Large London banks have long conducted trades of European derivatives through a bilateral over-the-counter process. With the rollout of a new service this year, EDX London becomes the first exchange to offer those customers the ability to clear trades through a third party, driving down costs while maintaining the flexibility that banks need.

Large London banks interested in trading European equities derivatives have long done so through a cumbersome process involving bilateral trades directly between two banks.

That’s in the process of changing, with potentially dramatic consequences for financial institutions.

EDX London, a joint venture of the London Stock Exchange and OMX, has gone live with a new service that enables such trades to be moved through a clearinghouse, offering customers a more efficient alternative to direct trades while maintaining the flexibility that over-the-counter (OTC) trading offers.

Banks prefer the OTC process to trading on exchanges for various reasons, including the ability to work out more flexible contract details than may be available on a traditional exchange. The new EDX platform strives to offer the same degree of flexibility but at much more competitive costs.

Stuart Frith, Head of Business Development for EDX London, says that EDX is the first exchange to go live with a clearinghouse approach for its large wholesale trading customers. Currently, three large London banks are connected to and trading on the platform, and by year’s end, EDX expects to have five or six customers up and running, a level that the exchange believes will help create critical mass and foster more demand for the service.

“There are other competitors that are coming out with alternatives to help make the OTC and bilateral trade process more efficient, but we’re the first to put the clearinghouse option before customers,” he says. EDX London will become a third party in the trades, a transparent intermediary that uses its technological platform to enable the trades to be cleared and confirmed quickly. The project realizes at least partly a longstanding goal of EDX to bring a new level of sophistication to the automation of OTC trades in the European marketplace. OTC trading has long been seen as both a problem and an opportunity: It handles far more volume than exchange-listed trades, but it lacks the widespread automation to clear and confirm those trades.

Frith acknowledges that the market for the service is not expansive, with consolidation leaving as few as 20 major UK banks that still conduct large block trades of derivatives. Still, he says, adding the service is important and may, over time, help increase the amount of such trading.

“It’s going to be an important part of our business,” Frith says. “The number of players isn’t large, but the volume of business, the number of trades and the value of them is quite substantial. And I think the number of trades will grow, as participants see the benefits of our approach.”

In addition, the service will be one more offering on the EDX menu, one that no competitor currently offers directly. As a result, it could help generate additional trading business from large institutional customers. “The more choices for trading we can offer our customers, the better it is for them and us,” Frith notes.

EDX and OMX are currently working on a project that will also help expand trading options by giving UK customers access to more overseas derivatives trading opportunities, which are in increasing demand among the exchange’s customers.

The clearing process for the OTC trades will use OMX’s SECUR platform, one that many of the institutions that trade derivatives in Europe are already familiar with, since they trade Scandinavian derivatives through EDX.

EDX London was created in late 2002 as a joint partnership between the London Stock Exchange (LSE) and OMX’s London Exchange, a derivatives marketplace. The electronic exchange went live in 2003 and has since been actively seeking ways to make more equity trading options available to its customers.

EDX gave London-based traders direct electronic access to Scandinavian derivatives from the outset. In fact, one of the strategic reasons behind the partnership between the LSE and OMX was the ability to link with the London Clearing House to quickly clear and confirm wholesale derivatives trades.

Frith says the technical challenges of adding the service were few, with most of the work involving installing end-user systems at the banks’ customers.

“There were not many technical difficulties at all,” he says. “What took time was getting the banks comfortable with the new system and the flexibility it afforded them.”

By Keith Regan Photo Eva Edsjö

MarketView 2005:3