CME Europe on dealing with derivatives

There are a range of trials ahead for the European derivatives market, not least a wave of new regulation. However, for those that are successfully fighting the current, new prospects could place the region at the forefront of the global game

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An offer is signalled in the Eurodollar options pit at the Chicago Mercantile Exchange. CME Europe is the European arm of the exchange

With new financial regulations at play, such as reporting under the Markets in Financial Instruments Directive (MiFID II) and the introduction of the European Market Infrastructure Regulation (EMIR) in 2014, Europe’s derivatives exchange market poses a wide range of complex challenges. Although there has been some degree of improvement in the aftermath of the global financial crisis, a degree of fragility still exists, leaving investors and stakeholders vulnerable to sudden shocks – both economic and political. In such a multifarious environment, those that survive in the industry do so through careful navigation and insight, while those that flourish can only be described as having highly progressive strategies and a wealth of expertise. One such success story is CME Group, the world’s leading and most diverse derivatives marketplace, which has experienced impressive growth over the past year. European CEO had the chance to speak with Cees Vermaas, CEO of CME Europe, CME Group’s European exchange, about the current challenges facing the industry, as well as the opportunities now arising for the region.

The challenges for Europe are visible for everyone. We are trying to get back on a growth path and out of the crisis, which economists expect to be limited

Before CME, you led the Amsterdam Exchange. How has the move been from equities to derivatives?
Well, it’s pretty substantial. For the last four years I was indeed CEO of the Amsterdam Exchange, but I’ve been part of the whole Euronext development, i.e. equity consolidation development in Europe, since the introduction of the Euro in 2000. We’ve been trying to consolidate the European exchanges to create a European cash equity platform prior to MiFID I, the first regulatory move in 2007, up until the preparation of MiFID II and EMIR. If I look back at that period, and that includes the last four years as CEO of the Amsterdam Exchange, equities is actually at the forefront of all the developments to progress financial markets in continental Europe. This involves the creation of an internal European financial market. With MiFID II and EMIR in the third stage, now, for the first time, derivatives markets are becoming subject to that whole process. So, for me personally, stepping out of equities and getting into derivatives happened at the right time, because I can take my experience of the internationalisation of equity markets in Europe to a new set of asset classes in the derivatives world, which will be going through a similar process in the next few years.

Do you see European derivatives markets growing in the near future?
I think this question also relates to the new regulatory environment. Lending in Europe is still highly dominated by banks. This is very different to what we see in the US. I’ll give you an example: between 70 and 80 percent of finance in continental Europe goes via regional, local and international banks, and so solutions presented by the market in terms of funding or trading only total 20 to 30 percent. That means that listed derivatives markets, such as home exchanges, are actually underdeveloped if you compare with the US. Now, taking a step back, Brussels and Frankfurt are introducing new regulations and, obviously, they are doing so in a secure way because they do not want to get to a crisis point, like we have seen over the last five to six years. In the coming years you will see the number of banks reduce steadily, and there will be more room for capital markets to develop under the new regulatory regime. I foresee potential growth for listed derivatives markets in Europe, particularly retail, institutional clients, more regionally orientated hedge funds, and asset management firms, as well as proprietary training firms that are active in the region, such as those in Germany, Israel and Amsterdam. For instance, Switzerland will be able to develop further with these European derivatives markets through its global role.

What challenges do European bodies face to get to the point when they can implement regulatory reform?
The challenges for Europe are visible for everyone. We are trying to get back on a growth path and out of the crisis, which economists expect to be limited. I’m not an analyst and I’m waiting myself, but very limited growth is expected in general over the next few years in Europe. At the same time, this whole regulatory reform is going to take place because it’s a prioritised point on the agenda of the European Central Bank in Frankfurt and of European politicians. An internal European market is essential in order to have Europe sitting at the table together with an upcoming China, India and US. So, it’s pivotal that Europe continues to create this strong internal market, and that means banks should refer back to their initial roles much more and we should create room to develop financial markets in Europe. That’s the challenge; to overcome the political issues we have coming out of the crisis, with Greece, but also with Portugal and Italy. Another challenge in that same environment is the UK EU referendum, which is expected to take place in 2017 – what is Great Britain going to do? And in the meantime, there is limited growth and everything is very fragile, so if something happens and disturbs the recovery process in Europe, it may work against these developments.

How do you think that growth and competitiveness can be restored with all these issues in mind?
The good thing is that we are working in an environment with over 500 million people, so the market is potentially even bigger than that in the US. The political challenges should not affect the real economy principle too much. We have great companies here in Europe, which have a global business and provide income and jobs for the European community. Apart from the politics, there is a real economy that is very strong – I’m talking about the big companies listed in Europe and in the UK, which you may never hear about, but they are there and they will not leave. That’s the strength of Europe.

What other geopolitical risks are affecting the market?
The energy industry is a good example of a further risk. Energy is much cheaper than it was before, and we are also seeing developments in shale gas. If you talk about geopolitics, it’s important to note how distribution channels are going to be affected by growth in Asia. Europe is playing a major role in the distribution of energy and commodities globally, so changes in these industries might impact our markets. However, there are good prospects for CME in general, as we serve global markets. Take CME Europe; it is located in London as a European exchange, and is focused on Europe, but the business itself is going far beyond that – it’s a global business.

How do you think China’s slowdown will affect European markets?
Well, there are two possible outcomes. Firstly, it might be the case that global markets are affected negatively. However, on the other hand, investors, traders and players in our industry are looking for new opportunities to put their money into, to trade and to be active. If the Chinese economy is slowing down, which is something we can only judge over a longer period, it may have positive effects for Europe as an alternative, because you’re talking about a stable environment with AAA ratings for investment opportunities in the UK, Germany and the Netherlands. So, it might even have » a positive effect, because money has to flow somewhere where it is safe and provides at least some return.

How do you see the volatility of forex markets playing out over the next year?
Again, I’m not an analyst and I’m not predicting, but if you consider the challenges, pressures and geopolitical stresses that we’ve seen globally, the uncertainty for foreign exchange and currency markets indicates that there is volatility. Luckily, in our business that has a positive effect on providing trading and currency paths, so our business model might actually see us benefit.

Cees Vermaas, CEO of CME Europe
Cees Vermaas, CEO of CME Europe

You mentioned utilities and energy. CME is stepping up natural gas and electricity contracts – what led to this?
It’s actually very simple. On the one side, the energy market is very mature, especially for oil. But, if you look at Europe, the energy market, or (in a broader sense) the utility market, is still regional, fragmented and in early business cycles; most of the trading is bilateral, it’s not electronic and 70 to 80 percent is still non-clear. So, for an exchange with a value proposition like CME, it’s a logical moment to step into that industry, try to build our community and be part of the next move within the energy world in Europe. We are dealing mainly with natural gas power and emissions, so we are part of the whole new consolidation phase that will be more pan-European, less regional and more regulated. There is a mandate also, where the regulator would like to see more transparency in terms of price formation, publication, more competition and a cleared regime, and this all fits into the model that we are able to offer, so that’s why we stepped into this area.

Are there are other areas you are focusing on at the moment and over the next year?
In March, we became active in agricultural products, so far cocoa, and the first results have been promising. Our industry partners came to us and we worked out a renewed business model that had a more secure, modified process. In agricultural products, like cocoa, the physical delivery process, from the harvest of the beans to storage just before preparation, is very delicate. It’s a process in which the quality of the goods has to be maintained throughout. We renewed the contract and presented it to the market with strong support from our euro-denominated industry partners. And what we’ve seen so far, over the last three to four months, is that there is a lot of attraction towards these new cocoa contracts. So, this is another angle of our business, but it is more competitive because it is a mature market and there are offers from our competitors.

What have been the defining moments for CME Europe over the past year?
Foremost is the traction we are getting in the utilities and agricultural markets. We were previously very much focused on the foreign exchange market – it’s a huge market and our biggest challenge there is to crack the over-the-counter markets, currently in place between banks. But, in general, we took the decision earlier this year to start to build a pan-European, multi-asset class derivatives exchange. In January, we had one asset class: foreign exchange products. Today, just six months later, we have three asset classes. We now trade natural gas, power and cocoa, and within this proposition, we have futures and options.

I am very proud that we are well on our way to providing choice to our market participants, such as investors, hedge funds, proprietary trading platforms, and asset managers. Across all these asset classes, we now have over 50 types of client in total, and if you think that barely a year ago we had nothing, that is a big achievement, especially within the timeframe and with all the challenges that we have spoken about. We will continue building our community, and I hope that in a year’s time from now we will offer five or six asset classes. We will also continue to connect clients in all different segments, so that we can provide them with choices in order to manage their risk. Building up markets organically as a newcomer takes time, but with the reputation of the CME Group as a major shareholder and given our achievements both globally and at the European exchange here in London, I’m sure we will achieve successes in the asset classes and products that we are developing at the moment.

Deriving value

Derivatives trading is a complex field, with a range of available instruments

Futures – Futures contracts deliver a set amount of shares or commodities on a specified date, with interest or price locked in. Investors can hedge by taking a futures position opposite to a current stock position

Options – A popular type of derivative, stock options give the holder the right to buy or sell a set amount of shares or commodities by a specific time. Crucially, there is no obligation to take the option

Forwards – A forward contract is an agreement to buy shares or commodities on a specified future date, but at a price agreed at the time that the contract is made. This potentially limits gains, but can be used as a hedge

Contracts for difference – Two parties agree that, on a future date, the seller will pay the buyer the difference between the future value and current value of shares or commodities, or vice-versa if the difference is negative