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Interest Rates Derivatives ProductsAn Overview
Moscow Interbank Currency Exchange21 November 2006
liquid capital__________________________________
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• Liquid Capital Market’s - who we are and what we do
– Our markets
– Our specialities
• Options market making
– A view from the trading desk
– How do we provide liquidity
• Futures trading
– A word on pricing
– Basic strategies
• What makes a market?
– Product development as an integrated process
– A fine balancing act
• MOSIBOR / MOSPRIME: key considerations
– Futures contracts: what market structure?
– The virtuous circle: liquidity breeds liquidity – how do you build it and maintain it
Summary
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liquid capital__________________________________
•Liquid Capital - who we are and what we do–Our markets –Our specialities
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A short introduction
• Liquid Capital Markets leading Market Maker
and liquidity provider on the main European and
Asian equity and fixed income products
• Liquid Capital Securities offers an
independent global
execution brokerage service for futures and options to an institutional client base spanning more than
16 countries
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Who we are
•We are the first port of call for brokers with institutional business
•We trade large volume
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What do we think
•Profitable trading is
a function of:
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What do we think
•Speed and accuracy
•Research, knowledge and
insight
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What do we think
•We believe passionately
in:
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What do we think
•Building
relationships based on trust
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Why are we different•We are able to absorb more trades in
larger volume therefore we can make
narrow spreads
even in difficult market conditions
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Why are we different
•We control volume and therefore keep our
prices competitive
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Why are we different
•We are able to be the
first to act to the
changes in
risk
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Why are we different
•We commit to
stand by our prices
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Why are we different
•We understand the interplay between
technology and our
markets and
products
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Our specialities – Liquid Capital Markets
•Options
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Our specialities – Liquid Capital Markets
•Pure market making
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Our specialities – Liquid Capital Markets
•Volatility
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Our specialities – Liquid Capital Markets
•Risk management
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Our MarketsLondon
• Single stock options– All component stocks of Dax
30– Nokia AG
• Interest rate options
– Eurex Euro-BUND– Eurex Euro-BOBL– Eurex Euro-Schatz– Euronext LIFFE Euribor– Euronext LIFFE Short Sterling
• Equity Index options
– FTSE 100– DAX 30– EuroStoxx 50– AEX
Sydney• Asian Index Product
– KOSPI options– KOSPI futures– NIKKEI options– NIKKEI futures (NK225)– JGB (Japanese Government Bond)– XJO (options on ASX 200)– AP (futures on Australian Share Price
Index – SFE)
• Australian Single Stocks– National Australia Bank (NAB)– Telstra Corp (TLS)– BHP Billiton Ltd (BHP)– Rio Tinto (RIO)– Woodside Petroleum (WPL)– Woolworths (WOW)– Commonwealth Bank (CBA)– News Corporation (NWS/NWSLV)
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Our specialities – Liquid Capital Securities
•Best execution
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Our specialities – Liquid Capital Securities
•Price discovery
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Our specialities – Liquid Capital Securities
•Specific
product expertise
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Our specialities – Liquid Capital Securities
•Coverage of futures and options
worldwide and across asset classes
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Our specialities – Liquid Capital Securities
•Access to quotes from Liquid Capital Markets
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Our specialities – Liquid Capital Securities
•Analysis and
research
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•Options market making
–A view from the trading desk
–How do we provide liquidity
Summary
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A view from the trading desk – A day in the life…
• 6:30 am: trading team gets in
• 6:35 am: catch-up with news and review of book marks and quote sheets
• 6:55 am: coffee and gents break
• 6:59 am: last checks
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A view from the trading desk – A day in the life…
•7:00 am: hell breaks loose!
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A view from the trading desk – A day in the life…
•6:00 pm: market closes -
world returns to its
normal state
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Who is the Market Maker?
•He is not a car dealer
•He is looking for fair market equilibrium
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Who is the Market Maker?
•With his pricing he ads transparency to the market
•For a market maker it’s all about
demand and supply
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The bottom line•Trading options is a very demanding job. You are supposed to:
•Deal with the unknown
•Make split-second decision
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The bottom line
•Keep tight spreads
•Keep the market happy
•Keep your sales staff happy
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The bottom line• Keep your risk manager happy
• Keep your boss happy
•Keep the money coming in
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How we do it
•Continuous two-way prices
•Strict delta, vega and theta
limits
•Each position is
dynamically hedged
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How we do it•Initial hedge via futures then we
lock in the value of the option via a
combination of spreads
• The natural order flow is sufficient to
absorb most of the hedge activity
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How we do it
•Tightness of spreads
heavily dependant on size
•We watch out for
directional players
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How we do it
• We pay attention to
“distressed options” i.e. options that have moved
uncharacteristically away from fair value
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How we do it
•We watch out for spreads that can turn
very quickly close to
maturity if near to at-the-money strike prices
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Interest Rates Options
General hedging categoriesType of exposure Strategy
Short-term debt issuer Buys puts on short-term IR future
Short-term investor Buys calls on short-term IR future
Medium-term debt issuer Buy series of puts on short-term IR future
Medium-term debt investor Buys series of calls on short-term IR future
Long-term debt issuer Buys puts on long-term IR (Bonds)
Long-term debt investor Buys call on long term IR (Bonds)
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A typical trade• Market participants with different aims
•Speculator forecasts a rate hike
• He enters a probability-based trade on an expectation
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A typical trade
•Hedger: wants to hedge exposure against rate hike
• He wants to eliminate the
risk of an
expectation
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A typical trade
•What do they do:
•Speculator - buys ladder
•Hedger - buys call spread
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A typical trade – In practice
• Euribor cash rate: 3.50 %
• Euribor March 07 Future: 96.09 (implied rate 3.91)
• Indicative option prices AskBid
– March 07 Euribor 96.000 call 0.11 0.12– March 07 Euribor 96.250 call 0.015 0.020– March 07 Euribor 96.500 call 0.050 0.070– March 07 Euribor 96.750 call 0.000 0.001
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A typical trade – In practice•Speculator buys ladder:
–Buys 1 March 07 Euribor 96.250 call
–Sells 1 March 07 Euribor 96.500 call
–Sells 1 March 07 Euribor 96.750 call
-1500
-1000
-500
0
500
1000
95.5 95.75 96 96.25 96.5 96.75 97 97.25 97.5
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A typical trade – In practice
•Hedger sell call spreads
–Buys 1 March 07 Euribor 96.250 call
–Sells 1 March 07 Euribor 96.000 call
-1500
-1000
-500
0
500
1000
95.5 95.75 96 96.25 96.5 96.75 97 97.25
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A typical trade – In practice
•LCM:
–Sells 2 March 07 Euribor 96.250 call
–Buys 1 March 07 Euribor 96.200 call
–Buys 1 March 07 Euribor 96.500 call
–Buys 1 March 07 Euribor 96.750 call
-800
-300
200
700
1200
1700
95.5 95.75 96 96.25 96.5 96.75 97 97.25 97.5
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Considerations
•No pull to par but drift
•Mean reversion of
volatility and rates
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Considerations
•Price options off an
underlying future or fwd instrument
•Use implied volatility
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•Futures trading
–A word on pricing
–Basic strategies
Summary
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Pricing an Interest Rate Future (1)
The price quotation of a 3 month interest rate future is 100 minus the (expected) future 3 month interest rate, and the interest rate is quoted on a per annum basis
3m rate = 3.57%Dec future
=100 - 3.57 = 96.43
3rd Wed
of DecToday
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3rd Wed
of Dec
3m rate = 3.57%
Dec future = 100 - 3.57 = 96.43
This demonstrates convergence
Pricing an Interest Rate Future (2)
As time passes the Jun contract price will fluctuate according to changing expectations
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These can be calculated from EURIBOR rates0 3
m6m 9m
3m
=3.6% 6m =3.7%9m =3.8%
3f6=?
6f9=?
91 days
90 days
92 days
Calculation of Forward Rates in the Money Market (1)
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(1+0.036 x 91/360) (1+3f6 x 90/360) = (1+0.037 x 181/360)
3f6 = 3.767%
x360
90
1+ 0.037 x 181/3601+ 0.036 x
91/360
3f6 = -1
Calculation of Forward Rates in the Money Market (2)
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0 3m 6m 9m 3m =3.6%
6m =3.7%
9m =3.8%
3f6=3.77%
6f9=?
91 days 90 days 92 days
Calculation of Forward Rates in the Money Market (3)
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6f9 3.9237%
(1+0.037 x181/360) (1+6f9 x 92/360) = (1+0.038 x 273/360)
x360
92
1+ 0.038 x 273/3601+ 0.037 x
181/360
6f9 = -1
Calculation of Forward Rates in the Money Market (4)
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0 3m
6m 9m 3m
=3.6% 6m =3.7%9m =3.8%
6f9=3.92%
91 days
90 days
92 days
Calculation of Forward Rates in the Money Market (5)
3f6=3.77%
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Matching delivery date
Matching period
Co. needs to borrow €20,000,000 for three months starting in the future on the delivery
date of the Dec 3m € interest rate future (15/06)
Hedging with Interest Rate Futures (1)
No. of futures = €20,000,000 = 20€1,000,000
15/09 15/033m borrowing
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Matching delivery date
Non-matching period
Hedging with Interest Rate Futures (2)
Co. needs to borrow €20,000,000 for six months starting in the future on the
delivery date of the Dec 3m € interest rate future (15/12)
Period being hedged
Period covered by future
No. of futures = €20,000,000 x 6m = 40 €1,000,000 3m
15/12 15/03 15/066m borrowing
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Hedging with Interest Rate Futures (3)
The previous slide showed that we needed to sell 40 contracts.
The question now is which contracts should we sell?
There are two possibilities
1. Sell 40 Dec futures
2. Sell 20 Dec and 20 Mar futures
Stack Hedge
Strip Hedge
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Calculating the Strip Rate
360period 6mth inDay
r1 strip
If a strip hedge is utilised, the expectedrate (the strip rate) achieved can
be calculated as follows
360MarPeriodsinDay
360DecPeriodsinDay
Mar Dec r 1r 1
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Non-matching delivery date Matching period
Hedging with Interest Rate Futures (4)
Co needs to borrow €20,000,000 for three months starting in the future on 15/01. The delivery date of the Dec 3m £ interest rate
future is 15/12
No. of futures = €20,000,000 x 3m = 20 €1,000,000
3m
15/1215/01 15/033m borrowing
Let’s say we choose to sell 20 Mar contracts
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Hedging with Interest Rate Futures (5)
The basic hedge must now be adjusted to reflect the mismatch in
dates.
As a borrower, using a later dated contract
will expose the hedger to a flattening yield curve, whilst using an earlier dated
contract will expose the hedger to a steepening yield curve
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Yield Curve Exposure - Steepening
Longer-dated rates rise more
Shorter-dated rates rise less
Steepening yield curve
The forward rates will rise relative to near rates,i.e. the further futures contract will fall MORE
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Yield Curve Exposure - Flattening
Longer-dated rates fall more
Shorter-dated rates fall less
Flattening yield curve
The forward rates will fall relative to near rates,i.e. the further futures contract will rise MORE
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Hedging with Interest Rate Futures (6)
To protect against yield curve risk we should execute an appropriate number offutures intra-market spread trades
Long spread - buy nearer dated, sell later dated - will be profitable if the yield curve
steepens
Short spread - sell nearer dated, buy later dated - will be profitable if the yield curve
flattens
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Hedging with Interest Rate Futures (7)
A hedger protecting against an increase in interest rates will have sold futures as the
basic hedge.If, because of mismatching dates, they are using later dated contracts, they need to
additionally execute an appropriate number of short spreads.
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Hedging with Interest Rate Futures (8)
No. of spreads
Time between start of exposure period and future’s
delivery dateFuture’s contract length
Basic number
= x
15/1215/01 15/03
3m borrowing
2 monthsNo. of spreads = 20 x = 13.33 23
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Hedging with Interest Rate Futures (9)
Summary Dec Mar
Basic -20
Spreads -13.33 +13.33
Total -13.33 -6.67
Sell 2.67 Dec/Mar spreads
Rounded to -13 -7
i.e. still short 20 contracts net total
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Hedging with Interest Rate Futures (10)
Alternatively: sell 20 Mar futures and additionally
Sell 13.33 Mar/Jun spreads
Summary Mar J un
Basic -20
Spreads -13.33 +13.33
Total -33.33 +13.33
Rounded to -33
+13i.e. still short 20 contracts net
total
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Hedging with Interest Rate Futures (11)
Another alternative would be to do the basic hedge by selling 20 Dec futures
As this is using earlier dated contracts, the short hedger will now have to do a
number of long spread trades
No. of spreads = 20 x = 6.66 13
15/01 15/03
3m borrowing1 month
15/12
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Hedging with Interest Rate Futures (12)
Summary Dec Mar
Basic -20
Spreads +6.67 -6.67
Total -13.33 -6.67
Rounded to -13 -
7Note that after the basic hedge has been adjusted with spreads to cover the yield curve risk, the answer comes to the same whether we start with Dec or Mar contracts as the basic hedge
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Calculating the Strip Rate for Non-Matching Periods (1)
A company needs to hedge for a 6-month period starting on 20 Jan. What is the
anticipated strip rate if the following futures prices apply?
Dec (15/12) 94.45 Mar (20/03) 94.62 Jun (19/06) 94.14
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Calculating the Strip Rate for Non-Matching Periods (2)
15/12
20/03
19/06
20/01
20/04
20/07
+ +( ) x 360/1815.55% x 59/360
5.86% x 31/360
5.38% x 91/360
= 5.5176%
Futures prices: Dec 94.45 Mar 94.62 Jun 94.14
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•What makes a
market?–Product development as an integrated process
–A fine balancing act
Summary
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• A liquid underlying
•Diversity of players
•Easy access to liquidity
What makes a market
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•Technology –
sophisticated trading platform
• Product range
•Margining – efficient usage of collateral
What makes a market
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•Simple contract design
•Reasonable
exchange fees
•Transparency
What makes a market
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•A well capitalized clearing house
•The upshot: no need for credit lines
What makes a market
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• Exchange traded product development is
about meeting users needs
and filling gaps in the offering
• It takes deep
understanding of your
client base
• It implies hard choices
Product development
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• It requires focus
• It takes time
•Exchanges cannot do it alone
anymore
Product development
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•Market participants
cannot do it alone
• It takes a partnership
• It’s a crowded market you are
fighting for attention
Product development
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• It is a phased approach
• The priority is in creating a healthy
underlying market
• The success is a mix of
ingredients
Product development
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•Incentives
•Visibility
•Relevance
Product development
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• Ask the question:
Who needs it
most?
Product development
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• Above all choose the path of least resistance!
Product development
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Product development +
Market Structure +
Marketing =
Successful Product
A delicate balancing act
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• Market structure is key
•Order driven book
•Designated Market Makers and
Liquidity Providers with
contractual obligations
A delicate balancing act
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•Best form of marketing?
Education!
Product development - Marketing
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• Identify who has more to
gain from using these products
and in return can provide support
• Be pervasive
Marketing
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• Create a community of users
•Educate, educate,
educate
Marketing
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• Enrol people who will
champion your product
• Be open minded
•One on one
Marketing
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•Seminars
•Sponsored articles
•More seminars
Marketing
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• Be committed•
Be passionate• Be
uncompromising•
Make it relevant
Marketing - Communication
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•MOSIBOR / MOSPRIME–Underlying market
–Futures contracts: what market structure
–The virtuous circle: liquidity breeds liquidity
Summary
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• Underlying market still relatively
small
•Promote the underlying
market actively
• Market it to issuers – supra and
corporate
• Improve overall visibility
MOSIBOR/MOSPRIME - Key considerations
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•Clarify legal status of Exchange
Traded Derivatives contracts is Russia
•Order-driven based on
pro-rata algorithm, with priority given to the
first order at best price
MOSIBOR/MOSPRIME – Market Structure
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• Introduce a Designated Market
Maker (DMM) scheme with incentives
• Introduce wholesale facilities
MOSIBOR/MOSPRIME – Market Structure
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• Work with brokers and parties that provide flow
• Make data freely available
• Continue to improve the technology – STIRS are
sophisticated products!
MOSIBOR/MOSPRIME - Key considerations
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The benefits of central markets
•Natural venue where
counterparts can be found
• Price discovery
•Transparency
•Liquidity reduces spreads and execution cost
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The benefits of central markets• Market depth reduces execution
risk
• Liquidity is “sticky” - easy to access, difficult to move
• Exchanges invest in developing liquidity
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Liquidity breeds liquidity
•The virtuous circle
Prop.Traders
Market Makers
Brokers
Retail
Banks
Liquidity Pool
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• Individual Liquidity Provider (ILP)
• Euribor Futures Contract STIR Liquidity Provider (SLP)
• Short Sterling Futures Contract (SLP)
• Eurodollar Futures Contract (SLP)
• New Market Participant – (NMP)
Liquidity breeds liquidity
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• Individual Liquidity Provider (ILP)
•Lower exchange fees for individual
proprietary traders
• Focus on developing liquidity on the back months
•Proven consistency in supporting order flow
in long-dated contracts
Liquidity breeds liquidity
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• Euribor Futures Contract STIR Liquidity Provider (SLP)
•Volume based discounts for
proprietary traders – firms and individuals
•Proven consistency in facilitating
price-discovery and injecting liquidity
Liquidity breeds liquidity
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• Market makers love incentives
• Incentives reward them for
adding value and putting capital
at risk
• They have to work hard for them
Liquidity breeds liquidity
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Liquidity breeds liquidity• Requires the right balance of
incentives and fair market structure
• In Euribor the exchange offers liquidity
provision schemes aimed at different market participants
• The result is a vibrant and tight market
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Disclaimer
The material and information set out in this presentation is not intended to be an offer to buy or sell any derivatives. Any expression of opinion is based on sources believed to be reasonably reliable but is not guaranteed as to accuracy or completeness.
The material and information herein is general and for informational purposes only. The derivative market comprises volatility and considerable risks. To the maximum extent permitted by law no responsibility or liability can be accepted by Liquid Capital Securities Limited, any company or employee within its group for any action taken as a result of the information contained in this presentation. You are requested to seek specific advice when dealing with specific circumstances.
Liquid Capital Securities is regulated by the UK Financial Services Authority.