Online business-to-business exchanges have surfaced in the commodity, currency, equity and fixed-income over-the-counter derivatives markets. Platforms have also been created to facilitate risk transfer in newer markets including catastrophe, credit, electricity and weather derivatives. Here we focus on three areas in which B2B derivatives exchanges can benefit both the end-user and dealer communities in the USD88 trillion global OTC derivatives markets.
INFORMATION ACCESS & DISTRIBUTION
In specialized markets, such as OTC derivatives, valuable information may be difficult to access and must be obtained from multiple unrelated sources. Although the Internet has dramatically increased information flow, there remains a need to filter, organize, and bundle relevant information. An online exchange enables the delivery of a suite of content, expertise, and quantitative tools that are valuable to market participants.
Content includes industry-wide information such as price and volume data, business reporting, conference listings, and links to relevant web sites. Expertise includes market analysis and forecasting, tax and accounting advisory, regulatory updates, new product ideas and derivatives research. Quantitative tools include pricing models, portfolio analytics, volatility surfaces and access to a historical database of information.
In the same way that end users are challenged to efficiently access information, dealers are challenged to streamline the methods they use to distribute products and information. By providing an electronic link to the end-user community, the online B2B exchange can improve this distribution model by enabling dealers to seamlessly push research, new products and market axes to end users globally.
THE PRICE DISCOVERY PROCESS
Since the risks of OTC derivatives are often difficult to evaluate, there may be discrepancies in the pricing of these products among competing dealers. As a result, the derivatives end user typically requests quotes from multiple dealers. In most OTC markets, the price discovery process is carried out via the telephone. Here, the salesperson intermediates between the end-user and trader in seeking to find the "right" price. B2B derivatives exchanges offer the potential for adding efficiency to this process by:
* Enabling the end user to request pricing from multiple
dealers simultaneously
* Standardizing both the pricing inquiry and the dealers'
responses, thus enabling the end user to make an
apples-to-apples comparison
* Formalizing the process by which the end user delivers
feedback to dealers involved in a given transaction inquiry
These elements of a B2B derivatives platform combine to provide a further potential benefit: a trail of historical price inquiry. Since OTC transactions are not currently reported to an official tape, there is a paucity of historical information available. Such information, if compiled and properly made available, could help dealers to understand better the demand for their products, where they are most or least competitive, and how risks are priced in the marketplace.
DOCUMENTATION MANAGEMENT
OTC derivatives are contracts between two counterparties that agree to exchange economicssometimes for an extended period of time. As such, there are documentation requirements that must be fulfilled by both parties.
Managing transaction-related documentation is a challenge for both end users and dealers. In its 1998 survey of 30 leading OTC derivatives dealers regarding settlement procedures1, the Bank for International Settlements reported that "the existence of significant backlogs of unsigned master agreements and outstanding confirmations" warranted "a potential weakness in practices." A B2B derivatives exchange stands to improve documentation management by providing a secure electronic meeting place in which counterparties can exchange, negotiate, and complete necessary documentation. Once completed, the exchange may store and organize transaction-related documents.
CONCLUSIONS
While online B2B derivatives exchanges hold great promise, they are not without limitation. An online platform can replace neither the consultative role played by a salesperson nor the financial decision-making required of an end user. What the online exchange can do, however, is automate many of the routine aspects of a transaction such as price inquiry and documentation management. This automation enables professionals to employ their skills more effectively.
Because each OTC derivatives market has a unique set of products, participants and risks, a slightly different B2B platform is warranted in each market.
1 "OTC Derivatives: Settlement Procedures and Counterparty Risk Management," September 1998.
This week's Learning Curve was written by Dean Curnutt, a founder of online OTC equity derivatives platform StructuredMarketsin New York.
