Managing Operational Risk in Financial Markets

between OTCs and exchange traded products. The advantage of

flex options is that participants can choose various parts of the

contract specification such as the expiry date and exercise price.

Table 4.2 The top exchange traded contracts

3

Rank Contract Exchange Country

1 UST-Bond CBOT USA

2 3-month Eurodollar CME USA

3 BUND Eurex Germany

4 3-Month Euromark LIFFE UK

5 US T-Bond options CBOT USA

6 Interest rate BM&F Brazil

7 3-month Sterling LIFFE UK

8 S&P 100 Index option CBOE USA

9 3-month Eurodollar option CME USA

10 BOBL Eurex Germany

Understanding the market structures

This section looks primarily at how the structure of the markets

for trading exchange traded derivative (ETD) products. An

exchange is the place where futures and options are traded by

members (corporates or individuals) who carry out their business

under the rules and regulations of the exchange. The exchange in

turn is subject to regulation by the domestic government

agencies.

The debate about which trading method, open outcry or elec-

tronic trading, has been raging for the last few years and the argu-

ment now appears to be tilting towards electronic trading. Since

the largest exchanges in the world, i.e. CBOT and CME are open

outcry, most of the trading is still done on the floor of the

exchange using this method. Electronic trading systems are

Managing Operational Risk in Financial Markets

Understanding the market structures

42

becoming more established with virtually all the new exchanges

adopting this method of trading. Even the open outcry exchanges

are using electronic trading systems to supplement the more tra-

ditional trading method. LIFFE has recently decided to list all its

products on an electronic platform and now offers both electronic

trading as well as floor trading facilities.

In light of the organizational and technological changes that have

taken place over the past few years, and the global nature of the

financial markets, it is surprising to note that the majority of the

futures and options business still takes place on the floor of

exchanges. In the futures exchanges, where the total dollar volume

of all futures contracts world-wide is over $500 billion

4

a day,

traders still meet in designated locations (the trading pit) and buy

and sell products by a combination of shouting and hand signals.

The process is known as open outcry, or pit trading or floor

trading. Figure 4.3 shows the trading volumes for open outcry and

electronic exchanges.

5

Whatever the trading mechanism, the exchange plays a key role in

4 Introduction to derivatives

Understanding the market structures

43

Figure 4.3 Trading volumes for open outcry and electronic

exchanges.

the trading process. The exchange, through its clearing house, acts

as the counterparty to every transaction and provides the systems

for the clearing and settlement of the contracts.

Impact of technology

Whatever the trading mechanism offered by the exchanges, tech-

nology has an ever-increasing role in this environment. For

example, the client enters the trade on a computer in their office;

this is automatically routed to the broker’s booth on the exchange

floor; the trader in the pit is informed through his headset; he exe-

cutes the trade on the floor and enters the details on his electronic

pad; the information is routed to the clearing house, price vendors

and the trade confirmed back to the client.

There is an increasing amount of technology on the trading floors.

CBOT’s

6

trading facility includes 12,000 computers, 6,000 voice

devices and 2,000 video devices all linked together with 27,000

miles of cable.

Despite all this technology, open outcry exchanges are under

increasing pressure to move to electronic trading. In Europe, the

battle for market share is at its fiercest between LIFFE, which has

traditionally operated open outcry, and Eurex, which is the largest

electronic exchange. The Eurex exchange was created by the

merger between Deutsche Terminborse (DTB) and the Swiss

Options and Financial Futures Exchange (SOFFEX). The battle in

Europe, at least, has been won by electronic trading with LIFFE

and MATIF both moving to electronic trading.

As the derivatives market becomes global, exchanges are linking

together in order to list their most successful products on mutu-

ally beneficial exchanges. There has been evidence of this recently

with LIFFE listing the Euroyen contract (also traded on TIFFE)

and the Japanese Government Bond (also traded on TSE). Both

contracts are cleared by the Japanese exchanges with open posi-

Managing Operational Risk in Financial Markets

Understanding the market structures

44