Downside of OTC

Terry Flanagan

New OTC-style exchange products without a built-in user base have their disadvantages.

The price OTC market participants pay for the ability to create bespoke transactions is illiquidity and a lack of transparency, two factors that have become more highly problematic than ever since the financial crisis. The exchanges may find liquidity providers to support complex listed exotics with bids and offers, but if the derivatives remain illiquid, counterparties will charge significant premiums to compensate for the risk.

“Unless there is a very active, two-way market that develops for the structure, it’s likely to have high premiums, a wide bid/offer spread, and lack liquidity,” said Jack Hansen, principal and chief investment officer of The Clifton Group, which works with corporate financial plans, hospitals, and other institutions seeking specific risk profiles using OTC or listed options.

Times have changed, however, since the pre-crisis years of ever-higher volumes and more complex OTC structures, and for some investors the benefits of a listed OTC-type product may outweigh the disadvantages resulting from less liquidity. Bill O’Keefe, director of derivatives and customized options at online brokerage TradingBlock, noted market participants’ ongoing concern about counterparties’ credit risk as European banks face the ongoing threat of credit downgrades. As a result, he sees several factors pushing traditional OTC derivative users onto listed markets.

One factor is the listed market’s centralized clearing and backing by the OCC; another is the transparency arising from anonymous exchange members putting up quotes rather than a bilateral counterparty; a third motivation is independent, mark-to-market pricing.

“If you call a big bank, they might say the underlying bonds are worth 72 cents on the dollar, but that’s their opinion and it might be totally wrong,” O’Keefe said. “OCC-backed options are priced by a third party and the pricing reflects current volatility and can be extrapolated out further and further.”

Related to pricing is the fungibility of listed financial products. O’Keefe noted that if an investor is long an OTC product and wants to sell, the bank counterparty may give a lousy bid. The investor may find a better bid from another party, but then the investor must enter into a second bilateral trade under the auspices of an International Swap Dealer Association (ISDA) agreement, and he or she must put up collateral against both transactions.

In addition, O’Keefe said, ISDA agreements are expensive to maintain, resulting in derivatives users becoming dependent on a few counterparties. And because some investors’ guidelines limit their exposures to any one bank, they may have to split a large transaction among several bilateral agreements and accept inferior pricing.

Exchange-traded options would eliminate most of these concerns, assuming the central counterparty, in this case the OCC, remains viable. The CBOE used many of these arguments in market materials to generate interest in the CEBOs, so far to little effect.

Given CBOE’s dominant position in flex options and the major indices, Nasdaq OMX and NYSE Euronext are no doubt seeking to design products that walk the fine line between providing sufficient customization to attract OTC market participants while still drawing enough liquidity to generate the benefits of a listed product.

In the case of barrier options, Hansen of Clifton Group said they’re not widely deployed in client portfolios. “But those products are certainly out there…They have a certain appeal to investors because you have greater certainty of your objectives’ outcomes,” Hansen said, noting that a client could use a ‘knocked-in’ put to protect against a market move below a specific level, and only pay a premium if it reaches that level.

“If you had standardized structured products — and that might be an oxymoron — with a one-tick wide bid and offer, 1,000 options up, using the same standardized structure, then it could become something of interest to us,” Hansen said.

Time will tell whether some form of exotic options succeed in the listed market. In the meantime, options exchanges are competing elsewhere to bring OTC benefits to the listed markets. The fully electronic International Securities Exchange received belated approval a year ago to launch qualified contingent cross (QCC) order types, which permit orders of 1,000 contracts or more that are hedged by stock to be matched prior to arriving at the exchange, and then printed on the exchange without exposure to competing bid and offers.

The QCC stirred concerns among competing exchanges, but they soon offered their own variety of the order type. The concern emerged because QCC officially brings dark liquidity to the listed options market that previously was only available in the OTC market. The exchanges now offering QCC orders, including the ISE, NYSE Amex and Nasdaq PHLX, declined to attach volume numbers to their QCC businesses, although one executive noted, “There’s healthy activity. It’s not a substantial chunk of business, but it’s not de minimus.”

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