Implied Liquidity From Redundant Futures Markets. John Curran, MD, Products and Services, CME Group October 15, 2007

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1 Implied Liquidity From Redundant Futures Markets John Curran, MD, Products and Services, CME Group October 15, 2007

2 Overview of futures contracts Futures are standardized contracts to buy or sell a commodity or financial instrument at a pre-determined price in the future. Key features of futures contracts: They are standardized in size, quality and settlement measure Traded on a regulated commodity futures exchange Guaranteed against default by an exchange s clearinghouse Futures contracts cover a wide range of delivery dates. For example, CME s Eurodollar futures has listings for forty quarters and four nearest serial months, effectively allowing market participants to hedge or speculate this benchmark interest rate for up to ten years in the future. 2

3 Concentration of Liquidity and Positions in Futures Many futures markets concentrate activity in the nearest to expiration contract month Individual contract months are highly correlated Market shocks impact all contract months similarly Mismatch costs are relatively small Instantaneous liquidity tends to be cheaper order flow can concentrate % of Volume in Lead Month % of Open Position in Lead Month S&P 500 Futures 99% 96% US 10-Yr T-Note Futures 99% 98% * For July

4 Concentration of Liquidity and Positions in Futures Other futures markets distribute activity across different contract month Different contract months, while correlated around systemic shocks, still have strong delivery month variation that end-users want to hedge or speculate against % of Volume in Lead Month % of Open Position in Lead Month 3-month Eurodollar Futures 16% 18% Corn Futures 56% 44% * For July

5 Designing electronic markets to optimize liquidity and trading efficiencies Factors driving futures electronic market design choices: Trading interest Order flow arrival rates Day trading? Long-dated position trading? Both? Traded contract months Lead contract or distributed contract month trading Price volatility High, low, digital? Futures electronic market design choices such as: Matching model Single or multiple market matching Execution priority First-in first out, pro-rata methodology, preferencing, Designating market-makers Overall market and underlying product complexity 5

6 The Eurodollar contract What it is Eurodollar time deposit having a principal value of $1,000,000 with a three-month maturity. Users and Usages CME Eurodollar is the most actively traded futures contract in the world. Banks and other lenders hedge their interest rate risks with Eurodollar futures. Graphic showing the Eurodollar yield curve Eurodollar Yield Curve Interest Rate DEC07 MAR08 JUN08 SEP08 DEC08 MAR09 JUN09 SEP09 Three-month Interest Rate 6

7 Eurodollars - A multi-month futures market Eurodollar Volume by Month - July 2007 Eurodollar Open Interest by Month - July % 25% 20% 15% 10% 5% 0% Less than a year More than a year Less than 2 years 7 Percentage of Total Open Interest 20% 15% 10% 5% 0% Less than a year More than a year Less than 2 years Sep-07 Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 All Others Sep-07 Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 All Others Expiration Expiration Percentage of Total Volume

8 The Eurodollar Open Outcry Market in 1997 Thousands of brokers, traders and clerks organically trading 44 contracts together Deep, tight continuous quote market Deep, tight Request-For-Quote market Lead : Expires in 3 months 2 nd : Expires in 6 months 3 rd and 4 th : Expire in 9 and 12 months Red contracts: Expire in 15 and 18 months All Other s: Expire in 21 months to 10 years 8

9 Leaning on liquidity in other markets Open outcry market participants created a web of liquidity through the creation of spread markets by some particpants, being able to observe all markets simultaneously and being able to trade in multiple markets quickly and at low risk Lead 2nd 3rd Longer Dated s 4th 5th 9

10 Original Electronic Model for Eurodollar Futures Independent markets with participants responsible for linking liquidity across different markets Lead 2nd 3rd Spread s Longer Dated s 4th 5th 10

11 Bridging liquidity: The CME Globex matching engine executes orders from outright and spread markets in combination simultaneously Lead 2nd Implied Matching - The Matching of Multiple Order Books 3rd Spread s Longer Dated s 4th 5th 11

12 Implied Orders and multiple order book matching: A calendar spread example Dec 2007 Dec 2008 BI AS Calendar Spread Buy Dec07& SellDec 08 BI AS D K BI AS D K (10) (10) (1) (1) D K 24 (10) Buy 10 Dec 2007 at 9525 Implied (Multiple-market) matching yields Sell 10 Dec 2007 at Buy 10 Dec 2008 at 9501 Tighter Bid-ask Spread Deeper Market Dec 2008 BI D (10) 9501 (1) 9500 AS K 9503 (1) 12

13 Implied Orders and multiple order book matching: Globex implies orders/construct matches from a large set of spreads Combinations of Individual leg markets Calendar spreads (buy 1 month sell a later contract month) Calendar spreads vary with the steepness of the eurodollar curve Butterfly spreads (buy 1 month, sell 2 later months and buy 1 even later month) Butterfly spreads vary with changes in the curavature of the eurodollar curve Butterfly spreads are linked to both individual leg markets as well as calendar spread markets 13

14 Contribution of implied markets to liquidity Implied matching bridges liquidity from the more liquid to the less liquid contract months Spreads with low volatility is crucial to maximizing the bridge 100% Top of the Order Book 100% Second level of the Order Book 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Jun-07 Sep-07 Dec-07 Mar-08 Jun-08 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Jun-07 Sep-07 Dec-07 Mar-08 Jun-08 14

15 Growth in electronic trading of Eurodollars 3,000,000 Average Daily Volume 5-yr CAGR Q Q3 07: 28% 12,000,000 Average Daily Volume of Eurodollar Futures s 2,500,000 2,000,000 1,500,000 1,000, ,000 Average Daily Open Interest 5-yr CAGR Q Q3 07: 21% Implied Spreads Implied Spread Enhancements Algorithm enhancement Implied Butterfly Spreads 10,000,000 8,000,000 6,000,000 4,000,000 2,000,000 Average Daily Eurodollars Futures Open Interest - Q1 02 Q2 02 Q3 02 Q4 02 Q1 03 Q2 03 Q3 03 Q4 03 Q1 04 Q2 04 Q3 04 Q4 04 Q1 05 Q2 05 Q3 05 Q4 05 Q1 06 Q2 06 Q3 06 Q4 06 Q1 02 Q1 07 Q2 07 Q Electronic ADV Open Outcry ADV Avg Daily Open Interest 15

16 Future Enhancements Two directions Adding more spreads To generate liquidity in less liquid markets through spreads To generate liquidity in spreads themselves Inter-commodity spreads Chaining more markets together for simultaneous execution First generation implied : Creating an implied quote from resting orders Second generation: Creating a new implied quote from resting orders and a first generation implied quote Identifying all combinations of eligible legs and spreads that could generate a match 16

17 Implied Matching Implications Implied Matching and Order Execution Priority Pro Rata Matching Hybrid Matching Automated Trading Systems in implied markets Speed and market complexity Applicability to other markets Front-month futures markets Option Markets 17

18 Concluding Thoughts 18