The financial crisis has slowed trading at Mexico City’s derivatives exchange MexDer, and led to some nasty smells in the OTC market. But participants are sure this is a temporary dip. Mexico’s market, led by MexDer, is full of drive. The exchange has up-to-date technology, is easily accessible to foreign traders, and could be on the verge of attracting a wave of new interest. FOW’s Agnieszka Troszkiewicz reports.
Jorge Alegría Formoso, chief executive of Mercado Mexicano de Derivados, is heading for Huatulco, a tourist resort in southern Mexico. But instead of taking some time off, he is attending the annual convention of Mexican pension funds.
As Alegría explained when FOW caught up with him, he is relentlessly working to attract new market participants to MexDer, and pension funds, known as Afores (Administradoras de Fondos de Retiro), are the country’s largest institutional investors.
They are increasingly given permission to use a wider range of financial products, presenting a big opportunity for MexDer.
On October 1, President Felipe Calderón proposed allowing Afores to invest freely in stocks, which would involve using single stock options. The reforms, which also include allowing Afores to invest in infrastructure and IPOs, have yet to be approved by the National Commission for the Pension System (Consar) and by Banco de Mexico, the country’s central bank.
“This is very good news for MexDer,” Alegría says. “Because of the changes in the regulation, we are very bullish on individual stock options, and potentially individual stock futures.”
Big ambitions
For an 11 year old exchange, MexDer has come a long way. “We took, and we are taking, the necessary measures to be the market of choice for the conduct of heavy activity in Mexico and Latin America,” Alegría says.
MexDer’s “dual strategy” for the next few years involves attracting both domestic and international investors.
On the local front, the main challenge is on the training side, Alegría explains: “Teaching funds; teaching the local investor base about the advantages of using derivatives and how to use them.”
He also wants the local banks to start favouring exchange-traded derivatives above the over-the-counter market.
Internationally, MexDer wants to attract high frequency traders and global players. “We’re actively promoting the very easy access to the exchange,” Alegría says. “We have big advantages on the regulatory and the clearing side to attract international players to our market.”
Seeking out customers
Others have noticed Alegría’s eagerness. “He’s been pounding the streets in North America, Europe and Asia about his exchange,” says Gerald Perez, managing director of Interactive Brokers UK, an online broker in London that provides direct market access (DMA) to MexDer.
“He’s been very receptive to hearing about needs from remote members, as well as customers and independent software vendors. The exchange has come up with solutions relatively quickly, compared to other exchanges in the same categories,” Perez says.
Interactive Brokers’ customers include individuals, hedge funds, brokers and proprietary trading firms. Those trading on MexDer mainly come from Europe and the Americas. “As we become more global, they want to diversify their portfolios; they want to take advantage of more opportunities; they want to go into emerging markets,” Perez says.
“It’s easy to connect to MexDer through brokers like us, which creates arbitrage opportunities,” he adds. Mexico’s location also makes MexDer an attractive marketplace for both north and south Americans.
Ryan Keough, managing director at SunGard Global Trading in New York, is in charge of business development in Latin America. He says that SunGard’s clients typically opt to trade more than one market in a region. “In Latin America, we have clients who are Spanish banks; but also some of the American banks, being full service providers, need to have a Mexican presence,” Keough says.
MexDer has been vigorous in its quest to reach out to remote members and increase its volumes. With support from the local authorities, the exchange took the first steps to modify local regulations to create an omnibus account scheme, allowing foreign financial firms to trade through MexDer members. In 2005, the exchange authorised remote trading.
MexDer was helped by the US Commodity Futures Trading Commission, which in 2006 allowed its IPC equity index futures to be used by traders in the US. And the abolition of withholding tax for foreign participants boosted foreign interest in the Mexican exchange.
MexDer accepts collateral in dollars without requiring that it be converted into pesos or transferred to a Mexican-based account. It also allows the use of US Treasury notes, bonds and bills as margin.
The exchange has also worked to improve its technology. “Communication, communication, communication,” says Gloria Roa Béjar, head of BBVA Bancomer Derivados in Mexico City.
She points to connectivity as an area of progress for the exchange. The Fix Protocol has allowed fast direct access to the exchange, encouraging independent software vendors to write to the exchange.
ISVs have used Fix to build gateways and interfaces and add MexDer to the list of exchanges they offer, further increasing participation from overseas. “That’s an indication that the exchange is moving forward and meeting the needs of technology partners,” Perez says.
Technical upgrades
The exchange has chosen software vendor RTS Realtime Systems Group to supply its new front end trading platform. John Dempsey, vice-president for business development at RTS in Chicago, says the platform helped put local players on a more level playing field with the rest of the derivatives markets.
“It gave them a new set of tools to be able to manage their risk and get their trading done, perhaps in a more efficient and faster way,” he says, adding that the front end solution has brought a lot of interest from abroad.
“They really needed to get a single solution into the hands of the options market makers as well as into the traders and their customers, and to have a consistent, current capability to attract traders and so on from the outside and keep in line with the rest of the world. And it’s working!” Dempsey says.
To increase algorithmic trading, MexDer plans to introduce co-location in November. Keough at SunGard is convinced that co-location is an excellent service for MexDer to provide to its members and that it will improve the technical aspects of electronic trading, such as matching engines and the ability to handle big volumes.
With co-location, volumes should increase. But to be really attractive to algorithmic traders, the exchange needs more liquidity.
Falling volume
Although MexDer has taken several important steps to facilitate foreign participation in the past few years, its winning streak has been broken by the global financial crisis. As in most parts of the world, interest rate derivatives, which are at the heart of MexDer’s product suite, were hit worst by the financial crisis.
Alegría admits this. “The deleveraging process outside and inside Mexico affected the activity of the banks and their risk positions, and we were hit by that,” he says.
But he emphasises that the situation was the same everywhere, especially in the interest rate market.
MexDer’s total trading volume fell from nearly 229m contracts in 2007 to 70.2m in 2008, but that figure gives a misleadingly bad impression.
Almost all of the decline was due to a technical reconfiguration of one contract – the exchange’s benchmark future on the main interbank interest rate, the 28 day Tasa de Interés Interbancaria de Equilibrio, or TIIE 28.
A change to the product in September 2007 meant that market participants needed to trade much less often. Annual volume plunged from 220.6m contracts in 2007 to 57.9m in 2008. So far, 28.9m contracts have been traded in the January-August period this year, a monthly average of 3.61m, down from last year’s average of 4.83m.
Roa points out that in times of turmoil, market participants shifted from the TIIE 28 to peso/dollar futures and longer term interest rate swap futures of three and 10 years.
Fight for liquidity
“We were once among the 12 largest derivatives exchanges. We would like to regain our place,” Roa says.
The challenge for the market, she argues, is to raise volumes and liquidity without compromising financial strength. The obstacles to bringing in more traders include the heavy paperwork needed to open an account and the language barrier. But Mexico can compete on speed, Roa claims, and MexDer is changing its servers to be fast enough.
Above all, liquidity remains the main challenge and precondition for winning new customers. But falling volumes have been discouraging, especially to algorithmic and proprietary traders who take large positions.
Due to the financial crisis, several brokers and prop traders, which before the crisis had wanted to get involved in the exchange, delayed their plans to start trading.
One source at an international bank says the bank put its plans to trade on MexDer on hold due to the decline in volume and high connectivity costs.
“Our customers that desire access are high volume, algorithmic proprietary trading groups. They would either need co-location or expensive high bandwidth data lines,” the source says. “So with the lower volumes and high cost of access, we have put MexDer on hold.”
Instead, the bank is now focused on accessing Brazil’s BM&F Bovespa, which even though it has a far more cumbersome process for opening third party omnibus accounts, benefits from an order routing agreement with CME Group. All the bank’s customers have access to the Globex order routing system, through which BM&F’s contracts can be traded.
And although MexDer allows remote non-clearing membership, the cost of accessing the exchange was “the next biggest issue” after the drop in liquidity, the source says.
Alegría disagrees with the notion that connecting to MexDer is costly, arguing that execution and clearing costs are comparable with similar products on other emerging market exchanges. But he admits that connectivity costs may vary, depending on the location of the member.
The exchange has been “adding a lot of efficiencies in terms of access, no taxes and on clearing, that makes our market more easy to access and trade, thus reducing all-in costs as well,” he says. “We are of course exploring some reduced fee schedules for liquidity providers, for certain market making programmes that we will publish in the future.”
On the bright side
Though the crisis has affected the exchange’s activities, market participants believe it has passed the test. “Although our volumes decreased, it was a very solid market,” Roa says, pointing to the fact that there was no default in the clearing house and margin calls were honoured. “The September 2008 crisis was one of these big tests of the market and we survived without problems. A solid clearing house and solid clearing members,” she says.
“The exchange did pretty well from the risk management point of view,” Alegría says. “I guess all the exchanges have demonstrated that the model works well… This is the model that should be used in the future for regulation and preferred use of derivatives.”
Trouble over the counter
Alegría’s confidence about the benefits of exchange-traded derivatives is in sharp contrast with the sour mood in the OTC market.
Last year, as in many emerging markets from Poland to Brazil, some Mexican companies suffered mark-to-market losses from positions in currency derivatives, which totalled about $15bn.
The losses almost led to the collapse of several Mexican household names. Brewer Grupo Modelo, conglomerate Alfa, cement maker Cemex and tortilla maker Gruma were among companies that took heavy losses on the contracts. Comercial Mexicana, the country’s major food retailer, sought bankruptcy protection last year after losing up to $1.1bn on non-deliverable forward contracts it had made with international banks.
In 2007 and 2008, the companies bet against the depreciation of the currency by selling foreign exchange options in the offshore market, due to the strengthening of the peso before August 2008.
The contracts allowed the companies to sell dollars at low cost when the peso rose in value. But, at the same time, they forced them to sell dollars at a loss if the Mexican currency fell beyond a set limit.
A month after the collapse of Lehman Brothers, the peso dropped by more than 30% and the companies were forced to sell double the amount of US dollars at the higher price.
Pablo Perezalonso Eguía, partner at Ritch Mueller law firm in Mexico City, says banks are now more careful about the type of products they offer clients, and about how they document their transactions. “Especially, they are more careful about requesting collateral, because in many of the instances there was no collateral requested in these transactions, which complicated things for banks and broker-dealers,” he says.
There are now discussions about changing a standard local master agreement to make things more clear, Perezalonso says.
Evan Koster, partner at Dewey & LeBoeuf in New York, adds that “From a banker-dealer perspective, there is a lot of hesitancy to do derivatives with Mexican counterparties as a result of that experience.”
The obstacles, he says, are now more than regulatory – they are related to perception and credit.
Smart state
This bad experience of derivatives in Mexico contrasts sharply with the clever use of OTC options by the Mexican government, which successfully hedged its revenue from oil taxes during one of the most turbulent periods for the oil price (see FOW Awards on page 22).
“Here we have an interesting contrast of prudent use of financial products for financial planning and risk management, and not so prudent use of this type of products,” says Gerardo Rodriguez Regordosa, director of public credit at the Mexican Ministry of Finance and Public Credit.
“The fact that some people did not make responsible use of financial products does not imply that the product itself is not something good. I think that people understand that difference very well in the market,” Rodriguez says.
Nevertheless, the Treasury’s success has failed to reverse the poor public image of derivatives in Mexico. Participation in general has been restrained. “When there is turmoil in such hard times, people abstain from derivatives at all,” Roa observes. “They don’t make distinction between the OTC and organised markets. We have seen, as a market as a whole, a decrease in volume in 2009.”
But she asserts that people should differentiate between the organised and OTC markets: “Derivatives got a bad name after the crisis, but the organised markets are transparent, solid and efficient.”
MexDer’s OTC plans
Alegría has a “three-layered” plan that would help MexDer capitalise on market participants’ loss of appetite for OTC products and lure trading to the exchange.
In December, MexDer will list deliverable versions of its two and 10 year interest rate swap futures contract. “You will be able to trade interest rate swaps in MexDer with a central clearing counterparty, which is Asigna,” Alegría says.
Market participants will be able to close open positions before the expiration of the contract, which will be settled by the clearing house.
“This is the first step – to move one step closer to OTC trading [coming] on to exchange trading and clearing,” Alegría says.
The second phase is to develop an OTC clearing service next year. Finally, Alegría wants to see a registry of OTC trades, to serve as a database for the authorities – similar to the way the Depository Trust and Clearing Corp works in the US.
CME on the horizon
Changes might happen soon with a potential alliance with CME Group. In September, Bolsa Mexicana de Valores, the owner of MexDer, announced it had entered talks “of a preliminary nature” with CME Group, which could involve selling a minority stake in the BMV Group to the Chicago exchange. The talks centre, of course, on MexDer.
Bernardo Mariano, an analyst at the Equity Research Desk, an investment advisory firm in Greenwich, Connecticut, says a relationship between the two exchanges could mean an order routing agreement.
“CME has about 150,000 terminals around the world and that will provide MexDer with an audience. For them to achieve 150,000 terminals can take many years, if not even decades,” Mariano says.
For CME the deal could mean being able to offer more products to its clients, as well as reaching new customers in Mexico.
The source at an international bank reckons that MexDer would benefit from partnering with a major global exchange. He says it has been approached by the likes of CME, NYSE, Nasdaq OMX, International Securities Exchange and Eurex. “They just need to choose one and move on or they will miss the party. I believe the MexDer representatives that I have met are smart, conscientious and enthusiastic and they believe a partnership is inevitable,” he says.
Alegría is silent about the potential alliance, saying it is too early to talk about it. But it is widely hoped that the potential deal will bring an increase in volume thanks to CME’s expertise and network. SunGard’s Keough believes MexDer might also gain “additional credibility” owing to CME’s reputation.
The next stage
The exchange might enjoy a similar experience to BM&F Bovespa’s. In October 2007, CME Group acquired a 10% stake in BM&F, which later became a 5% stake in the merged BM&F Bovespa. The Brazilian exchange received 1.7% of CME Group.
The deal has resulted in a mutual order routing agreement, and the two groups have also jointly developed new products.
“We saw the BM&F go through a whole revamp in Brazil and I think [MexDer] would see a similar renaissance occur,” Keough says. “These partnerships help drive innovation within the markets and that will continue especially if this CME partnership goes through.”
The partnership with CME helped the Brazilian exchange push its technology forward. “This partnership means firms trading on the CME can have access to these markets as well. That way the exchange will need to make sure that all the infrastructure is in place to then support the additional users and more electronic trading,” Keough says.
Guillermo Camou Hernandez, director at Scotia Capital, which clears futures and options on MexDer, reckons: “Once Mexico makes some structural changes, as other emerging countries have, it will be a target of many foreign investors, and with the synergy with the CME, MexDer will increase the participants, customers and then the volume.”
Source: FOW, 06.11.2009
Filed under: BMV - Mexico, Exchanges, Latin America, Mexico, News, Risk Management, Trading Technology, Algo Trading, BM&FBOVESPA, CME, Co-Location, Currency, Derivatives, DMA Direct Market Access, Exchanges, financial futures, FIX, Fixed Income, FOREX, Futures and Options, FX Foreign Exchange, Index, IPC, Latin America, MexDer, Mexican Pesos, Order Routing, RTS Real Time Systems
