appears that the clearinghouse is “cashflow” neutral, so there is no need for the transaction entity (MexDer) to fund the increase in working capital
generated by the growth of the activity. This is a major financial advantage with regard to the original design of
the exchange structure. In addition, the funding of the clearinghouse does not depend on the financial
performance of the exchange, which fosters its solvency. As far as the funding of the transaction entity is
concerned, funds are proportionally less used investments compared to our international benchmark. Three
main investments are clearly evident since the launch of the market, compared to one major investment in
general for international competitors over the same period. Nonetheless, CFinv/revenue rate is lower than the
average of our sample due to the incorporation into the BMV group. As a consequence, MexDer relies more
7
heavily on yearly profit than international peers for its funding, which makes it more vulnerable to swings of
the activity.
In terms of profitability, the operating margin grew very rapidly after the restructuring and reached
comparable levels to the best players among our sample. However, operating profitability has been under
pressure since 2004, due to cost-driven factors (as a result from the launching of the options platform) as well
as revenue-driven factors (induced by the contraction of the activity). MexDer/Asigna has actually less
diversified sources of revenues than does our international benchmark and is more dependent on revenues
directly related to transactions. The interbank-rate future is the instrument that generates the lowest relative
revenue whereas equity derivatives are the most profitable products: a price-cutting strategy was clearly
pursued to compete with OTC. The cost structure is not significantly different from international peers, but
more than 80% of expenses are made to other entities of the BMV group so virtually everything is outsourced.
Regarding net profit margins, we distinguish between exchanges with high, medium and low profitability.
It appears that the high commercial profitability of MexDer/Asigna is not an exception amidst exchanges in
emerging economies. Furthermore, commercial profitability of derivatives exchanges is more driven by the
adaptation to electronic trading and by the type of instruments traded than by the choice of “universal vs. pure
derivatives” exchange. By contrast, this strategic positioning impacts on asset management and financial
leverage. Assets are better exploited by pure derivatives exchanges, whereas leverage is higher for universal
exchanges. This translates into better return to shareholders for pure derivatives exchanges, except for two
exchanges (CBOE and PHLX) that failed to adapt their technology and corporate structure. MexDer/Asigna
belongs to the category of successful “pure derivatives” exchanges.
We also assess the liquidity and solvency of the Mexican exchange, and contrast the situation. The
current ratio is in line with competitors who have a clearinghouse but cash is still insufficient with respect to
activity. No debt hinders the solvency but equity per contract still is at a low level. However, we believe this is
not problematic given the architecture of the clearinghouse.
Finally, we calculate what the expected return of shareholders should have been based on market data
for the Chicago Mercantile Exchange. This also allows us to value MexDer as a company of approximately 18
mil. USD, which is consistent with the price paid by BME though it entails lower valuation ratio compared to
US pure derivatives exchanges (this is in line with the higher risk of an investment in MexDer).
To conclude, we assert that the example of MexDer shows that the development of a derivatives
exchange in an emerging country, though not an easy task, can be done quite successfully. Nonetheless, the
high dependence on a single product indicates that much remains to be done, from a macro-economic, microstructural and financial perspective; MexDer is still a niche player by international standards. The financial and
strategic investment of the Spanish Exchanges BME in the company is likely to help it in strengthening its
competitive position, which is currently threatened by US exchanges, OTC and internalization of transactions
inside financial groups.
8
Abbreviations
BME
Bolsas y Mercados Españoles/Spanish Markets
BM&F
Bolsa de Mercadorias & Futuros/Brazilian Derivatives Exchange
BMV
Bolsa Mexicana de Valores/Mexican Stock Exchange
CETE
Certificado de la Tesoreria/Mexican 3m Treasury Bill
CBOE
Chicago Board of Option Exchange
CBOT
Chicago Board of Trade
CME
Chicago Mercantile Exchange
CNBV
Comision Nacional Bancaria y de Valores/Mexican Financial Supervisory Authority
DEUA
Peso/Dollar Future Contract
FIA
Futures Industry Association
IPC
Indice de Precios y Cotizaciones/Index of the Mexican Stock Exchange
ISE
International Securities Exchange
ISV
Independent Software Vendor
MEFF
Mercado Español de Futuros y opciones Financieros/Spanish Derivatives Exchange
MexDer
Mexican Derivatives Exchange
M3
3 year government bond futures
M10
10 year government bond futures
OICV/IOSCO International Organization of Securities Commissions
PHLX
Philadelphia Stock Exchange
SHCP
Secretaria de Hacienda y Credito Publico/Mexican Ministry of Finance
Taifex
Taiwain Futures Exchange
TIIE28
Tasa de Interes Interbancario de Equilibrio/Mexican Interbank Interest rate
9
Introduction
The concept of a market refers to one of the oldest forms of social and economic organizations. Its
basic function has not changed much over the years and could be summarized as follows: bring buyers and
sellers together and enable them to price a transaction. However, it is difficult to argue that current
financial markets, and especially derivatives markets, are similar to those in Ancient Greece. Actually,
derivatives markets differ in two main respects. First, the product that is traded is no longer a tangible
asset. Second, with the development of electronic platforms, a physical location for the market is no
longer necessary! We shall refer to this as a double intangibility, as far as asset and place are concerned,
which makes them radically different from the traditional view of a market.
1. The market
1.1 A clarification
The concept of a “market” deserves some more attention before we start analyzing exchanges.
Can we talk about “the” market, as it is often referred to by the press? According to a paradigm introduced
by Stoll (2003), investors are actually involved in three different markets, which together form the notion
of a “market”:
•
A market for securities
•
A market for information
•
A market for transaction services
As explained in the scheme hereunder, each of these markets and the links between them have
been investigated by different areas of finance. The market for securities relates to the determinants of the
“fair” asset price and has been illustrated by models such as the CAPM for stocks or the Black-ScholesMerton model regarding derivatives1. Efficient market theories link together asset pricing and information
theories, which concentrate mainly on asymmetric information problems. Market microstructure theories
are at the heart of the market for transaction services. The most recent theories in market microstructure
are now closely related to information theories, and especially to information asymmetry. Hence, as
claimed before and as highlighted by Madhavan (2002) in the case of microstructure, these categories are
permeable and enrich one another.
1
Interestingly, most of those models assume perfect markets, with free and costless entry, and no frictions. These
assumptions show that they do not investigate the two other dimension of “the” market
10
Given that we shall analyse derivatives market from a microstructural and corporate perspective,
the term ‘market’ will be used as a synonym for ‘transaction market’. Questions of asset pricing will not
be addressed, so the term ‘market’ will not be used to signify a ‘market for security’.
Behavioural finance has not been included in the framework because it relies mainly on the
investor’s personal – psychological characteristics, rather on pure market issues. Microstructure would
belong to a different paradigm, termed by Merton and Bodie (2004) as neo-institutional finance.
According to these authors, neo-institutional and behavioural finance should be two alternative and
competing paradigms that share a common objective: to challenge the “old” neo-classical paradigm2.
A framework of the concept of
« market »
« The » Market
Area of Research
Theories
CAPM, DDM
Market for securities
Asset pricing
Market efficiency
Black & Scholes
Strong, semi-strong
or weak efficiency
Market for information
Information theories
Asymmetric info.
Disclosure
Information-based
Market for transaction services
Microstructure
Inventory-based
Bid-ask spread det.
1.2 Transaction on a market
The concept of a “transaction” in a financial market is similarly not irreducible: it is a sequential
process that can be decomposed into four steps3. These functions correspond more or less to the four
services provided by an exchange to its customer.
•
First, before initiating the transaction, the investor must have some information at his/her disposal
(this information is derived from the market for information). Therefore, the exchange provides
price-information services.
2
These authors introduced a new paradigm, Functional and Structural Finance, which synthesizes neo-institutional
and behavioural finance. It deals with functions rather than institutions.
3
This sequence is also suggested by Stoll (2003)
11
•
Second, there must be some order routing mechanism in order to transfer the order (see next
paragraph) into the exchange.
•
Third, only at this stage in the process can the execution of the transaction take place: both
counterparties agree to the deal.
This last stage relates to the trading service of the exchange.
•
Fourth, the transaction ends with a clearing and a settlement: the asset is formally transferred from
the seller to the buyer (very often through a compensation or netting scheme). From a customer’s
perspective, this is the settlement service.
1.3 Market and Exchange are not synonymous
An exchange is very often defined as an “organized market”, i.e. a trading system that must4:
•
Provide trade execution facilities;
•
Provide price information in the form of buy and sell quotations on a regular or continuous basis;
•
Engage in price discovery through its trading procedures, rules, or mechanism;
•
Centralize trading for the purpose of trade execution;
•
Have members;
•
Exhibit the likelihood, through system rules and/or design, of creating liquidity.
Unfortunately, this categorization might be too simple to address the complexity of the current
exchange industry: new organized markets have appeared that are not exchanges5 and existing exchanges
should be considered as more than just markets. Di Noia (1999) suggests three other perspectives on the
nature of an exchange: apart from an exchange being regarded as a market, it could also be viewed as a
firm (see the chapter on demutualization) or as a broker-dealer (an intermediary of traders).
2. Trading mechanism and exchange
In order to compare an exchange to other trading structures and distinguish between various forms
of exchanges, we shall analyse this notion with regard to the main features of a trading mechanism which
allow for price-discovery. These features can be summarized in three categories6:
-
the participants involved in the trade
-
the place where the trade occurs
-
the rules that apply to the trade
4
This definition is based on Harris (2002) and on interviews
They are referred to as Electronic Communication Networks or “quasi-exchanges”
6
Based on O’Hara (1995) and Domowitz (1995)
5
12
2.1 Market participants
The empirical distinction
The end-user: despite being the end-user of the market, the investor usually has no direct access to it, so he
may not be considered as a “participant”. Investors can be of two types: individual (person, company) or
institutional (financial institutions, pension funds, mutual funds, hedge funds…). They can also be
classified according to the use they make of the market7:
-
hedgers use it to reduce the risk caused by a movement of the underlying asset
-
speculators use it to bet on the future direction of the market
-
arbitrageurs take offsetting positions on two instruments to lock-in a profit with no risk
The trader: he interacts directly on the market, and can be of three types
1. The broker, who acts as an intermediary between a buyer and a seller in the over-the-counter
market (thus, he is the market). The broker is often described as an “active trader”, trading on
behalf of a third party rather than for his own account.
2. The dealer, who trades for his own account
3. The market maker, who is a special type of dealer who quotes a bid and an offer price for a
given security. This means that he is ready, willing and able to buy or sell at this quoted price.
For this reason, he is a main provider of liquidity. Not all markets use market makers (see
next paragraph) 8 . Some authors (e.g. Stoll (2003)) refer to “market makers” as being
synonymous to “passive traders”, although recent literature has demonstrated that they play an
active role as well.
It is important to insist that the same financial institution, say a bank, can be an investor, a broker
and a dealer all at the same time. But in line with the principle of Chinese Walls, those three functions
must be performed by separated divisions of the bank.
The theoretical distinction
Microstructure studies, especially information-based models, introduced another paradigm to
distinguish among market participants: the informed vs. the uninformed trader. The latter, who is also
called a noise trader, is motivated by liquidity. The informed trader9 possesses private information. (for
more information about this distinction, please refer to appendix 1)
7
Hull (2003)
Cf. the buoyant debate on Chinese Walls
9
It is important to note that « informed traders » are not synonymous with “insider traders”
8
13
As some traders are more informed than others, their trades are supposed to reveal the underlying
value of the asset and should impact the behaviour of prices. However, such a distinction is not useful for
our investigation and we shall not use it.
Auction versus dealer markets (or order-driven versus quote-driven)
In an auction market, brokers (or occasionally investors directly) trade with one another without
the intervention of an intermediary (i.e. a dealer). Auction markets can be divided into two sub-categories:
-
Call auction markets: as defined by Stoll (2003), “(the market) takes place at a specific time when
the security is call for trading”
-
Continuous auction markets: investors trade with two possible counterparts. They can either trade
with other investors who have placed orders before, or with what is called the “crowd” of brokers.
The NYSE is a typical example of such a market, which is now the dominant form of exchange
organization.
In a pure dealer market, such as the Nasdaq for instance, dealers quote a bid and an offer prices
and the investor chooses the dealer with whom he is willing to trade.
In reality, the distinction between a dealer and an auction markets is much less obvious than might
appear at first glance. In fact, many markets have adopted hybrid structures that share the features of both
types of organization. (e.g. order-driven with the presence of market makers).
2.2 The place
Over-the-counter vs. exchange
Overall, an OTC market is a network of dealers that is not centralized in a single location or trading
platform, but works through telephone or screen-based communication. By contrast, an exchange provides
a central location (physical or virtual) where trades are gathered. 10 Both architectures vary from one
another on four main dimensions:
1. Instruments
The distinction between over-the-counter markets and organized exchanges (EXT) is especially
relevant for derivatives markets 11 since it almost perfectly matches a product distinction: swaps and
forwards are typically traded in the OTC, whereas futures and, to a lesser extent options, are traded in
EXT.12 According to practionners, most innovations first appear on OTC and then transfer to EXT once
the instrument has matured (e.g. : credit derivatives)
10
Nevertheless, an OTC broker considered individually also provides a single place for location
For stock markets, the literature usually refers to « off-exchange trading» instead of OTC
12
See part 1 on volume
11
14
2. Standardization
Contracts available on EXT are standardized as far as size and maturity is concerned, whereas
OTC contracts tend to be more tailor-made. The advantage of standardization is that it enhances the
liquidity of the derivative instrument, but on the other hand OTC contracts provide greater flexibility that
is more likely to fulfil the needs of the investors.
3. Clearinghouse
Exchanges also differ by the presence of a clearinghouse, which acts as a counterparty for each
deal, through the mechanism of marking-to-market. The clearinghouse reduces the credit risk to near-zero
but increases the costs for the customer. These costs are mainly the opportunity costs incurred by the
inability to use the margin requirements and margin calls for another purpose.
4. Regulation
Both structures are of course highly regulated, but the essence of this regulation differs according
to Gonzalez-Hermosillo (1994). Interbank OTC markets are not directly regulated; regulation is actually
applied to their participants. On the other hand, exchanges and OTC brokers are regulated as an entity.
Among exchanges, regulation can be accomplished by a third party (often a public institution) or by the
exchange itself13 (a public institution then acting as a supervisor14).
The coexistence of OTC and EXT market architectures is due, according to practitioners, to a
difference in market participants: OTC markets are used by important financial institutions that know one
another, whereas EXT markets are more often utilized for smaller transactions between individuals or
companies 15 . Theoretically, Gonzalez-Hermosillo (1994) argues that the difference between OTC and
EXT is not much of a microstructural question. In reality, both structures would fulfil different needs for
different types of investors: OTC-users would be more uninformed users looking for efficient risktransferring instruments, whereas EXT-users are better-informed users looking for liquidity-enhancing
instruments and a price-discovery efficient structure.
Nevertheless, traders highlight the fact that both structures are highly interdependent (despite their
obvious differences): positions on the OTC are often hedged on the EXT and vice versa.
The distinction between OTC and EXT has also been fading away over time: there are now
standardized OTC contracts and some of them are even traded on exchanges. As far as credit risk is
13
Many exchanges are still Self-Regulatory Organizations (SRO’s)
E.g the Securities Exchange Commission (SEC) in the USA
15
Source: interview K. Dejonckheere (KBC), B Delcour (ING), J. Lévy
14
15
concerned, institutions called Derivatives Product Companies have been created to provide a similar
function to that of the clearinghouse but for OTC derivatives (Kroszner (1999))16.
Floor-based versus electronic-based markets
Exchanges can differ in that trades can occur in a physical location (called the floor or the pit) or
through electronic systems. In the latter case, traders no longer meet physically. The first electronic-based
system was introduced in 1977 at the Toronto Stock Exchange, and since then it has revolutionized the
way markets work. Many quasi-exchanges (automated trading systems) have also been developed. From
an economic point of view, an automated trading system can be seen as a special kind of exchange, which
specializes in producing trading services without producing listing services, given that it generally trades
securities already listed in regulated exchanges
2.3 The rules
The third dimension of the trading mechanism, i.e. the rules under which it is performed, is
certainly the most prevalent yet complicated one according to O’Hara (1995). 17 It differs for every
exchange and among various contracts available in a given exchange. In other words, a comprehensive
model of exchanges according to the rules that prevail on them is impossible. Rules actually include
numerous dimensions, such as opening time, protocols (opening and closing procedures, limit positions,
circuit breakers, trading restrictions and halts…), types of orders, degree of continuity and transparency
(information disclosure or anonymity) (Madhavan (2000)). For the sake of simplicity, we shall only
develop two of those dimensions: the orders and the anonymity.
Orders
Transactions in an organized market are represented by orders. An order can be defined as the
formal declaration by a market participant of his intention to trade a given quantity of security. Most
markets allow different types of orders.
A market order is the simplest form: the broker is required to trade a given quantity immediately
and at the best available price. In a limit order, the investor specifies a reference price and the transaction
must be executed either at that price or at a more favourable one. The distinction between market orders
and limit orders is very important from a microstructural perspective because each order type conveys a
different amount of information.
Other less prevalent forms of orders are18:
16
Exchanges-owned clearinghouses have also started providing clearing services for OTC transactions (e.g. : CME
Clearinghouse)
17
« What determines the operation of the market is not its location, but rather the rules by which trades occur » P17
18
Based on Hull (2003)
16
•
The stop order, which must be executed at the best available price if another transaction takes
place at a specified price or a worse price (used to limit a loss when long).
•
The stop-limit order, which combines a stop order and a limit order.
•
The market-if-touched order, which must be executed “at the best available price if a trade occurs
at a specified price or a most-favourable one” (used to benefit from a potential gain when long).
•
A discretionary order is similar to a market order, except that the broker may chose when to
execute it.
The anonymity
In some markets, the identity of the trader is disclosed (in the over-the-counter) whilst in others it
is not (in many exchanges). As with most of the above categories, the classification shouldn’t be viewed
as a Manichean alternative but rather as a continuum; pure anonymous or non-anonymous markets are
extreme points between which lie several possibilities. For instance, on the OTC in the USA, only the
broker is known whereas in Mexico, counterparties must know each other.19
3. Conclusions from the theory
A comprehensive review of the microstructural literature is provided in appendix 1. Based on this
theoretical survey, two major conclusions may be drawn, which will be useful to assess derivatives
exchanges from a practical perspective:
1. There are elements that are clearly important when aiming at lowering trading costs and
enhancing liquidity, such as the volume of transactions, the role of market participants (i.e.
presence of market makers, the transparency provided to them or the protocols (rules)
implemented in the market). A clear and enforced legal framework is also highly necessary to
allow for the proper functioning of the market. (Madhavan (2000), Tsetsekos & Varangis (1998))
2. In spite of these elements, it is very difficult to explain the diversity of market structures and it
seems that there is not a unique, optimal type of organization. The Golconda20 exchange seems
like a myth (O’Hara (1995)).
19
20
Source: J. Lévy (CEO Remate – Interdealer Broker Mexico)
The expression comes from O’Hara (1995)
17
Section 1 - Financial markets in Mexico
As an introduction to the analysis of the Mexican Derivatives market, we shall first explain the
context in which it was developed. A first chapter will be dedicated to the recent history of Mexico’s
financial market, in particular to the 1994 financial crisis and its aftermath, the “Tequila effect”. In a
second time, we shall investigate the debt market more specifically. Stock market characteristics will be
addressed in a short third chapter and a fourth chapter will provide some preliminary insights into the
development of derivatives markets in the country.
Chapter 1 - A Brief History of Mexico’s Financial Markets
1975 - 1994: Towards globalization
Mexican financial markets have undergone a major shift towards liberalization and globalization
over the last thirty years. The country was one of the emerging markets that embraced liberalization most
vigorously, and within twenty years, Mexico was transformed “from a closed, protected economy, with an
interventionist state to one of the most open and least interventionist economies in Latin America.”
(Gonzalez-Anaya and Marrufo (2001))
The origin of the modern Mexican financial markets rests upon the Law of the Stock Market (Ley
del Mercado de Valores) of 1975, which initiated the creation of an organized stock exchange (the
Mexican Stock Exchange or Bolsa Mexicana de Valores). The entrance to the GATT in 1986, and the
privatization of the telecom & financial sectors in the beginning of the nineties fuelled the liberalization
process further. Banks were actually re-privatized in 1990, after a nationalization that had occurred in
1982. The technical process encompassed clear and transparent procedures, and according to Unal and
Navarro (1997), “Mexico’s experience with bank privatization is considered to be very successful and
stands as an example to other countries considering the privatization of their banking system”. However,
the success of the bank privatization was short-lived and banks are held responsible for the last major
financial crisis that affected Mexico, in 1994 (Gil-Diaz (1998))
1994 was a crucial year in several regards. In January, Mexico officially joined the NAFTA,
which boosted its trade with the United States and, to a lesser extent, with Canada. Mexico also joined the
OECD that same year, and the central bank was granted its official independence at last.
The NAFTA membership had a positive impact on foreign investment21 and on Mexico’s financial
stability. Indeed, the country was rated BBB- at the end of 1994, with positive outlooks.: the public sector
balance reported a surplus of 1% GDP, international reserves reached a peak and the Mexican public debt
21
See Tornell, Westermann and Martinez (2004)
18
was very close to being considered as investment grade for the first time in the country’s history.
Unfortunately, it did not occur, and 1994 is often remembered as the year of a major financial crisis,
known under the nickname of Tequila Crisis.
1994 – 1996: The Tequila Crisis and its aftermath
The 1994 crisis was not the first one22 in Mexico but it was especially harmful because the three
main financial markets - currency, stock and debt markets - collapsed at the same time. 1994 was an
election year, which used to be a synonym for political instability and hence higher uncertainty in the
country23. Furthermore, the financial crisis was worsened by a rebellion in the south of the country: the
Zapatist “army”, under the lead of the famous Subcomandante Marcos, invaded the capital of the State of
Chiapas and occupied it for several weeks.
In spite of these “exogenous” explanations, weaknesses in the financial system were held
responsible for the crisis. A vast literature has tried to explain what occurred to Mexico’s capital markets
and to understand the financial roots for such a crisis.
To sum up, the conjunction of 3 elements have induced the crisis:
1. semi-fixed exchange rates: : since 1987, the peso was pegged to the dollar but allowed to
fluctuate inside a narrow band, similarly to the EMS in Europe. Interventions by the central bank were
limited by the necessity to maintain the semi-fixed parity.
2. credit expansion
Between 1987 and 1994, the monetary aggregate M2 increased by more than 200% in nominal
terms24, an occurrence driven by 3 main factors:
1.
Credit expansion by commercial banks allowed by lower capital requirements since the
liberalization. An example from Gil-Diaz, who is now Minister of Finance (Secretario de Hacienda y
Crédito Público), gives an idea of the importance of this phenomenon: “from December 1988 to
November 1994, credit from local commercial banks to the private sector rose in real terms by 277
percent, or 25 percent per year”! Bank credit increased from 10% of GDP to 40% over the period.
2. Large capital inflows, in particular in the forms of bank deposits due to unattractive interestrates in the US. Mexican government short-term bonds became increasingly popular among foreign
investors
3. a high growth of private consumption
22
The first default on Mexican public-debt bonds took place in 1827…only three years after the first issuance on the
London Market. Since then, Mexico has had a “strong” record of defaults and financial crisis, the last being in 1982.
(Heyman (1998) )
23
The most popular candidate, Luis Donaldo Colosio, was assassinated in March 1994.
23
Source: Calvo and Mendoza (1996)
19
Mexico was not an isolate case, and as in other financial crisis of the nineties (e.g. the
Scandinavian countries in 1992-1993), the economy was becoming more and more debt-driven, with a
prevalence of short-maturity instruments denominated in foreign currency (Kaminsky (1998)). According
to Calvo and Mendoza (1996), the problem was not the gap between the monetary aggregate M2 and
reserves (i.e. credit expansion per se) but the large and possible shocks that could affect M2. On the one
hand, Mexico’s debt was very liquid but on the other hand it was very short-term oriented, as more than
70 percent of bank liabilities were payable overnight! As foreign capital inflows were coming through
short-term movements, Mexico was under the threat of a possible rapid capital outflow which should have
been compensated by a decrease in its foreign reserves (incompatible with a currency peg on the long
run).
3. Institutional weaknesses
Some institutional failures led to a rise in unproductive loans and a decline in the quality of
banking assets. Following are some of the associated factors:
- The recent liberalization, which allowed financial institutions to lend without closely monitoring
risks. As stated by Gil-Diaz, “there were no capitalization rules based on market risk. This
encouraged asset-liability mismatches that in turn led to a highly liquid liability structure.”
- Insufficient capital requirements
- Poor bank supervision and ineffective prudence “compounded by inadequate accounting
standards and a lack of transparency, hiding the true financial situation of banks, as well as
problems at the level of bank management” (Bonturi (2002))
Bank deposits plummeted and banks entered into large repurchase agreements. Due to its role as
lender of the last resort, the central bank had to make use of its international reserves to protect the peso:
dollar-denominated reserves owned by the central bank fell from $30bn to $5bn in a only few months. At
the same time, foreign investors shifted from peso-denominated Cetes to dollar-indexed Tesobonos and
the proportion of tesobonos in the total domestic debt rose from 4% in January 1994 to 75% at the end of
the year. (Jeanneau and Perez Verdia (2005)).
The second attack on the peso occurred at the end of 1994: the conjunction of political instability
and a rise in US interest rate provoked a decrease in the demand for peso-denominated assets. Investors
were reluctant to roll-over their tesobonos and in December 1994, the government was forced to abandon
the semi-fixed parity between the peso and the dollar and devaluate the peso in order to avoid a complete
collapse of the financial markets. The currency crisis induced a real panic in the debt and stock markets,
with foreign investors literally running away.
20
To sum up, Mexico’s crisis began as a banking crisis, which turned into a balance-of-payment
crisis due to the semi-fixed exchange rates and insufficient reserves of the Central Banks (Kaminsky
(1998)).
The following graphs illustrating the evolution of the currency, stock and debt markets are useful
to perceive the magnitude of the crisis.
Foreign-owned
Fig 1 –Debt
Debtmarket
Market capitalization
Capitalization
60
50
40
30
20
10
0
debt
increased
steeply from 1991 to 1993, by
more than 400%. It collapsed very
Total market
capitalization
(US$ bn)
rapidly between 1994 and 1995,
Foreign
investment (USD
bn)
with levels in 1995 even below
those of 1991 (only 3.5 bn USD)
source: Heyman (1998)
1991 1992 1993 1994 1995 1996
Rate evolution
Fig. MXP/USD
2 : MXP/USD
Rate
Between November and December
1994, the semi-fixed parity with
the dollar was abandoned and the
peso lost 55% of its value. The
exchange rate stabilized only at the
janv-92
mai-92
sept-92
janv-93
mai-93
sept-93
janv-94
mai-94
sept-94
janv-95
mai-95
sept-95
janv-96
mai-96
sept-96
beginning of 1996.
10
8
6
4
2
0
source: Central Bank of Mexico
Stock market
capitalization
Fig. 3 : Stock
Market
Capitalization
capitalization that was 6 times higher than three years
250
200
150
Total market
capitalization
(US$ bn)
100
50
19
9
19 0
91
19
92
19
9
19 3
94
19
9
19 5
96
0
The stock market reached a peak in 1993, with a
Foreign
investment (US$
bn)
before. Market capitalization then contracted by 50%
within a year.
Foreign investment in Mexico’s stock market followed
the same pattern: it rose from $4 bn. to $55 bn. between
1990 and 1993, and then dropped by almost 40%.
source: Heyman (1998)
21
The issue of the predictability of the crisis remains questionable: the rapid change in international
investors’ expectations after the devaluation was driven not only by a change in fundamentals but also by
herding behaviours that induced a self-fulfilling-prophecy effect (Sachs, Tornell and Velasco (1996)).
However, as pointed out by Calvo and Mendoza (1996), the cost of these herding behaviours were
magnified in the case of Mexico by the fact that the stock of short-term debt was too large with respect to
international reserves.
The Tequila Crisis highlighted the dependence of Mexico to external funding and the necessity to
develop better internal capital markets.
The crisis was followed by a deep recession and it took years to the country to recover. Some
particularities in the markets can still be explained by the Tequila Crisis, such as the underdevelopment of
the equity market.
1997 – Present : An improvement of the financial stability
The situation of financial markets has improved gradually since 1995, due to the help of the
United States and the IMF as well as to a set of reform carried out by the Mexican financial authorities
(SHCP and Central Bank). As a result, Moody’s assigned the investment grade to Mexico in 2000 and
Standard & Poor’s in 2002. The development of an organized derivatives exchange was part of this
reform, but numerous changes in the Mexican financial system were implemented before. We shall
concentrate on only two at this stage of the analysis: the reduction of inflation and the consolidation of the
banking system.
1. The reduction of inflation
One of the major improvements is indeed related to inflation. Prices increased greatly after the
crisis, and inflation reached 35% p.a. in 1995
F ig 4 - A n n u a l in f la t io n ( 1 9 8 0 - 2 0 0 5 )
and 1996 (however well below 1987’s peak at
140
129 %).
The
ambitious
Central
program
Bank
to
initiated
control
an
inflation
120
100
80
through cautious
monetary policy and
respected its targets 25 . Since 2002, inflation
60
40
has stabilized below the 5% level. This
20
0
19
80
19
82
19
84
19
86
19
88
19
90
19
92
19
94
19
96
19
98
20
00
20
02
20
04
stabilization has had major impacts on the
25
Source: World Bank (2006)
Source : Centro de Estudios de las Finanzas Públicas de la H.
Cámara de Diputados
22
financial markets, especially on the debt market. According to Mark Yale, head of Latin America
derivatives marketing and structuring at HSBC in New York, quoted by Natel (2005) “the development of
the Mexican government bond as a liquid fixed rate government instrument contributed hugely to the
evolution of a local long-term yield curve. That could only happen because the market believed that
inflation was no longer a serious problem.”26
2. The recovery of the banking sector27
A second improvement is related to the banking industry. As highlighted in figure 5, the health of
the sector improved soon after the crisis, not only in terms of profitability but also of asset quality and
capital adequacy.
Figure 5 – The recovery of the banking system - Selected indicators
1997
1998
1999
Asset quality
Past due loans/Total loans
11,1% 11,3%
8,9%
Capital Adequacy
Net Capital/Credit risk assets
16,9% 17,5% 20,4%
Profitability
ROAE
5,8%
6,9%
5,8%
2000
5,8%
18,2%
10,4%
source: IMF - Mexico Financial Stability Assessment (2001)
A trend induced by the late-1994 crisis was the consolidation in the banking system. According to
the IMF Stability Assessment (2001), the share of assets owned by the 5 largest banks rose from 65% in
1994 to 82% in 2001. Foreign participation
also rose considerably during this period: the
share in total assets of foreign-controlled banks
1.
went from 24% in 1998 to 70% in 200128. The 2.
purchase of Banamex, Mexico’s number two
bank, by Citibank in 2001 was a major event in
that regard. Mexican banks are now mainly held
by foreign hands: 4 of the top-5 institutions are
3.
4.
5.
6.
7.
Figure 6 - Main Mexican Banks
Total Assets (Sep 2005) - millions MXN
BBVA-Bancomer
533.113 Spanish
Banamex
478.882 American
Serfin
367.925 Spanish
HSBC
220.757 English
Banorte
168.699
Scotia Inverlat
112.740 Canadian
Inbursa
83.283
source: Asociación de Bancos de Mexico (ABM)
owned by a foreign group! (see figure 6). The seven most important banks, depicted in Figure 6, represent
88% of total banking assets under management, which indicates a high concentration. Moreover, local
subsidiaries of international players account for much of the remaining 12% (JP Morgan, ING, Bank of
America).
27
Commercial banks account for 51% of total financial system financial assets and development banks (which are
still government-owned for 12%). Source: CNBV
28
IMF (2001)
23
Despite these consolidation and globalization processes, Mexico’s banking system is not as
developed as it seems. As far as individual investors are concerned, the utilization of banks by the
population remains at a fairly low level: only “between 15 and 25 percent of the urban population, and as
little as 6 percent of the rural population, has access to accounts in financial institution”29. Credit to the
private sector has also been decreasing and is now much lower than in most of Latin American countries,
and it represented only 15% of GDP in 2004 (see figure 7). Although the banking sector has strengthened
from a financial point of view, its importance as a capital intermediary has clearly diminished.
Figure 7 : Credit to the Private Sector in Latin America
Source : World Bank (2006)
29
Klaehn, Helms & Deshpande (2005) – P3
24
Chapter 2: Debt and money markets
Following the Tequila crisis, the Mexican policymakers (in particular the Central Bank) became
aware of the necessity to reduce the exposure to external financial flows and to develop a strong local debt
market. The creation of a derivatives exchange to hedge interest-rate in the local currency was part of this
development, as we shall see, but structural reforms were first necessary on the cash market to ensure the
viability of the derivatives exchange.
Inconsistent monetary policy and inflationary expectations lead many emerging countries to
encounter difficulties when borrowing in local currency. 30 Thus, in order to solve this issue and to
develop the local debt market, reforms were necessary; these were aimed both at improving the
management of the supply of debt instruments and at strengthening the demand.
2.1
Improving the supply of debt
A. An increase in domestic financing
Mexican debt instruments can be classified according to the currency in which they are
denominated and according to the issuer (public or private). The following table provides a summary of
the different types of debt and the amounts outstanding at the end of 2005.
Table 1 - A summary of the Mexican debt market (dec 2005)
Internal debt – MXN-denominated
External debt - USD-denominated*
'000 MXN
'000 USD
Public
1.522.428.162 Public
71.674.500
Federal State
1.259.774.726
Short-term
785.800
CETE (Short-term)
300.028.437
Long-term
70.888.700
BONDE (Medium term)
294.786.210
UDIBONO (Long term)
101.606.859
BONOS (M&L Term)
563.353.220
Other**
262.653.436
short term (<1y)
1.000.000
medium & long term
261.653.436
Private
225.670.310 Private***
52.914.000
short term (<1y)
51.344.863
Capital market
19.160.000
medium & long term
174.325.447
Commercial banks
24.603.000
External trade & other
9.151.000
Source: Central Bank of Mexico (Banxico), Ministry of Finance and Public Credit (SHCP)
* more than 90% of external debt is USD-denominated
**: regional states, municipals, government-owned companies.
30
Eichengreen, Hausmann and Panizza (2003) refer to this inability as the “original sin”
25
*** figures for June 2005
The stock of Mexican debt is dominated by publicly issued instruments. Corporate bonds issuance
31
remains small compared to public-debt instruments as indicated in table 1 , and issuances in USD remain
dominant. Nonetheless, it should be noted that the amounts outstanding on the corporate debt market have
been multiplied by a fourfold factor since 2001.32
MXN-denominated public securities are grouped in four categories:
1. CETES (Certificado de Tesorería) are Treasury Bills, which were introduced in 1975. They
gave birth to a money market in Mexico (Levy (1979)), and constituted the first attempt to
develop a domestic debt market in the country (Sidaoui (2002)). Maturities are now 28, 91,
182 and 384 days.
2. BONDES (Bono de Desarrollo) are also Treasury Bills, but with longer maturity (3 and 5
years). They were introduced in 1987.
3. UDIBONOS are index-linked inflation bonds. They were introduced in 1996 to replace the
Ajustabonos. Their maturities are 5, 10, 20 and 30 years.
4. BONOS (Bono a tasa fija) are fixed-rate government bonds with maturities ranging from 3 to
20 years.
Exactly two third of Mexico’s public debt (66.5% of amount outstanding at Dec. 31) is now
MXN-denominated, compared to 30% in 199533. USD-denominated instruments only represent 11% of
the GDP, the lowest figure ever34. There has been a clear shift from foreign to domestic financing, and,
among the foreign debt instruments, the two instruments that used to prevail until a few years ago have
now disappeared:
•
Tesobonos, which were partially blamed for the 1994 crisis, were short-term government
bonds, similar to CETES, but dollar-indexed. They accounted for approx. $29 bn. in the
beginning of 199535 and were bought back at the end of that year.
•
Another major source of external financing for the government were the Brady bonds,
which were tradable public debt instruments denominated in USD and which were part of
the US “rescue plan” after the Tequila crisis. The Mexican Brady bonds were completely
repurchased in 2003, earlier than original maturities.
31
. Navarette (2001) showed the corporate debt market used to be weak in three fundamental dimensions :
completeness (lack of products), liquidity and efficiency (due to high concentration: 6 brokerage firms controlled
80% of the market)
32
Based on Navarette (2001) figures
33
Janneaux & Perez Verdia (2005)
34
Central Bank of Mexico
35
Heyman (1998)
26
B. Improvements in the primary market
In order to achieve a better functioning of the debt market, authorities improved the transparency
and the liquidity of the primary market. The Central Bank, under its role of government’s financial agent,
carries out auctions of government debt securities every week. In order to mitigate the uncertainty, the
government now publishes its auctioning targets quarterly and announces its debt strategy every year 36 .
According to Jeanneau & Perez Verdia (2005), “predictability and transparency [on the primary market]
has been at the heart of the government’s debt management strategy” (P98).
Primary auctions take place through an electronic system, usually on Tuesday, and the range of
market participants has been broadened from banks and brokerage houses to pension funds, mutual funds
and insurance companies. According to the Central Bank of Mexico, the electronic bidding platform has
been substantially improved so that results can be published a few minutes after the process, compared to
five hours ten years ago.
As far as corporate bonds are concerned, the launch of flexible instruments (Certificado Bursatil)
in 2001 has facilitated the access to capital markets for firms, and more than 70% of corporate bonds are
now Certificados Bursatiles.37
C. The development of the secondary market
Another objective in strengthening the domestic debt market was to enhance the liquidity of the
secondary market. Secondary trading of government securities is almost exclusively conducted in overthe-counter markets38. An interesting reform on the secondary debt market was the introduction in 2000 of
primary dealers or market markers. They provide continuous bid-ask quotation and, as a counterpart for
this, they may bid for additional securities on the primary market once the price is known (and at this
price)39. Liquidity in short-term zero coupon bills (Cetes) and fixed-coupon bonds (Bonos) has increased
substantially after this change. (Sidaoui (2002)) Other measures to increase liquidity have been taken (see
Jeanneau and Perez Verdia (2005)), including proactive liabilities management strategy undertaken by the
Central Bank.
D. Better market information
Changes were also implemented to provide better information to the market participants, and
reliable benchmark rates were developed.
36
Those announcements include : the type of securities to be auctioned, the minimum amount tendered and the
maximum nominal value of the total placement during the quarter
37
Source: SHCP
38
Sidaoui (2002), interviews
39
This mechanism is called “green shoe provision”
27
Two rates are considered as benchmarks for the Mexican short-term interest rate”40.
•
The CETES 91 is the yield of the Treasury Bill with maturity of 3 months and is the main
indicator of the short-term interest rate on government bonds. It is the benchmark for risk-free
rate.
•
The TIIE 28 (Tasa de Interés Interbancaria de Equilibrio) is the reference for interbank rate,
used as benchmark for the floating rate. It is determined daily by the Central Bank after an
extensive analysis of market conditions. The Mexican debt market still relies much on voice
trading, but the calculation has been made possible by the fact that the trades are recorded
electronically. When trades were only conducted by phone, it was impossible to determine the
TIIE rate, and so market participants were forced to use the primary auction rate as a reference
rate. The main disadvantage was that this rate was calculated only once a week, so participants in
the debt market were much less informed.
Fig 8 - Evolution TIIE 28
The evolution of the TIIE over the last five years
indicates that interest rates have considerably decreased at
25
the beginning of the 21st century, from levels as high as
20
15
2/01/2006
2/07/2005
2/01/2005
2/07/2004
were close to zero or even negative (in August of that
2/01/2004
nominal interest rates were very low (in 2003), real rates
2/07/2003
0
2/01/2003
and real interest rates actually increased in 2002. When
2/07/2002
5
2/01/2001
However, the decrease in real terms was less important,
2/01/2002
10
2/07/2001
19,34% (Jan 2001) to a historical 4,745% (Aug 2003).
year).
source : Central Bank of Mexico
Fig. 9 : Volatility TIIE
(std dev. in %)
Recent evolution of the TIIE 28 is not as flat as it
might appear at first glance on figure 8. The rate soared
from 5% to 10% in a bit less than a year and a half, and
4
started decreasing aggressively in August 2005. 41 The
3
nominal inter-bank rate in Mexico remains volatile on a
per-month basis.
42
2
1
However, as Figure 9 indicates
0
2001
2002
2003
2004
2005
40
14 of the major banks in Mexico have recently launched their own reference rate, the Mexibor (in reference to the
Libor) but the TIIE still remains the “most favoured” rate. (source: interview ING)
41
The analysis may be applied to real interest rates, as inflation has been stable over that period.
42
1.25% monthly std dev. over the period March 2004 – April 2006
28
clearly, the annual volatility has stabilized much, especially since 2004. On a day-to-day basis, Mexican
inter-bank rates are much less volatile than they used to be.
2.2
Strengthening the demand
Increasing foreign participants
The second major objective pursued by the Mexican financial policymakers was to improve the
scope of participants active on the debt market. After the crisis, foreign investors deserted the local market
and the foreign involvement in the Mexican domestic debt dropped to 2% in 1999 (from 69% in 1994)43.
Foreign participation has increased since then, and the Central Bank estimates that 8% of the public debtowners are now non-Mexican residents. Besides, bonds issued at long maturities are more held by foreign
residents: according to Janneau and Perez Verdia (2005), “foreign investors held 54% of 10-year
securities and 84% of 20-year securities at the end of 2004”.44.
To attract foreign participants, Mexican authorities had first to create a liquid local market and to
broaden the range of local participants. Since 1997, the Mexican pension system has been liberalized, and
“one of the objectives of privatizing the Social Security was [precisely] to increase the domestic savings
rate in order to increase domestic private sector investment” (Gonzalez-Annaya & Marrufo (2001)).
Figure 10 – Repartition of public debt by owners
9%
8%
Siefores (pension funds)
30%
13%
Natio nal
Residents
Foreign Residents
Individual & companies
Comercial and devel.
Banks
Public sector
92%
Source : Central Bank of Mexico
48%
The role of Pension Funds
Pension funds (Siefores - Mandatory Specialized Retirement Funds), which were virtually
inexistent until 1997 have become important capital providers in the public debt market. At present, they
own 30% of all public sector securities, whereas half of the public debt is still in the hands of individual
investors and non-financial institutions (see figure 10). Every Mexican worker registered within the social
security system is required to invest 6.5% of his wages with an Afore (or Pension Fund45). They are 16
43
Janneau and Perez Verdia (2005)
This is confirmed by Mr Jacques Lévy, CEO of Remate (one of the leading InterDealer Broker in Mexico): “75%
of bonds issued in pesos at 20 years are in the hands of foreigners”
45
The system was shifted from a pay-as-you-go to an Individual capitalization scheme
44
29
different Afores, and each of them manages several Siefores (or Retirement funds). Siefores can be of two
types: SB1 (for risk-averse, older workers) and SB2. Only SB2s are allowed to invest in stock markets,
and only through principal-protected structured notes. SB2 dominate over SB1, as they manage
approximately two third of the 33 millions of accounts. 46Although it has been loosened over the last year,
the regulation on Siefores remains “highly proscriptive by international standards”
47
Restrictions on
investments in equities are for instance much less important in the other Latin American countries (ChanLau (2005))48
Siefores approximately managed MXN 621
Figure 11 - Repartition of Siefores Investments (Jan
31 2006)
bn. in 2005, or some USD 55 bn. (7.85% of GDP and
12.5% of total asset of the financial system 49 ).
2%
16%
Therefore, they have become especially important
Bank assets
2%
Government
assets
Private assets
players on the debt market, either cash or derivative. A
major feature of Siefores assets is their short-term
exposure: according to Morgan Stanley, more than 60
Others
80%
% of their assets have a Cete (short-term) yield.
Source : CB of Mexico
Siefores have been granted the authorization to hold assets with longer-term yield but the shift in
their portfolio has been very slow (this is confirmed by figure 11), mainly because of a lack of
performance disclosure. According to Natel (2005), the problem rests in that there is currently no
benchmark to assess Afores performances, so herding in asset allocation seems to be the name of the
game.
The role of mutual funds
Fig 12 – AUM Siefores vs Mutual
Funds
Mutual Funds are not new market participants
(they were created in the fifties) and are managed
50,000
by the main Mexican banks. They are also
40,000
important capital providers, although they grew
less rapidly than Retirement Funds (figure 12).
Their assets under management are less important
SIEF ORES
M UTUAL
F UNDS
30,000
20,000
10,000
source: MexDer
0
1998
1999
2000
2001
2002
2003
2004
46
According to the statistics provided by the Central Bank of Mexico.
47
Pavroz Natel (2005)
48
Investments Limits in domestic equities by pension funds is 49% of AUM in Argentina, 50% in Brazil and 39% in
Chile
49
Source : Wolrd Bank (2006)
30
than those of Siefores since 2002, but they still account for 5% of GDP.
F i g 1 3 - M utual funds po r tfo l i o
As far as mutual funds asset allocation is
concerned, mutual funds are less conservative
4 ,2 2 %
1 0 ,2 6 %
0 ,1 2 %
than Siefores and rely more heavily on stocks
3 7 ,7 8 %
2 3 ,5 2 %
(10.26% - figure 13). Nevertheless, the
overwhelming majority of their investments is
in debt securities and government instruments
2 4 ,1 0 %
are prominent, although much less than for
G o v e rn m e n t
Ba n k se cu ritie s
R e p o 's
S to c ks
Pr iva te E q u ity
D e b e n tu r e s
Siefores (37.8%)
Source: Central Bank of Mexico
Conclusion from the debt market
Two major changes have gradually taken place on the Mexican debt market, particularly since
1995, allowing us to say that the local debt market is now well developed:
•
The rise of the proportion of public debt issued in local currency
•
The increase in the maturity of these issues, which allows the
Fig 14 : Mex. Yield Curve
existence of a peso yield curve (see figure 14): average maturity
of the domestic government debt went from 300 days in 1996 to
700 days in 2001.50
In 1998, the country had no long-term debt in local currency. As a
comparison, in February 2006, Mexico was able to borrow in peso for 20
years at a rate of 10.06%, whereas Brazil could not borrow in local currency
at maturities beyond 18 months and this at a rate of 18,8%! 51 A similar
tendency appears to be emerging for corporate bonds: in 2005, the first pesodenominated global bond was issued by a Mexican corporate issuer, America
Source : Janneau and Perez Verdia
Movil (first mobile phone operator in Mexico).
(2005)
50
51
Source : SHCP
source : Bloomberg
31
Future outlook
Although 2006 is an election year and uncertainty might increase, Mexico’s position in the
international debt markets remains very good. Mexico’s country souvereign spread has reached its lower
level ever (see Fig.15), with an EMBI spread at 100 basis points over US treasury bills. In Latin America,
only Chile is able to borrow on international markets with a lower spread.
Fig 15 – Mexico’s Country Sovereign Spread (EMBI)
source: JP Morgan, Latin Focus
The government has announced the biggest dollar-denominated issue of the country’s history in
February of this year. Actually, Mexico will buy back some 25 different issues (with maturities ranging
from 1 to 17 years) and issue a single bond (with maturities between 10 and 15 years). This restructuring
operation will improve the liquidity of Mexican bonds. The two main advantages for the government are
the following:
1. First, it takes advantage of good conditions on the international markets
2. Second, by improving liquidity on its debt, it sends a good signal to international investors.
32
Chapter 3 : Stock markets
There is only one stock market in Mexico, the Bolsa Mexicana de Valores (BMV). Ever since
1999, the exchange is purely electronic52 and conducted operations using its internally developed platform
Sentra.
1. Size of the market
The stock market is considered to be underdeveloped in Mexico, especially since the Tequila
Crisis. A common indicator to assess the development of a stock market is market significance (i.e. market
capitalization over GDP). Before the crisis, the country was ranked #13 worldwide in term of this
indicator, with an approximate value of 50%53. This value decreased to 26.3% at the end of 2005, well
below most of the developed and even emerging markets (see table 2)
Table 2 : Market Significance of selected exchanges (dec 2005)
Country
Exchange
Market Significance
Mexico
Mexican Stock Exchange
USA
Nasdaq
USA
NYSE
Europe
Euronext
Spain
BME Spanish Exchanges
Emerging
Brazil
Sao Paulo SE
Korea
Korea Exchange
South Africa
JSE South Africa
source: Bank of International Settlements
Developed
26,3%
25,80%
103,00%
76,30%
86,60%
46,00%
48,50%
163,10%
The Tequila Crisis appears to be one of the causes of this:
-
trades in the MSE have been diverted to the NYSE. Soon after the crisis, some of the biggest
Fig. 16 - Proportion of trades for Mexican
stocks listed in Mexico & USA
Mexican companies decided to be listed on
the New York exchange in order to attract
investors. Redirecting these trades to Mexico
150
seems to be a very difficult task. Mexican
100
58,8
59,4
62,7
54,3
62,7
41,2
40,6
37,3
45,7
37,3
2001
2002
2003
2004
2005
50
0
stocks traded both in the USA and Mexico
are still traded at double intensity in the USA
and as shown in figure 16, this proportion
BMV
USA
has not been reduced over the last five years
source: BMV
52
53
The first electronic trading had taken place 1995.
Martinez & Werner (2003)
33
despite the efforts of BMV.
-
some institutional restrictions imposed after the crisis still limit the access to the stock market
(especially for pension funds)
Another reason for the underdevelopment of the Bolsa might be the functioning of the market
itself. In their paper “When an event is not an Event – The Curious Case of an Emerging Market”,
Bhattacharya, Daouk, Jorgenson and Kehr (2000) show that trades on the Mexican Stock Exchanges do
not react to information release (for the period ranging from July 1994 to June 1997). Using an event
study, they insinuate that “insider trading is responsible for a Mexican corporate news announcement to be
a non-event”.(P92) The authors also develop an interesting methodology to assess the integrity of an
organized market, a topic that is highly relevant for emerging markets.
Measures and guidelines have been taken since then, but, to our current knowledge, no qualitative
research has been conducted as of yet to determine how the integrity of the Mexican stock market has
evolved. According to an OECD Report on the Observance of Standards and Codes published in
September 2003, “the Principle IIB [of OECD guidelines] that insider trading and abusive self-dealing
should be prohibited is largely observed” (P12) in Mexico. From my point of view, progress could still be
made in terms of transparency and availability of data, mainly because the BMV still relies, partially, on a
mutual principle.
Martinez and Werner (2002) suggest a third reason for the stagnation of equity issuance since
1995. They argue that the corporate governance problem evident in Mexican firms is the “most
important factor contributing to this trend”. The IMF Financial Stability Assessment (released in 2001)
provides a further, sociological, explanation: as in many other Latin-American countries, wealth
concentration is very high in Mexico. Families or rich individual own significant stakes in major
companies, which reduces listing but also participation in the market 54 . For this reason, the OECD
estimates that free float is only between 12% and 15%.55
54
According to CNBV (regulatory authority), only 0,15% of the population participates to the stock market. This is
confirmed by interviews and press checks.
55
source: “Report on the Observance of Standards and Codes” (2003)
34
1. Major facts for the stock market
Fig 17 : Monthly Amounts
operated on capital markets
1. Returns and volumes
The Mexican Stock Exchange index, the IPC,
has grown substantially over the last 15 years. The
market soon recovered after the Tequila crisis, but
600.000.000
(in thousands pesos)
500.000.000
stagnated in the first years of the new century (also
because of external crisis in other derivatives markets).
The MSE index started growing strongly at the
400.000.000
300.000.000
beginning of 2003 and this upward movement has
200.000.000
been almost uninterrupted since.
The nominal return of the index, taking into account
100.000.000
56
only capital gains , was 43.53% in 2003, 46.87% in
Latin American markets over this period, but in spite
of good index performance, the equity market remains
small in terms of amounts traded. The activity has
0
av
r-0
2
oc
t-0
av 2
r-0
3
oc
t-0
3
av
r-0
4
oc
t-0
4
av
r-0
oc 5
t-0
5
2004 and 37.81% in 2005. BMV outperformed all
Operations on Equity markets
Operations on Debt Market
source: Central Bank of Mexico
clearly been growing faster in the debt market over the last four years (see figure 17).
2. Volatility
Volatility in the Mexican Stock Market
(Figure 18) has been decreasing since 2000 and
40
was in 2004 at 18%, a comparable level to that
30
57
seen in developed markets. BMV also uses an
index to measure volatility, called Vimex. In
2005, this index has remained fairly stable at a
level of about 19% throughout the whole year.
Fig. 18 : Annual Volatility of MSE
35
25
20
15
10
5
0
4
r-0
av
03
20
02
20
01
20
00
20
99
19
98
19
97
19
96
19
95
19
94
19
93
19
Source : MexDer
The IRT (Indice de Rendimiento Total) includes capital and dividend returns.
Goldman Sachs estimates that the annual volatility of American stock markets was on average 17.8% over the
period 2000-2005. Source: analyst reports (Ghaffari (2006))
56
57
35
3.Concentration
The market capitalization of the companies listed on the Mexican Stock Exchange is highly
concentrated: the ten biggest companies of the IPC (which includes 35 companies in total) account for
70% of its value. Furthermore, eight of the companies present in this index are controlled by a single man,
Carlos Slim, and would represent around 43% of the market capitalization. 58 Furthermore, the proportion
of foreign investments in the stock market (46.3% in 2004 according to BMV) is much higher than for the
debt market.
3. Future outlook on the equity market
Whereas the domestic debt market has recovered well from the Tequila crisis, the equity markets
have remained “anemic” 59 ever since. Mexican authorities are well aware of this situation and a new
Securities Market Law has recently been approved by the Congress, with the aim of invigorating the
equity markets and the risk capital. The new law aims at enforcing corporate governance and transparency
for listed companies. It clarifies the role of the supervisory entities and creates “a new legal form for
private enterprises, to facilitate private equity investment” called SAPI60.
58
Sources: Mexican Brokeragehouses Association (AMIB) and Bolsa Mexicana de Valores (BMV)
World Bank (2006) P15
60
World Bank (2006) P48
59
36
Chapter 4 : Derivatives markets
Seventies and eighties: the enfancy
Derivatives appeared in Mexico soon after the development of organized debt and stock markets61.
The first Mexican derivative was the petrobono in 1977, a government bond whose value was dependent
on oil prices and the MXN/USD exchange rate. (it was not a pure derivatives but rather a “hybrid debt
instrument”).
Between 1978 and 1982, currency futures on the MXN were listed in the Chicago Mercantile
Exchange. Their trade stopped because of the implementation of fixed parity in 1982. Between 1983 and
1987, stock futures were traded on the Mexican Stock Exchange (BMV). Those derivatives instruments
did not survive due to insufficient volumes. (Heyman (1998), interviews MexDer)
1990 - 1995 : unsustainable growth
Mexican derivatives flourished in the start of the nineties, but growth was chaotic due to the
shortages of the legislation (Heyman (1998)). The following instruments were buoyant:
1. Warrants
The beginning of the decade saw the launch of new derivatives instruments on the BMV, namely
warrants. Between 1992 and 1994, warrants on Mexican stocks were available for trade in the London and
Luxemburg markets.
2. The development of a local Interest-rate OTC market
The over-the-counter market also developed considerably, especially for interest-rate related
products. Forward contracts on government bonds interest rate were already popular when their trade was
suspended, in 1992, due to the absence of legislation and some operational chaos. Norms in line with the
recommendation of the Group of the Thirty were implemented in 1994 by the Central Bank. They allowed
for a better control of risk and gave a new rise to the OTC activity.
3. Mexican options on international exchanges
The third major trend seen in the beginning of the nineties was the growing availability of options
on Mexican stocks. It started in 1992 with options on Telmex ADR’s
62
on the CBOE, and it quickly
expanded to other main options exchanges (American Stock Exchange, Philadelphia Stock Exchange,
New York Option Exchange). Telmex options encountered consequential success: in 1993, trades on that
61
Heyman (1998) mentions that pre-columbian civilizations, like the Aztecs, might have used some forms of
derivatives (futures) while trading with other tribes. However, no formal proof of this assumption has been found.
62
ADR is “a certificate that trades on a US stock market but represents a non-US stock. ADR's enable American
investors to buy shares of non-American companies without having to buy the shares on a non-US exchange.”
(source: Atlantic Financial Dictionary www.atlanticfinancial.com)
37
contract represented a total volume of USD 30 bn. (or almost 50% of the value of trades on the Mexican
Stock Exchange that year).
1995 - present: the rise of exchange-traded IR derivatives
American exchanges
The first organized exchange to trade Mexican Interest Rate derivatives products was the Chicago
Mercantile Exchange in 1996, with futures and options on Brady Bonds. Soon after this, the exchange
expanded its range of Mexican derivatives by offering options and futures on the Mexican Stock
Exchange index (IPC), and then on CETES and the TIIE. The CBOE also began trading options on the
IPC in 1996, under license of the MSE.
It is thus important to note that the recent development of Mexican exchange-traded derivatives
was initiated in the USA, not in Mexico. Besides, the efforts deployed by the Chicago exchanges, which
are located in the same time zone as Mexico, constitute one of the factors that explains why Mexico had to
wait for so long before setting up an organized derivatives exchange. 63
MexDer
The Mexican Derivatives Exchange (MexDer) was officially launched on December 18th 1998.
However, talks between the government, regulatory authorities and financial institutions began soon after
the 1994-1995 crisis, with the purpose of creating an organized derivatives exchange inside Mexico.
According to Mr Alegría, “given that the crisis was to some extent the result from irresponsible and
unhedged speculation by Mexican banks, there was an urgent need for an efficient and liquid derivatives
market in order to manage those risks effectively”.
The creation of the market can be decomposed into two stages:
a.
1996 and 1997 were dedicated to the shaping of a legal framework for the new exchange (to
define the architecture of the market, the role of the participants,…)
b.
Mid-1997 to 1998: under the lead of Bancomer, a trust was set up to collect financial means
and a list of 192 potential shareholders was proposed. This initiated the constitution per se of
the exchange. Formally, the MexDer was created by the Mexican Stock Exchange (BMV –
Bolsa Mexicana de Valores) and SD Indeval64: the first was responsible for the financing of
the project and the latter for the creation of the Clearinghouse.
63
Source: interview Jorge Alegría
SD Indeval is a securities depository jointly owned by some 490 Mexican financial institutions (banks, mutual
funds, BMV,…). The basic services it provides are: deposit and custody, administration, transfer, clearing and
settlement.
64
38
Table 3 - Evolution of Exchange-traded Mexican Derivatives - 1998 vs 2005
in percentage of number of contracts traded
1998
2005
CME
CBOE
MexDer
CME
CBOE
MexDer
Underlying Asset
Exchange rates
100%
0%
0%
56%
0%
44%
Interest rates
100%
0%
0%
0%
0%
100%
Stock and indices
0%
100%
0%
0%
0%
100%
Sources: Heyman (1998), MexDer, CME, CBOE
During its seven first years of operation, the MexDer was able to progressively attract most of the
trades in “Mexican” derivatives, as depicted in the table 3. The only type of instrument that is still traded
on an American Exchange is the MXN/USD future contract65. The CME is only slightly dominant if
volume is measured in terms of number of contracts, but clearly dominates when notional amount is used
as benchmark (because CME contracts are approximately ten times bigger than MexDer contracts).
MexDer in Mexico’s financial context
In fact, the clearinghouse of MexDer, Asigna, is a different legal entity from the market, although
MexDer is the only exchange for which it performs this role. The two institutions differ in term of legal
status: MexDer is a subsidiary of BMV, a private mutual company, whereas Asigna is a trust of banks.
Information disclosure is thus different: for instance, Asigna accounts are public and MexDer’s are not.
The ownership structure
At the start of its existence, from 1998 to 2001, the shareholders of MexDer used to be small
companies, some banks and some brokerage houses (56 institutions in total in 2001). Being a shareholder
was a condition for participation in the market. The situation changed radically in 2001, with the nearbankruptcy of MexDer. The BMV
Group,
who
was
a
minority
shareholder with a stake of less than
5%,
rescued
the
market
from
bankruptcy and increased its stake
Fig.Fig19XX: The
of BMV
BMVGroup
Group
- TheBusiness
businessModel
model of
Internal
activities
Real Estate
Cebur
Corporativo
Staff
to around 85%.
Since then, MexDer is a
Bursatec
Technology
support
subsidiary of the BMV Group,
BMV
MexDer
which was originally formed upon
Mercado
global
Asigna
Spot market
65
Derivatives m arket
SIFGarban
OTC broker
Indeval
Valmer
Financial
Financial
Custody
Information
Futures on CETES and the TIIE are still present in the folder of the CME but are no longer traded.
39
External
activities
the the stock exchange but also performs other activities:
•
Central securities depository (Indeval)
•
Financial information, more specifically price supplier for valuation of financial instruments
(Valmer)
•
OTC broker (Sif Garban)
•
Listing of foreign instruments (Mercado global)
Within the group, independent business units provide specific services to all subsidiaries (see
figure 19): Bursatec is in charge of technology-related activities, Corporativo of personnel and Cebur of
real estate.
Within the group, independent business units provide specific services to all subsidiaries: Bursatec
is in charge of technology-related activities, Corporativo of personnel and Cebur of real estate.
MexDer is part of a strategic model that intends to offer a “complete market”: this model is
backed by the government and the World Bank to increase the use of capital markets, especially by nonfinancial firms. So far, the BMV Group has not been completely demutualized: brokerage firm active on
the stock exchange owns one share of its equity but it is not compulsory to be a shareholder to participate
in the market.
The structure of shareholders ownership changed in 2004, with the entrance of the MEFF in the
equity of MexDer. This change in the equity reflects the strategic move to launch options trading in a
Mexican organized market, which is very much in line with the complete market strategy. The Spanish
market acquired 7.5% of the capital in exchange for providing its electronic options trading platform. The
MEFF itself is part of the BME group,
which
owns
most
of
the
Fig 20- Shareholder Ownership
Spanish
exchanges, including the Madrid Stock
15%
Exchange. In total, they are some 50
shareholders
of
MexDer.
Minority
8%
shareholders, which own some 15% of the
equity, are Brokerage firms (whether
77%
specialized in derivatives or not) and
banks. Some of these financial institutions
BMV Group
MEFF
Other financial institutions
are thus direct shareholders and indirect
shareholders through BMV.
Source : Interviews, BME Annual Report 2004
It should be emphasized that the
40
equity ownership structure of the exchange is radically different from the one of the clearinghouse,
although both are very interrelated from an operational point of view. The owners of the clearinghouse are
members of the exchange with a special status, but control of both institutions is clearly separated. In this
regard, the MexDer is an exception compared to most derivatives exchanges. The reason for that is the
Mexican legal framework: the trust, under the Mexican legislation, is the owner of the securities (the
margin deposits) and it is allowed to execute the collateral instantly. Risk management is thus easier, but
only banks are authorized to manage trusts. This explains why the shareholder structure of the exchange
and the clearinghouse differ.
Asigna
Bancomer
Scotia Inverlat
Banamex
Santander
Source : interview Casa de Bolsa Vector
The regulatory framework
Similarly to many other derivatives exchanges, MexDer and Asigna are self-regulated entities.
They operate under the supervision of the Ministry of Finance and Public Credit (SHCP), the National
Banking and Securities Commission (CNBV) and the Central Bank
66
. In practicality, those three
institutions elaborated the legal canvas to which the exchange must obey. To a great extent, the Mexican
regulation on derivatives exchanges was elaborated for MexDer, and the company is the only one that was
granted the authorization to be an organized derivatives exchange in Mexico. Thus, thanks to the
legislation, MexDer is protected from competition by other Mexican organized exchanges.
In practice, self-regulation means that the MexDer is allowed to develop its own rules and
operational handbook, but they must be accepted by the CNBV. This institution also performs operational
supervision, both in-situ (in the offices of market participants) and extra-situ (through own systems or
those of the MexDer). 67
The architecture of the exchange
MexDer started in 1998 with an open outcry system similar to American derivatives markets of
the time. A market making system was implemented in 2001 to improve liquidity. Prior to this important
66
SHCP, CNBV and Banxico are often referred to as “Mexico’s Financial Authorities”
CNBV is supposed to supervise the exchange, but information on its website about contracts specifications (size or
maturity for instance) is not always correct nor updated…
67
41
strategic move, an electronic platform (Sentra), was launched in order to supplement the “physical
market”.
However, this platform is only in use for futures contract. Since their launch in 2004, options are
traded exclusively on another electronic platform, S-Mart (System for Markets Automatic Real Time),
which was developed by the Spanish Futures and Options Exchange (MEFF). S-Mart is both a transaction
and clearing system, but MexDer only acquired the transaction facility (as clearing is performed by
Asigna, who kept its former system). Stock- and index-based futures migrated from the Sentra to the SMart platform; all trades on derivatives with “stock-market underlyings” are thus performed through the
S-Mart platform nowadays. Market making was put in place from the start for options.
The evolution of the architecture can be summarized as follows:
1998
FUTURES
Open Outcry
2000
SENTRA ® Derivados
100% Electronic
Platform
OPTIONS
2001
2004
Market Makers
S/MART ®
100% Electronic
Plattform
source: MexDer
The participants to the market
The different status of market participants is also very important in order to understand the way a
market actually works. They are three different types of participants on the MexDer:
•
Clearing Members (socios liquidadores)
The clearing members are participants of MexDer that are also shareholders of the Clearinghouse,
Asigna. They are four clearing members in total, which are the four leading financial groups in Mexico.
It is important to recall that the Clearinghouse is clearly separated from the exchange, from a legal
and ownership point of view. The clearing members make the link between the two institutions, and they
are capital providers of Asigna but not of MexDer. But it is also important to perceive that the clearing
members are really those who “make” the market.
•
Market Makers (formadores de mercado)
Market makers are banks or brokerage houses that provide continuous quotations in an assigned
class of assets, with the obligations to trade a minimum amount of contrac and to present Bids / Asks
quotations. In exchange for these obligations, market makers benefit from more interesting trading fees.
42
However, MexDer is an order driven market and market makers are present to enhance liquidity but are
not compulsory for a trade. Eighteen market makers are active on the market. (ten banks and eight
brokerage houses), but other institutions are reluctant to become market makers because of the constraints
on volumes to trade.68
Brokers (operadores)
As explained in the internal regulation handbook, “brokers are corporations authorized by MexDer
to trade contracts in the Exchange’s Electronic Trading Systems, acting as brokers for one or more
Clearing Members, representing agency and proprietary orders on the Exchange.”
Brokers include 19 Mexican financial institutions, among which banks, brokerage house and firms
specialized in derivatives. There is currently no foreign institution that is allowed, even as a broker, on the
market. In practice, brokers act as commissioners for the liquidating members.
68
source: interview A. Barush
43
Section 2: MexDer in the international context
The use of derivatives instrument has grown substantially over the last three decades and, in this
section, we shall attempt to provide insights on the worldwide context of financial derivatives markets in
which MexDer has developed. Commodity and energy markets will not be included in the analysis, as
they are not traded on the Mexican derivatives exchanges. We shall first try to assess the relative
importance of derivatives trading on organized exchanges (EXT), compared to the over-the-counter
(OTC) worldwide and in Mexico. We shall then investigate a little more the growth of EXT derivatives in
general, provide a classification of exchanges and finally analyze the strategic trends that have shaped the
evolution of the industry over the last decade.
Chapter 5 : Over-the-counter versus exchange-traded
5.1
The global situation
8.3 billion financial derivatives contracts were traded in 200469. Organized derivatives exchanges
(EXT) were responsible for slightly more than one third of this volume (3.23 bn. contracts) whereas
almost two third of contracts were exchanged through the over-the-counter markets. However, the number
of contracts is not a very good benchmark for assessing the activity in both types of markets; we are
attempting to compare things that cannot be compared. 70
Both markets could then be analyzed according to market turnover. Such an analysis (figure 21)
shows that both OTC and EXT markets have grown substantially over the last ten years, with a compound
annual growth rate of respectively 10.6% and 14.3%.
The absolute difference in daily
Fig 21 – Daily average turnover OTC vs EXT
(In billion US dollars – average for April)
turnover between OTC and EXT has
5000
actually increased much since 1998. It
4000
is also important to highlight that the
amounts presented in figure 21 are
3000
OTC
2000
EXT
extremely important: worldwide daily
turnover of derivatives instruments was
1000
0
1995
1998
2001
2004
above 7000 billions USD in April
2004.
Source: BIS Triennial Survey
69
70
2005 annual figures for the OTC market are not available yet
By definition contract size and specificity varies for OTC contracts
44
In terms of broad risk category, OTC is dominant in foreign-exchange derivatives, but interest-rate
derivatives are more traded in organized exchanges. Nevertheless, the proportion of IR-related derivatives
compared to foreign exchange derivatives has risen substantially on the OTC.
IR derivatives on the OTC are dominated by Swaps, which are responsible for 60% of total turnover
(Vanilla Swaps being dominant inside this category). Forward Rate Agreements account for almost one
quarter of turnover and options for slightly less than one fifth.
However, market turnover is not a flawless indicator of activity either, favouring EXT over OTC.
The reason is that a position on the OTC that involves only one transaction might necessitate several
trades at several times on the EXT.
For this reason, it is better to assess activity on these respective markets through a “stock
variable”, and not a “flow one”. This is done in Figure 22, which provides the notional amounts
outstanding in both markets at the end of the last six years.71
Fig 22 - Amounts Outstanding Of OTC Vs EXT Derivatives
(In bn US dollars - amounts dec 31)
Notional amount outstanding measures
the value of the underlying assets
hedged through derivatives. In this
case, OTC clearly dominates over
300.000
250.000
200.000
150.000
100.000
50.000
0
EXT: amounts outstanding are five
times higher on the OTC. As for the
flow variables, this indicator has been
increasing
continuously
and
substantially over the last 6 years (cagr.
1999 2000 2001 2002 2003 2004 2005
22,6% for OTC and 27,4% for EXT).
TOTAL OTC
TOTAL EXT
source: BIS Quarterly Reports
5.2
OTC vs EXT in Mexico
Every three years, the Bank of International Settlements provides a comprehensive review of the
OTC activity, through its Triennial Central Bank Survey. The last estimate of OTC derivatives volume in
Mexico was calculated by the BIS for April 2004. The daily average net turnover for OTC IR derivatives
was $1340 mn USD, compared to only $366 mn USD in April 2001. This represents an increase of 281%
over three years, or a constant annual growth rate of 56%. As a comparison, worldwide IR OTC
derivatives grew by 25% annually over the same period.
71
Figure for the OTC for 2005 is June, as data for December is still not available
45
As far as instrument repartition is concerned, FRA’s remain the most favoured IR derivatives on
the OTC, with 56% of volumes, whereas the relative volumes of Swaps dropped from 40% in 2001 to
30% in 2004. The Mexican OTC market is thus quite different from the worldwide market, where Swaps
dominate over FRA’s (60% of volumes compared to 23%). Options were almost inexistent in 2001 and
now account for 15% of OTC interest rate derivatives turnover, which is a figure comparable to the
worldwide average.
Fig 23 : OTC Interest derivatives volume in Mexico
Daily average turnover in millions US$
Apr 2004
FRA
SWAP
Apr 2001
Options
0
500
1000
1500
source: BIS Triennial Central Bank Survey(2005)
Figure 24 depicts the repartition according to the currency and the user/buyer of the OTC product.
The bulk of the volume is for peso-denominated instruments, which is in line with the importance of
MXN-denominated debt compared to the USD-denominated.
Fig. 24: OTC single currency IR derivatives turnover
(net of local inter-dealer double-counting) - April 2004 - percentage of total net turnover
By currency
By user
13%
17%
15%
USD
reporting dealers
abroad
20%
other financial
institutions
MXP
85%
reporting local
dealers
50%
nonfinancial
customers
Source: BIS Triennial Central Bank Survey (2005)
As far as users are concerned, half are financial dealers located abroad, meaning that the Mexican
OTC market is very open to foreign brokers (in particular towards the USA)72. Within the category “other
financial institutions”, half of the activity is performed by institutions abroad, whereas the overwhelming
72
Foreign brokers active on the market include: Prebon, GFI, Cantor, Eurobrokers, Tradition and ICAP
46
majority of non-financial users are located in the country. Furthermore, this category accounts 13% of
volumes, which is actually more than double the worldwide average.73
The growth of IR OTC derivatives is remarkable when it is compared to foreign exchange OTC
derivatives. Although the net turnover for this category is much higher (a daily average of $4543 mn
USD), forex derivatives only grew by an average 2.7% a year between 2001 and 2004. The volumes of
foreign exchange derivatives worldwide increased by 14% a year over that same period.
The success of peso interest-rate derivatives relates to the fast development domestic bond
74
market but also to the growing participation of local financial institutions. 75 The development of a local
and liquid cash market is thus highly necessary to foster the activity on the derivatives market.
The increase in the activity on MexDer will be addressed in the next part, but, at this stage of the
analysis, we would like to assess the respective importance of OTC and EXT interbank-rate derivatives
markets in Mexico.
In April 2004, 10.58 million TIIE derivatives contracts were traded on MexDer for a total notional
value of 1056 bil. MXN. Taking into account the fact that there were 22 business days during that month
and that the average MXN/USD rate was 11.1293, we estimate the daily average turnover of IR
derivatives on the organized exchange was $4314 mil. USD. At first glance, this indicates that volumes
were almost three times higher in the EXT than in OTC.
Practitioners interviewed in Mexico did not feel comfortable with such an estimate and were at an
overall consensus that OTC trades in IR derivatives should be more important than EXT.
“Technical” reasons may provide an explanation for this:
-
BIS figures are based on Central Banks estimates. There is no obligation to declare OTC
transactions, at least not in Mexico. Figures might thus be underestimated., and this is a
general problem when dealing with OTC figures.
-
EXT figures exaggerate the importance of exchanges with regard to OTC because a single
OTC transaction will involve several EXT transactions (in particular the “engrapados”
technique to replicate Swaps)76. For instance, the replication of a 3-year swap will require 39
contracts on MexDer.
73
According to interviews and press releases, we believe this category is mainly composed of prominent Mexican
firms (such as Pemex or Femsa)
74
Janneau & Perez Verdia (2005): “The growth of the domestic bond market in Mexico has spurred the development
of an increasingly sophisticated OTC Mexican peso derivatives market.”
75
Source: Ignacio Mayordomo, IRS trader, ICAP
76
See appendix 5
47
Through contacts with brokers in New York and Mexico77, we estimate that the OTC daily turnover is
comprised between USD 500 and 1000 mil. for brokers and between USD 1350 and 1500 mil. for
interbank operations (so brokers estimate is between 38% and 92% higher than BIS).
OTC is especially favoured for contracts with long duration: according to G. Vargas from JP Morgan
Mexico, “when someone is looking for more duration, he usually goes to the OTC. The 5 and 10y IR OTC
contracts, which have 65 and 130 coupons respectively, are popular contracts”. Although futures with
maturities up to 10 years have been launched recently to challenge the OTC, open interest on MexDer is
considerable only up to 3 years. According to IMF (2002), this difference in maturity between OTC and
EXT is recurrent in emergent countries. 78
The consensus among brokers was that Mexican OTC in IR derivatives was 5 to 10 times more
important than exchange. Such an estimate entails that the operations in the EXT would have an average
maturity of 1.115 year, which is consistent with our calculations on market velocity (see chapter 8) and
with the concentration index provided by MexDer.
77
ICAP, GSI, Tradition, SIF-Garban and JP Morgan
Confirmed by IMF (2002) P 59: “ The OTC segment of the fixed-income derivatives market is significantly larger
(…) than the exchange-traded segment, although the daily average turnover in this latter is higher, possibly due to
the shorter maturity of the exchange-traded instruments”
78
48
Chapter 6: Trades on Organized Exchanges
6.1
Global trends
On a worldwide basis, the trades of derivatives instruments on organized exchanges (measured in
notional principal79) have been growing by an average 16% a year over the last ten years. Actually, the
growth rate was below 10% until 2001, with even a significant decrease in the activity in 1999.80 Since
2001, volumes have been soaring every year, with an annual growth rate over that period of approximately
30%!. Activity has thus been buoyant, and has clearly outpaced the growth on cash markets: the number
of contracts traded on cash equity market has only been rising by 4% (cagr 2001-2004) and fixed-income
cash markets by 16%.81
Fig 25 : Derivative Financial Instruments Traded
On Organized Exchanges
In terms of instruments, futures remain
1.500.000
dominant over options, but the relative gap
1.000.000
has narrowed over the last ten years
500.000
(futures accounted for 84% of principal
amounts in 1996 and 71% in 2005).
FUTURES
OPTIONS
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
0
Options showed annual growth rate of
22,7%, compared to 14,1% for futures
Total
Source : BIS Quarterly Reports
Interest-rate derivatives remain
overwhelmingly dominant in exchangetraded financial derivatives, with 90% of
the activity. Nevertheless, equity-index
instruments have showed a remarkable
growth, especially since 2002 (cagr
Fig 26 : Fin. Derivatives Traded On EXT By Underlying
(Notional principal in billions of US dollars)
1.500.000
1.000.000
500.000
0
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
05
Trades by broad risk
category
Interest rate
Currency
Equity Index
source: BIS Quarterly Reports
79
Notional principal is a flow variable that represents the number of contract traded times the value of the underlying
of each contract. As an indicator, it has been preferred over the number of contracts because contract size varies from
a market to another and from a risk category to another.
80
According to the BIS Quarterly Review (Feb 2000), this decrease was due to “the effort of market participants to
pare down their positions to a minimum ahead of the new millennium”
81
Source: Bank of America Analyst Reports
49
28%). Volumes of currency derivatives remain negligible (below 1% of the activity), but major exchanges
are targeting more and more this risk category.
Trades by region
Fig 27 : Fin. Derivatives Traded On EXT By Region
(Notional principal in billions of US dollars)
As far as geographical
repartition of volume is concerned,
the
situation
has
evolved
considerably since 1996 and three
main conclusions may be drawn
from figure XX :
•
Northern American and
European markets, which
1.000.000
800.000
600.000
400.000
200.000
0
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
North America
Europe
Asia and Pacific
Other Markets
source: BIS Quarterly Reports
already concentrated 80% of activity in 1996, strengthened their dominant position over time
(with 92,63% of worldwide activity in 2005). European markets grew fast in 2003 and 2004, but
American markets have clearly taken the lead since 2004 (with an annual growth rate of 36% over
the last two years).
•
The relative importance of Asian exchanges has been decreasing continuously, from 20% of
worldwide activity in 1996 to only 6,63% in 2005. Morgan Stanley estimates that exchange-traded
IR derivatives penetration level in Asia one ninth of the US level. 82
•
The activity on the “other markets”, that is to say mainly Latin America, is much more volatile
(there were four years of decrease since 1996 for instance) and the worldwide proportion of their
activity remains below 1%
•
It is important to mention that the picture looks rather different if the number of contracts is taken
into account, instead of principal amounts. In this case, Europe and the US only account for 52%, and
Asia-Pacific is the leading region with 43% of trades. However, there is a strong bias in this case, as 91%
of contracts traded in the region are Korean equity-index options83. This is actually due to the success of
one specific contract as we shall see in the next paragraph. The relative importance of “other markets” is
82
Penetration level reflects the multiple of exchange-traded interest rate futures and options turnover over
total dollar value of domestic debt outstanding.
83
For this reason, some surveys (e.g. IOMA – Derivatives Markets Survey 2004) exclude the Korean Market from
figures.
50
also higher if contracts are taken into consideration (4.5% of contracts traded), which indicates that
contract size is smaller on average than in Europe or the US.
6.2
Trades by Exchanges
Table 4 shows the volume as a function of the number of contracts traded on the main derivatives
exchanges. Volumes have increased greatly in most of the exchanges over the last year, with the notable
exceptions of EuronextLiffe, the American Stock Exchange and the MexDer.
Table 4 - Top 20 Derivatives Exchanges by Volume
Volume – millions of contracts
Rank Country Exchange
1y 2005 Change
Rank Country Exchange
1y 2005 Change
1 Korea
Korea Exchange
2.593,10
0,20%
11 Brazil
Bolsa de Mercadorias & Futuros
199,4
8,70%
2 EU
Eurex
1.248,70
17,20%
12 USA
Philadelphia Stock Exchange
162,6
21,90%
3 USA
CME
1.090,40
35,40%
13 USA
144,8
40,20%
4 EU
Euronext.liffe
757,9
-4,20%
14 India
Pacific Exchange
National Stock Exchange of
India
131,7
75,30%
5 USA
CBOT
674,7
12,40%
15 Mexico
Mexican Derivatives Exchange
108,2
-48,60%
6 USA
CBOE
468,2
29,70%
16 EU
OMX Exchanges
103,5
8,90%
7 USA
ISE
448,7
24,30%
17 China
Dalian Commodity Exchange
99,2
12,70%
8 Brazil
Bovespa
268,6
14,10%
18 Taiwain
Taiwan Futures Exchange
92,7
56,70%
9 USA
Nymex
American Stock
Exchange
204,6
25,40%
19 EU
London Metal Exchange
78,6
9,30%
201,6
-0,50%
20 USA
Boston Options Exchange
78,2
277,00%
10 USA
Source : Futures Industry Association
Among the twenty most active derivatives markets, nine are located in the United States, and only
four are based in Europe. The remaining seven are from emerging countries, with three in Latin America
(Brazil and Mexico) and four in Asia (Korea, India, China and Taiwan).
Some other insights can be drawn from table 4:
o
#1 exchange is by far the Korea Exchange, with a volume twice as higher as #2 (Eurex). Trades
on this market are concentrated in the Kospi 200 Option (stock index option), which accounts for
97.76% of contracts traded on KFX. The Kospi 200 Option contract is besides the most traded
derivative contract, with 2535 mil. contracts exchanged in 2005. According to the IMF (2002), the
outstanding level of activity for this contract is due to the presence of many individual investors in
the market and to speculative movements.
o
Japan is absent from the Top-20 although the country ranks #2 in term of GDP. Derivatives
markets are actually very fragmented in Japan, with no less than 11 different exchanges.
o
In Europe, derivatives activity is mainly concentrated in two markets, Eurex and Euronext.Liffe
51
o
In the USA, derivatives trading is still dominated by the traditional Chicago exchanges (CME,
CBOT and CBOE) but relatively new markets, such as the International Stock Exchanges or the
Pacific Exchange have achieved to take significant stakes in the market.
o
The number of contracts is the most common tool to measure trading activity but, as already
mentioned above, it is far from being flawless.
substantially from one market to another
6.3
Indeed, the size of contracts may vary
84
Exchanges classified by type of product
Until recent times, organized derivatives markets could easily be categorized according to size. 85
However, given that the sector has been affected by major changes over the last years (see next chapter),
we are forced to adopt a new classification to distinguish between exchanges.
As markets now tend to have a few star products, in which they are specialized and provide high
liquidity, an alternative categorization that we suggest is along a “product of high liquidity”. We shall see
that some exchanges are specialized in short-term IR derivatives, whilst others concentrate in long-term IR
derivatives and in stock-based derivatives.
For each category, we shall analyse which are the specialized exchanges and which are the
dominant ones. If specialized and dominant differ with one another, it would mean that a classification
along specialization is too restrictive.
1. Short-term IR markets86
This category includes markets that have more than 80% of total volume traded in short-term
interest rates futures or options.
Table 5 – STIR Derivatives Markets
Market
Country
Bolsa de Mercadorias y Futuros (BM&F)
Brazil
Chicago Mercantile Exchange (CME)
USA
MexDer
Mexico
European
Euronext
Union
Singapore Exchange
Singapore
TIFFE
Japan
* volume of STIR products as a percentage of total volume
(2004)
source: BIS
Table 5 indicates that the CME
Prop STIR*
N.A.
84%
99%
97%
94%
99%
is the leading STIR derivatives
market
in
the
USA
and
EuronextLiffe in Europe. Two
exchanges dominate in Asia,
Singapore Exc. & TIFFE and
two in Latin America (BM&F
and MexDer).
84
For instance, the size of the MXP/USD futures contract is 500,000 Mxp on the CME (~50,000 USD) compared to
10,000 USD on the MexDer.
85
Chouikri (1994) and Barria (2000) used such a paradigm in their dissertations
86
“Short-term” is defined by BIS by less than 12 months
52
If volume is measured by the number of contracts
Fig. 28 - STIR Futures traded
(#contract - 2004)
traded on the exchange (figure 28), four markets
actually dominate worldwide: the CME, Euronext,
6%
MexDer & BM&F.87
Source: BIS
15%
BM&F
Chic a go Me rc a n tile
Exc ha n ge (CME)
Me xDe r
24%
Euron e xt
33%
Fig. 29 - STIR Futures volume
(Notional amount - 2004)
Oth e rs
22%
15%
However, the picture is rather different when
CME
46%
MexDer
notional amount is taken into account (figure 29).
Euronext
Two markets, CME and Euronext, concentrate
Others
39%
85% of the value of STIR trades88. The two Latin
0%
American markets are no longer prevalent and are
thus clearly niche players (the value of STIR trades
on the MexDer doesn’t even reach 1% of worldwide value).
2. Long-term IR markets
Figure 30 enables us to see that two markets
actually
dominate
worldwide
trades
of
LTIR
derivatives : Eurex in Europe and CBOT in USA. 89
Fig. 30 - LTIR futures volume
1%
(# contracts - 2004)
Chicago Board of Trade
1%
(CBOT)
3%
Eurex
2%
SFE (Australia) and the Tokyo SE in Asia have a
Euronext
39%
proportion of respectively 65% and 90% of their
SFE Corp.
trades in LTIR but are much smaller than CBOT and
Eurex. It may also be inferred from the BIS data that
54%
nor Latin American markets, nor any emerging
market in general, are present in this category.
Tokyo SE
Other
Source : BIS
87
volumes in STIR options are much lower than in STIR futures and have not been included in Fig. 29
With respectively the Eurodollar future contract on CME and 3m Euribor contract on Euronext
89
US Treasury Futures on CBOT, Euro Bund Futures on Eurex
88
53
Fig 31 - LTIR Futures volume
(notional amount - 2004)
1%
5%
27%
16%
2%
Chicago Board of Trade
(CBOT)
Eurex
Once again, the situation is quite different
Euronext
when notional amounts are analyzed and a
SFE Corp.
third exchange must be considered as a major
Tokyo SE
player in this category, the Sydney Futures
Other
Exchange in Australia. The absence of
49%
exchanges located in emerging markets is due
Source : BIS
to the higher sophistication of those products,
in particular the need for a well developed yield curve in the local currency.
Stock & index derivatives markets
This category includes markets specialized in four types of products:
- stock futures
- index futures
- stock options
- index option
Except stock futures (for which volumes are very low), each of the three types of products
deserves a separate analysis in terms of dominance of a market
Fig 32 - Stock Index Futures Volume
(# contracts - 2004)
The two most active markets as far as stock
indexes are concerned are CME (S&P 500
futures) and Eurex. A lot of smaller markets,
24%
CME
41%
Eurex
Euronext
7%
Korea Exchange
7%
Other
mainly in Western Europe and Asia, are also
involved in the trade of such products.
Together, they account for a quarter of
volumes.
21%
Fig 33 - Stock Index Options Volume
(#contracts - 2004)
4%
8%
CBOE
Eurex
Euronext
Korea Exchange
Other
81%
Stock Index Options, with more than 80%
of volumes, both in number of contracts and
4%
3%
The Korea SE concentrates the bulk of
notional value. Although CBOE is dominant
in this category in USA, there are still many
players with fairly low volumes. This is also
the case for Europe and Asia.
54
By contrast, trades in individual equities options are much less concentrated and no exchange
dominates the worldwide market. In North America, pure electronic markets such as the International
Stock Exchanges or the Pacific
Fig. 34 - Stock Options Volume
(#contracts - 2004)
SE challenge “old players” such
as the CBOE, the American SE
or the Philadelphia SE. In Latin
America,
stock
options
7%
are
usually traded on stock markets
(Mexico and the MexDer are an
exception in this regard). In
5%
17%
5%
6%
16%
9%
Europe, Eurex and Euronext are
well ahead of their competitors
11%
(i.e. “purely national markets”
12%
12%
ISE
Euronext
Sao Paulo SE
CBOE
Eurex
American SE
Philadelphia SE
Buenos Aires SE
Pacific SE
Other
such as Borsa Italiana or BME).
Stock
options
are
clearly
underdeveloped in Asia, except in India and Hong Kong (the region accounts for only 1.7% of worldwide
volume, and not even 1% if the Austalian SE is substracted).
Compared to interest-rates exchanges, stock & index derivatives differ in three main regards:
•
There has been much less consolidation in this category.
•
In many countries, but especially in Europe, stock derivatives are traded in the same market as the
underlying asset (Athens SE, Copenhagen SE, Borsa Italiana, Warsaw SE, Budapest SE, Wien
SE). The convergence between cash and derivatives markets is thus more evident in equity
derivatives.
•
Some emerging markets are well-established in this category, in Asia (Korea Exchange, National
Stock Exchange in India) and in South Africa. In contrast, exchange-traded equity derivatives are
still in their infancy in Latin America.
Conclusion
Except for equity options, activity in financial derivatives is now concentrated in a handful of
exchanges, which provide a high liquidity in a segment of instruments. This liquidity is a tremendous
barrier to entry for competitors and recent examples by Eurex and Euronext to challenge their American
rivals CBOT and CME on their star-products show how difficult it is to dislodge established liquidity,
55
even when offering below-market prices. 90 This ability to create “pools of liquidity” results from major
changes in the derivatives exchanges industry over the last years, and the next chapter will show how
those changes occurred. Before that, we shall provide some more insights about the instruments traded in
MexDer.
6.4
Trades on MexDer
Futures trading activity
The different products traded on MexDer and their features are explained in appendix 2. Some
108 millions futures contracts were traded on MexDer last year. Trading activity is clearly concentrated in
interbank-rate futures, which account for more than 90% of contracts exchanged. Futures on short-term
government bonds and 10-year gov. bonds respectively rank # 2 and # 5 with 4,2% and 0,25% of trading
volume. As already stated, MexDer is clearly a STIR futures market, and more than 95% of its volume
took place in those instruments.
Figure 35 : Volume by type of futures (# contracts - acc. 2005)
0%
5% 3%
0%
CETE91
TIIE28
Other
92%
USD
8%
IPC
36%
56%
BONO M10
Ind Equities
EUR
source: MexDer
As far as exchange-rate derivatives are concerned, futures on USD represented 2,7% of total
trading activity last year but are a fast growing segment. The amount of EUR futures contracts traded was
negligible (only 125 contracts), which can be explained by the fact that this instrument is “brand new”. (it
was launched on Oct 2.)
90
Euronext challenged CME on Eurodollar contracts and achieved a 3% market share in November 2004. Six
months later, less than 1% of Eurodollar futures were still traded by Euronext. Eurex attacked CBOT on US Treasury
futures and managed to “steal” a monthly volume of 300,000 contracts in Feb. 2005. In July, volumes had
plummeted below 50,000 contracts! (Source: Morgan Stanley Analyst Reports)
56
The most liquid stock-based instrument is the MSE Index future contract, but volumes are very
low compared to IR-based derivatives (only 0,4% of total volume). Individual equities futures show
almost negligible volumes, so liquidity is still problematic in equity-based derivatives.
The dominance of debt-related instruments is consistent with the higher development of the spot
market compared to equity-related instruments. Moreover, we saw in the former chapter that short-term
debt remains the dominant instrument for pension funds, which provides some explanation for the success
of short-term interest rates futures. Nevertheless, we should point out that the proportion of STIR futures
trades in total trades has been decreasing
over the last four years, from 99,88% in
2002
to
96,47% in
2005,
Fig. 36 - Repartition of operations
which
1%
4%2%
indicates a timid diversification.
TIIE contracts are used, for their
overwhelming
majority,
to
31%
create
57%
synthetic swaps, through a technique
5%
called “contratos engrapados”. (see
Appendix 3) This enables MexDer to be
a direct competitor to OTC brokers, and
TIIE28
Cetes21
it explains why so many maturities are
IPC
DEUA
M10
Others
Source: Asigna Annual Reports
available for TIIE contracts (120). Engrapados have also recently been launched for exchange-rate
contracts, which is also a well-developed segment on the OTC, and this is why those contracts have been
growing fast recently.
If the number of operations is taken into account instead of the value of trades, the picture
becomes different. STIR futures only concentrate 62% of operations, much less than their proportion of
trades in value. The case of the IPC index is even more interesting: it represents 31% of the operations but
only 0,57% of trades in value. This indicates that trades in STIR futures are more concentrated than for
stock-index futures. Besides, the number of contracts per operation is on average 2216 for TIIE28 futures,
around 1000 for Cetes 21 and DEUA and only 17 for IPC futures!
Costs of trading may not be blame for this: both IPC and TIIE28 have decreasing trading fees with
respect to the size of the operation. The only plausible explanation for such a difference in concentration is
the nature of end-users. TIIE28 futures are more traded by institutional investors, in particular pension
funds, which manage large amounts of money and require large amounts of contracts at once. IPC futures
57
are more traded by individual investors, with a lower wealth than big institutions. This explanation is also
consistent with the legal limitations for Siefores explained in the chapter on Mexico’s financial system,
which prevent some of them from investing on the stock market.
Options trading activity
The trading of options is very limited
Fig37 - Volume by type of options
(# contracts - acc. 2005)
compared to futures, with only 173000 contracts
traded in 2005. Nevertheless, this small amount
hides a significant improvement since 2004 (the
0%
22%
year the options were launched and that totalized
Naftrac
no more than 40000 trades). The market actually
IPC
only exists for equity indexes (IPC and Naftrac).
Other
Trading activity is more important for put
78%
contracts than for calls, with 58% of options
traded being puts. The prevalence of puts over
calls can be explained by the fact that the market
Source : MexDer
Other includes : Nasdaq-100, i-Shares S&P 100, i-Shares S&P 500
is mainly used by institutional investors for
portfolio insurance, more precisely for Option Based Portfolio Insurance (OBPI). Nevertheless, provided
the lack of liquidity of the organized market, international fund managers still prefer to apply Constant
Proportion Portfolio Insurance (CPPI) for investments in Mexico, which do not require the existence of a
liquid secondary option market91.
91
source: interview K. Duchateau (KBC Asset Management)
58
Chapter 7 : Recent trends in Derivatives exchanges
The landscape in the derivative exchanges industry has changed considerably over the last decade.
Three major trends have shaped this evolution: the upsurge of electronic trading, the process of
demutualization and the consolidation of the sector. Each of these trends will be analyzed separately,
using both theoretical and empirical insights. Strategic conclusions will then be drawn from these
(r)evolutions and their impact on MexDer will be assessed in the next chapter.
7.1
Electronic trading
Futures markets were among the first organized exchanges to embrace electronic trading systems,
especially in Europe. Even before they began consolidating at the end of the nineties, traditional futures
exchanges such as France’s Matif, Germany’s Deutsche Terminbörse (DTB), and the UK’s LIFFE had
abandoned the old-fashioned pits. As can be seen on Fig. 38, most futures trading in Europe was already
being done through electronic systems in 1999, whereas open outcry was still prevalent in the USA.
Fig 38 : Eletronic trading, Eur. vs US American markets were slower to automate, and in 2002,
2000
only one fourth of their trading activity was executed
1500
500
Battan (2004), order execution and handling have
0
remained in the hands of human intermediaries because
Screen (Electronic)
USA
USA
1999
EUROPE
through screen-based systems. According to Peterffy &
EUROPE
1000
2002
Floor (Open Outcry)
the rules under which markets used to perform had not
been changed and there was no financial incentive to
automate.
source : MexDer, FIA
As the authors summarize, “asking the exchanges to fully automate (…) amounted to asking them to
spend money in order to lose money”. However, the successful launch of ISE in 2000, the first 100%
electronic options market which took up to 18% of the market share in US options trading within its first
18 months of existence92, forced the traditional Chicago exchanges to react.
The concept of automation is still different in Europe and in the USA. The main European markets
(Eurex, EuronextLiffe, OMX) adopted a radical change when shifting to electronic systems and are now
purely electronic. Entrenched American markets, on the other hand, have favoured a gradual, less radical,
approach and are currently composed of “hybrid structures”. On the CME for instance, electronic trading
(Globex) and floor-based system co-exist: CME’s brochure states that “some products are offered only on
92
The example is provided by Harris (2002)
59
CME Globex, some trade side-by-side on the CME trading floor and CME Globex during the trading day,
and a few trade only after open outcry trading hours”93
One of the major outcomes of electronic trading systems was that they helped reducing trading
costs and enhanced liquidity. The Futures Industry Association calculated the evolution of the bid-ask
spread 94 of the nine most actively-traded derivatives contracts between 1999 and 2005 95 . The seven
contracts traded through electronic platforms showed a decrease in their bid-ask spread of at least 60%,
and the spread of two of them even dropped by more than 90%. In contrast, the two contracts still traded
on a pit demonstrated a rise in their bid-ask spread over that period.
For the management of an exchange, the major decision associated with the implementation of
electronic trading platforms consists the “doing or buying” question. Given that the design of such
platforms require very high-standard technological skills and thus huge investments in human capital and
money, exchanges are progressively shifting towards external resources to develop those electronic
capacities. This will be confirmed in the last part, especially in the profitability analysis of derivatives
exchanges. However, Figure 39 already shows the increase in technology-related investments by
derivatives exchanges and the growing tendency to outsource.
Fig. 39 - Electronic-trading system spendings
(mil. USD)
The outsourcing of the trading platform can
be achieved through partnerships, which is
often the case for emerging derivatives
2500
exchanges.
Partnerships
opportunity
for
provide
an
access
the
2000
1500
them
to
1000
technology developed by a major exchange.
500
Technology acquisition is also sometimes an
argument for merger or acquisition. For
0
1996
2000
2004
instance, the purchase of Liffe by Euronext
source: FIA
external
internal
was used as an opportunity to acquire its
state-of-the-art Connect system.
The question of “doing or buying” has been crucial for the evolution of the sector, because of the
close relation between electronic trading and consolidation. Many practitioners argue that the former was
in fact a rationale for the latter. As explained by Robert Iati, of TowerGroup, in 2002, “if a small exchange
93
CBOT and CBOE also adopted a hybrid structure
Which is a measure for implicit cost (Harris (2002) )
95
FIA – Annual Volume Survey (2006)
94
60
cannot afford to purchase an electronic trading systems from one of its larger competitors, it will need to
merge with one of them, becoming part of the global trend of consolidation of exchanges. This trend is
likely to greatly benefit established exchanges such as Eurex, OM, and LIFFE, which have the capital and
ability to market their electronic trading systems aggressively and are large enough to operate systems for
multiple markets.”
The shift towards electronic systems has also allowed for product innovation, particularly in the
form of smaller contracts. For instance, when the CME launched its electronic platform (Globex) in
1997, the first product to be listed on it was the E-mini S&P 500, an index futures whose size is equivalent
to one fifth of the traditional S&P 500 future contract. E-mini S&P 500 was a success story, as it enjoyed
the fastest growth in CME’s history96. Smaller contracts enabled exchanges to enhance revenues, because
transaction fees are nearly always calculated on a per contract basis, rather than on the basis on notional
values.
7.2
Globalization and consolidation
The most obvious effect of globalization on derivatives markets was a wave of consolidation,
especially in Europe, that started at the end of the last century. Consolidation took place through mergers
as well partnerships. Globalization was also characterized by an increase in the reach of new foreign,
customers through the “hub system”.
Mergers
According to Ramos (2003), the nineties were characterized by an explosion in the number of
securities exchanges (whether cash or derivatives). 97 The first mergers were induced by domestic
rationalization and gave rise “national champions”. The cross-border concentration move was initiated by
the creation of Eurex in 1998, a 50-50 merger between the German and Swiss derivatives markets (DTB Deutsche Terminbörse & SOFFEX - Swiss Options and Financial Futures Exchange). It paved the way
for an increasing integration of Europe’s derivatives exchanges, which was mainly driven by the
Investment Service Directive (ISD) and the monetary union. 98
The second step in this process, which was also the biggest M&A in derivatives exchanges
history, occurred in 2001: the recently-formed Euronext Group purchased the London International
Financial Futures & Options Exchange (LIFFE) for $805 million USD. This acquisition was a real shock
96
With an average daily volume of approximately two million contracts, this contract accounts for more than half of
all trades carried out at CME and is the fifth most actively traded derivative contract
97
Clayton, Jorgansen and Kavajecz (1999) found that no less than 60 financial exchanges were launched in Europe
during that decade.
98
Di Noia (1999) insists on the effects of remote membership allowed by the Directive
61
for London, due to the surprising rejection of a competing offer made by the London Stock Exchange
(The Economist (2005)). Trading activity of derivatives markets in Paris (MATIF – Marché à Terme
International de France and MONEP - Marchés des Options Négociables de Paris), Amsterdam, Brussels
(Belfox – Belgian Futures and Options Exchange) and Lisbon was progressively transferred to London,
under the “roof” of LIFFE (namely through its electronic platform Connect). This integration was
completed in November 2004.99 The European derivatives exchanges are now very concentrated: the Top3 exchanges accounted for 93% of trading volumes, compared to 65% in the USA.
Concentration is still progressing in the United States; the electronic stockmarket Archipelago has
recently acquired the Pacific Exchange, the 13th biggest derivatives market, in order to enter the rapidlygrowing options business. There are also persistent rumours claiming that the CME is to lead a new
consolidation wave, according to analysts.
Asia lags behind Europe in this consolidation process, with its national exchanges still converging.
For instance, the Korea Stock Exchange (KSE), the Korea Futures Exchange (KOFEX) and the KOSDAQ
Market merged in January 2005 into a single entity, the Korea Exchange (KRX). As mentioned above,
Japanese markets are very fragmented with 10 different markets whose combined volume accounts for
only one ninth of the volume in Europe.
Partnerships
Globalization through partnerships has also become a growing trend over the last years and it is
impossible to list all the existing partnerships between derivatives exchanges. The three Chicago markets
(CBOT, CME & CBOE) have built up a joint venture for individual stock futures, called OneChicago.
CME carries out clearing and settlement for CBOT, US and European exchanges collaborate through the
cross-listing of some products100. In Asia, for instance, the KRX has recently signed a “Memorandum of
Understanding on the formation of cooperative relationship” with the Central Japan Commodity
Exchange.
A special type of partnership has been referred to by microstructure literature as an “implicit
merger”101. It refers to an agreement between two exchanges to list an instrument that was originally listed
on one exchange, onto the other exchange (with remote access provided to the traders of each
99
According to Euronext’s official figures, it reduced the cost of trading by an average of 25%. (source: Annual
Reports)
100
e.g. : CME and EuronextLiffe have a strategic partnership for crossmargining on STIR contracts
101
The term was introduced by Domowitz (1995)
62
exchange). 102 Di Noia (1999) found that “implicit mergers always strictly improve welfare when there are
cross advantages in marginal cost of the exchanges” (P9). In accordance with this condition, regulatory
authorities should favour such a sort of venture. An example of such an agreement in the derivatives
industry is the one signed in 1997 between CBOT and Liffe to carry out cross-trading (T-bond futures on
Liffe and Bund futures on CBOT) in order to expand trading time for the customers. 103
Increase in global reach: the hub system
Most of the major players have also broadened their geographical scope of activity by opening
offices abroad. With the disappearance of trading pits, exchanges are becoming less and less restricted to a
single country and turned to global players. As an illustration, Eurex currently has a network of more than
400 “participants” all over Europe and the USA. In 2004, the exchange opened Eurex US, a fully
electronic market for USD-denominated interest rate derivatives. On the other side of the Atlantic, CME
has expanded its global presence thanks to its Globex electronic platform, and has also opened a hub in
Singapore this year. Analysts 104 believe that exchanges should, and will, target Asia first, due to the
weakness of organized derivatives exchanges in the region (as we have seen in the former chapter).
As a result of consolidation, the derivatives exchanges sector is now highly concentrated: the Top5 exchanges account for no less than 65% of contracts traded in 2005, compared to 53% in 1999105, and
the Top-10 for 81%.
As far as benefits for the customer are concerned, Harris (2002) points out that two
counterbalancing forces are at stake. On the one hand, consolidation improves the competition among
traders, as they are forced to provide the best price for their customers seeing as prices are easily
comparable. Within a market, consolidation is a good thing. On the other hand, competition among
market centres is more likely to be improved by fragmented markets. Among markets, consolidation
would not be such a good thing. Our point of view is that the situation with regard to competition amongst
markets is probably more balanced. The consolidation has given birth to international players, which are
now able to compete at oversees level: Eurex and Euronext.Liffe compete against CME for instance. So at
the regional level, consolidation might indeed be reducing competition, but at the same time, competition
at an international level is increased. Given the increase in market activity over the last five years, which
is highlighted in the previous chapter, it is reasonable to claim that horizontal consolidation has had an
102
This definition is based upon Di Noia (1999)
Cross-trading is especially relevant for futures exchanges, because of the non-fungible nature of the contract: a
position opened in an exchange must be closed in that same exchange. This is not the case for options, a fact which
reduces the appeal of such partnerships.
104
Camron Ghaffari at Morgan Stanley, Joshua Carter at Goldman Sach and, Chris Allen at Bank of America agree
on this statement.
105
The Top-5 exchanges in 1999 were: Eurex, CBOT, CBOE, CME and Monep (France)
103
63
overall positive impact. On the other hand, the soaring profitability of derivatives exchanges is an
argument that supports defenders of the competition among market centres. (see also chapter 11)
7.3
Demutualization
Demutualization is another major issue that primarily affected stock exchanges, and in which
derivatives exchanges have followed a similar pattern
106
. According to Aggarwal’s definition,
“demutualization is the process of converting a non-profit, mutually owned organization to a for-profit,
investor-owned corporation”. In some countries, such as Italy, where exchanges were held by the state,
demutualization was more of a privatization process. Nevertheless in all cases, the main outcome of
demutualization is the segregation between exchanges’ membership and ownership.
The process of demutualition has led to a radical shift in the nature of exchanges: they are now
driven by the necessity to generate profits for their shareholders rather to provide the best access to their
members. Using Di Noia’s (1999) terminology, they have transformed from customer-owned to outsideowned structures.107
The debate concerning the benefits and dangers of demutualization is buoyant, but it is not our in
purpose to investigate it in details. From a theoretical perspective, demutualization transformed the
perception of the market’s objective. Many authors, such as O’Hara (1995), recognize the importance of a
well-functioning exchange for the welfare of the economy. O’Hara states that “the notion of “public
interest” underlies much of the current regulation of existing markets”. For instance, by going public, an
exchanges risks the possibility of bankruptcy, which could lead to many adverse effects on the economy in
general.108
Demutualization also has a tremendous impact on the way exchanges should be regulated (Karmel
(2000)), as it might raise the fear that a for-profit company would not perform its self-regulatory function
well. Nevertheless, this danger is mitigated by the importance of reputation, especially for derivatives
markets. Fishel and Grossman (1984) found a strong relationship between the extent to which a future
exchange provides regulations to achieve customer protection and the volume of trade. And, as
highlighted by Aggarwal (2002), “exchange reputation and branding is even more important in a
demutualized environment”.
In practice, demutualization is often a step-by-step process and Aggarwal (2002) summarizes it in
four stages.
106
The first exchange to demutualize was the Stockholm Stock Exchange in 1993
Exchanges are no longer held by their direct customers (brokerage firms) but rather by their indirect customers
(investors).
108
As shown by MexDer, the danger of a bankruptcy of the exchange does exist and is crucial to the corporate
governance design of the exchange.
107
64
Fig 40 – The process of demutualization
Mutual
Society
For-profit
Private
company
Private
company
Listed
Company
Listed
Company
(without ownership
restrictions)
Member owned
source: Aggarwal (2002)
First, an exchange typically turns from a non-profit mutual society to a for-profit private company
that is still owned by its members (i.e. brokers and dealers). Secondly, equity is made available to
institutional investors through private placement. The third step involves going public, or becoming the
subsidiary of a publicly traded company. The American Stock Exchange for instance is currently
advancing towards this stage for instance, as it has recently announced its intention to undergo an IPO.
ISE has completed this stage: the exchange went public in 2004 although there are still ownership
restrictions.109
Empirically, demutualization has been implemented more quickly in some regions than others, but
as indicated by table 6, many of the major derivatives exchanges are now public for-profit company
(whereas none were such ten years ago):
In Europe, Liffe was demutualized de facto through its purchase by Euronext in 2001. Eurex is
jointly owned by Deutche Börse, a publicly listed company, and SWX Swiss Exchange, which is not
demutualized. For this reason, it is quite difficult to classify Eurex as a pure demutualized exchange.
However, as Deutsche Börse receives 85% of the profits made by Eurex, it is reasonable to considere the
exchange as demutualized
In 2002, the Chicago Mercantile Exchange demutualized, converted into a holding company
structure, and went public all at the same time. The CBOT restructured in 2005, converting its
organization from a not-for-profit membership company into a for-profit holding company with
stockholders. The Board of Trade's members became stockholders of CBOT Holdings and remained
members of its exchange. The International Securities Exchange was founded as a for-profit private
company in 2000 and underwent an IPO in March 2005. The other big US electronic market, namely the
Pacific Exchange, is a for-profit private company. CBOE, Amex and PHLX are yet to be demutualized.
109
Only market makers are allowed to own B-shares. For this reason, financial institutions that participate in the
market still possess 47% of voting rights
65
In
Table 6 - Demutualization of Derivatives Exchanges: a summary
Rank
Exchange
1 KRX (Korea)
2 Eurex
3 Chicago Mercantile Exchange
4 Euronext.liffe Group
5 Chicago Board of Trade
Chicago Board Options
6 Exchange
7 International Securities Exchange
8
9
10
15
Incorporation
Subsidiary*
private company
« public company »
public company
public company
public company
X
X
X
contrast
to
developed markets, the pace of
demutualization in emerging
market jurisdictions has been
relatively slower.110
Asia is ahead of other
emerging
private company
public company
private member- owned
Bolsa de Valores de São Paulo
company
Private member-owned
American Stock Exchange
company
New York Mercantile Exchange public company (holding)
MexDer
private company
* Derivatives activity is a subsidiary of a broader group
markets,
with
X
derivatives exchanges that have
X
either
X
(Malaysia, Philipines) or that
X
already
have initiated
demutualized
the process
(India). According to OICV-
IOSCO (2005), demutualization in Asia, including in such developed markets as Singapore or Australia,
was initiated by an integration of corporate structures and products within futures and equities exchanges.
With regard to Latin America, most of the derivatives exchanges remain non-profit organizations,
although some no longer demand membership as a compulsory prerequisite for participation. The
Mexican Stock Exchange, which owns 75% of the Mexican Derivatives exchange, is still owned by
brokerage houses (Casas de Bolsa) though it has expanded the range of participants allowed in the market,
and the same applies to BM&F in Brazil. The other Brazilian exchange active in derivatives, Bovespa, is
still a non-profit mutual association.
7.4
Conclusions from the international evolution
Consolidation, demutualization, and electronic trading appear to be the three elements that
comprise a unique process, induced by the ITC revolution and the globalization of financial flows.
Aggarwal (2002) emphasizes that “the dramatic changes in the organizational form of the exchanges
reflect major changes in their business environment, notably the rise of global competition and
technological advances.”
Together, these three radical moves indicate that the underlying nature of derivatives markets has
changed,
from
physically-based
liquidity
providers
to
technology-based
solution
providers.
Demutualization has changed the rules of the game: exchanges are no longer protected associations of
entrenched members. Competition between exchanges, whether in cash or derivatives, has become a
reality, forcing them to develop new business models. These business models can be summarized along
two dimensions (figure 41):
110
Only 8% of exchanges (cash or derivatives) in emerging markets completed the demutualization process
according to the IOSCO (2005)
66
-
The proportion of revenues that do not relate to derivatives instruments, whish distinguishes
between “pure derivatives exchanges” (a model more prevalent in the US 111) and “universal
exchanges”
-
The proportion of revenues provided only by transactions fees, which distinguishes between
exchanges that are diversified in their activity and those that focus only on transactions.
(vertical integration versus focus on transaction only)
Fig. 41 – Business models among derivatives
exchanges
Process Focus
% rev from transaction
100%
CBOE
90%
ISE
80%
CBOT
70%
60%
Eurex/DB
Euronext.Liffe
CME
50%
40%
OMX
30%
30%
50%
70%
90%
Product Focus
% rev in derivatives
Nevertheless, it is hard to place MexDer in this framework:
-
derivatives trading is an independent entity but inside a universal exchange
-
clearing is not performed by the exchange for legal reasons but Asigna and MexDer are
closely related in practice
For this reason, it is better to assess MexDer’s strategic positioning from a chronological point of
view.
111
The two main reasons highlighted by specialists are
1. Former legal restrictions and different regulatory authorities in the USA (CFTC for futures exchanges, SEC
for stock exchanges)
2. Historical heritage and differences in the banking industry due to the Glass Steagal Act. The universal
exchange is better adapted to the model of universal bank in Europe
Source: interviews
67
Chapter 8 : The adaptation of MexDer
MexDer was launched during a period of tremendous changes in the industry, so it had to adapt its
organizational structure in order to compete with international peers. Microstructural reforms had to be
implemented to foster liquidity and new market participants had to be found.
8.1
Progressive reforms on the sell side
As can be seen in figure 42, we have divided the chronological evolution of the volume into four
different phases: the hard start, the reforms, the euphoria and the hangover.
Figure XX –Fig.
Evolution
of trades
on MexDer
42 : Evolution
of trades
on MexDer
# contracts
35.000.000
The reforms
The hard start
The euphoria
Hangover
30.000.000
25.000.000
20.000.000
15.000.000
10.000.000
5.000.000
VOLUME
Jul 2005
Oct 2005
Apr 2005
Jan 2005
Oct 2004
Jul 2004
Apr 2004
Oct 2003
Jan 2004
Jul 2003
Apr 2003
Jan 2003
Jul 2002
Oct 2002
Apr 2002
Jan 2002
Oct 2001
Jul 2001
Apr 2001
Oct 2000
Jan 2001
Jul 2000
Apr 2000
Jan 2000
Jul 1999
Oct 1999
Apr 1999
Jan 1999
0
OPEN INTEREST
1. Dec 98 – 2000: The hard start
The first two years of operations were especially difficult, with volumes close to zero and an
obvious lack of liquidity. The weakness that characterized the first year can be explained by the fact that
instruments were launched gradually and market participants were scarce at the beginning (only five
institutions at the opening of the market, 21 a year later and around 50 presently). As derivatives did not
form part of the Mexican financial culture nor were they taught in its Universities, time was also needed in
order to gather users and participants. A timid take-off took place in 2000112, especially in exchange-rate
112
The take-off was timid in absolute terms but not in relative terms: volumes grew by 65% a month over the first six
months of 2000.
68
futures on account of the presidential elections, but market activity was far from buoyant: an average
118500 contracts was traded each month, that is to say slightly more than 5000 contracts traded every day.
Moreover, the total number of operations during the first two years amounted to 17 652, or an
approximated average of 32 operations per day in the exchange.
2. 2001 – 2002: The reforms
As an independent exchange with a floor platform, the Mexican derivatives exchanges obviously
failed to comply with international standards and with customers requirements. As a result, it was at the
verge of bankruptcy in 2000 and equity had fallen below the minimum required level. The possibility of
closing the market was given serious consideration113. MexDer was finally rescued by the BMV Group,
owner of the Mexican Stock Exchange (BMV), which took control of the market. According to Mr
Sanchez Arriola, who was CEO of MexDer at the time and who managed the restructuring, BMV bought a
majority stake in MexDer with the informal support of the authorities because “they were convinced an
organized derivatives exchange was necessary to Mexico”. Furthermore, Mr Sanchez Arriola admits that
the original business model of MexDer was flawed.
In consequence, a set of reforms was implemented in order to save the Mexican Derivatives
Exchange and adapt it to the recent changes in the industry:
•
An electronic platform was launched on March 8 2000 with the aim of allowing the exchange to
offer better prices and better execution. MexDer abandoned its costly trading floor and became a
pure electronic market. The electronic platform, SentraDerivados, was based on BMV’s Sentra
platform. Providing technology was part of the “rescue plan”, but nevertheless volumes were not
affected much by this technological improvement. MexDer also turned to anonymous trading, as
most international exchanges and the quotation of instruments was changed114.
•
The market was demutualized: as BMV became the main shareholder, membership and thus
access to the market was made available for non-shareholders. In reality, the demutualization was
only partial: some brokers remained (minority) shareholders whereas others preferred to sell their
stake. A legal change was also implemented in order to facilitate the access to the market: prior to
2001, brokers and dealers had to set up an independent subsidiary for trading derivatives.
However, this obligation was abandoned, thus considerably decreasing the cost of capital.
113
114
Asigna auditors, in the annual reports, were still considering a bankruptcy of MexDer as very plausible until 2001
TIIE-futures are now quoted in rates, contrary to US or European exchanges where quotation is 100%-rate
69
•
The clearinghouse changed its operational handbook in 2001. The most evident change was a
change in Initial Margin Requirement calculation, with the aim of making them risk-adjusted.
The adaptation of risk-monitoring procedures by Asigna reduced the costs of clearing for many
market participants and made the exchange more attractive to foreign participants.
XX - Volumes
of contracts
Fig. 43 Fig
: Volumes
of contracts
400000
350000
300000
250000
200000
150000
100000
50000
0
Reform
The last two changes occurred in
January 2001 and had a very
positive
impact
on
trading
activity, both in terms of volume
and open interest. These were
multiplied by a threefold factor,
mai-00 juin-00 juil-00 août00
sept- oct-00 nov-00 déc-00 janv-01 févr-01 mars00
01
although trading activity was low
compared low compared to later
years (around 350.000 contracts per month compared to an average of 17.000.000 in 2004).
•
A market maker system was implemented in May 2001 to boost liquidity and speed. Volumes
exhibited a sharp increase due to the
Fig 44 : Evolution of volume after MM
implementation
arrival of market makers 115 , rising to
850.000 contracts in May. Open interests
Reform
4.000.000
3.000.000
2.000.000
1.000.000
0
Fe
b
Ma 2001
r2
Ap 001
r
Ma 2001
y
Jun 2001
2
Jul 001
20
01
4.000.000
3.000.000
2.000.000
1.000.000
0
VOLUME
OPENINTEREST
followed
a
different
pattern:
their
evolution remained much flatter than that
trades. The difference between the two
proves that volume growth results from
the implementation of market makers,
who trade the contracts on their own
behalf and with no purpose of holding
open positions.
Although it had an immediate impact on trading activity, it is important to mention that the
market-making framework was implemented gradually, instrument by instrument.
115
See among others: Day, Paul. “Mexico derives benefit from MexDer reforms”, The Financial Times, Jun 7,
2002.
70
3. 2002 – 2004: The euphoria
Volumes doubled in January 2002 and remained at a level above 5.000.000 contracts traded per
month, with open interest soaring continuously. Both MexDer and Asigna were profitable in 2002, for the
first time in their history.
As it will be shown in the next chapters, the reforms accomplished the objective of rescuing the
exchange. It is already important to highlight the fact that the restructuring focused not only on financial
restructuring but also on microstructural issues: changing the platform from an outcry system into a pure
electronic, reforming the Clearinghouse and allowing for market makers and non-shareholders
participants. This reform gave rise to three main factors that enhanced liquidity:
1. better information on the market
2. better execution of orders
3. better cost efficiency (and so lower costs for the end-user): we have calculated that the
average commission for transaction and clearing dropped from 31.72 MXN per contract
to 9.28 MXN thanks to the combined effects of the reform!
Monthly trading activity reached a peak in June 2003, with slightly less than 30 millions contracts
traded. Trades diminished quickly in the following months (mainly because of regulatory constraints for
market makers), but open interest kept on growing. In August 2003, open interests became superior to
trading volumes for the first time, and have remained thus up to this day. This indicates that marketmaking activity was quite unstable, showing important downwards and upwards movements throughout
the euphoria period. Nonethelesss, activity by the end-users, for which open interest provided a good
proxy, was constantly growing.
The subject of open interest as compared to volume can be assessed through the use of market
velocity. Market velocity is defined as the number of contracts traded during one month divided by the
Figure 45 – market velocity
open interest at the end of that
month. It shows the number of
8
times a contract has changed
7
hands over a month, on average.
6
Market velocity provides a good
5
indicator of market users, for the
4
following reason:
3
according to the Futures Industry
2
definition,
“high
open interest figures typically
represent commercial, institu-
1
0
Ap
r
Se 199
p1 9
Fe 999
b2
Ju 000
l
De 200
c 0
Ma 200
y 0
Oc 2001
t
Ma 2001
r
Au 200
g 2
Ja 2002
n
Ju 2003
n
No 2003
v
Ap 200
r 3
Se 2004
p
Fe 2004
b2
Ju 005
l
De 200
c2 5
00
5
Association
71
tional and even retail interest in the market - traders who hold positions longer than their professional
trading counterparts.”116 Seeing as a decrease in velocity indicates a relative increase in open interest with
regard to volume, this means that the nature of market participants is changed in favour of those who hold
contracts for a longer time periods, and thus for hedging purposes. This relates to the launching and the
growing success of engrapados, in which each future contract used remains open until maturity. The
decrease in velocity shows the growing use of MexDer instruments as hedges or substitutes for OTC
derivatives. 117 The success of the euphoria period thus also rests upon product innovation.
Within three years, MexDer evolved from a minor player into the ninth derivatives exchange
worldwide in terms of contracts traded in 2004, on account of its ability to adapt to international
requirements. If futures trading is taken into account, MexDer was ranked number 5, with the Mexican
interbank-rate futures contract being the fourth most actively traded contract.118
4. 2005: The hangover
In August 2004, for the first time since the launch of the exchange, open interest started
plummeting, but showed renewed growth at the end of the year. Open interest decreased drastically in
May 2005, and has remained at low levels throughout the rest of the year compared to the last two years of
operations. Volumes followed the same pattern and dropped by over 50% from 2004 to 2005.
International conditions cannot be blamed for this sharp decrease in market activity: worldwide volume in
derivatives exchanges grew by 13,7 %119 last year. MexDer’s fall was the greatest worldwide and, as a
consequence, the exchange’s rank dropped from #9 to #15. The decrease in TIIE-28 future trading, of over
106 millions contracts, was four times greater than that of any other future contract. No significant change
in the national cash market could provide an adequate explanation either.
In reality, the TIIE future was the only contract affected by the decrease120, but the impact on the
overall activity of the market was nonetheless tremendous due to the concentration of trades in this
contract.
According to Mr Treviño, president of the BMV group, and to Mr Alegría, CEO of MexDer, the
fiscal environment is to blame for this contraction of market activity: the migration of operations (TIIE
116
Source: Burghardt (2005)
This is really a specificity of MexDer, which had the highest open interest in STIR contracts among all derivatives
exchanges
118
Based on statistics provided by the Futures Industry Association
119
Source: BIS. Volume is expressed in number of contracts. In principal notional amount, growth was 22.63%
120
Most of the contracts actually kept on growing (IPC & USD futures) or were stable (M10 future)
117
72
swaps) to off-shore markets was fuelled by an asymmetric fiscal treatment that made those markets,
particularly the American OTC market, more interesting for Mexican investors121.
Thanks to intensive lobbying by the exchange management, the law was modified and the
asymmetric treatment was abolished. As a consequence, activity began to recover at the beginning of
2006, with average daily volumes of 500,000 contracts (which is still less than in 2003 or 2004). The
growing presence of foreign participants on the exchange also explains this positive outlook122 (see next
paragraph).
Nonetheless, the sharp decline of 2005 emphasized the need for MexDer to acquire a more
balanced portfolio of instruments: the concentration in TIIE futures needs to decrease in order to prevent
such a drop in activity in future.
8.2
Expanding market participants on the buy-side
Factors that are endogenous to the market organization itself may explain some of the rapid
growth of volumes. We have already mentioned, when discussing the restructuring of the exchange in
2001, some microstructural changes that have improved the liquidity and the efficiency of the market.
Thanks to progressive changes in the Mexican legal framework, under the lobbying of the management,
new participants have been allowed to the market. This strategy, initiated at the beginning of the
“euphoria” period once microstructural functioning had been improved, aims at enlarging channels of
distribution. According to John Ross from BCG, “distribution has become the main strategic tool on
which derivatives exchanges can play now”, thus it is worth analyzing the impact of these new
participants in greater detail.
A gradual increase in the types of participants123
•
The Pension Funds
Since the end of 2003, Afores have been allowed to trade all types of derivatives – interest rate
swaps, currency forwards and listed futures and options on specified underlyings. As already stated, an
important characteristic of Afores assets is their short-term exposure. The entry of pension funds into the
market is thus a plausible explanation for the growth in STIR futures. However, specific approval has to
121
Mexican OTC was also affected by the asymmetric treatment; it was not a transfer from EXT trading to Mexican
OTC trading. The asymmetry related to a withholding tax on gains which was not compensated by a tax rebate on
losses for operations in Mexico.
122
Since the beginning of the year, gains on derivatives are tax-free for international investors, which should boost
their presence.
123
All figures provided were collected in interviews with MexDer and from internal documents
73
be granted by the regulatory authorities before Afores actually start trading derivatives, and only a handful
of institutions actually had this approval last year whereas the others were only working towards gaining
certification, according to Natel (2005)..
Nonetheless, the entry of pension funds into the market is far from being negligible: in February
2005, institutionnal investors accounted only for 0.1% of open interest. A year later, in February 2006,
they were responsible for 7.97%! These figures, provided by MexDer, further suggest that there is still a
potential for the growth of STIR-instruments, despite the prominence of these instruments in the market.
Furthermore, SB2 pension funds are now allowed to invest 15% of their assets in equity, but only
through capital protected instruments. In order to build these synthetic instruments (structured notes),
financial institutions wneed to hedge with derivatives. As a result, trading in index futures (IPC) by
institutionnals
124
changed from 0% to 43,35% within a year and Afores are likely to become major users
of options. As a result, liquidity in the cash stock market should improve: according to the World Bank
(2006), “options may play a significant role in Afores’ penetration of the stock market through indexreplication instruments, given the difficulty of trading on the cash market and complying with the
requirement to replicate the index at all times, due to varying liquidity among individual stocks”.
As mentioned in chapter 2, mutual funds are important capital providers as well, but they have yet
to acquire the permission to use derivatives125.
•
Foreign participants
Omnibus accounts were implemented in 2004 (prior to this, they were not permitted by the
legislation). These accounts, also known as global accounts (or cuentas globales), allow financial
institutions that participate in the market to group customers into a single account. The advantage this
technique provides for banks or brokerage house is a cost reduction. Moreover, omnibus accounts may be
managed, under several conditions, by external participants.
Omnibus accounts actually provide the means by which foreign participants can buy or sell
instruments traded in the MexDer, thus greatly facilitating their access to the market. According to
Wolinsky (2005), “until January 2005, foreign banks had to navigate a maze of regulations to be allowed
to trade directly on MexDer. In particular, they were required to disclose client lists and draft individual
agreements for each investor to trade on the exchange. They were also not allowed to trade directly, and
instead were required to trade through a Mexican brokerage firm.” With the emergence of omnibus
accounts, all these administrative impediments have disappeared and according to sources in foreign
institutions, this has greatly enhanced the attractiveness of the exchange.
124
125
measured by the proportion in open interest. Figures are for Feb 2005 and Feb 2006
Unofficial sources indicate that the legislation to grant the authorization is ready
74
The access of foreign participants is highly crucial due to their growing importance on the cash
market. This is especially true for the debt market: foreign holdings of Mexican Government debt
securities increased from US$ 1 bn in December 2000 to US$ 9 bn in February 2005 according to the
Central Bank. Foreigners are especially active in long-term debt, and this is confirmed by their positions
on the derivatives market: they account for 26.61% of open interest in 10 year Fixed Rate Bond futures
(M10 contracts), but only for 1.08% on TIIE28 futures contracts.
MexDer will also allow for remote membership in the near future, meaning that foreign investors
will be granted an approval to trade directly on the exchange. With this innovation, offshore participants
will have 3 ways to access the exchange at disposal:
1. an omnibus account: the foreign participant’s customer accounts are handled by a
Mexican participant
2. regular client: the foreign participant is a regular customer of a broker
3. remote member: the foreign participant trades directly on the market
Foreign participants targeted by MexDer are mainly located in the United States. Financial
institutions contacted in Belgium have no intention of entering the market in the short or medium run. 126
Only BBVA is considering the possibility of launching funds including Mexican bonds on the Benelux
market, a task for which it could use MexDer to hedge the currency risk. 127
• Capital requirement for the users
In addition to the extension of end-users, the requirements for existing users have been loosened.
The positions of derivatives must be recorded in the balance sheets of Mexican banks, which implies a
cost of capital due to capital requirement legislation. In December 28th 2005, the law on capital
requirement was adapted and banks are now allowed to “net” their positions on OTC and EXT, thus
substantially reducing the cost of capital on derivatives.
Conclusions on strategic positioning
MexDer has progressively adapted to international standards, achieving similar, or even better
levels of structural organization than the most successful derivatives exchanges in emerging markets.
Partially based on Tsetsekos and Varangis (1998) methodology, Table 6 shows that five of the more active
exchanges located in emerging countries are still lagging behind in the following areas:
- Electronic trading: BM&F in Brazil is still not completely electronic and about 40% of trading
activity still takes place through the pit.128
126
ING, Fortis, KBC, Petercam
Source: interview P-Y Domeneghetti
128
Source: L. Bonnoti (BM&F)
127
75
- Corporate governance and regulation: Asian markets are yet to be demutualized and are stateregulated.
- The original design of MexDer’s clearinghouse, backed by 4 international institutions, is unique
- MexDer’s strong cooperation with an international player, beyond a Memorandum of
Understanding, was achieved before other emerging exchanges engaged in such activity.
Improvements in legislation that allowed entry to new market participants also played a critical
role in the development of the exchange. This stands in great contrast with markets that have no organized
derivatives exchanges, such as Chile, where “a stringent regulation has dampened the development of the
derivatives market” (Fernandez (2003)).
Nevertheless, the absence of independent software vendors 129 limits the potential growth on
international markets. The Mexican exchange also lags far behind peers in emerging markets as far as
equity derivatives are concerned (the proportion of derivatives turnover compared to cash turnover is only
7% whereas equity derivatives markets are at least as important as cash markets in other “advanced”
emerging markets). This weakness seems to be the result of the legal framework that controls pension
funds investment as well as the slowness of their change towards the use of derivatives.
Table 6 – MexDer vs Emerging Derivatives Exchanges
Business
Model
Futures &
Mexico (MexDer) options
Futures &
Brazil (BM&F)
comm.
South Africa
(JSE)
Universal
Korea (KFX)
Taiwan (Taifex)
Universal
Futures &
options
Architecture
Creation
Clearinghouse
Corp. Gov
Regulation
1998
not inc.
private company
SRO
electronic
1985
inc.
mutual
SRO
floor + electronic
1995
inc.
private company
SRO
electronic
1999
inc.
mutual
government
electronic
1998
Eq
Der/Cash
inc.
mutual
government
electronic
Coop. intl
players
prop.
Mexico (MexDer) OD + MM
Foreign part.
omnibus
accounts
Type of trading
ISV
0,07
< 5%
yes
no
MEFF, CBOE
Brazil (BM&F)
South Africa
(JSE)
OD
3
15%
yes
no
CME (MOU)
OD
0,99
N.A
yes
yes
/
Korea (KFX)
OD
54,31
0%
no
yes
Tiffe (MOU)
Taiwan (Taifex)
MM
1,77
< 5%
yes
yes
CBOT (MOU)
source: company websites, interviews, BIS
Overall, MexDer has reached high standards among emerging derivatives exchanges but can we
truly claim that it now “resembles European derivatives exchanges [at the end of the nineties], which grew
129
ISV’s are technological intermediaries that provide an interface between trading systems of exchanges and of
financial institution.
76
significantly in the 1980s and 1990s with the firm and often direct backing of their governments”. (John
Mathias130 (2005))? A financial analysis is needed in order to provide a precise answer for this question.
Section 3 : Financial analysis
In 2001, MexDer was nearing bankruptcy and thus carried out a major restructuring, which also
encompassed financial aspects. This third part is aimed at assessing the success of the operation and the
financial situation as compared to international peers. MexDer and Asigna will be analyzed together, as a
single entity. The purpose of this is to get closer insight to the actual situation of the Mexican Derivatives
exchange as well as to compare it with a benchmark of international players, the majority of which
combine an exchange and a clearinghouse. The benchmark group includes 9 exchanges grouped in 2
categories:
o
Universal (“European-style”) exchanges: Euronext.Liffe, Eurex/DB, OMX, MEFF/BME
o
Pure derivatives (“US-style”) exchanges : CBOE, CBOT, CME, ISE, PHLX
The comparison is made between a recently launched derivatives exchange in an emerging
country and well-established international players. Unfortunately, we have been limited in our analysis by
the refusal of some derivatives exchanges in emerging countries to disclose information; two exchanges
accepted to submit their accounts, Taifex in Taiwan and BM&F in Brazil, which will be added to the
panel in the chapters on profitability and financial strength.131
In case of significant differences between MexDer and Asigna, a separate analysis will be
provided for the two entities. From a methodological point of view, consolidation may be carried out just
by adding the two entities because they have no common accounting operations.132
The international comparison is based on US GAAP 133, and on USD as common currency. Values
are always book values to make the comparison more accurate given that neither MexDer nor its main
shareholder, BMV, are listed companies.
The period of analysis ranges from the creation of the market in Dec. 1998 up to 2005. However,
given the important restructurings that took place at the start of 2001, the time frame has been reduced to
2000-2004 for the purpose of the international comparison.
All calculations are our own, based on financial statements of the exchanges.
130
Mr Mathias is a director at Merril Lynch in London
Insufficient information did not allow for their inclusion in the chapter on financing
132
There is one exception to this in 2004 (a payment from MexDer to Asigna). As it represents less than 0,005% of
total turnover, we consider it as negligible.
133
They provide a better comparison with Mexican GAAP. MexDer/Asigna have not implemented IFRS yet.
131
77
Growth at glance: Accounting versus activity
Figure 46 provides basic insights on the growth of very broad financial indicators, revenues and total
assets134, compared to activity135.
Figure 46 : Selected indicators for MexDer/Asigna vs US-panel
1167%
368%
200%
60%
150%
50%
40%
100%
30%
50%
20%
0%
10%
2000
-50%
2001
2002
2003
2004
2005
0%
-10%
-100%
Asset growth
Volume growth
Revenue growth
2001
assets grow th
2002
2003
volum e growth
2004
2005
revenues growth
To sum up, three main issues arise from this rapid overview of financial growth versus activity
growth, each of which will be covered in a separate chapter:
1. Total assets under management were plummeting up until the restructuring, but activity and
revenues were growing. Then, during “the reform period”, assets started growing though at a
relatively lower rate than revenues. During the subsequent euphoria period, assets growth
outpaced activity and revenue growth. As can be seen in Fig 46, there appears to be a time lag of
one year between activity growth and total assets growth. By contrast, assets evolve more in line
with activity for the US panel group, except in 2001 and in 2004. These exceptions are both due to
CME, which is an outlier in the sample as far as these assets growth is concerned136. We shall
investigate the sources of funding of the markets in order to understand the differences between
MexDer and US players, and more specifically to explain the “time lag”.
Margin fund not included (see next chapter)
1999 has not been included because variations in relative terms were very high but not at all relevant (comparison
would only be based on one month of activity, in Dec 1998)
136
The steep increase in 2001 is due to the demutualization of the exchange that translated financially into a merger
between CME and CME holding. The decrease in 2004 is due to the incorporation of clearing assets (Performance
Bonds and Security Deposits) the balance sheet of CME; the value of clearing assets was especially low at Dec 31
2004 because of very low open interest levels on the exchange at that date.
134
135
78
2. Revenues and activity are highly correlated, but revenues are less volatile. MexDer shares this
feature in common with international exchanges, but the elasticity of revenues with regard to
activity is lower for MexDer (0.54) than for US players (0.75 on average). A profitability analysis
will help us in understanding the reasons behind this as well as link the generation of revenues and
profits to the financial structure.
3. Compared to international players, variations in activity, revenues and assets have been extremely
large for MexDer. US derivatives markets are less volatile with regard to these three indicators
than MexDer, as is seen in both their joint analysis and an individual analysis of each. Even the
International Stock Exchange, which was launched later than MexDer (in 2000), has never had to
endure such powerful shocks. Nevertheless, it should be mentionned that the average of the panel
conceals the different situations among exchanges. Three of them clearly are clearly superior on
the three indicators: CME, CBOT and ISE. The two others, CBOE and PHLX, are
underperformers, showing slow or negative growth in activity which translates into worse
revenues and assets indicators.
The crucial question at this stage is whether these large variations entail that MexDer/Asigna is
still vulnerable from a financial point of view? We shall address this in a third chapter dedicated to
a ratio analysis of financial strength indicators and to a valuation of the exchange.
79
Chapter 9: Financing
How do financial derivatives exchanges finance their activity and investments? To answer this
question with regard to MexDer/Asigna, the two entities will be first explained separately because funding
sources and requirements differ considerably. For international comparisons, the presence or the absence
of a clearinghouse to perform market-to-making has a major impact on the financial structure of
derivatives exchanges as well.137 For most international exchanges, funds that are used to back-up clearing
activities are included in the total assets but are actually netted in the working capital. The net assets
(working capital + non-current assets), which also represent the capitalization of the firm (Equity + LT
Debt) should be much smaller than the total assets used. This is largely confirmed by our sample:
1
average capitalization/total assets is 37% for sample members with clearing facilities.
2
exchanges with no clearing activities have a firm value that is much closer to the actual assets
employed, with a capitalization/total assets ratio of 82,3%
Fig 47: Capitalization/Total asset (MexDer/Asigna)
100%
the second group to the first. Prior to the
80%
restructuring, clearing assets were not very
60%
important due to poor market activity. It was
40%
only after the reforms, that MexDer became
20%
comparable to international exchanges with
0%
1998 1999 2000 2001 2002 2003 2004 2005
9.1
MexDer/Asigna has gradually evolved from
clearing facilities.
The patrimony of the Clearinghouse
Serving as a counterparty for every transaction, the clearinghouse must be designed in such a way that
credit risk is minimized. The funding sources must address a fundamental concern: liabilities should be
sufficient to absorb shocks on the market and remain solvable. The mechanism of intervention can be
divided into three steps, which also represent the main categories of the legal patrimony of the
clearinghouse and its main funding sources.
•
Margin fund: this fund includes deposits, margin requirements and margin calls, from
contractors. The margin fund is considered by the Mexican Financial Legislation as off-balance,
137
Vertically integrated exchanges: CME, PHLX, DB, BME, OMX, BM&F, Taifex. The two pure options
exchanges, ISE and CBOE, rely on OCC (Options Clearing Corp.), which clears all option trades for the USA.
Clearing is not visible at all in ISE accounts because the exchange relies on “pure market makers” that form the
interface between OCC and the counterparties to the trade. CBOT outsources to CME, and Euronext to
LCH.Clearnet (an associated company which is thus consolidated as a financial investment)
80
although it is part of the clearinghouse patrimony138. The margins differ depending on the type of
contract and are calculated in such a way that the probability of insufficiency is below 0.0001%
(4,8 times the standard deviation of the underlying). Additional margin can also be required from
clients depending on their credit quality. Appendix 4 provides a practical example of how these
margins are calculated
•
Compensation fund: this is funded by the trustees of the clearinghouse, rather than by the
contractors of derivatives. It is necessary to use this fund in case the margin fund is not sufficient
and its value is calculated in such a way that the probability of using it completely is below
0.000001%. The compensation fund is a current liability139 and, by legal obligation, must be worth
at least 10% of the margin fund.
•
Trustees Equity (own patrimony): the patrimony of the house includes the reported results and the
funds originally provided by the trustees. It should be used when both the margin and
compensation
funds
are
not
sufficient for the absorbance of a
Figure 48 : Legal patrimony of Asigna
(‘000 MXN)
very extreme price variation on
8000000
100%
the
6000000
80%
derivatives
(Appendix
5
exchange.
provides
examples
of
such
Mexico
proving
recent
events
that
in
the
60%
4000000
40%
2000000
20%
0
0%
1998 1999 2000 2001 2002 2003 2004 2005
likelihood of using the trustees
equity is minimal). There is a
minimum threshold below which
shareholders have to intervene
Legal patrimonium asigna
% trustee equity
% margin fund
% compensation fund
(54.563 mil MXN).
The total value of the legal patrimony has shown an increase that is almost proportional to trading
activity as measured by open interest (and not by volume, as it depends on the contracts open at a given
time)140. The legal patrimony was worth 7.25 bn. MXN in 2004, but dropped to 6.44 bn. MXN in 2005,
due to lower open interest at the end of the year compared with the year 2004.
138
Until 1999, the margin fund was included in the equity, a conceptually illogical rule as funds are provided by
contractors, not trustees. Furthermore, the change now allows for a comparison with US markets (for instance, the
$47.5 bil worth margin fund managed by CME is not included in its consolidates statements either)
139
Until 1999, the compensation fund was considered an equity
140
Correlation is not perfect because:
- trustee equity is independent from open interest
- change in derivatives prices affect the value of the margin fund and the relationship between value of open
interest and value of margin fund is not linear due to margin calls
- margin requirements depend on the underlying and the client
81
Together, the margin and compensation funds represent 97% of Asigna’s patrimony. This
proportion has remained quite constant since 2003. Prior to this, when market activity used to be much
lower (1998-2002), the proportion of equity in the clearinghouse’s patrimony was more important. Several
years were thus necessary for the exchange to mature and for the clearinghouse to rely relatively less on
equity funding. It is important to insist that, nowadays, only 12% of the patrimony is funded by the
trustees (the margin fund being funded by market participants) and included in the total assets and
liabilities.
Given the amounts at stake, Asigna can extract substantial revenues from (very short-term)
investments of its patrimony (26% of its revenues in 2005); funding sources are also revenue sources.
9.2
The patrimony of MexDer
As opposed to the clearinghouse, the patrimony of the exchange only represents a small
proportion of the total assets managed by MexDer/Asigna, even if the margin fund is excluded from the
analysis (the total assets of MexDer represent 13% of the total in 2005). In other words, when balance
sheets are analyzed, it is important to bear in mind that the trading activity is much less capital-requiring
than the clearing activity.
9.3
Cash flows from Asigna
Ever since 2002, Asigna no longer has any influence on the free cash-flows of the Mexican
Derivatives Exchange as a whole, a fact that is conceptually consistent with its legal framework (a trust
that is only involved in the proper functioning of the exchange). Cash flow from operations is equal to
zero because all profits are reinvested in marketable securities (included in working capital requirement)
and because the assets and liabilities which form the compensation fund are both part of the working
capital requirement. Cash flow from financing was important during the four first years of operation:
Asigna had to expand its financing through equity issuance (in 1998 and 1999). It decreased in 2000 (see
figure 49) because of a change in the accounting treatment of the margin fund: this latter was excluded
from the balance sheet and thus no longer visible in the cash flows. CFfin rose again with the growth in
activity, which had a positive impact on the compensation fund. It has become much less important since,
again because of a change in the accounting legislation (the compensation was transferred from equity to
current liabilities and from CFfin to CFop).
Cash flow from investment activity has always been equal to zero, with the exception of 1998
when investments had to be made to set up Asigna. The clearinghouse hasn’t required any significant
investment since, not even for the launch of options trading in 2004.
82
Since 2002, we can say that clearing operations have been “cash-flow neutral”: initial margin and
Fig 49 – FCF Asigna
Figure XX
Asigna Free
Cash Flows
(in: thousands
MXN)
margin requirements are absent from cash
flows, and compensation carried out by
clearing members does not impact on the final
140000
120000
value of operational cash flows. Asigna’s cash-
100000
flow is only affected by a change in its
80000
structure, such as the arrival of a new member,
60000
40000
but not by a change in activity. A change in
20000
structure occurred in 2004: Santander Serfín
0
-20000
1998 1999 2000 2001 2002 2003 2004 2005
became a new Clearing Member for third party
position, which impacted CF from operations
-40000
CF operations
CF investment
CF financing
Var. cash/FCF
negatively due to a rise in the WCR (as the
funds provided were invested in marketable
securities)
This cash-flow neutrality that characterizes Asigna is a major financial advantage because it
entails that the transaction entity (MexDer) does not need to fund the increase in working capital
generated by the growth of the activity. In addition, the funding of the clearinghouse does not depend on
the financial performance of the exchange, which fosters its solvency.
9.4 Cash-flows from MexDer
As far as MexDer is concerned, cash flow from operations is very similar to the net income.
Working capital requirement is not a concern given the architecture of the clearing and the MexDer’s
integration in the BMV group (almost all payables and receivables are to other entities of the group).
Similarly, depreciation and amortization are very low because MexDer is not proprietary of much of its
infrastructure.
Cash flow from investing activities has always been limited, used for expenses for equipment,
with the exception of 4 years that clearly highlight the major investments or divestments:
1. In 1998 and 1999, it was highly negative due to the expenses needed to launch the market
2. In 2000, it was positive thanks to the sale of a 32% stake in Bursatec to BMV. It is very plausible
that this divestment was a means for BMV to supply cash to MexDer, which was already lacking
financial liquidities.
3. In 2003, CFinv plummeted due to the investment made to launch the options trading platform.
83
Figure 50 : MexDer Cash flow from investing activities
(in ‘000 MXN)
D iv e s tm e n t
B u rs a te c
15000
10000
5000
0
-5 00 0
1998
1999
2000
2001
2002
2003
2004
2005
-10000
-15000
-20000
Laun ch
L a u n c h o p tio n s
E xcha nge
tr a d in g
Investments are limited to very specific projects: for instance, the entrance of new participants is
made at no cost for the exchange (and thus participants bear the investment).
Cash flows from financing activities highlight that MexDer was financed three times externally:
-
In 1998, some 45 mil. MXN were brought in by shareholders to launch the business
-
In 2001, BMV injected 16.65 mil. MXN to rescue the exchange from bankruptcy
-
In 2003, MexDer acquired the license from Meff for the option trading platform, but the capital
increase occurred in 2004. In 2003, the investment was financed through current liabilities (an account
payable to MEFF), which were transformed into an equity issuance in 2004. This operation was
internal for financial cash-flows and thus was not evident. The amount, 17.84 mil MXN, covered
exactly the investment necessary for the platform.
In 2005, a dividend of 22 mil. MXN was paid to shareholders for the first time in MexDer’s history.
Figure 51 : Cash flows from financing activities
(in ‘000
As we can see, MexDer has thus never relied
on MXN)
debt issuance for its external financing.
L a u n c h o p ti o n s
Launch
tr a d in g
E xch a ng e
50000
40000
30000
20000
10000
0
-10000
1998
1999
2000
2001
2002
2003
2004
2005
-20000
-30000
R e s t r u c t u ri n g
D iv id e n d
P aym ent
84
9.5
Comparison with International Competitors141
As far as the panel is concerned, operational cash flow has been positive every year and for almost
every exchange, with a few exceptions for the least profitable exchanges (OMX, PHLX and CBOE). On
average, cash generated by the activity soared from 15% of revenues in 2002 to 32% in 2005, with no
significant difference between the US model (pure derivatives) and the European model (universal
exchanges).
What differs between the Mexican derivatives exchanges and its international competitors is the
nature of CFop: for MexDer, they are very similar to the net income, but this is not the case for the panel. 142
In 2004, derivatives exchanges extracted an average 45% of their operational cash from the net income.
(compared to 94% for MexDer). Cash inflows are thus much more sensitive to fluctuations of the net
income for MexDer than it is for the panel. Financing is highly dependent on profitability.
For this same reason, MexDer has also a lower CFinv/revenues ratio compared to the international
benchmark. Cash flows for investment is actually very different between American and European
exchanges (see fig 52), and MexDer is much more similar to the US panel. The difference is especially
visible for 2002 and 2003, and reflects the major changes in the industry in Europe143. As far as American
derivatives exchanges are concerned, it should be noted that every exchange except CBOE has made one
major investment over the period 2000-2005144.
The lower investment rate in MexDer also relates to its operational structure: being a subsidiary of the
BMV group, the exchange does not own its building nor computer facilities. With regard to cash flow
from financing, MexDer was in the need for external cash in 2000 and 2001 in proportions much higher
than any other exchange in our panel group. The situation was thus catastrophic by international standards.
However, the restructuring proved to be successful from a financial perspective as the Mexican exchange
managed to acquire levels of external funding (measured by the ratio CFfin/revenues) comparable to those
found in US derivatives exchanges. This latter category relies very little on external funding: the cash
generated by activity has been sufficient to finance all recent investments. External funding used to be
141
The only major accounting difference between MexDer and international benchmark refers to marketable
securities for compensation activity, which are considered as working capital requirement in Mexico (CFop), current
investments in USA and Germany (CFinv) and financial investments in Holland for Euronext (CFfin).
142
On average, and for every exchange every year, the ratio CFop /Net Income is significantly higher than one.
143
2002: full purchase of Clearstream by DB. 2003: Disposal of LCH.Clearnet by Euronext.
144
Major investment is defined as a ratio CF to investment/revenues of over 30%. Investments were the followings:
PHLX (2000), CME (2003 – Common Clearing Link), ISE (2004 – Purchase new trading software to OMX), CBOT
(2005 – Short-term financial investments)
85
more prevalent in the European model at the time of the restructuring of the industry (2000-2002),
especially due to equity issuance by DB/Eurex and OMX.
Figure 52 – Cash flows/Revenues ratios of Derivatives Exchanges
CF (op)/Revenues
CF (fin)/Revenues
50%
250%
0%
150%
2000
-50%
2001
2002
2003
2004
50%
-100%
-50%
-150%
-150%
Average US
Average panel
MexDer/Asigna
2000
Average US
2002
Average panel
2003
2004
MexDer/Asigna
FCF/Revenues
CF(inv)/Revenues
150%
100%
100%
50%
50%
0%
2000
-50%
2001
2002
2003
2004
0%
-50%
-100%
2000
2001
2002
2003
2004
-100%
Average US
9.6
2001
Average panel
MexDer/Asigna
Average US
Average panel
MexDer/Asigna
Conclusions on financing
A comparison between the sources of funding indicates that MexDer has relied much more on
profits from activity for the financing of its growth since its restructuring than did international derivatives
exchanges (measured in 2004), and much less on past investments. In consequence, asset growth
depended much on past revenues. With regard to international peers, MexDer was also forced to rely more
greatly on external funding through equity issuance to finance its growth.
Fig 53 : Sources of funds - MexDer after restructuring (2002-2005) vs Panel (2004)
11%
2%
5%
11%
7%
21%
47%
60%
6%
Profit
Depr & Am
Equity issue
30%
Working capital
Differed taxes
Prof it
Depr, am & imp.
W orking capital
Debt issue
Other
86
The funds at MexDer’s disposal are invested to an overwhelming extent in working capital, and
more specifically in cash. Dividends were paid for the first time in 2005, so it would be meaningless to
compute a pay-out ratio, but Figure 54 indicates that they nevertheless represent a smaller proportion of
the employment of funds than they do in international levels. The investment rate is also much lower,
which explains why depreciation and amortization rates are so low.
Fig 54 : Uses of funds – MexDer after restructuring (2002-2005) vs Panel (2004)
12%
6% 1%
7%
9%
22%
13%
34%
68%
Loss
Cash & WCR
Dividends
28%
Investments
wcr
Cash
Dividends
Investments
Debt rep.
Other
87
Chapter 10 : Profitability
Return on equity is clearly the main indicator of a company’s profitability. But we shall divide it
by analyzing the determinants of the commercial profitability, than the industrial profitability and finally
the equity profitability.
10.1 Commercial Profitability
A. The revenue mix
Revenues have been almost equally distributed between MexDer and Asigna since 2001.
Transaction and clearing fees account together for 83% of revenues, some 10% more than in the
international panel. The Mexican exchange is thus more exposed to revenues directly related to trading
Figure 55 – Revenue mix (2005)
activity, a factor that increases the
business risk as management cannot
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
control it directly.
proportion
of
145
such
However, t he
revenues
has
decreased however, from 91% in 2004,
MexDer/Asigna
Panel
Source : annual reports, analyst coverage
Other
and it is also lower than for Taifex
information technology
(95%). Furthemore, figure 55 indicates
market data
that MexDer relies to a lesser extent on
Transaction,membership
& clearing fees
the sale of market data, than the average
of international players.
Overall, European exchanges rely much
less on transaction related revenues and
complete their revenue mix with sales of IT systems or solutions to other exchanges. Euronext and OMX
are especially active in this area, with more than half of the revenues for OMX being derived from the sale
of technology. By contrast, MexDer is rather a net buyer of IT systems, similarly to “old and medium US
players”. As already stated above, Asigna also earns financial revenues from short term (3 to 5 days)
investments of the compensation and margin fund, which is included in the “other” category.146
In general, revenues that relate to transaction and clearing still represent about 70% of total
revenues: the transaction function of an exchange, as described in the introduction, is thus still prevalent in
145
This was the rationale for an extension of the revenue mix, especially for IR derivatives exchanges where trading
volumes are highly affected by changes in interest rates (over which exchange management has no control)
146
These revenues are considered as operational revenues. This is also the case for some international players: for
instance, BME (Spain) extracts substantial revenues from investments of its clearing facility’s patrimony.
88
the generation of revenues although it has decreased much147. Not all exchanges provide specific figures
for clearing vs transaction revenues but it seems that revenues from clearing are proportionally high for
MexDer. When Euronext was in ownership of its clearing facility, up until 2003, clearing amounted to
exactly one third and transaction to two thirds of revenues generated by derivatives trading. (compared
with an almost equal distribution in MexDer).
B. A decrease in commissions
As mentioned above, a difference was observed in revenue and activity growth between 2001 and
2003, incidentally also the period of greatest growth. Following the restructuring, MexDer/Asigna clearly
pursued a volume-growth strategy by cutting prices: average clearing and trading commissions per
contract decreased by 30% in 2002 and 10.6% in 2003. On average, commissions also decreased in the
US panel, but to much limited proportions: 3.8% in 2002 and 2.4% in 2003.
Over the last two years, average revenues per contract ceased decreasing but prices still remain
higher than international players. Compared with other STIR-der. exchanges, we have calculated that each
100,000 USD notional amount traded on the Mexican market generated 78 cents transactions and clearing
revenues in 2004, compared to 12 cents for CME and 7.7 for Liffe148, but 75 cents for Yield-X (JSE) in
South Africa. A transaction on MexDer is thus obviously more expensive than on big international
exchanges if notional amount is taken into account, but the comparison provided above is not really
meaningful. Users pay different prices depending on their status and the size of their order.149 According
to derivatives brokers, liquidity and tick size are more important for the total cost of trading, and in this
regard, MexDer is worthy of competition150.
C. Revenues by instruments
When transaction and clearing revenues are analyzed according to the different instruments traded
on MexDer, it appears that the TIIE28 contract has actually become less profitable than the others
(especially compared to the IPC and the CETE91 contracts), particularly in terms of transaction revenues.
The relative profitability151 of TIIE contracts dropped from 85.5% to 74.6%!
We find broadly two reasons for this downward movement:
147
Transactions revenues represented 94% of revenues for Eur. Derivatives Exchanges in 1993 (Chouikri (1994))
Excluding clearing fees. Provided that clearing fees represent on average 30% of total transaction costs, prices on
CME and Liffe are very similar
149
According to a trader at Fortis Bank, prices can be negociated for important orders
150
“Until 2002, trading on MexDer was more expensive than on American exchanges, but now it is very
comparable” (Ing. Firmin Gutierrez, Casa de Bolsa Vector).
151
Relative profitability: prop of total revenues derived from the instrument / prop of total trades made by the
instrument.
148
89
1. TIIE28 are more commonly traded by market makers, who pay lower transaction commissions.
2. Competition from OTC markets forced MexDer to cut prices (e.g. decreasing fees for
engrapados).152
Figure 56 : Revenues by instruments
Figure
56
shows
that
the
ratio
revenues/volumes differs greatly from one
100%
instrument to another. Stock-index futures
90%
80%
and options are the most profitable
70%
O t h e rs
60%
IP C o p t io n s
50%
IP C fu t u re s
contracts in relative terms153, followed by
M 10 fu t u r e s
U S D fu t u r e s
40%
C E T E S 9 1 fu t u r e s
T IIE 2 8 fu t u r e s
30%
20%
LTIR contracts. Limited volumes do not
entail low profitability for the exchange;
the most successful products are rather
10%
those that face less competition from OTC
0%
volum e
revenue
or international exchanges.
These products of relatively low volumes
but high profitability are more likely to fulfill the needs of specific investors who are then willing to pay
for this specificity. The analysis of the Mexican financial system, particularly with regard to the lack of
development of the stock exchange, supports this to a certain extent. But pricing strategy based on high
margins limits the further growth for such instruments and a price cutting strategy has obviously worked
well with TIIE contracts.
Moreover, what the lower probability of TIIE28 clearly indicates is that liquidity has a “price” for
the exchange; it doesn’t increase costs but it does lower revenues. This is consistent with the theoretical
literature (e.g. O’Hara (1995) ): liquidity provides a competitive advantage to the exchange, but it also
pressures revenues down. Thus there is a “cost” for building the advantage.
D. Expenses
As far as costs are concerned, it is first important to mention that all expenses relate to fix costs; there
is no marginal variable cost for trading an additional contract. Personal costs represent more than half of
the expenses, both for MexDer and Asigna. The proportion seems lower for our international panel, but is
actually comparable if taking into account the outsourcing and consultancy expenses, which mainly relate
152
The argument is confirmed by the fact that the revenue from TIIE28 fell from 83.5% to 68.9% in 2004, as
competition increased from US OTC.
153
IPC futures only account for 0.4% of trades but provide 13.8% of revenues, IPC options for 0.03% of trades and
1.52% of revenues. This renders them respectively 6.7 and 3.4 times more profitable than TIIE28 contracts.
90
to staff expenses. Exchanges are still staff-intensive, even pure electronic exchanges, which do not have
significantly lower staff expenses.154
Outsourcing to external companies is indeed lower in MexDer than the international players.
Nonetheless, the vast majority of the operational activities are performed by other entities of the BMV
group:
-
Staffing is paid to Corporativo, MexDer and Asigna having no employees
-
Premises are cashed out to the real-estate subsidiary Cebur
-
IT expenses go to Bursatec
81% of total expenses are paid to related parties, within the BMV group, demonstrating that the
derivatives exchange is operationally integrated within the stock exchange.
Fig 57 - Operationnal Expenses MexDer/Asigna
Operationnal Expenses Panel
11%
5%
11%
6%
13%
41%
56%
19%
6%
2%
13%
1%
Compensation and benefits
Advertising & marketing
Premises
Other
3%
Outsourcing & consultancy
Communication, sofware & IT
Depr & Am
Compensation and benefits
Advertising & marketing
Premises
Other
13%
Outsourcing & consultancy
Communication, sofware & IT
Depr & Am
sources: Annual Reports, Financial Statements MexDer & Asigna, analysts reports
Expenses incurred by MexDer do not differ much from those incurred by the panel group.
Premises and marketing expenses for instance are very similar. Inside the panel group, expenses remain
also similar; IT spending is the category that varies most, in absolute terms, from one exchange to another,
with proportions ranging from 8% for BME or DB to 20% for Euronext and even 22% for ISE. In relative
terms, marketing and advertising costs conceals important variations, from 0,2% for a rather traditional
exchange such as PHLX to 5% for ISE.
E. Operating margin (Operating profit before tax/Income)
Operating margins were negative for MexDer/Asigna up until 2001, although they improved on a
yearly basis. The operational and financial restructuring of the exchange had an immediate, and important,
impact on profitability: operating margins were already consistent with international competitors in 2002
154
The only exchange with significantly lower staff expenses is CBOT. The reason for this is that clearing has been
outsourced to CME. If outsourcing costs are included, CBOT figures are very near average
91
and were close to top-performers such as CME and ISE in 2003. Although the growth of their operational
profitability was less radical than that of MexDer/Asigna, the operational margin of American derivatives
exchanges improved yearly from 2000 to 2004, and even to 2005 for the exchanges that have already
published their accounts. Margins were negative for all the US exchanges included in our panel in 2000
due to bad market conditions. They now differ greatly between highly profitable exchanges (ISE, CME
with margins above 40%) and less profitable ones (PHLX and CBOE). Taifex and BMF are also very
similar to top US performers in terms of operating margins, so the profitability of MexDer is not an
exception in emerging markets.
Contrary to US competitors and despite the stability of volumes traded between 2003 and 2004,
the operating profitability contracted a
little on that year. On the transaction side,
Figure 58 – Profitability margin (Mexico vs US)
100%
this was due to the slow growth of the
50%
option business, which required additional
0%
fixed costs. On the clearing side, there was
-50%
a general increase in costs as well, and
2000
2001
2002
2003
2004
2005
-100%
-150%
especially staff costs that went up by 30%.
The decrease in profitability was thus
-200%
-250%
clearly cost-driven in 2004. In contrast,
Op margin MexDer/Asigna
Op Margin US Panel
operating margin plummeted in 2005, as
trading activity went down. In this case, the drop was rather revenue-driven. There was even a slight
reduction in costs, but not enough to compensate for the revenue decrease.
F. Conclusions on Commercial profitability (Net profit margin)
As far as commercial profitability is concerned, exchanges can be grouped into three categories:
a. Exchanges with high commercial profitability (net profit margin above 25%)
This category includes the Brazilian, Spanish, Mexican
and Taiwanese exchanges and CME. The latter benefits
Fig 59 – EXT with a high commercial
profitability
from its strong leadership in STIR futures as well as the
60,00%
success of its highly profitable e-mini contracts. Its
40,00%
20,00%
margins have been improving constantly. MexDer took
0,00%
advantage of its restructuring and buoyant activity, and
-20,00%
-40,00%
joined the category after 2001, similarly to Taifex (where
-60,00%
volumes exploded in 2003). BM&F is stagnating despite
-80,00%
2001
BME
BMF
2002
2003
CME
MexDer
2004
Taifex
92
strong volume growth (+58%) and BME is the only universal exchange present in this category.
b. Exchanges with medium commercial profitability
Exchanges included here are CBOT, ISE, DB and Euronext. The two European companies
underwent
a
decrease
in
their
margins,
due
to
restructurings
Fig 60 – EXT with medium
commercial profitability
- For Euronext, the sale of the highly profitable clearing
facilities LCH in 2003 and the progressive transfer of all
derivatives activities to London (completed only in 2004)
- For DB the integration of Cedel and the lower
profitability of its clearing facilities (which range far
30,00%
20,00%
10,00%
0,00%
-10,00%
-20,00%
2001
beyond clearing for derivatives instruments). Pressures to
CBOT
downsize margins also originate from a (failed) attempt to
2002
ISE
DB
2003
2004
Euronext
compete on prices with US derivatives exchanges and from a strong lobbying by investment banks.
c. Exchanges with low commercial profitability (profit margin below 5%)
Two US options exchanges included in our panel are
amid the least profitable exchanges, CBOE and PHLX.
They are also the last ones that have yet to demutualize
Fig 61 – EXT with low commercial
profitability
20,00%
and show a stronger reliance on floor-trading than their
10,00%
competitors. Furthermore, they suffered from the greater
0,00%
competition from new entrants such as the ISE or recently
-10,00%
the Boston Exchange. In Europe, OMX was unprofitable
-20,00%
2001
2002
2003
2004
until 2004, mainly because of restructuring effects
(integration of Helsinki exchange in 2003) but also due to
CBOE
PHLX
OMX
a very different business model which focuses more on technology (and thus renders it more vulnerable to
downturns in the IT industry)
To conclude:
•
Different business models do not necessarily entail different commercial profitability: pure
derivatives and universal exchanges are present in all three categories
•
Emerging derivatives markets are amidst of the best players, having demonstrated significant
improvements in their net commercial profitability until 2003.
93
10.2 Industrial profitability
A. Return on total average assets
If total assets are taken into account when assessing industrial profitability, significant differences
appear between exchanges depending on the presence or the absence of an incorporated clearinghouse.
Some examples will illustrate this fact:
-
The return on average total assets of Euronext changed from 2.777% to 6.854% with the sale of its
clearing facilities (LCH) in 2003.
-
The purchase of Clearstream lowered the ROA of Deutsche Börse from 9.54% to 3.59% (2002).
-
CME, which is the most profitable exchange of our sample in terms of net margin, has a close-toaverage ROA on account of its important clearinghouse. CBOT, which outsources clearing to
CME, has a higher ROA but a lower net margin.
From a theoretical point of view, it seems logical that clearing facilities should lower the return on
asset, because they also reduces the risk of the assets. Clearing assets are composed of restricted cash and
marketable securities (government bonds)155, which are liquid and risk-free assets. When added to the
balance sheet of the transaction entity, they assets reduce the â assets and in turn, asset profitability is
lowered. We calculated that the â assets for CME without clearing is 4.8 times higher than it is with
clearing.156
B. Return on net assets
The return on net assets (defined as the ratio of profit/ avg. operational assets
157
) is thus a better
measure for assessing the profitability of investments made by the exchanges. As it can be inferred from
figure 62, the return on investment has been
Fig 62 – Return on Net Assets
extremely volatile for MexDer ever since its
60%
launch, which highlights the high risk of its
40%
activity. BM&F and, to a lesser extent Taifex,
20%
showed more stable ROI over that period. The
0%
-20%
2000
2001
2002
2003
2004
2005
take-over by BMV improved the commercial
-40%
profitability through activity but also reduced
-60%
fixed assets (through the sale of its stake in
Panel
MexDer/Asigna
155
The range of financial assets that can be used for margins has been expanding over the years (some
clearinghouses even accepting stocks as collateral) and is used as a strategic tool to increase activity (source: Capco
(2005))
156
Asumptions: US-TBill as risk-free rate, 5% market premium (analysts consensus)
157
Operational assets are composed of non-current assets and working capital. They are equal to the book
capitalization of the firm (Equity + Financial Debt)
94
Bursatec, MexDer was no longer in ownership of its trading facility), and industrial profitability was thus
exceptional in 2002 and 2003, but though in an artificial manner. The investment in options brought
MexDer back to levels similar to those of international peers. As far as these are concerned, return on
investment grew steadily from an average of 2.3% in 2001 to 12.19% in 2004. Globally, the evolution has
been positive but the situation varies greatly from one trading place to another. For this reason, asset
management will be examined individually.
C. Commercial vs industrial profitability: sales to net assets
Return on investments can be related to the commercial profitability through the sales to net asset
ratio, which measures the efficiency of the management in using the assets at its disposal. Four categories
of exchanges can be distinguished as far as asset turnover is
concerned (fig 53):
-
Two US exchanges (ISE and CME) for whom the sales to
assets ratio decreased, due to an increase in their working
Fig. 63 : Sales to net assets
2
CME
ISE
1
capital. Both of them have been accumulating cash over
0
the last year in order to prepare for a possible take-over
2001
2002
2003
2004
of a competitor.
-
Two other US exchanges, CBOE and PHLX for whom the
ratio increased: the management of these exchanges
(especially PHLX) lowered investments in order to
compensate for the weakness of their commercial
2
1,5
1
0,5
0
CBOE
PHLX
2001 2002 2003 2004
profitability. It placed these exchanges in what currently
appears to be an even more problematic situation.
-
The European exchanges have a much lower ratio than the
US exchanges on account of their different business
model. There has been no particular change in the net asset
1,2
1
0,8
0,6
turnover ratio, with the exception of OMX in 2003. Fixed
intangible assets increased by 113% with the take-over of
0,4
0,2
0
2001
the Helsinki Exchange (due to an important goodwill)
2002
Euronext
-
The Emerging exchanges have turnover to assets ratios
1
comprised between those of US and European exchanges.
0,8
As far as MexDer is concerned, asset utilization improved
0,6
with the restructuring (from 0.25 in 2000 to 0.86 in 2002)
DB
2003
OMX
2004
BME
Taifex
MexDer
BMF
0,4
0,2
0
2001
2002
2003
2004
95
but worsened with the launch of the options platform. This clearly indicates that the exchange
should now ideally focus on increasing sales in this segment. In Taiwan, asset efficiency
improved greatly with the rise in the activity in 2003 that was neither induced by higher
investments in working capital nor fixed equipment. BMF suffers from the presence of a floor
platform and remains at lower levels than peers.
10.3 Financial Leverage
Leverage indicates the level to which a company relies on financial debt to fund its activity. If
leverage is measured by the ratio capitalization/equity, the return on book equity can be broken down as
follows:
ROE = Leverage ratio x sales to assets ratio x profit margin158
The average leverage ratio in the derivatives exchange industry, with regard to our total sample,
was 1.15 in 2001 and 1.22 in 2004. These levels are much lower than the leverage of the services sector in
general (1.52)159. On the other hand, they are similar to the leverage of European derivatives exchanges in
the nineties (1.17).160
MexDer/Asigna does not rely at all on debt financing but it appears to be a recurrent phenomenon.
CME and BME also have no leverage, and PHLX progressively reduced its long-term debt between 2000
and 2004, so its leverage ratio decreased from 1.65 to nearly 1. Taifex and BM&F are also “debt-free”,
although their leverage ratio is slightly higher than one because local legislation considers some clearing
reserves as non-current liability.
Among the other US exchanges, long term debt actually refers to provisions for CBOE and ISE
(in this case, deferred revenues resulting from the demutualization of the exchange). CBOT is in fact the
only pure derivatives exchanges to rely on debt financing, with a
Fig 64 - Leverage Ratio
(Eur. Panel)
leverage ratio of 1.32 in 2004.
By contrast, the three main European universal exchanges
1,35
rely more heavily on interest-bearing debt, with 2004 leverage ratio
1,3
1,25
1,2
of 1.32 for Euronext and DB, and 1.21 for OMX. The restructuring
1,15
of the industry led to an important increase in leverage for these
1,05
1,1
1
three companies in 2003, which already started repaying their debt
2001
2002
2003
2004
obligations in 2004 (see figure 64).
158
For non-financial firms, it is possible to extract interest payments from the profit margin and to compute a debt
burden ratio (Ebit-tax-interest)/(EBIT-tax).
159
Source: Bloomberg
160
Chouikri (1994) found an average leverage of 1.17 in 1992 for 10 European Derivatives Exchanges
96
A clear difference can be seen between the two main business models: universal exchanges
increased their leverage whereas pure derivatives exchanges remained unleveraged. The most plausible
explanation for this is that changes in the industry occurred faster in Europe and that exchanges in the US
kept debt capacity for the future.
10.4 Equity profitability
Table 7 summarizes the equity profitability of the main derivatives/mixed exchanges and provides
a qualitative assessment of how exchanges can play on commercial profitability, use of assets and debt
level to improve the profitability for their shareholders
Table 7 : Comparative equity profitability of derivatives exchanges (2004)
Taifex
ISE
CME
MexDer/Asigna
CBOT
OMX
BME
Euronext
DB
BMF
CBOE
PHLX
+++ : significant advantage
Commercial
Asset turnover
Leverage
Equity prof
ROE
+++
+
+++
+++
+
+
+++
+
+
+++
-
0
+
+
0
+
0
+
+++
+++
0
+
+
+
0
0
-
+++
+++
+++
+
+
+
0
0
0
0
-
32,90%
+ : above average
0 : close to average
32,12%
27,02%
20,36%
14,30%
14,21%
12,39%
10,60%
10,43%
10,39%
1,24%
-0,29%
- : below average
The “pure derivatives” model prevails amidst the most profitable exchanges. Taifex, CME and
MexDer achieve high returns to shareholders thanks to an excellent commercial profitability. ISE is less
profitable from a commercial perspective but still benefits from high financial leverage thanks to its
demutualization, providing an exceptional case in the industry.
CBOT and OMX are similar in terms of shareholder profitability, although the different business
model of OMX (vertical integration and universal) entails a lower asset turnover but a better leverage.
BME and BM&F are also quite similar despite different business models (universal exchange vs
pure derivatives) but BM&F is at a disadvantage on account of its floor. Euronext and Deutsche Börse
have a lower commercial profitability, which can be explained by their (failed) policy of price competion
with US derivatives exchanges and by the lower profitability of cash stock markets.
CBOE and PHLX are the least profitable exchanges for their shareholders. They suffer from a
very poor commercial profitability, due to a history of under-investments in the past (especially for
PHLX) and to their focus on options trading were competition is fiercer. (see chapter 6)
97
Chapter 11: Financial strength
11.1 Liquidity
Financial liquidity is the capability of an entity to maintain its short-term debt-paying ability.
Financial liquidity of the exchange as a company is thus radically different from micro-structural liquidity
in the exchange. However, if an exchange aims at achieving sustainable micro-structural liquidity, it must
rely on highly liquid assets in order to be able to realize them rapidly in case of distress.
A. Current ratio (Current assets/current liabilities)
The information provided by the current ratio is similar to the one provided by the working
capital: a positive working capital implies that the current ratio is greater than one and, in this case, shortterm debt is not used to finance non-current assets.
Fig 65 : Current ratio
The current ratio is indeed greater than one for almost all
2,0
the exchanges in our sample, implying a surplus of long
1,5
1,0
term financing over long term assets and thus prudent
0,5
management. The only exceptions are OMX and DB in
0,0
2001
2002
2003
2004
2002, which engaged in aggressive growth strategies that
were partially financed by operational short-term debt.
Panel
EXT w clearing
MexDer/Asigna
In general, derivatives exchanges are thus liquid
companies. Moreover, the average current ratio has been growing over time, indicating that the capacity of
derivatives exchanges to comply with their short-term obligations has improved. The decrease that
occurred in 2002 is mainly the result of a very sharp decline in the ratio for Deutsche Börse/Eurex,
induced by the purchase of Cedel. Within our sample, the two American options exchanges (ISE and
CBOE) have significantly higher current ratios, especially the ISE in 2005 (with a value of 5.32), which is
explained by the fact they have no clearing activity. With regard to MexDer and judging from a theoretical
perspective, the inclusion or exclusion of the clearinghouse in the balance sheet should not influence the
working capital because clearing deposits and liabilities are “netted” inside the working capital
requirement (see financing Asigna).
The problem here is that clearing assets and deposits are separated by the numerator and the
denominator in the current ratio: the current ratio is lowered artificially for exchanges with a
clearinghouse and tends to one as open interest grows, although it should have no absolute impact (figure
65 shows that exchanges that perform clearing have indeed a lower current ratio). This is the case for
MexDer: although it has good liquidity, the Mexican exchange followed an opposite evolution with
respect to peers. Indeed, its current ratio was very high at the end of its first year of existence (above 6)
98
and started decreasing down to 2.3 at the time of the restructuring. However, the decrease did not stop, but
rather continued until 2003 when it reached 1.27 (a level comparable to international exchanges with a
clearing house). In other words, although the working capital was improving in absolute terms, the
liquidity was not improving because activity (i.e. open interest) was growing faster. 161 Liquidity as
measured by the current ratio only started improving once the growth in activity slowed down.
B. Immediate liquidity162
The current ratio assesses the liquidity of the exchange as a whole and shows that MexDer/Asigna
is consistent with international peers. However, a good current ratio is not sufficient for an exchange,
which must be able to react very rapidly in case of distress and requires readily-available cash at its
disposal. For this reason, we compute the cash ratio, defined by cash/marketable securities. This ratio
disentangles between liquidity of the transaction activity
and of the clearing activity, as opposed to the current
ratio.163
Fig 66 : Cash Ratio (MexDer /Asigna)
0,15
Indeed, the restricted cash ratio clearly indicates
0,1
that MexDer faced a very serious lack of immediate
0,05
liquidity in 2001, as a result of which the exchange
almost went bankrupt. The management of the exchange
0
1999 2000 2001 2002 2003 2004 2005
gradually improved the immediate liquidity following
the crisis, by using the sources of funding to expand the cash reserves on a yearly basis (see also chapter
9).
Nevertheless, compared to pure derivatives exchanges, MexDer still lags behind as far as
immediate liquidity is concerned (as measured by cash per contract traded164), as indicated in fig. 67. The
case is worse for BM&F, which favours financial investments over cash. Amidst US derivatives
exchanges, futures exchanges show highly favourable immediate liquidity, especially the CME. Although
immediate liquidity is important for their activity (important fluctuations in open interest render it
necessary), analysts believe CME accumulated an amount of cash that what was beyond operational
161
A similar conclusion can be reached if the Working Capital/assets is analyzed instead of the current ratio. The
same conclusions can be applied for Taifex, for which activity was growing fast as well.
162
The acid test is not interesting in our case. The difference between the current ratio and the acid test is mainly due
to inventories, which are the less liquid category among the current assets. But as most of the derivatives exchanges
have negligible inventories because they do not produce physical goods, the analysis does not provide other insights
than the current ratio.
163
Clearing assets are excluded from restricted cash: they are not readily available for sale because they are part of
the activity. A derivative exchange that would use clearing deposits for other purpose would threaten the solvability
of its clearinghouse, and thus its viability (source: Annual Reports)
164
Which provides a better assessment of immediate liquidity with regard to activity
99
necessity in order to prepare for the take-over of a competitor (very low interest rates didn’t make shortterm investments very interesting with regard to the need to react quickly). 165 Taifex also has a high
immediate liquidity, with 1.65 USD in cash per contract traded but has not been included in figure 67
because its ratio is probably over-estimated. 166
Fig 67 - Cash per contract traded
(USD - 2004)
0,5
0,4
0,3
0,2
0,1
0
BM&F
MexDer
CBOE
PHLX
ISE
CBOT
CME
165
Persisting rumours evoked the possibility of a take-over of CBOT until mid-2005, but the opportunity was
abandoned. CME would also be interested in LSE (sources: M. Allen, J. Sachs, J. Schmitt)
166
Financial Statements do not allow to verify whether this is truly unrestricted cash
100
11.2 Solvency
Solvency refers to the company’s ability to meet with its long term obligations. The avoidance of
the counterparty’s credit risk has been one of the major rationales for the development of organized
exchanges and, given that the credit risk is borne by the clearinghouse, solvency is crucial for such
companies. Having enough equity at disposal to fund the growth is also important and under-capitalization
was a problem encountered by MexDer prior its restructuring.
Solvency ratios can be based either on the balance sheet (static view) or on the activity on the
market, and it is important to combine the two approaches to assess solvency.
A. The static view
Long term liabilities of exchanges encompass long-term financial debt and other non-current
liabilities (such as tax provisions and employee benefits). We shall assess the ability of the exchange to
repay these through two static ratios
•
167
:
The LT liabilities/net assets ratio: on average, this ratio grew from 15.01% to 17.68% for the
sample. In fact solvency improved in pure derivatives exchanges but its decrease in universal
exchanges was proportionally more important. Having no long-term liabilities, MexDer is
exceptionally solvent with regard to this
ratio.
Fig 68 : Solvency Ratios (Panel)
168
• The LT liabilities/ tangible net assets
30%
ratio. In this case, intangible assets are
25%
abstracted from net assets, so the ratio is
20%
more conservative. On the other hand, it
15%
enables to take into account the fact that
10%
intangibles may become worthless in case
5%
of distress. The evolution of this ratio has
0%
LT Debt to
net worth
LT Debt to
tangible net
worth
2001
2002
2003
2004
been very similar to the former for pure
derivatives exchanges (on average, it is only 2.19% higher than the LT liabilities to net assets
ratio). Intangibles are in fact very limited for exchanges in this business model, except for CBOE.
The picture is radically different for universal exchanges: the restructuring of the sector induced
167
A more conservative version includes short term liabilities. It makes the implicit assumption that short term
liabilities as a whole are carried out on a yearly bais and should be considered as long term sources of financing as
well. We do not make this assumption.
168
However, the absence of provisions is biased by the fact that MexDer is a subsidiary of BMV (employees are
outsourced). Nevertheless, this organization clearly improves the static solvency of the derivatives exchange.
101
an important growth of intangibles, especially in DB/Eurex and Euronext. Their LT liabilities to
tangible net assets went respectively from 11.39% to 43.71% and from 7.63% to 52.38% between
2001 and 2004.
B. Dynamic view
The solvency of a derivatives exchange can also be assessed with regard to its activity. Given that
the indebtedness of pure derivatives exchanges is very limited, the main risk is not the ability to comply
with debt obligation but the fact that equity is sufficient with regard to the trading activity. The first ratio
used to assess solvency dynamically is the average
Fig 69 : Equity per contract traded
equity per contract traded. In this case, figure 69
In USD
indicates that solvency is clearly problematic for
3
MexDer (only 0.12 USD per contract traded in 2004)
2,5
and that capitalization is yet insufficient. The two
2
1,5
2003
other derivatives exchanges located in emerging
2004
countries, Taifex and BM&F, have a much better
1
solvency with respect to their activity. Nonetheless,
0,5
the ratio decreased for the two exchanges from 2003
0
MexDer CBOE
CBOT
CME
BM&F
Taifex
to 2004 because activity grew faster than average
equity. Pure futures exchanges (CBOT and CME) also have a better solvency than MexDer, with an
average of 0.9 USD equity per contract traded.
The solvency with regard to activity is even better assessed when open contracts is taken into
account rather than total contracts traded, seeing as open interest represents the value at risk on the
exchange. The solvency of MexDer compared
to its peers is even worse in this case, because
Fig. 70 : Equity per open contract
open interest is proportionally higher than it is
In USD
in other futures exchanges due to the success of
60
engrapados (see chapter 8). The equity per open
50
contract was 1.10 USD in 2004, compared to
40
2003
31.5 USD on average for futures exchanges. By
2004
20
contrast, BM&F (54 USD/open contract) and
10
Taifex
30
0
(167
USD/open
contract)
are
overcapitalized as compared to US exchanges.
MexDer
CBOE
CBOT
CME
BM&F
102
With regard to the other US exchanges, the CBOE is also much less solvent, and its solvency has
worsened over time due to a persistent lack of profitability. Nevertheless, a lower solvency is less
problematic for CBOE than for MexDer because CBOE already has an established reputation and, above
all, it does not perform clearing (so the risk for the customer is much lower). The solvency of CBOT also
decreased, due to the fact that clearing activity was abandoned to CME.
Activity has grown much faster than equity on MexDer, and for this reason, solvency is well
below international standards. However, there is no reason for market participants to worry about this:
thanks to the architecture of its clearinghouse, MexDer can afford a lower solvency, similarly to US
option exchanges which rely on the OCC for clearing. The patrimony of the clearinghouse is legally
separated from the exchange and backed by four solvent international institutions.
Conclusion on financial strength
The image of MexDer’s financial strength is contrasted. From a pure accounting perspective,
liquidity and solvency correspond to international benchmarks. Though they have improved since the
restructuring, when compared to activity, it is evident that there is still need for them to be fortified.
103
Chapter 12 - Valuation
At this stage, all financial performances have been assessed with respect to book values. However,
return to shareholders should be calculated with regard to their past expectations of profits, i.e. the market
value of the exchange.
We shall first calculate what the expected return to shareholders should be given the risk of the
activity. Asigna will not be included in this analysis because the risk associated with clearing is
diversifiable and so it does not affect the calculation of the â (which measures only the non-diversifiable
risk)169
It is very difficult to compare MexDer to similar firms that are public, and we are thus restricted
using only the CME as a benchmark:
- CME is the only pure derivatives exchange that has been listed for a sufficiently long period to calculate
the Beta of its stock170
- Similarly to MexDer, CME is focused on STIR futures so activity is relatively similar
171
12.1 Expected Return
A. The risk of the activity
Using data for the stock of the CME, we have calculated the beta activity of this exchange and
taken it as an estimate for the industrial risk of a STIR derivatives exchange.
Table 8 - Estimation of the activity risk
2002
LT Debt (MV)
Equity (MV)
(D+E)/E
2003
2004
2005
19,383
21,666
19,246
20,783
1472,576
2463,174
7845,55
12696,124
1,01
1,01
1,00
1,00
Beta equity
1,0742
1,0742
1,0742
1,0742
Beta asset
1,0602
1,0648
1,0716
1,0724
The following assumptions were made:
•
There is no tax-shield to be taken into account because the long-term debt is a non-interest
bearing debt (it is composed of provisions alone)
•
The market value of the debt is equal to its book value and it is risk-free (â debt = 0)
•
The calculation of the â equity is explained in Appendix 6
169
And moreover, the shareholders of Asigna are not those of MexDer.
ISE and CBOT underwent their IPO in 2005, CBOE, PHLX, BM&F and Taifex are not public.
171
DB, Euronext and OMX are too different in terms of revenues and use of assets, as seen in the previous chapters.
BME would be a “nice” benchmark with regard to the BMV Group in total, but is not yet public
170
104
B. The expected return
Knowing the â assets , we are now able to calculate the return expected by shareholders. It is not
necessary to estimate the value of the company at this stage, because MexDer has no long-term or interestbearing liabilities.
Table 9 - Estimation of the expected return
2002
Rf (Mex. Gov. Bonds)
Market premium
E/V
Beta activity
eROE
2003
2004
2005
6,98%
5,92%
6,60%
9,01%
6%
6%
6%
6%
1
1
1
1
1,0602
1,0648
1,0716
1,0724
13,34%
12,31%
13,03%
15,44%
•
The risk-free rate is the annual average of the Mexican ST government bond rates (CETE)
•
The market premium is set at 6%, a figure comparable to that of developed markets 172.
This assumption is reasonable because the volatility of the Mexican stock market is
similar to that of US stock markets over the period (see chapter 3).
12.2 Estimated value
A. Enterprise value
If market expectations for MexDer and CME are equal, then their market-to-book ratios should be
also be equal, and MexDer would be worth 1363 mil Mexican pesos at the end of 2005 (line 2). But this
value is not correct because MexDer surpassed expectations in 2002 and 2003 (actual return on equity was
greater than the expected return on equity) but failed to reach expectations in 2004 and 2005. Its MtB
should be different from that of CME.
Line 5 shows the value of MexDer for which expected returns were equal to actual returns. The
problem is then that the value of the company fluctuates greatly depending on profits, and varied between
340 mil MXN in 2003 and 80 mil. MXN in 2005. The value of that year is very much influenced by the
(temporary) bad results, and the M-to-B ratio is reduced at 0.66 (compared to 5.11 in 2003).173
Table 10 - Estimation of the enterprise value
(mil. MXN)
2002
MTB (CME)
MV Equity MexDer
Profits available to SE
realized ROE
Enterprise value 1
2003
3,30
2004
4,38
9,65
2005
11,35
77
290
1079
1363
13,11
41,74
42,75
12,29
17,04%
14,38%
3,96%
0,90%
98,26
339,18
328,14
79,59
172
Brealey & Myers (P155) estimate the average risk-premium at 9.1% over the period 1926-2000. However,
analysts use lower figures, comprised between 5% and 6%. The approach based on practice was favoured.
173
The (theoretical) hypothesis that the industrial risk is similar to CME would certainly not be respected in this case.
105
DF
0,882
0,786
0,695
0,602
Actualized profits
11,57
32,79
29,71
7,40
sum actualized profits
81
Value Jan 1 2002
123,31
Enterprise value 2
204,80
What would be a “fair” value based on passed performance of MexDer then? Our reasoning is
based on the non-arbitrage principle: let us assume that an investor can replicate the investment in
MexDer through an investment X which bears the same risk (expected return should be the same) and
provides the same pay-offs over the period 2002-2005. In order to obtain profits equal to those of MexDer
shareholders, he should invest 123.31 mil. MXN on January 1 2002. On Dec. 31 2005, this investment
should be worth 204.8 mil. MXN (18 mil. USD) which is then equivalent to the value of the company
based on its performance in the previous four years.174 Is this value realistic? The two arguments support a
positive answer.
B. Comparison with past deal
When MEFF invested in MexDer in March 2004, the Spanish exchange paid MXN 17.84 mil. in
compensation for a 7.5% stake, which then valued the company at 238 mil MXN. Furthermore, the fair
value of its investment was not changed in its statements since then: “no provision for depreciation has
been passed” 175 , so according to BME, this value still reflects the situation of the Mexican Derivatives
exchange. However, we believe that the temporary hangover of 2005 should be taken into account when
valuing MexDer, so that a slightly lower value than of BME is consistently found.
C. Comparison with peers
As
compared
to
listed
US
financial
derivatives
Table 11 : Comparison with peers
P/E
MtB
exchanges, our estimation seems reasonable in terms of valuation
ratios. The price/earnings
176
and market-to-book ratios are
depicted in table 11 and are well below the figures of established
US peers. Factors that explain why market expectations should be
lower for MexDer relate to the situation in the US and Mexico:
-
Dec. 31 2005
MexDer
CME
CBOT
ISE
Dec. 31 2005
7,44*
41,37
70,55
29,71
1,70
11,35
9,98
5,68
* average earnings 2004/2005
Analysts believed US derivatives exchanges were overvalued at the end of 2005 because of
speculations that arose from rumours of take-overs, especially the CBOT. 177 Competition is
174
It is not possible to do with a longer time frame because:
- CME was not listed yet
- MexDer had just undergone its restructuring
175
BME Annual Report, P23
176
P/E in table 7 is calculated with regard to the average earnings 2004-2005. P/E remains lower than peers even if it
is calculated wrt. 2005 earnings (16.65)
177
Source: Analysts Reports
106
tougher within the options industry (see chapter 6) and penny quoting threatens revenues, so ISE
trades at lower ratios.
-
MexDer is a recent exchange that faces numerous challenges for its further development (see also
conclusion). Compared to the American exchanges, worse indicators regarding market conditions
(underdevelopment cash market), legal environment and financial strength (liquidity and
solvency) explain why MexDer so lacking in terms of valuation ratios.
12.3 Sensitivity analysis
How should the value of MexDer evolve if the market conditions were to change? Given that we were not
in possession of much information, we were forced to use quite a simple reasoning (an not a discounted
cash flow method for instance:
-
First we calculated the sensitivity of earnings to a change in revenues related to transactions for
each class of instruments
-
Second, we calculated the sensitivity to a change in volumes for each class of instrument.178
-
Then we aggregated all classes of instruments to assess the evolution of the total net earnings,
hence assuming that all instruments were affected by the same variations (in revenue or volume)
-
Finally, we assumed that the P/E ratio remains constant in order to find the sensitivity of value
Table 12 - Sensitivity of value to volumes and revenues from
transactions
volume
Trans. Rev./contract
-50%
-25%
0%
25%
50%
-10%
92,2
138,3
184,4
230,5
276,5
-5%
97,3
146,0
194,6
243,3
291,9
0%
102,4
153,6
204,8
256,1
307,3
5%
107,5
161,3
215,1
268,9
322,6
10%
112,7
169,0
225,3
281,7
338,0
The most likely situation is depicted in the the grey area: a decrease in transaction revenues to attract more
international participants and resist to competition from OTC, and an increase in average volume up to
pre-2005 figures thanks to a change in the tax legislation. In terms of instruments, value would be
particularly enhanced by a growth of equity-index options, which are the most profitable instruments.
178
Based on the average of the last four years
107
Conclusion
To conclude, we are convinced that the example of MexDer shows that the development of a
derivatives exchange in an emerging country, though not an easy task, can be done quite successfully. But
on the other hand, MexDer is still a niche player compared to international giants and it is questionable
whether such a regional derivatives exchange is feasable on the long run? We shall try to provide some
answers this and conclude with a SWOT analysis.
1. Strengths
A. Reforms and original design clearinghouse
The technological and structural restructuring that was implemented in 2001 enabled MexDer to
adapt to the global evolution of derivatives exchanges and to become competitive. Moreover, its
clearinghouse, which is backed by four international financial institutions and independent from the
profitability of the transaction entity, renders it a trust-worthy partner.
B. Liquidity in interbank-rate futures
MexDer has benefited from the macro-economic reforms, which are the main contributors to the
proper development of the underlying debt market. The exchange has adapted through product innovation
and through the broadening of market participants in order to achieve good levels of liquidity and a
favourable profitability. The recent growth of exchange rate contracts further shows that MexDer can be
an interesting alternative to OTC markets.
C. Partnership with BME
The launch of options trading is too recent to draw definitive conclusions from, but a major factor
stands in favour of MexDer: the commitment of the Spanish market, MEFF. Not only did MexDer acquire
an adequate technology, which is now indispensable in the derivatives industry, but it also opened its
equity to an international player that provided financial support in the past and is still providing strategic
support in the present. MexDer is the only exchange located in an emerging market to benefit from such
an advantage.
2. Weaknesses
A. Product dependence
95% of trading activity and 70% of revenues are still generated by a single instrument:
profitability is highly dependent upon the success of TIIE futures. From a corporate perspective, given that
profits are a major source of funding, this fact increases the financial risk considerably.
108
B. Poor development of the cash market in stocks
The underdevelopment of the stock market in Mexico prevents the rapid growth in equity
derivatives, given that a liquid cash market is necessary in order to foster activity in derivatives. Structural
reforms have been undertaken but their effects will not be evident in the short term.
C. BMV’s lack of demutualization
The role of BMV as the main shareholder could be seen as a disadvantage in some regards. On the
one hand, BMV rescued MexDer from bankruptcy and is also in possession of a strategy for derivatives
within the group. BMV follows a strategy of Universal Exchange, which is turning into the dominant
paradigm in the industry179. On the other hand, in order to be further developed, such a strategy will
require significant investments in both the derivatives activity and in other areas, as was seen from our
European sample in the financial analysis. Given that BMV is still a member-owned private company, its
financial capacities might not be sufficient to sustain such a strategy.
3. Opportunities
A. Foreign participants and Technology :
Similarly to other derivatives exchanges in emerging countries, foreign participation in the market
is still at a fairly low level. 180 Two steps should be undertaken in order to improve the distribution
channels:
•
Target Independent Software Vendors
•
Adopt the international FIX standard, i.e. an open standard that defines the structure of a
transaction and allows a participant to access the market with any trading software (not
necessarily the one of the exchange). 181
Allowing foreign participant to make margin deposits in their own country rather than in Mexico is also an
opportunity for further growth, which has been successfully implemented by BM&F in Brazil.
B. Strengthening the international partnership
As there is a general consensus among analysts that most of the international giants are now
turning to Asia, there might be an opportunity for Latin American exchanges to converge and form a
“regional giant”. BMV and Bovespa (the Brazilian Stock Exchange) have initiated talks regarding a
179
Jos Schmitt (Capco), John Ross (BCG) and Chris Allen (BofA) forecast a convergence of US exchanges to such a
paradigm
180
Foreign participation is below 5% in Mexico, Brazil, Taiwan and South Africa. At the time it merged with the
Belgian Stock Exchange, foreign participation on Belfox (Belgian Derivatives Exchange) had reached 30%
181
MexDer implemented FIX standards very recently
109
possible partnership, but talks are still in their preliminary stages182. The absence of an integrated financial
market in the region, as opposed to Europe, as well as the important legal differences form major obstacles
to this possible consolidation and render it implausible in the short or medium term. Strengthening the
partnership with the Spanish market is certainly a more realistic opportunity: BME considers MexDer as
“an important aspect of [its] international expansion”183 and is open for further development, for instance
in the clearing. Compared to a possible take-over by a major US exchange, which gives rise to the
possibility that MexDer would simply be “a small piece of a giant”, the venture with BME is
advantageous in that it would permit to MexDer to develop quite independently but with strategic support.
C. Introduction of new instruments
MexDer also need to foster its further growth through the launch of new derivatives instruments.
An option on the VIMEX volatility index was recently launched. Energy futures might also form an
interesting opportunity, though this segment is already challenged by important international players (ICE,
Nymex and even CME). Given that these products are highly standardized, it would be hard for MexDer,
or any regional player, to develop a substantive competitive advantage, except in a very specific
product.184
4. Threats
A. The regulatory environment
The first weakness of MexDer that should be pointed out with regard to its future development is
the legal risk. As stated by John Ross of BCG, “the legal framework under which an exchange acts is
crucial for its further success, even more in less developed markets such as Mexico or India”. The
Mexican exchange relies mainly on transaction-related revenues, which of course depend on trading
activity. The 2005-episod highlights the dependence of the exchange on legal issues and the need to
reduce this dependence for purposes of long-term viability.
B. Competition from major players
As major derivatives exchanges consolidate and become more global, they are expected to fuel
their additional growth through the listing of new products. According to BofA analyst Christopher Allen,
“these products are likely to replicate other exchanges more liquid products (like MexDer's star product)”.
That is to say, it wouldn’t be a surprise to see most major products listed on multiple exchanges. Given the
scale achieved by the global players and the financial strength of the four industry leaders (CME, CBOT,
183
184
Source: interview I. Soyoa
Sources: John Ross (BCG), Chris Allen (BofA)
110
Eurex and Euronext), it seems likely to be they will be able not only to charge much lower fees than a
regional exchange but also to provide broader services. American exchanges are rapidly expanding
towards Asia and European exchanges more towards Eastern Europe, so Latin American markets are
under no direct threat. Nevertheless, in the long term (over five years), the regional players’ ability to
compete for the most liquid products is likely to be under strong pressure.
C. OTC and internalization
Off-floor trading has always been a threat to the business model of exchanges. Nevertheless, the
growing concentration of users, both in Mexico and elsewhere, is forming a new threat: major financial
institutions are now capable of creating internal markets and would require intermediaries such as
exchanges only for positions which cannot be offset internally.
111
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115
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Trading”, Futures Industry Association Magazine 2005, FIA
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Futures Industry Association Magazine 2002, FIA
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(internal presentation provided by MexDer)
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(report of speech – available at www.bmv.com.mx)
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Market Developments (Statistical Annex)”, Mar 1998
Other issues used: Mar 2000, Mar 2002, Mar 2004 and Mar 2006
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Exchange and Derivatives Market 2004”, March 2005
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Consultant Survey to FIA/FOA
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Consultant presentation to Deutsche Börse Strategic Committee
116
The two former documents are used with the firm’s approval
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October 2001
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Global Financial Stability Report, IMF World and Economic Surveys, Dec 2002, P54-70
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January 27,2006
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117
Annual Reports
CBOE: 2000, 2001, 2002, 2003, 2004
CBOT: 2001, 2002, 2003, 2004
CME: 2001, 2002, 2003, 2004, 2005
ISE: 2002, 2003, 2004, 2005
PHLX: 2001, 2002, 2003, 2004
EURONEXT: 2000, 2001, 2002, 2003, 2004, 2005
OMX: 2002, 2003, 2004, 2005
DB: 2000, 2001, 2002, 2003, 2004, 2005
BME: 2003, 2004, 2005
BMV: 2002, 2003
Central Bank of Mexico: 2004
Audited Financial Statements
MexDer: 1998, 1999, 2000, 2001, 2002, 2003, 2004, 2005
Asigna: 1998, 1999, 2000, 2001, 2002, 2003, 2004, 2005
BM&F: 2002, 2003, 2004
Taifex: 2001, 2002, 2003, 2004
Analysts Reports
Carter, J. (2005), “ISE”, Goldman Sachs Global Investment Research - December 19, 2005
Ghaffari, C.(2006), “CME Holdings”, Morgan Stanley Research North America, March 29
2006
Ghaffari, C.(2006a), “CBOT Holdings”, Morgan Stanley Research North America, March 29
2006
Ghaffari, C.(2006b), “ISE”, Morgan Stanley Research North America, March 29 2006
Hecht M (2005), “Chicago Mercantile Exchange Holdings”, BofA Securities, September 15
2005
118
Hecht M (2005a), “CBOT Holdings”, BofA Securities, November 21 2005
Interviews
Alegría, Jorge – MexDer (Mexico DF, MX) – Director
Allen, Christopher – Bank of America (New York, NY) – Analyst
Barush, Allan – MexDer (Mexico DF, MX)
Delcour, Bernard – ING (Brussels, BE) – Interest Rate Derivatives Trader
Dejonckheere, Koen – KBC (Brussels, BE)– Managing Director KBC Securities
Domeneghetti, Pierre-Yves – BBVA (Paris, FR) – Fund Manager Benelux
Gutierrez, Firmin – Casa de Bolsa Vector (Monterrey, MX) – Asset manager
Ross, John – The Boston Consulting Group (Chicago, IL) – Manager
Schmit, Jos – The Capital Market Company (Chicago, IL) – Former Director Belfox
Soyoa, Ignacio – BME (Madrid, SP) – MEFF – In charge of strategic development
Sluys, Bertrand – Fortis Bank (Brussels, BE) – Trader
Not extensive phone calls with Johannesburg Stock Exchange (Merenda Maja), BM&F
(Luciane Bonotti), Taifex (Sarah Chiu),CME (John Steal), ICAP NY (Ignacio Mayordomo),
Tradition Mexico (Jorge Banuelos), GSI New York, JP Morgan Mexico (Gerardo Vargas),
ING Mexico (Jose Jorge Ramirez), GL Trade (Brussels).
119
Appendix 1 – Micro-structural theories
1. A review of the microstructure literature
1.1 Definition
Numerous definitions of market microstructure have been provided in the literature. Although
many authors refer to the well-known metaphor of “opening the black box”, the exact meaning of the
term deserves further attention.
•
According to O’Hara (1995), “market microstructure refers to the study of the process and
outcomes of exchanging assets under a specific set of rules”.
•
Madhavan (2000) defines it as “the area of finance that is concerned with the process by
which investors’ latent demands are ultimately translated into transactions”.
•
Roll (2003) provides a more functional definition: “market microstructure studies the cost of
trading securities and the impact of trading costs on the short-run behaviour of securities
price”
Although they seem different, those three definitions by very prominent researchers in the field
share common characteristics:
1. microstructure studies a process. It is an applied field of investigation, where theory is
in constant dialog with empirical and practical issues.
2. the effects of the process are measured through prices, the bid-ask spread being the
most favoured measurement tool.
3. the objective underlying the research is to find the type of market that would minimize
frictions and maximize liquidity (what O’Hara describes as the “Golconda exchange”
or what could be named the “perfectly transparent exchange”185)
4. contrary to other scholars, nor O’Hara nor Madhavan nor Roll limit the scope of the
definition to what is often referred as market architecture. But implicitly, the three
authors consider market microstructure as a subfield of investment in the financial
theory. We shall see that recent research has expanded to other fields of investigation,
such as corporate finance for instance.
1.2 The Pioneers
Market microstructure is quite a recent area of investigation, which has flourished over the last
twenty years in the aftermath of a paper by Harold Demsetz published in 1968. Before that, the
dominant paradigm on price-setting was called Walrasian auctioneer.
185
Transparent is the sense that it would not impact the transaction at all. Kant would call it “a perfect shape”
120
a. The Walrasian auctioneer
The adjective “walrasian” originates from Leon Walras, a French marginalist economist of the
19th century. The Walrasian auctioneer model is the first attempt to analyse how prices are fixed on a
market. It assumes that an auctioneer announces a range of price at which he is ready to buy (or sell),
and traders determine their optimal order at that price. If demand and offer don’t match perfectly, a
new range is announced and the process is repeated sequentially until equilibrium is found. 186
Furthermore, the model assumes that the market is frictionless and that participants are perfectly
informed.
A major flaw of the Walrasian auctioneer paradigm is that actual markets do not work that
way. In particular, traders are usually not ready to wait for so long until a clearing price is found and
might thus remunerate for immediacy.
b. Other works on the functioning of markets
Of course, scholars have not waited until recent times to study how markets actually work.
Keynes, for instance, in his book The General Theory of Employment, Interest and Money provided a
well-known analysis of market participants’ behaviour through his metaphor of the “Beauty Contest”.
Bubbles and market crashes were also popular topics among scholars, probably as a consequence of
the 1929 crash187.
However, “pre-microstructural” researchers didn’t apply a mathematical method to the
problem and focused more on the psychology of the investors (often by highlighting their irrationality
or even madness).
c. Determinants of the bid-ask spread
The key insight of Demsetz, beyond the fact that he was one of the first to use a mathematical
model to explain market mechanisms, was that he insisted on the role played by market markers. He
showed they provide a service of “predictive immediacy”, meaning that the bid-ask spread can be
considered as a remuneration for this immediacy. However, one should bear in mind that market
makers remain passive in his framework, “simply adjusting the spread in response to changing
conditions”
188
He also showed that the spread depends on competition between market makers (i.e. on their
number) and thus that market structure has an impact on prices, more precisely on the bid-ask spread.
186
No transaction takes place until the final (or clearing) price has been found.
One of the explanations for a very old bubble, the Tulip Bubble that occurred on the Amsterdam tulip futures
market in 17th century is microstructural: the absence of clearing house would have been responsible for overvolatility. (see Garber)
188
Madhavan (2000)
187
121
Empirical studies based on Demsetz’s work were conducted in order to find the determinants
of the bid-ask spread. According to Madhavan, most of the studies found four main determinants to
explain the volatility of the spread:
•
volume (to measure the trading activity)
•
riskiness of the security (measured by volatility of past returns)
•
price inverse189
•
market capitalization (to measure the firm size)
+
/
0
1.3 Inventory-based models
Compared to Demsetz, those models developed in the 1970’s consider market makers as
passive but also as active participants, who are likely to adjust the spread not only for external reasons
but also because of internal constraints. As price-setting agents, market makers have to “balance
supply and demand over time”190; given that flows are not certain over time, they may not accumulate
significant short or long positions. So they have to participate in the market not only to provide
liquidity to other agents, but also to control their own inventory level. Inventory-based models also
highlight the importance of market makers capital; it is an indicator of a market’s solidity.
To summarize, we can say that the main innovation of these inventory-based models is that
they show that the behaviour of traders, induced by the inventory requirements, affects the price
prevailing on the market. The most cited works are : Smidt (1971), Garman (1976), Stoll (1978) and
Cohen, Maier, Schwartz and Whitcomb (1981)
1.4 Information-based models
Information-based models also enlighten traders’ behaviour in the price-setting process, but
from a radically different perspective. They are now the beating heart of microstructure research.
Those models share in common the assumption that they are actually two types of traders:
•
the uninformed traders (or noise traders) who are motivated by liquidity
•
the informed traders191 who think they can make a profit from the information they
own and others don’t
This distinction means that there is information asymmetry in the market, and the behaviour of
informed agents becomes fundamental because it should reveal the underlying value of the asset.
In a very comprehensive study, Madhavan (2000) distinguishes between four categories of
informational theories inside microstructure and I shall adopt his useful classification.
189
As spreads are measured in percentage of the price, the minimum tick is responsible for a convexity when
prices are low
190
O’Hara (1995)
191
« Informed » does not mean he own insider information
122
a. Price formation and price discovery
Those works remain in line with pioneering and inventory-based models in the sense that they
keep focusing on the role of market makers. They differ by assuming that the bid-ask spread conveys
informational components as well. In fact, they consider market makers as uninformed participants
(and empirical evidence suggest this hypothesis is valid) who lose money on informed traders but
compensate by gaining on uninformed ones. Logically, in order to remunerate the loss, the spread
should be proportional to the percentage of informed traders times the uncertainty of the value of the
security.
b. Market architecture and design issue
Following Madhavan’s definition, “market architecture refers to the set of rules governing the
trading process, determined by choices in: market type, price discovery, order forms, protocols and
transparency”. So compared to the previous ones, those models radically broaden the scope of research
_ they no longer focus on market makers _ and include several new dimensions that might be very
useful when analysing the efficiency of a market.
Given that this part of the literature is very much in line with our investigation, it will be
covered more extensively and applied to derivatives markets in the next chapter.
Nevertheless, Madhavan points out two puzzling issues on which researchers are now focusing
and that are closely related to our investigation:
1. The network externality puzzle: why do markets remain fragmented although strong arguments
plead for consolidation ?192 They are actually two aspects to this controversy:
- why does a single market fail to consolidate in time, or with other words why do continuous
markets encounter such a big success although call auction markets are more efficient to
aggregate information and are more resistant to market failures?
- why does geoFig.y still impact on markets, even in the same time zone (this is especially
relevant for the MexDer) ?
2. The dealer puzzle
Continuous markets can be of dealer type or of limit-order book type. This second category,
without intermediaries, is especially suitable for very liquid markets. However, in reality, some very
active markets remain dealer-driven. Why is it the case? It is worth noting that this puzzle is clearly
similar to the one of the prevalence of OTC markets in derivatives markets.
Two important questions arise from that puzzle:
192
Madhavan’s paper was written before the consolidation wave in stock and derivatives markets. The puzzle
has probably faded a little bit away, although it has certainly not disappeared
123
1. Do market makers perform some special function that creates value?
2. Why are auction markets unable to provide such a function?
c. Information and disclosure
Literature in this category mainly refers to “transparency”, a concept defined by O’Hara (1995) as
“the ability of market participants to observe information about the trading process”. The notion of
information can be very broad, so Madhavan suggests distinguishing between two types of
transparency:
•
pre-trade transparency: all pertinent information for a participant in order to take a trading
decision (quotes, depth, existence of limit orders away from the price,…)
•
post-trade transparency: “public and timely transmission on past trades”
Transparency can also be decomposed along two other dimensions: dissemination (to whom does
the information go?) and speed (how fast is it available?)
A central issue regarding transparency is the question of the anonymity of market participants. If a
market is not anonymous, disclosing the identity of a trader may reveal that he is informed or not. As
shown by Benveniste, Wilhem and Marcus (1992), the spread should be lower in this case.
Furthermore, the disclosure of his identity would provide to a broker an opportunity to form a
reputation-based strategy. Non-anonymity should hence reduce information asymmetry, and increase
liquidity.
Nevertheless, there is a big debate regarding transparency193, about which some authors argue that
“one should avoid too much of a good thing”. Although a higher transparency should imply a more
efficient price formation process, some very prominent experimental studies such as Bloomfield and
O’Hara (1999) have shown that too much transparency is responsible for a decline in liquidity. There
would be some optimal level of transparency above which volumes would go downwards because
market participants unwilling to reveal their intention to trade (for any reason) would avoid
transacting. Interestingly, the same authors emphasized in a further study that most of the dealers
prefer not to disclose their identity, although theory would suggest it enhances liquidity!
d. Informational issues arising from the interface of market structure
As market microstructure theories have become more and more popular, there is a growing
tendency to apply their methodology to other areas of finance. This is interesting, because it maybe
paves the way for some further developments of financial markets (like a deeper integration for
instance). Madhavan (2000) highlights three main interfaces:
193
In our so-called information society, « transparency » has become more and more important not only on
economic ground (e.g. disclosure of managers remuneration) but also on political or social ground (e.g. the
growing success of real-television). Financial markets are just no exception in that regard.
124
1. assets pricing: a microstructural approach allows to consider liquidity as one of the determinants of
an asset price (meaning that expected return should include a compensation for illiquidity194)
2. corporate finance: this mainly deals with the issue of IPO underpricing and the role of the
underwriter 195
3. international finance: foreign exchange markets are analyzed from a microstructural perspective.
1.5 Conclusions from the literature
I would like to emphasise two main insights from the theoretical literature that I think will be
useful for the next chapters:
1. There are elements that clearly matter in order to lower trading costs and enhance liquidity,
such as the volume of transactions, the role of market participants, the transparency provided
to them or the protocols (rules) implemented in the market.
2. But in spite of these elements, it is very hard to explain the diversity of market structures
and it seems there is not a unique, optimal type of organization. The Golconda exchange looks
like a myth.
2. Studies on microstructure of Emerging Derivatives Exchanges
Due to data availability, most of the research presented in the former chapter focuses on cash
markets, especially on American stock markets. Nevertheless, several studies have been conducted
about the microstructure of organized or OTC derivatives markets and we shall refer in particular a
survey conducted in 1997 by the World Bank and try to update some of its result.
World Bank Survey
In 1997, two researchers at the World Bank, George Tsetsekos and Panos Varangis, conducted
an empirical survey on the microstrucure of organized derivatives markets, with a special emphasis on
emerging markets. Their study of 42 exchanges conveys interesting insights in the following
dimensions of market architecture:
•
194
195
ownership
One of the most famous paper in that regard is probably Fama and French (1999)
See Ritter and Welch (2002) for an overview of the literature on IPO underpricing
125
13%
3%
35%
8%
Non-profit self-governing
Subsidiary
Privately-owned
Limited company
Government-owned
Others/Hybrid forms
33%
8%
• regulatory status
Parliamentary
Regulation via a law &
Government via Ministry
20%
31%
Government Regulation
via government
commitee
17%
Government Regulation
via ministry
Self Regulated
Exchanges
32%
• market making system
pure open outcry
3%
3%
pure electronic screen-based
11%
33%
11%
open outcry & electronic
screen-based
open outcry & market making
electronic screen-based &
market making
11%
28%
open outcry & electronic
screen-based & market
making
specialist-auction market
126
Appendix 2 – Product mix MexDer
Three major types of derivatives instruments are traded on the MexDer.
1. Exchange-rate derivatives
o
USD Futures
Futures on the US dollar were the first instruments to be available on the MexDer. Contract size is
10,000 US dollars, and maturity can be every month up to 3 years (36 different maturities). Settlement
date196 is the third Wednesday of maturity month.
o
Euro Futures
Those contracts were launched in October 2005. Their size is 10,000 Euro and 120 different maturities
are tradable (each month up to ten year). Settlement is identical to USD futures.
2. IR derivatives
Interest-rate futures started trading soon after US-dollar futures, in May 1999 and instruments can be
grouped in three categories197.
o
TIIE28 futures
The underlying asset is 28-day deposit and its yield is the TIIE28 rate. Its quotation is 100 – the
annualized rate expressed in percent. Contract size is $100,000 pesos.
o
Fixed-rate bonds (M3 & M10) futures
Maturity is expressed per month and up to ten years (so there are 120 different maturities). Settlement
date is the third Wednesday of maturity month.
o
CETE 91 futures
The underlying asset is the 3-month treasury bill. Maturities available are monthly up to one year and
then per trimester up to seven years (36 different maturities), with settlement date being the third
Tuesday of maturity month. Quotation is similar to TIIE28 futures, but contract size is 10,000 Cetes
(which is equivalent to $100,000 pesos)
The underlying assets are the 3-y or 10-y fixed-rate government bonds. Contracts mature every
trimester up to 3 years and are for 1000 bonds (equivalent to $100,000 pesos)
3. Stock-related derivatives: futures and options
Initially, stock-related derivatives available were futures on the Mexican Stock Exchange
Index (IPC-Indice de Precios y Cotizaciones) since April 1999 and on the five main Mexican stocks
(América Móvil, Cemex, Femsa, Grupo Carso and Telmex).
o
IPC futures
196
Settlement date is always two business days after maturity date (last day of trade)
Udibonos futures are also available but are not included in the analysis as not a single contract of this type
was traded last year.
197
127
The value of a contract is the IPC index multiplied by $10 pesos. Maturity can be March, June,
September or December, with a maximum of one year. Settlement date is the forth Tuesday of
maturity month.
o
Individual stocks futures
The underlying asset is 100 stocks. Maturity is again every trimester (March, June, September or
December) up to maximum one year, but Settlement date is the forth Wednesday of maturity month
this time.
A major innovation as far as products are concerned took place in 2004 with the launch of stockrelated options. Options are limited to stock-index instruments, either Mexican index (IPC) or
American indexes (Naftrac, Nasdaq-100, S&P 100 and S&P 500)
128
Appendix 3 – Engrapados198
According to Vera Juarez (2004) calculations, more than 95% of TIIE28 contracts traded on
MexDer are used to create “engrapados” positions. This technique aims at replicating interest-rate
swaps through the use of IR futures on the organizad exchange.
For example, an “engrapado 3x1” is equivalent to a contract with 3 TIIE28 futures, which
have successive maturities up to 3 month. Each contract is quoted by a rate (not by 100-rate as for
most IRF contracts, such as T-bills contracts on CME). It can be used to replicate a 3-month interestrate swap with pay-offs every 4 weeks (28 days).
By definition (Hull(2004)), a swap is a contract by which the buyer (long) commits to pay the
fixed rate in exchange for receiving the floating rate (in this case, the TIIE). A short position on a swap
contract is replicated through long positions on successive IRF (where the buyer (long) receives the fix
and pays the floating).
Let us suppose we are on May 30 and want to lock-in the variable interest rate we shall receive
from an investment M which pays a 3 variable-rate coupons (every four week). To hedge the risk
implied in this investment, we can chose either a short position on a swap or a long position on 3
futures, both with a notional amount M. The pay-offs at coupon payment would be the followings :
Short/receive
Long/pay
time
position
May 30
short swap
long fut 1m
June
t=1
July
t =2
August
t=3
M*(R-r0)*28/360
M*(R1-r1)*28/360
M*(R-r1)*28/360
M*(R-r2)*28/360
M*(R2-r2)*28/360
long fut. 2m
M*(R3-r3)*28/360
long fut 3m
Where :
198
R is the fixed rate
r is the floating rate
I thank Mr José Jorge Ramirez (ING Americas) for his helpful comments on this appendix
129
Overall, there are four main differences between swaps and engrapados :
•
the coupon R is fixed in advance for the swap (i.e. on May 15 in our example) whereas it is
fixed in arreas for the future (i.e. at the maturity of the contract)
•
the fixed-rate is different for each maturity for engrapados. To compare it with the swap
rate, practioners use the average
•
the pay-offs differ because of marking-to-market for the futures (which also require a
margin deposit and possible margin calls)
•
convexity also differs: each flows for the swap are discounted to time 0 whereas in the
future, each flow is discounted to the futures maturity
On the exchange, the price will include transaction fees, clearing fees and the broker’s commission if
the financial institution does not have direct access to the market. Nonetheless, according to Mr
Ramirez from ING, the final cost is on average the same for both instruments for a financial institution
such as ING (which is one of the most active participant on the TIIE futures).
Apart from hedging purposes for institutionnal investors, engrapados can also be used by
individual investors for the following hedging strategies:
- convert a floating-rate bond into a fixed-rate bond (and vice versa)
- set a cap on floating-rate debt or a floor on a floating-rate investment
130
Appendix 4 - Margin calculation by Asigna199
A key role of the clearinghouse is to determine the margin requirements (initial and
maintenance margins). A user-friendly benchmark for initial margins required by clearinghouses of
derivatives exchanges, suggested by the director of MexDer, Jorge Alegria is 3,5 times the standard
deviation of the underlying asset.
In practice, the methods to determinate and monitor margins are much more complicated. In
order to calculate the margin, one has to know first the volatility of the underlying asset. Then margin
requirements can be calculated using four different methodologies:
•
Confidence interval at 99.9%
•
Parameters
•
Historical data
•
Monte Carlo simulation
Maturities taken into account by Asigna are 1 month, 3m, 6m or one year. A risk committee
assesses the results periodically to make sure the four methods are consistent and decides the amount
of the margins.
Table A : Margin requirements
for USD Futures Contract
Monte Carlo simulation
Parameters
Historical data
Actual
NB: contract size = $10000 USD
source: MexDer
199
Table A provides an example for currency futures.
$2010
MXN
$2971
MXN
$2773
MXN
$3000
MXN
(USD futures contract). Requirement estimations
range from 2010 and 2971 pesos per contract
depending
on
the
method.
Actual
margin
requirement, 3000 pesos, is higher than any
estimation and represents approximately 2,6% of the
value of the contract (10.000 USD)
Main sources for this appendix : Alegría (2004) & interviews
131
Appendix 5 - Examples of Extreme Events200
The Clearinghouse has been designed to resist to very extreme events (extreme variations in the
value of underlying assets), for which margins are not likely to be sufficient. Here are some examples
of extreme events in the recent financial history of Mexico:
•
The TIIE28 moved by 270 bp in one day on April 3 1995. Over the last year, the biggest
movement was much more limited: 27 bp lost on Dec. 13. The last very important move took
place on Sep 23 2002, when the interbank rate soared by 120 bp within one day.
•
The sharpest daily change on the stock exchange was a rise of 14,5% in the IPC index on Jan
31 1995. The strongest change on the MSE in recent times was a 3,21% escalation on Jan 3
2006.
•
The sharpest move in the USD/MXN exchange rate also occurred during the Tequila Crisis,
with a loss in value of 20,3% of the peso on Dec 22 1994. Last year’s largest change took
place on Dec 9 ; it was a 1,5% decrease in the peso.
The figure hereunder summarizes the mechanism of intervention by Asigna, with the three major
steps that have been explained:
1. margin fund intervention
2. compensation fund intervention
3. own patrimony of the clearing house
These three steps are of course a simplification, and the figure hereunder details how the
patrimony of the house is protected.
200
Statistics are collected from the Central Bank of Mexico. Other sources used: interview MexDer
132
Asigna Security Network
F ig u r e X X - A s ig n a S e c u rity N e tw o r k
P r o b a b il i ty o f U n s u ffie n c y
3 .5 0
4 .8
.0 0 1 % .0 0 0 1 %
5 .8 7
6 .9 4
7 .9 8
9 .0 0
300
1 0 .0 7
+ 300
+
…
V a r.
1 1 .1 3 +
…
V a r.
Patrimony of the House
The Compensation Fund
Extraordinary Apportation of
Own Minimum Patrimony
Minimu Patrimony Third Parties
Compensation Fund Third Parties
3900 + 300 + 300 + 150 + 120 +
The Compensation Fund
3000
2nd Extraordinary Apportation of
S ta n d a r d D e v ia tio n :
Own Compensation Funds
Initial Margins requirements
E f fe c ti v e :
Margin Excedent
E x a m p le
F u tu r e s C o n t r a c t o n U S D
.0 0 0 0 1 % .0 0 0 0 0 1 % .0 0 0 0 0 0 1 %
source: MexDer
133
Appendix 6 – Beta Calculation
The beta equity for CME has been estimated as follows:
-
it has been measured 5 times over the last year and a half
(figures provided by John Steal at CME Holdings in line with Morgan Stanley, BofA and
Bloomberg estimates)
-
it could not be measured before, because time series were not long enough (the exchange went
public in December 2002)
-
our assumption was to take the average (deviation around this value is low). CME uses a value
of 1.1
Date
Dec 7 2004
Jul 25 2005
Oct 3 2005
Feb 2 2006
Apr 7 2006
Average
Beta
1,065
1,123
1,041
1,117
1,025
1,0742
The risk of the equity is very close to the market risk. Chouikri (1994) found a similar result
for a pure derivatives exchange listed in the nineties (the OM Stockholm): the beta equity was
comprised between 1 and 1.2 for the period 1989-1992.
134
135
136