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For the global futures and options industry, 2008 was a wild year. Several major market participants, including some of the largest players in the markets, vanished from the scene. Counterparty credit risk shot to the top of market user worries. Volatility skyrocketed and liquidity evaporated, especially after Lehman Brothers declared bankruptcy in September, and volume for some of the industry’s biggest and best-known contracts took a definite turn for the worse.

Despite all the turbulence, the overall growth trend was still positive. The total number of futures and options contracts traded on the 69 exchanges tracked by the Futures Industry Association rose 13.7% over 2007. Volume in the U.S., the epicenter of the credit crisis, rose 14.0% from 2007, and Europe and Asia did even better (see Global Volume by Region table).

But there was no question that the pace of growth, which had been so strong for so long, slowed down considerably. 2008’s global growth rate of 13.7% was a far cry from the 30.9% increase recorded in 2007 and the 18.9% increase in 2006.

Equity products across the board had a tremendous year, as did the commodity products, but the credit crisis put a big dent in the trading of interest rate products. On a global basis, interest rate volumes sank 14.4% relative to 2007, the first time in many years that we have had such a big setback.

Long-term interest rate futures were especially hard hit. Ten-year Treasury futures trading tumbled 26.5% from 2007; Euro bund futures fell 23.8%; and JGB futures slid 21.5%. Short-term interest rate products were mixed, with Euribor futures up slightly, Eurodollar futures down slightly, and Euroyen futures way down by 42.6%.

Part of the reason why the interest rate category was down on a worldwide basis was a staggering drop in the trading of TIIE futures, the Mexican short-term interest rate contract. Total volume in that contract, which last year ranked seventh largest among the world’s interest rate contracts, plunged 73.8% to 57.9 million. It appears, however, that this was more related to a market user preference for a larger contract size than to the global financial turmoil that affected interest rate trading in other countries.

In September 2007 Mexder introduced 10-year swap futures as an alternative to using large strips of the TIEE contracts as an interest rate hedge. Volume in the swap futures contract, which is 1,000 times larger in size than the TIEE, reached 171,000 in 2008. Mexder officials estimate that once the different sizes are taken into account, the level of trading activity in 2008 was effectively the same as in 2007, except that market users now have a more efficient size for their interest rate hedges.

Interestingly, Mexder’s 10-year government bond contract took off last year, with volume soaring 154% to 3.0 million contracts. And trading in the Cete 91 day contract rose 45.3% to 4.1 million. These are still minnows in global terms, but it is good to see a healthy interest rate complex beginning to take shape outside the traditional financial centers in the developed world. 

After Lehman

What is really scary is that the slump seemed to steepen at year-end. Eurodollar futures trading in November and December combined plunged 45.9% compared to  November and December of 2007. Ten-year Treasury volume was down a stunning 65% during the same period. Hopefully this will turn out to be a cyclical downturn, but we probably will not know for sure until well into 2009.

Because of the way the futures industry works, it is difficult to get a clear view on how much volume comes from the various types of trading firms that participate in our markets. Each exchange has its own way of tracking the identity of its customers, and it may not always know who the end-customer is. 

Fortunately the CME Group has given us a window into this. In its year-end financial results presentation, the exchange broke out its fourth quarter volume by customer segment (see CME table and pie graph). The data only covers the third and fourth quarters of 2008, so we cannot make any comparisons to 2007. All the same, the data gives us a sense for how the different customer groups were behaving in the last part of the year.

One observation is that hedge funds pulled back the most. The number of contracts traded by the top 25 hedge funds fell by 32% from the third to the fourth quarter, a much larger reduction than the exchange-wide decline of 22%. Hedge funds, as we all know, faced one of their most difficult years ever in 2008 and many were forced to wind down their trading activities in order to reduce leverage, exit losing strategies and meet redemption calls.

It is also interesting to see that traditional customers such as pension funds pulled back the least. The amount of volume traded by these customers, which is more likely to be driven by a desire to hedge market risk, fell by only 13%. If the CME continues to publish this information, it will be interesting to see if the decline in this segment turns out to be a temporary dip or a more serious long-term decline in hedging activity.

Volatility and Liquidity

One of the astonishing things about these comparisons is the completeness of the sweep. In normal times, one can expect volatility to rise in some markets and fall in others. Not this time. Not one of the markets shown was less volatile in 2008 than it had been the previous year. Interest rate and equity index products were the most volatile, but even the commodity contracts were way above normal. Volatilities for wheat, soy, crude oil and gold were all above 50%.

The rise in market volatility definitely took its toll on liquidity. For several years, the combined effect of increases in trading volume and decreases in volatility was to reduce dramatically the costs of trading futures. As shown in the Index of Implied Bid/Ask Spreads chart, the costs of trading bottomed out in 2005 and took a sharp turn north in 2008. These index values are calculated simply as the ratio of price volatility to the square root of trading volume, a measure that is consistent with our understanding of the determinants of market liquidity.

In the three futures markets that we have chosen here—Eurodollars, 10-year Treasury notes, and the E-mini S&P 500—the cost of filling a typical large order increased dramatically during the last four months of the year. And in both of the interest rate markets, where trading volumes were falling, the depth of book—a key measure of liquidity—fell sharply as well. 

One way of measuring this is to estimate the average number of contracts available at the best five bid or ask prices in the limit order book. That is, if one found 4,000 contracts at the best five bid prices, and 3,000 contracts at the best five ask spreads, we would report the average of these two, or 3,500. 

If we apply this approach to these three contracts, we see a very steep drop-off in liquidity in the last part of the year in the interest rate contracts. For Eurodollar futures, the depth of book was generally 4,000 to 5,000 contracts during the first eight months of the year, but only 1,000 to 2,000 contracts during the last four months. In Treasures, the drop was even more pronounced. The depth of book fell from over 6,000 in August to under 2,000 post Lehman and to just 400 at year-end. 

Trading volume in the E-mini stock index futures never did fall, however. As a result, while the market impact of filling a stock index futures order went up substantially, the demand for trading these contracts remained high, and the depth of the book appears to have been unaffected by the increase in volatility. There was a brief plunge below 2,000 in September, a couple of dips below 3,000 in October, and from then on the depth of book stayed more or less at the same level as the first part of the year.

While the loss of liquidity and market depth was pronounced in the outright markets for interest rate contracts, it was almost catastrophic in the case of the spread market for Treasury futures. The market for the calendar roll appears briefly for a few days in the month preceding expiration. Once the roll is completed, the roll market packs up its tents and goes home until the next quarter. The accompanying Treasury Calendar Roll chart shows the average number of contracts (spreads) on the bid or offer for the first five bids or first five offers during the three most active days of this market. 

Traditionally, this market is one of the most liquid on the planet. The volatility of the spread is low, and a trader usually can find tens of thousands of contracts on both the bid and the offer. For example, in the Jun08/Sep 08, the average number of spreads bid or offered was more than 20,000 during the most active three days. The Sep08/ Dec08 spread market was even deeper. One could find more than 50,000 contracts on the bid or offer during the most active day. 

Then came the collapse of the credit market, which brought more than price and interest rate volatility. It also caused the term lending market to evaporate. Not only were banks not lending to one another, the term repo market, also one of the most liquid and actively traded financing markets in the world, stopped working as well. As a result, cash/futures arbitrage, which can usually be counted on to produce fair prices and liquid markets for the futures, dried up. 

As the cash/futures arbitrage went away, so did the liquidity of the Treasury futures roll market. During the most active three days of the Dec08/Mar09 roll market, one was hard pressed to find as many as 1,000 spreads on either side of the market.

Emerging Markets

For example, most of the big emerging markets that have been moving up the volume tables in the last several years kept right on growing in 2008. Exchanges in China, India, Russia, South Africa, and even Turkey turned in huge increases in volume. Some of these markets may be difficult to access right now because of regulatory issues or technological complications, but the basic trend is very positive. 

We also saw a real surge in interest in trading gold products, especially in Asia. As Bennett Voyles explained in his article in the Outlook 09 issue, more and more exchanges are trading gold futures, and two of the newest entrants—Taiwan and Russia—really took off in 2008. (See Top 20 Metals Contracts Table)

Perhaps the best indicator of how much interest there was in gold comes from the old Comex contracts, which migrated to the Globex platform last year when CME took over the New York Mercantile Exchange. Comex gold futures volume soared 53.1% to 38.4 million contracts in 2008, which is astounding for a contract that has been around as long as that one has. 

Another measure of the popular interest in gold is in the explosion in the volume of options traded on the exchange-traded funds that hold physical gold. The leader in that segment of the market is the SPDR Gold Trust ETF, which is listed on the New York Stock Exchange under the symbol GLD. The fund was launched in November 2004 and now ranks as one of the biggest ETFs in the U.S. in terms of assets under management. GLD options, which began trading this past June, proved to be a real hit, with 8.6 million contracts traded in less than six months.

The other side of that story is the long delay in bringing those options to the market. Because of the hybrid nature of the product—options on shares in a fund that holds a physical commodity—the two U.S. agencies that regulate derivatives could not agree on which agency should have jurisdiction. Along came the Treasury Department’s blueprint for financial reform, which recommended a consolidation of regulatory functions, and the two agencies suddenly saw the wisdom in cooperation. In March 2008, the heads of the Securities and Exchange Commission and the Commodity Futures Trading Commission signed an agreement by which they promised to streamline the approval process for hybrid products, and singled out the gold ETF options as the first example of the new era in cooperation. 

The other big trend in 2008 was a big uptick in the use of OTC clearing facilities such as CME’s Clearport and NYSE Liffe’s Bclear. Everyone in the OTC markets learned a painful lesson about counterparty risk in 2008, and the message about the benefits of clearing is getting a more receptive audience. One of the best examples of this is in the energy sector, natural gas in particular, which went through its own credit crisis earlier this decade after the Enron collapse. The OTC natural gas market in the U.S. has come around to a near complete embrace of clearing, and the two main players in this game—Intercon­tinentalExchange and CME Group—are reporting a booming business. 

ICE generally has not been willing to disclose how many contracts it is clearing, but occasionally it lets slip some tantalizing detail. For example, in its year-end financial review the exchange revealed that it cleared an average of 678,000 OTC energy contracts per day in the fourth quarter, roughly equal with the fourth quarter of 2007. In comparison, CME processed 489,000 OTC energy contracts per day through its Clearport service in the fourth quarter of 2008, up 58% on the year-ago quarter. 

The other area where OTC clearing has made deep inroads is in the European equity derivatives markets. NYSE Liffe’s Bclear service has attracted most of the attention, but Eurex has caught up rapidly. In both cases, the exchanges offer clearing for OTC transactions in futures and options based on indices or single stocks.

Liffe reported a total of 481.6 million in equity products volume in 2008. Of that total, 190.9 million contracts, almost two thirds of which were single stock futures, were transacted off-exchange and brought into the Bclear service for clearing. In other words, only 60% of Liffe’s equity futures and options trades are actually taking place on the exchange. 

It is also worth noting that this side of the business is growing much more rapidly than classic order-book trading. Bclear volume in 2008 was 55% higher than in 2007, while the comparable on-exchange volume in equity products actually declined by 1.5%. 

Eurex does not break out the OTC cleared volume in quite the same way, but there is no question that it has become a big part of the exchange’s equity derivatives business. For example, of the 64.3 million equity index futures and options cleared in December, only 53% were traded through the order book. Of the 18.7 million equity options cleared in December, only 47.5% were traded through the order book. And of the 2.5 million single stock futures that were cleared in December, less than 1% were transacted through the exchange’s order book.

One of the interesting things about this line of business is that it is effectively pan-European. While the underlying stocks are traded mostly on national exchanges, the Liffe and Eurex OTC clearing services are wide open for business from anywhere in the European Union. Eurex naturally does most of its single stock futures and options business on German and Swiss names, but French, Dutch, Finnish and Spanish names make up a sizeable part of its volume. Likewise, a large part of Liffe’s Bclear volume comes from the core Euronext markets of Amsterdam, London and Paris, but it also captures a lot of business related to German and Spanish names.

Exchange Rankings

The focus now is on integration. As the exchange group table shows, there are several exchange holding companies that consist of several large subsidiaries that many of us still view as separate entities. The New York Mercantile Exchange, the world’s largest energy futures exchange, is now part of the CME Group, and the Philadelphia Stock Exchange, the third largest U.S. equity options exchange, is now part of the Nasdaq OMX Group. 

This has considerably changed the complexion of the exchange rankings. When we did our volume article last year, CME’s acquisition of the Chicago Board of Trade boosted it into first place in the global derivatives exchange rankings. This year, however, the decline in interest rate futures trading held the CME-CBOT combination back just enough for KRX to move ahead.

Of course, now that CME has absorbed Nymex, the group as a whole remains in first place. On a combined basis, CME plus CBOT plus Nymex had 3.28 billion contracts traded in 2008, versus just 2.87 billion at the Korean exchange. Within CME, legacy CBOT trading was down 6.7%, legacy CME was up 6.6%, and legacy Nymex was up 19.8%. In other words, it was the energy products traded and cleared by Nymex that did most of the pulling last year for the CME train. That acquisition is looking smarter all the time. 

The same applies to Eurex. On its own, the German-Swiss exchange would have ranked behind KRX with 2.17 billion contracts traded. But Eurex owns the International Securities Exchange, the second largest equity options exchange in the U.S. On a combined basis, Eurex plus ISE had total volume of 3.17 billion contracts in 2008, moving it ahead of KRX and just behind CME. 

Looking a little bit lower in the exchange rankings, consolidation also affected the competitive balance among the U.S. options exchanges. The Chicago Board Options Exchange and ISE are still battling it out at the top, with 33.3% and 28.1% of the overall market, respectively. At the next tier down, however, the American Stock Exchange and NYSE Arca are now part of the same overall group, as are PHLX and the newly launched Nasdaq Options Market. On a consolidated basis, NYSE Euronext and Nasdaq OMX are almost equally matched, NYSE with a combined market share of 17.4% and Nasdaq OMX with 16.2%. The Boston Options Exchange has only a 5% market share but it is growing more rapidly than the industry, with volume up 37.6% vs. 25.1% for the sector as a whole. 

Moving to Asia, markets in India and China showed little impact from the crisis wracking Western financial markets. The National Stock Exchange of India, the second largest exchange in the region after KRX, reported a 55.4% increase in volume to 590.2 million contracts, driven mainly by a huge jump in index options trading. The Multi Commodity Exchange of India saw volume rise 36.8% to 94.3 million contracts, making it the fourth largest commodity futures exchange in the region. 

All three Chinese exchanges continued to grow very rapidly. Dalian Commodity Exchange, the largest of the two agricultural futures exchanges, rose 68.7% to 313.2 million contracts. The increase there was driven mainly by more active trading in soybean and soy oil futures. The Shanghai Futures Exchange rose 63.9% to 140.3 million, driven by strong growth in several existing products, notably its zinc, aluminum and fuel oil futures.

The Zhengzhou Commodity Exchange, which used to be the third largest exchange, grew 139.2% to 222.6 million contracts, making it the fastest growing derivatives exchange in the world. The jump in volume was driven mainly by a spectacular increase in its white sugar futures contracts, up 264% to 165.5 million contracts. Although ZCE’s contract is five times smaller than the benchmark sugar contract traded on ICE Futures U.S., the volume of trading was so great that ZCE’s market comes out slightly ahead in size. It’s no wonder that commodity traders worldwide increasingly look to these Chinese markets for price discovery.

That said, China’s markets have shown that they can quickly lose their allure. The volume of trading in wheat futures, the Zhengzhou exchange’s original mainstay, fell 29.4% to 27.5 million contracts. And aluminum futures trading on the SHFE has ridden a roller coaster, rising to 13.9 million contracts in 2006, plunging to 4.8 million in 2007, then rebounding to 14.8 million in 2008. 

Another amazing growth story is in South Africa, where the Johannesburg Stock Exchange, the home of the old Safex exchange, has become one of the top 10 derivatives exchanges in the world. Last year its volume rose 55.8% to 513.6 million contracts. The real story behind the JSE’s growth is the success of its single stock futures. Last year the JSE traded 431.2 million single stock futures, up 62.4% on the previous year. The JSE is now the largest single stock futures market on the planet, followed by India’s NSE at 225.8 million, Eurex at 130.2 million, NYSE Liffe at 124.1 million, Russia’s RTS at 83.7 million at Russia’s RTS, Spain’s Meff at 46.2 million, and OneChicago bringing up the rear at four million contracts.

Outlook for 2009

Are we headed for a severe decline in trading volume this year, as the data from the interest rate futures sector seems to suggest? Or are we instead going to be carried forward by the huge growth in emerging markets such as China and India? Can we sustain the incredible growth of equity index products that we saw in 2008, or will volume in those products decline as volatility gradually normalizes? And how much volume will come into the industry from the over-the-counter markets, now that counterparty credit risk has grabbed everyone’s attention?

There is no question that the year-over-year comparisons are not going to look very good. January of 2008 was an incredibly active month, with all sorts of volume records set on the U.S. exchanges. July was even bigger, and then in September we hit an all-time record of 1.9 billion contracts traded. It is going to take a long time before we get back to that level of trading, given all the deleveraging that has taken place and the decline in liquidity. 

It is important to keep this all in perspective, however. As the implied bid-ask spread chart shows, trading conditions have gotten significantly worse, but only compared to how things were two or three years ago. If we go back to the early part of the decade, the spreads were much wider, which is another way of saying that even now the futures markets are much more efficient than they used to be. Part of that comes from the advances in electronic trading that we have been talking about for so many years. Those advances are not likely to go away. And as the Eurodollar price discovery chart shows, the futures markets are still performing their core function in a very effective way. So there is good reason to expect that sooner or later those market participants who have pulled back from using these markets because of the financial crisis will eventually return for all the reasons they came in the first place. We just don’t know when. 

Galen Burghardt is senior vice president and director of research at Newedge and a member of the editorial advisory board of Futures Industry. He thanks Lauren Lei in the research department of Newedge for her contribution to the article. Will Acworth is editor of Futures Industry.