New Pecking Order in Derivatives?

Exchanges and clearinghouses are expected to win big from the new derivatives rules in the financial reform bill that passed last week. In a video interview with CNBC yesterday, Jon Najarian, co-founder of Optionmonster.com, said the new rules for derivatives are a game changer for the exchanges and a buying opportunity for investors.Najarian, a former CBOE options market maker, singled out the New York Stock Exchange, Chicago Mercantile Exchange (CME) and Chicago Board Options Exchange (CBOE), in particular, while CNBC flashed InterContinental Exchange (ICE) as the fourth contender on the screen as well. "All three of those leaders are very astute politically and those are the ones to watch," commented Najarian who disclosed that he owns shares in NYSE, CME and CBOE.

"I think all three exchanges have great facilities to do exactly what we'd like to see and that is transparency and collateralization as well as the drive for people to avoid contraparty risk and do that through a centralized mechanism. That's something that's not going to go away," said Najarian in the CNBC interview.

CME is well positioned under Chairman Terry Duffy with its Globex trading platform on every desktop around the world. While there is only one equity and options clearing platform, in futures, there are multiple clearing platforms in futures and CME has been aggressive in striking deals with exchanges in Latin America and Asia. In addition, the NYSE has had strong growth internally and in its systems upgrades under CEO Duncan Niederauer, said Najarian in the CNBC interview. He also praised the leadership of CBOE under Bill Brodsky which has remote market making as well as floor trading.

While top five banks (JP Morgan, Goldman Sachs, Citigroup and Credit Suisse) have exposure to about $240 trillion in OTC derivatives, according to press reports, some percentage of the trading will be pushed onto exchanges and into clearing houses to provide more transparency into pricing and to guard against systemic risk. Even if trading of even 10 or 20 percent of derivatives migrates onto exchanges, this will generate big revenues for exchanges, Najarian told CNBC.

However, the pecking order in exchange-traded derivatives may not change that much. A Financial Times article pointed out that a similar group of banks own the futures commission merchants or FCMs that will handle the clearing of exchange-traded derivatives.

While regs will push trading of the more standard over-the-counter derivatives onto exchanges and clearinghouses, most of the OTC derivatives contracts will mainly trade between these entities, noted Najarian. And the big banks tend to own the futures commission merchants (FCMs) that will process the trades, collect the margins and extend credit to customers.

Here's an excerpt from the FT: "The pecking order in the derivatives world will not change much to begin with, as a similar group of big banks dominate the ranking of FCMs, as they do the OTC markets. According to CFTC information, the top five FCMs, based on capital, are divisions of Goldman Sachs, UBS, Credit Suisse, JP Morgan and Citigroup In terms of customer assets under management, Newedge ranks first, followed by Goldman, JP Morgan Futures, Deutsche and UBS, according to CFTC data.

So although exchanges and clearinghouses are expected to win big, don't count out the large banks that dominate OTC derivatives, because they are likely to play a major role as FCMs.

Exchanges and clearinghouses could win big under the new derivatives regs, but large banks and brokers that own FCMs will play a role in the pecking order. Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio