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- How Would An Interest Rate Hike Impact CME’s Interest Rate Derivatives Trading?
Subject to securing an approval from British regulators, the CME Group (NASDAQ:CME) plans to launch its European futures market in London on September 9, according to the Wall Street Journal. The new exchange will initially offer 30 currency futures contracts and will later branch out into contracts based on equities, interest rates and commodity prices. 
The announcement comes soon after NASDAQ OMX (NASDAQ:NDAQ) launched its own London-based futures exchange late last month. NASDAQ’s exchange is christened NLX and aims to offer “a range of both short-term interest rate (STIRs) and long-term interest rate (LTIRs) euro- and sterling-denominated listed derivative products on a single market,” according to the company’s press release. 
The two new exchanges will challenge the duopoly of NYSE Liffe and the Deutsche Borse, which together hold over 90% of market share in the rapidly growing European derivatives market. Hence, it seems that this market is set to see intense competition in the coming months – especially when the IntercontinentalExchange (NYSE:ICE) enters the race after its acquisition of NYSE Euronext (NYSE:NYX).
We believe that the IntercontinentalExchange will have a slight advantage over the CME Group and NASDAQ OMX in the race to gain market share in this market because of its acquisition of NYSE Euronext.
The London Derivatives Market Is A Huge Opportunity
While there is no consensus on how big the global derivatives market is, it can be said for sure that it is much larger than the worldwide equity and bond markets combined. According to a McKinsey & Company estimate, the total value of the world’s capital stock, which includes equity market capitalization and outstanding loans and bonds, was just around $212 trillion in 2010. In contrast, estimates for the global derivatives market size vary widely from $600 trillion to 1,500 trillion.
However, only a small portion of these derivatives (16% according to an undated Deutsche Borse white paper) are traded on exchanges.  The majority of trading in derivative contracts actually takes place over-the-counter (OTC) – a way of bilaterally trading instruments without any regulatory hassles.
This proportion is soon going to change because regulators around the globe deem that OTC trading of derivatives is too risky in the wake of the mortgage crisis of 2008. In 2009, the G20 nations called for centralized trading of standardized OTC derivatives, and since then regulations similar to the Dodd-Frank Act are being implemented worldwide. While Japan has already implemented such regulations, the Dodd-Frank Act in the U.S. and the European Market Infrastructure Regulation (EMIR) in Europe will make centralized clearing of OTC derivatives mandatory for all eligible parties, latest by the end of 2013. This will ensure that a lot of derivative trading, that earlier took place over-the-counter will now be pushed onto exchanges or similar electronic platforms.
This is a big opportunity for the world’s largest securities exchanges, which are stung by low equity trading volumes and are looking for alternative sources of revenue. At $633 trillion at the end of 2012, the size of the global OTC derivatives market significantly overshadows the world equity markets, which were valued at $55 trillion by the World Federation of Exchanges in 2012. An exchange that is able to capture derivative volumes when these OTC contracts start trading electronically will be set for rapid revenue growth that will more than offset the revenue decline due to sluggish equity trading volumes.
However for that to happen these exchanges must have a presence in London, which is the world’s largest financial center and accounts for 46% of the global OTC interest rate derivatives market, the largest segment in OTC derivatives.  Given these facts, it is no surprise that all major U.S. exchanges are racing to set up derivatives exchanges in London.
Does Not Mean That Each Player Has An Equal Chance Of Winning
Although the whole derivatives segment is set for rapid growth, we believe that all players in the market do not have an equal chance of gaining market dominance. The CME Group and NASDAQ OMX are just entering the London-based derivatives market and have the task of setting up their businesses from ground up. On the other hand, the IntercontinentalExchange (ICE) is in the process of acquiring NYSE Euronext and will assume the role of the market leader immediately after the deal closes in Q3 2013.
Once complete, the NYSE Euronext acquisition will add LIFFE to the IntercontinentalExchange’s armory. LIFFE (short for “London International Financial Futures and Options Exchange”) is NYSE Euronext’s international derivatives business which operates derivative markets in each of Amsterdam, Brussels, Lisbon, Paris and London.  As mentioned above, it enjoys a virtual duopoly in the European derivatives market along with the Deutsche Borse and will immediately propel the IntercontinentalExchange into a leadership position in the European derivatives market.
Further, LIFFE’s offerings complement IntercontinentalExchange’s clearing platform and will allow the combined entity to launch innovative contracts in multiple asset classes. This will ensure that the IntercontinentalExchange keeps flooding the market with new and innovative products in the coming years.Notes:
- CME Plans September Launch in London, WSJ, June 11, 2013 [↩]
- NASDAQ OMX NLX and LCH.Clearnet Receive Regulatory Approval to Launch Trading & Clearing for New Market, May 29, 2013 [↩]
- The Global Derivatives Market: An Introduction, Deutsche Borse [↩]
- Financial Market Series: Derivatives, The City of UK, November 2012 [↩]
- SEC Filings, NYSE Euronext, 2012 [↩]