v12-062 canadian derivatives markets-co-existing in the shadow of a giant

Canadian Derivatives Markets: Co-Existing in the Shadow of a Giant

The US and Canada are indelibly intertwined. Sharing a 5,525 mile border, acting as

primary trading partners and having symbiotic economies that ebb and flow in tandem has

resulted in two distinct yet highly correlated capital markets that are actively traded by

investors around the world. Although Canadian securities markets operate in the shadow of

the world’s largest capital market, distinct differences in Canada’s marketplace appeal to

both domestic and international investors.

Canadian derivatives markets hold special appeal to investors. A thriving domestic investor

base is increasingly participating in the listed futures and options markets, even as

international regulators seek to move over-the-counter derivatives into central clearing

mechanisms and onto organized exchanges around the world. This slow moving but ongoing

shift, along with the eventual recovery of global economies, will drive continued growth in

Canada’s exchange-traded derivatives markets.

Andy Nybo

V12:062

November 2014

www.tabbgroup.com

Canadian Derivative Markets: Co-Existing in the Shadow of a Giant | November 2014

2014 The TABB Group, LLC. All Rights Reserved. May not be reproduced by any means without express permission. | 1

The Uniqueness of Canadian Capital Markets

Although sometimes overlooked by the US, Canada’s financial markets are substantial in

their own right. The country's equity markets, with a market capitalization of $2.3 trillion,

rank seventh in the world. Its fixed income markets are also expansive, with more than $1

trillion in outstanding government and corporate debt. Add to that a $1.2 trillion mortgage

market and all the ingredients are in place for a thriving securities market that is attracting

growing demand from investors around the world.

Canada occupies a unique position in the global capital markets. Its vast store of natural

resources has created an economy in which activity is closely correlated with the state of

the world’s energy, mining and commodity markets. Not surprisingly, Canada’s equity

markets are dominated by these sectors, with energy and natural resource companies

accounting for more than one-third of market capitalization.

Canada’s markets are also home to a vibrant financial sector, with financial institutions

accounting for 34% of total market capitalization. The strength of the Canadian financial

sector is a major attraction for global market participants. The sector’s conservative lending

practices, firm regulatory oversight and strong capital base are primary reasons why the

country’s banking sector avoided much if not all of the fallout from the global financial crisis.

Indeed, although the Canadian economy experienced many of the same recessionary

pressures that hit economies around the world, the banking sector suffered little financial

fallout from the crisis, and Canada still maintains its vaunted AAA credit rating. The

country’s appeal as a reserve currency for central banks and monetary authorities around

the world has thus been reinforced. That is a major factor driving interest in Canada’s cash

and equity markets and related derivative markets from the global investment community.

Exhibit 1: Canadian Equity Market Capitalization by Sector

September 2014

Source: Toronto Stock Exchange



The concentration in the natural resource and financial sectors is a double-edged sword.

Canada’s vast pool of natural resources provides it with a strong foundation for future

growth, yet its energy and mining industries are often held hostage to global economic

conditions that impact their performance. In addition, although it forces domestic investors

to look to foreign markets for diversification, it also creates an attractive opportunity for

foreign investors seeking to gain exposure to the energy and natural resource sector (see

Exhibit 1, previous page).

Derivatives trading occurs primarily on the Montreal Exchange (MX), a fully electronic

exchange where financial derivatives including equity options, options on ETFs, currency

options, index derivatives and interest rate derivatives trade. In addition, ICE Futures

Canada offers trading in agricultural derivatives with its most successful contract a Canola

futures contract.

Investor Base

Canadian financial markets are supported by demand from both domestic and international

investors. The domestic investor base is substantial and includes pension funds, insurance

companies, and mutual funds, as well as exchange traded funds (ETFs) that are seeing

rising assets under management. With assets of more than $3.2 trillion under management

they represent an important source of demand for Canada’s equity and fixed income cash

markets (see Exhibit 2).

Exhibit 2: Estimated Assets under Management in Selected Institutional Segments ($ Billions)

Source: CLHIA, IFIC, Statistics Canada, ETFInsights, TABB Group estimates

Canada’s equity and fixed income markets also enjoy considerable demand from foreign

investors that are attracted to its natural resource sectors, as well as its AAA rated

government debt markets.



Not surprisingly, US investors are active participants but Canada also attracts attention from

a broad range of international investors seeking to gain exposure to the natural resource

and financial sectors. According to Statistics Canada, foreign direct investment in Canadian

equities totaled $686.3 billion in 2013. More than half of the total came from US-based

accounts (51.3%), followed by European and Asian investors, who accounted for 31.9% and

13.1% of the total, respectively.

Canada’s bond markets are also growing as demand from money managers running global

macro and index strategies has reinforced domestic demand to add to an already active

trading environment. Net flows into Canadian fixed income securities (including government

and corporate debt) from international investors totaled $24.9 billion in the first eight

months of 2014, coming on the heels of significant net flows of $69.1 billion and $26.4

billion in 2012 and 2013, respectively.

Derivatives Trading in Canada

Canada’s derivatives markets appeal to a broad range of domestic and international

participants who use the country’s futures and options markets to generate income, make

directional plays and manage risk exposures for fixed income and equity portfolios.

Although stagnant volatility and economic weakness in the natural resource and commodity

sectors has caused trading in equity options to decline in recent years, the reverse is true

for its futures markets which have benefited from rising demand for fixed income exposure

(see Exhibit 3).

Exhibit 3: Futures and Options Trading on the Montreal Exchange

Annual Trading Volume 2001 to 2014 (as of October)

Source: Montreal Exchange, TABB Group



Although overall options volumes may be trending downward, the decline is likely to reverse

as recent spikes in volatility promise to stoke renewed interest in options trading. Rising

geopolitical tensions, concerns about international growth and the recent Ebola scare are

beginning to see growing investor attention, with the rising uncertainty resulting in

increased market volatility. Investors are also closely watching how US Federal Reserve

winds down its quantitative easing programs, with unanticipated adjustments met with

renewed volatility, especially in fixed income markets.

In addition, rising open interest suggests considerable demand exists to use futures and

options in longer term strategies, especially those intended to earn income or manage

longer term risk exposures. These types of strategies tend to build open interest, and thus,

volume, over time, as opposed to smaller, more speculative accounts that trade frequently

as part of short term directional or volatility strategies (see Exhibit 4).

Exhibit 4: Futures and Options Open Interest on the Montreal Exchange

2001 to 2014 (as of October)

Source: Montreal Exchange, TABB Group



Options Trading on MX

After a record year in 2011, options trading volumes have declined, falling victim to the

anemic volatility environment that has plagued derivatives markets around the world. In

addition, the global recession has resulted in falling commodity prices. Energy and mining

have borne the brunt of falling demand, which, six years after the recession's onslaught,

remains depressed. The decline in trading activity is most apparent in sector-specific

strategies, a situation expected to persist until the global economy fully recovers and

investor interest in the energy sector rebounds.

The vast majority of equity options traded on the MX are on individual equities, accounting

for 84% of the total, with volumes in ETF and S&P/TSX 60 index options representing 16%

of total activity (see Exhibit 5). Options on futures are also traded on the MX, with options

on bankers’ acceptances futures the most actively traded contract with just over 350,000

contracts traded in the first ten months of 2014.

Exhibit 5: Most Active Options on the Montreal Exchange

Jan-14 to Oct-14 trading volume (millions of contracts)

Source: Montreal Exchange

The Growing Presence of Institutional Investors in Options

Options trading in Canada is predominantly institutional, with traditional asset managers

(including pension funds, mutual funds and insurance companies) accounting for an

estimated 55% of total customer activity and trading by retail accounts and investment

advisors accounting for the remaining 45%.



The growing presence of institutional investors in Canadian options markets is a result of

both rising demand and a flexible market structure on MX that facilitates institutional flow

through a crossing mechanism first introduced in 2008. This capability allows specific types

of pre-arranged trades to be executed in the market after all orders in the central limit

order book at better or equal prices have been executed.

Although the crossing facility has been credited with building institutional participation on

the exchange, it does create challenges because it reduces the ability of market makers to

interact with customer order flow. Alternative methods of attracting market maker

participation with new mechanisms that improve their ability to interact with order flow is

and continues to be an important consideration to build liquidity.

Trading Choice Since many of the companies inter-listed in Canada and the US have options trading in each

market, the decision to trade Canada or US revolves around a number of factors.

Fees and commissions for institutional investors to trade options in the US or Canada are

roughly the same and so factors such as market quality metrics, execution price and fill

percentage are all incorporated into the trading decision.

As investors look at market quality and liquidity when deciding where to trade, the decision

to trade a derivative on an inter-listed stock needs to take each respective market structure

into account. Although US options markets may appear to have more liquidity, often times

investors need to balance the additional costs of trading in US markets against trading on

MX.

For example, an investor trading options on an inter-listed Canadian company needs to be

cognizant of the liquidity in the underlying cash market. Deeper home market liquidity

allows market makers and dealers to offer better pricing, since they are able to reduce

hedging costs and can manage their risk exposure more efficiently.

Another factor influencing Canadian institutions to use home markets is potential currency

risk for positions traded in US markets. Having to hedge a US dollar position adds a layer of

complexity and increases the cost of maintaining the position. Exposure to fluctuations in

US and Canadian dollars needs to be hedged by all but the most aggressive institutions.

Domestic institutions with limited foreign exchange exposure have little need to build out

these costly capabilities. Instead, they direct trading into MX listed options in order to lower

potential costs and minimize complexity of trading activities.

Futures Trading on MX

Futures trading on MX is concentrated in a small range of products, with two of the most

actively traded instruments fixed income products: the three-month bankers’ acceptances

future contract and the 10-year Canadian Government Bond futures contract.



Trading in these two products is driving much of the exchange’s volume growth, as rising

interest rate volatility resulting from shifts in global monetary policy attract hedging activity

from both domestic and international investors. Trading in the equity segment has been flat,

a by-product of low equity market volatility (see Exhibit 6).

Exhibit 6: Most Active Futures Contracts Traded on the Montreal Exchange

Jan-14 to Oct-14

Source: Montreal Exchange

Not only is rising international demand for access to fixed income exposure adding to

volumes but the regulatory preference for centrally-cleared products is slowly but surely

contributing to rising end user demand. For example, futures on bankers’ are increasingly

being used by investors seeking to hedge short term interest rate exposure associated with

their OTC activities as reference indices for many Canadian OTC floating rate swap

agreements are based on bankers’ acceptance rates. This increased demand bodes well for

the future, especially since investors are just beginning to use listed futures as an

alternative to OTC interest rate swap products.

The benchmark 10-year Canadian Government Bond futures contract is also seeing rising

international demand, as US and European-based customers are accounting for a growing

proportion of trading. MX has embraced these trends, opening offices in New York, London

and Singapore in an effort to attract a broader international investor base.

International demand should also drive growth in S&P/TSX 60 Index futures for two main

reasons. First, it’s the only contract that efficiently give investors broad exposure to the

Canadian equity market. Second, it also offers exposure to the energy and commodity

sectors, so when interest in those sectors returns, S&P/TSX 60 Index futures will benefit.



Canada’s derivatives markets will benefit from increased participation from a broader range

of institutional investors, a regulatory environment that favors centrally-cleared instruments

and ultimately, a more volatile trading environment. Indeed these are the same factors

driving growth in global derivatives markets.

What’s more, a broader range of market participants, not just large institutional investors

that have long been active users of listed and OTC derivatives, are increasingly exploring

ways to use derivatives to improve returns and manage risk. Use of derivatives by smaller

institutions represents a large growth opportunity as many of these institutions are just

beginning to use derivatives in their investment strategies.

To be sure, challenges associated with rising adoption from institutions exist. One of the

biggest challenges revolves around the time-consuming process of obtaining internal

approvals. Firm protocols for approving new trading strategies and instruments need to be

followed, presentations to management and investment committees need to be scheduled

and arranged, and ultimately, sign off from senior management needs to be obtained.

Despite this hurdle, rising demand from these segments will ultimately add to volumes.

OTC Market Developments

The Canadian regulatory environment is fragmented, with provincial bodies all having

authority over the financial industry within their respective jurisdictions. Each province and

territory in Canada has a regulatory agency but there is no true national regulatory

authority that operates at the federal level. Despite the fragmented structure (or perhaps

because of it) Canadian markets have avoided some of the regulatory missteps that have

dogged other countries and jurisdictions.

The lack of a national regulatory authority may also explain why Canada has not

implemented any major OTC derivatives regulatory changes. Instead, they have stayed on

the sidelines and let regulatory battles play out in US and Europe.

Although Canada has not effected a formal set of rules to regulate its OTC derivatives

markets, the global nature of OTC trading effectively forces market participants in Canada

to adhere to global best practices.

In the US, the Dodd-Frank Wall Street Reform and Consumer Protection Act (DFA) was

signed into law in July 2010, while European regulators addressed the issues through the

European Market Infrastructure Regulation (EMIR) and Market in Financial Instruments

Directive (MiFID) initiatives. The most far reaching components of the US and European

efforts are the requirements to centrally clear standardized OTC instruments, which will lay

the foundation for the shift of more liquid interest rate swaps to be traded on a regulated

trading facility such as an exchange, board of trade or swap execution facility.

The ultimate impact of this push will be rising costs since the buy side will now have to post

margin for all cleared swap transactions.



As these costs become more apparent and tangible, buy side managers will increasingly

explore the use of futures or futures swaps as more economic alternatives, driving more

demand for interest rate futures on MX.

The potential impact of investors switching from OTC to listed derivatives products could be

substantial, with trading in interest rate products expected to see substantial volume

growth, especially given the size of the Canadian dollar swap markets. According to

SwapClear, the Canadian dollar swap market measures $8.7 trillion in outstanding notional,

with $7 trillion of the total in interest rate swaps. Client notional volumes outstanding are

substantially smaller, with $727 billion of the total representing client cleared volumes (see

Exhibit 7).

Exhibit 7: Notional Amount Outstanding of Canadian Dollar Swaps Cleared on SwapClear

(Millions of contracts)

Source: SwapClear

As global clearing initiatives become mandated, a growing proportion of OTC swaps trading

will migrate to organized trading facilities such as exchanges and SEFs. The process will be

slow but steady as end users of swaps begin to evaluate the relative costs of centrally-

cleared OTC products against the costs of exchange-traded futures and options. The process

would accelerate dramatically if an iron clad regulatory mandate required all OTC swaps to

be centrally cleared and traded on exchanges.

Despite continued regulatory pressures to move OTC bilateral agreements onto exchanges

and into central clearing facilities, the utility of OTC remains a powerful attraction for larger

buy side institutions trading in size.



The ease in which a trade can be completed, along with the considerable flexibility in

structuring the details of the trade make OTC instruments a logical tool of choice for larger

buy side institutions with complex portfolio needs who have little alternative to OTC when

seeking to express a view on a position.

This is not to say that OTC swaps transactions will not eventually transition to interest rate

futures products. As end users begin to realize the explicit costs associated with margining

OTC swap instruments, listed markets will begin to see renewed demand. But the process

will be slow and only will add marginally to overall trading volumes.

Large investors with the need for size and structural flexibility use OTC products by

necessity but many small and medium sized investors are not able to participate in OTC

markets due to the complexity and necessary legal thresholds. These small- and medium-

size institutions represent an expanding sector that will increase their use of listed interest

rate futures for managing interest rate exposure, especially as new products like swap

futures become available on exchanges that provide similar structural capabilities as OTC

swaps.

Although equity swaps have effectively remained out of most of major global regulatory

initiatives, they will be impacted by efforts to improve the fiscal condition of global banks.

As these regulatory efforts are implemented, brokers will be forced to rationalize the cost of

providing capital, and will ultimately pass the higher costs on to clients. Although these

regulations will be phased in over a longer time frame, brokers are beginning to tighten the

amount of capital they extend to clients, especially smaller institutions without the

wherewithal to demand the banks attention.

A Look Ahead

Canadian derivatives markets are becoming an increasingly important part of global

financial markets, with both domestic and international investors focusing greater attention

on the use of derivatives as part of their investment strategies. Although anemic volatility

has hit trading volume, open interest in both options and futures continues to expand,

illustrating rising demand from institutions in using derivatives.

Canada’s conservative fiscal discipline is a prime factor behind the rising demand for

exposure to Canada, as investors in the country’s fixed income markets are attracted to its

financial stability and growing role as an international reserve currency. Continued gyrations

in global monetary policy will reinforce these trends, especially as global economies emerge

from recession and interest rate volatility reemerges.

The return of global economic growth also stands to benefit Canadian capital markets. As

growth reignites and price pressure on energy and commodities returns, the country’s

dominant energy and natural resource sector will see renewed interest from international

investors. Often considered both a benefit and a challenge, the concentration of these two

sectors in Canada’s economy will impact future growth prospects in both its stock and

derivatives markets.



Rising investor demand will also contribute to growth in Canada’s derivative markets.

Traditional asset managers such as pension funds, mutual funds and portfolio managers are

increasingly exploring the use of derivatives as part of strategies to provide investment

efficiencies, enhance income and ultimately improve returns. Part of the challenge in getting

this group to fully and enthusiastically embrace derivatives is education and market

acceptance.

Many of Canada’s small- and medium-sized asset managers are just beginning to explore

the potential benefits of using derivatives in investment strategies. These efforts will only

expand, especially as funds compete to attract new assets through improved returns and

risk management. Interest in using listed derivatives will only be enhanced through global

regulatory pressures designed to reduce risk and boost market transparency.

The wild card is the global pace of regulatory reform. As efforts to move OTC derivatives

onto central clearing mechanisms and organized trading facilities begin to gain steam, the

true costs associated with trading OTC instruments will become clear. As these costs

become transparent, investors will evaluate the best mix of instruments for gaining desired

exposure. When the regulatory dust settles, OTC instruments may still fit the needs of many

large investors while exchange-traded instruments will increasingly appeal to smaller and

mid-sized institutions looking for ways to manage risk and improve returns.

While still below the record volume peaks of a few years ago, Canada’s listed derivatives

markets are poised to benefit from three major trends moving in their favor: an improving

economic environment, regulatory initiatives and the return of market volatility. And

although some hurdles need to be cleared, both domestic and international investors are

showing signs of playing a bigger role in these markets.



About

TABB Group

TABB Group is a financial markets research and strategic advisory firm focused exclusively

on capital markets. Founded in 2003 and based on the methodology of first-person

knowledge, TABB Group analyzes and quantifies the investing value chain, from the

fiduciary, investment manager and broker, to the exchange and custodian. Our goal is to

help senior business leaders gain a truer understanding of financial market issues and

trends so they can grow their businesses. The press regularly cites TABB Group members,

and members routinely speak at industry conferences and gatherings. For more information

about TABB Group, visit www.tabbgroup.com.

Author

Andy Nybo

Andy Nybo has more than 25 years of experience in research and technology applications in

the global capital markets, and is a Principal and Head of Derivatives at TABB Group.

Currently focusing his research efforts on the OTC and listed equity derivatives markets,

examining how technology is playing an increasingly integral role on both the buy-side and

sell-side desktops, he has written the following recent TABB Group studies: “US Retail

Options Trading: It Doesn’t Get Any Better Than This,” “US Options Trading 2013: Looking

for the Edge,” “US Options Market Making 2013: Scale, Scope and Survival,” “US Options

Trading 2012: Standing Out in the Crowd,” “Processing Complexity: Back Office Challenges

of Listed Derivatives,” “Innovations in Accessing Asia: Listed Equity Derivatives & Delta One

Products,” and “Accelerated Expirations: The Growing Relevance of Short Term Options.”

http://www.tabbgroup.com/


www.tabbgroup.com

New York

+ 1.646.722.7800

Westborough, MA

+ 1.508.836.2031

London

+ 44 (0) 203 207 9027

http://www.tabbgroup.com/

v12-062 canadian derivatives markets-co-existing in the shadow of a giant

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