Since the beginning of 2020, global derivatives markets have absorbed increasingly large waves of trading volume and volatility as market participants have struggled to assess the potential impact of the coronavirus (COVID-19) on economic activity. While the industry has succeeded in managing these massive flows, the pandemic has put a severe strain on its capacity to process trades and has forced many market participants to make difficult adjustments to new working conditions.
The full impact of the pandemic on global trading of futures and options is not yet known, but several important trends have already emerged.
Closing of trading floors
Although most trading in modern markets is conducted electronically, a handful of futures and options exchanges retain traditional "open outcry" trading floors.
In the U.K., the London Metal Exchange announced open outcry trading will be suspended on March 23 in order to prevent the spread of the virus and all orders will be matched electronically. This is the first time since World War II that the exchange has closed its iconic "ring" and the switch to electronic trading will create many challenges for market participants. Unlike most futures exchanges which have one standardized contract per month, the LME allows daily trading out to three months and weekly prompts between three months and six months.
"The market should note that electronic settlement -- given the complexities of the LME date structure -- may generate a differently priced forward curve than would have been achieved on the ring and lead to a different set of market practices," the LME warned in a notice issued on 17 March.
In the U.S., Cboe and CME closed their trading floors in Chicago and Nasdaq closed its options trading floor in Philadelphia in mid-March. For those exchanges, the transition will not be as disruptive since the majority of orders are matched electronically. There are certain sectors, however, where open outcry predominates, most notably in the negotiation of complex options trades with multiple legs. For traders in these segments, the transition to all-electronic trading will require a very different approach to find the other side of the trade.
Working to keep markets open
In a few rare cases, exchanges closed the entire market.
The Philippine Stock Exchange suspended all trading for two days in mid-March. The move was born out of public health concern for employees, not out of concerns for market infrastructure or volatility, and a government exemption caused the exchange to reopen two days later.
At the same time, rumors swirled that Bursa Malaysia's futures exchange, the home of a widely used palm oil futures contract, could follow suit as a result of nation-wide movement restrictions meant to protect public health. The exchange was forced to issue a statement to shoot down the rumors and confirm that it would not close its derivatives markets.
Other exchanges have worked proactively to adjust rules to prevent confusion, and to ensure members could adopt new practices that would both protect public health and keep markets functioning smoothly. CME, Eurex and Intercontinental Exchange, for example, issued notices to their members clarifying that traders could work from home or alternate locations without violating certain requirements about office locations.
As the duration of the coronavirus disruption persists, however, issues continue to arise as business continuity needs collide with regulatory requirements that may not be appropriate to the new way of doing things.
For instance, banks and brokers record telephone calls on their trading desks and track order messages so that compliance departments can detect any signs of inappropriate behavior. But if banks and brokers send their employees home to reduce exposure to the virus, how will they ensure that the trading activity conducted at home will be adequately monitored? At an even more basic level, does working from home turn someone's house into an office of the bank and thereby trigger all the requirements that apply to such offices?
In recent weeks, industry leaders have entered into an intense dialogue with regulators about the need for flexibility and guidance. The U.S. Commodity Futures Trading Commission has issued a package of temporary relief and customer advisories related to the coronavirus pandemic and its impact on market participants, including eight separate letters for various market participants.
The U.K. Financial Conduct Authority, meanwhile, said that while firms should continue to record calls, it accepts that some scenarios may emerge where this is not possible and for firms to make it aware if they are unable to meet these requirements.
"We expect firms to consider what steps they could take to mitigate outstanding risks if they are unable to comply with their obligations to record voice communications. This could include enhanced monitoring, or retrospective review once the situation has been resolved," the FCA said.
The European Securities and Markets Authority (ESMA) also said that some scenarios may emerge where the recording of relevant conversations required by MiFID II may not be practicable. If firms are unable to record voice communications, ESMA expects them to consider alternative steps to mitigate risks related to the lack of recording.
"Firms are expected to deploy all possible efforts to ensure that the above measures remain temporary and that recording of telephone conversations is restored as soon as possible," it said.
Regulators also are concerned that a global economic downturn could make certain capital requirements overly onerous for derivatives market participants. For instance, the Bank of England has cancelled annual stress tests for the financial sector and delayed routine supervisory work to allow the sector to focus on the challenges of the coronavirus outbreak.
Interconnectedness and coordination
Above all this, the overarching challenge remains keeping market participants connected and coordinated. Derivatives markets remain resilient in the face of sustained high volumes and high volatility, but the unprecedented level of activity puts a heavy strain on back-office functions.
One particular challenge is the processing of "give ups," a procedure where an executing broker places a trade on behalf of a client and then transfers the resulting position to the client's clearing firm. Volatility has increased the number of trade breaks, or discrepancies in the details of the trade, and an increase in overall volume means these breaks have become more common in the last several weeks.
Resolving a high frequency of breaks as brokers, clearers and their clients cope with a fast-moving market in their home offices has proven a daunting task, according to industry executives. FIA has worked to reduce the pressure by facilitating bilateral communications between relevant parties via a shared contact list. This helps prioritize and resolve trade breaks before they can snowball into a larger problem for the system.
On a larger scale, the derivatives industry in the U.S. benefits from participation in the Financial Services Information Sharing and Analysis Center, an entity dedicated to reducing cyber-risk and technology challenges in the global financial system. FS-ISAC functions as an information network between the U.S. government and the financial services sector and provides an important channel for crisis communication. For example, FS-ISAC has given key market participants a way to voice their concerns about the potential impact of "shelter at home" policies and the need to preserve the ability of essential employees to maintain the technology infrastructure necessary for market connectivity.
FIA stands ready to assist derivatives market participants on all issues related to this unprecedented situation. Visit our Coronavirus Industry Response page for the latest regulatory updates and exchange guidance, or to find contact information for key staff that are working to resolve issues for our members.
