Principal, Xamax Consultancy Pty Ltd, Canberra
Visiting Fellow, Department of Computer Science, Australian National University
Version of 19 June 1994
© Xamax Consultancy Pty Ltd, 1994
This document is at http://www.anu.edu.au/people/Roger.Clarke/EC/PaperOMX.html
Options and futures are 'derivative' commodities. An option is a contract by a person to sell or to buy, some commodity such as a specific share, foreign currency or commodity such as corn, at a specific price, up to a specific date, at the option of another person who pays a fee for the privilege. A future is a contract by a person to deliver a commodity such as a specific share, foreign currency or commodity such as corn, at a specific price, on a specific date.
Futures were devised in order to enable the owner of a commodity (such as a farmer growing corn) to anticipate income from the forthcoming crop, and insure against a substantial fall in the price by the time it is ready for harvest. Options arose in order to facilitate the management of investment portfolios. They also enable the risk of major falls in prices to be hedged against, but in this case were originally associated with stocks and shares. Options and futures are now also traded against the values of indexes of baskets of shares (e.g. the Dow-Jones Index), of baskets of bonds, and of interest-rates.
The proportion of capital controlled by individuals has fallen dramatically during the course of the twentieth century, as superannuation insurance companies and pension funds have become the primary repository for savings. Associated with this has been an increase in the level of professionalism of portfolio management, and hence increased demand for hedging mechanisms such as options and futures.
In general, the party which takes over the risk must also hedge their risk, and hence options and futures stimulate trading in the underlying commodity. This increases the depth of the market for the commodity. Derivatives trading is therefore justified as being in the interests of the community as a whole, rather than a refined form of corporate gambling.
Options and futures can be, in principle, traded by any pair of buyer and seller, who might discover one another's complementary interest casually, or through an advertisement in the press. In practice, as with other commodities, it is normal for parties interested in making such contracts to use the services of agents who are in the business of meeting to conduct such business for their principals, and perhaps also themselves. The meeting-places for such agents is referred to as an 'Exchange'. Many conventional Exchanges have extended their support for trading to include options and futures. In addition, specialist Exchanges have been created to support it.
The primary function of an Exchange is to enable buyers and sellers to readily discover one another. This was traditionally done by establishing a meeting-place or 'floor' at which buyers or their agents congregated. The agents, or brokers, tended to control the 'floor' and to lock the principals out of the exchange. During the last two decades, the decision-making, discovery and trading processes have come to be supported by information technology, and physical meeting-places have been progressively giving way to electronic equivalents.
Long-established exchanges which deal in securities (stocks and shares) have large volumes and well-established ways of working, and are converting relatively slowly from floor-based to electronic form. Dealing in newer kinds of commodities is not constrained in this way. As a result, many derivatives exchanges are entirely, or at least heavily, dependent on information technology.
The A.N.U.'s Research Programme in Supra-Organisational Systems has been conducting a long-running project relating to IT support for exchanges. This case study is a further element of that research. It provides information concerning one particular, entirely electronic options and futures exchange. The OM Group is headquartered in Stockholm. It is, however, one of the first genuinely international electronic exchanges, with operations in both Stockholm and London, with copies of its software installed in several other European capital markets, and with developing associations in these and other cities.
This document focusses primarily on OM's OMLX - the London Securities and Derivatives Exchange, and one particular user of OM's software, ÖTOB - the Austrian Futures and Options Exchange. It has been prepared on the basis of visits to London and Vienna in June 1994, interviews with key executives of both organisations, and examination of documentation provided by them. No recourse has been made to third-party sources.
OM began in 1984 in Sweden as a private company, competed head-to-head against the Stockholm Stock Exchange for options business, and won a significant proportion of the market. It subsequently went public, and has been listed on the Stockholm Stock Exchange since 1987. OM's business concept was described in its 1993 Annual Report (p.6) as being "to create opportunities for financial risk management through the establishment, development and operation of markets and clearing organisations for financial instruments".
An amendment to the Swedish taxation law in c. 1988? was seriously threatening to OM's profitability, and it accordingly moved its operations off-shore in 1989, to London. There it continued to service its existing clientele in Sweden, and offered similar services to additional clients in the United Kingdom. In c. 1992?, Swedish taxation law was again amended, overcoming the detrimental effects of the earlier change. OM moved its primary operation back to Stockholm (hereafter OM Stockholm). It had, however, established a client-base in London, and accordingly sustained market operations there, supported by the equipment in Stockholm.
In mid-1994, OM's group structure comprises:
By 1993, OM had SEK913 million (c. $US115m) in shareolders' equity, and its turnover was SEK246 million (c. $US31m). It has been profitable throughout its listed history, with a return on shareholders' equity of 28% in 1993. The founder, Olof Stenhammer, still has about 7% of the company's capital, and remains its CEO. About 63% of the capital is owned by institutions, 20% by a single, un-named investor, and a total of 11.5% by non-Swedish companies and individuals. At the end of 1993, OM had 53 market operations and management staff based in Stockholm and 25 in London, plus 43 in the systems subsidiary, based primarily in Stockholm.
By late 1993, OM was the fourth-ranking financial derivatives exchange in Europe, led by LIFFE of London, MATIF of Paris and DTB of Frankfurt, but ahead of SOFFEX of Zürich, EOE of Amsterdam, ÖTOB of Veinna and MONEP of Paris. OM also has investments in options exchanges in several other countries.
OMLX and OM Stockholm publish a considerable amount of detail about their operations, partly because some aspects are required by law, but also as a means of maintaining publicity for their services. This document is based largely on publicly available information.
OMLX is a Recognised Investment Exchange under United Kingdom law. As expressed in its 1993 Annual Report (p.10), it has a marketplace function:
and a clearing function:
OMLX supports persons who wish to enter into options and futures contracts. In June 1994, contracts could be written based on the following 'series' of underlying commodities:
and, since February 1994, the first U.K. domestic product:
OM also supports trading in notional government and private sector bonds, treasury bills, and forward interest rates. These are not further considered in this document.
In order to use OMLX's services to trade in these options and futures, a person must be a Member of OMLX. There are presently about 50 of these, 6 of whom act as 'market-makers', and the remainder of whom trade as either agents, or principals, or in most cases both. A 'market-maker' has the responsibility to sustain bid and ask prices for all series for which it is registered. All series have at least one market-maker, and some have several. OMLX and OM Stockholm effectively operate as a single exchange, in the sense that all orders are visible to all members of both exchanges. There are about 60 further members in Stockholm.
OMLX is the only fully computerised derivatives exchange in London. It competes, at least indirectly, with two other registered options and futures exchanges, the London Stock Exchange (LSE) and the London International Financial Futures Exchange (LIFFE). The London operation achieved profitability for the first time in 1993, with a strong rise in volumes of Swedish stock and of interest-rate related products.
OMLX is open for trading in Swedish series during the hours 1000-1600 Stockholm time, which is usually 0900-1500 London time. For British products (at present only the FTSE mid-250 Index), it is open 0830-1630 London time.
The volume statistics in Attachment 1 show the number of 'contracts' or 'lots' traded in April 1994, and in each completed year since 1989. Contracts or lots are the units of exchange. In the case of share options and futures, it relates to 100 of the underlying shares, and in the case of index shares and options it relates to a multiplier of 100 Swedish Krone or #10 times the index level (i.e. a nominal value in the order of $US 50-100,000). Trades may of course be for any number of contracts, and in a week in mid-June 1994, each of the 3,500 trades averaged about 35 contracts.
A moderate amount of program trading is being undertaken by members, and some members do so intensively, using automated monotoring of the market to seek arbitrage opportunities. This results in large numbers of orders being placed which are never fulfilled: whereas on average there are 35 order placements or amendments for every trade actually consummated, program trading involves more like 350 order placements or amendments per trade.
OMLX's volume growth has been uneven, but considerable. OM Stockholm has a greater turnover than OMLX in options, but OMLX has overtaken OM Stockholm in the volume of futures trading.
Trading on OMLX is conducted using a workstation running OM's own software, which it markets under the name of 'Click Trading'. For each series which the trader nominates, they can:
Attachment 2 contains a copy of OMLX's material explaining the screens which are available, and how to conduct trading.
The conditions which can be applied are:
It is also possible to place 'combination orders', i.e. multiple simultaneous buy and sell orders. Some standard combinations are available, and others can be specified by members. These are automatically subject to the 'fill or kill' condition.
Market-makers have a modified set of windows available, which enable them to quote both bid and ask prices for the same series. They may enter a quote manually, by difference from the market price of the underlying security, or by applying their own parameters to a pre-programmed 'volatility' algorithm.
OM has made a considerable investment in user convenience. The windows are movable and sizable, and the background and margin colours of each window are user-selectable. Changes in the underlying data are updated continually in open windows, and are highlighted in colour, with a gradual fade back to black. Much of the activity involves the mouse, to move the pointer and select fields. The keyboard is required where new data needs to be entered.
OM's software runs in real-time, processing order acceptances, checking for matches between outstanding orders, and closing bargains automatically. An order placed by a trader on the system is legally binding, i.e. it is an offer in terms of contract law, which, if accepted explicitly by another trader, or automatically matched by OM's software, prior to being withdrawn, results in a binding contract for sale or purchase of the option or future.
The origin of orders is not visible to traders, i.e. all trades are anonymous to the members. OMLX is, however, aware of the parties' identities. Settlement is also anonymous, because the other side of each trade is performed by OMLX.
The workstation also makes information available to members. Most importantly, this includes:
Attachment 3 contains a copy of OMLX's material explaining the available information.
Data about OM's own index, OMX, and the FTSE Mid-250 Index are maintained and available for display. Current information about prices for the underlying stocks is not distributed by OM, partly because of the high fees charged by the data's owners or licensees (at present primarily the Stockholm Stock Exchange), but also because all members also subscribe to information providers such as Reuters.
OMLX's market support staff have additional application software, called CIBOIS, available to them, to enable them to monitor and manage the market's operation. They have the ability to broadcast 'market messages', which appear on members' screens automatically. They can issue a quote request, either at the request of a member, or if they consider that the market-makers are failing to stimulate a sufficiently active market.
In addition to 'Click Trading', OMLX provides a service to members whereby they may telephone an order into the Market Place Support staff, who will seek out one or more members to take out the other side of the trade. This service is of particular value in the case of large lots (which might otherwise flood the market and affect both price and turnover - since dealers may fear that there is new information of which they are unaware), and complex combination orders.
On members' workstations, a so-called 'heartbeat' pumps slowly on-screen, providing visual confirmation that the connection is 'live', and colour-coded indication if it has 'gone down'. The connections are monitored by OMSI systems support staff. Where a connection to a single member fails to perform, a telephone-link is established and kept open, and the market support staff operate on the member's behalf, enabling the market to stay open and that member to continue to participate.
Where multiple connections, the local network, the London-Stockholm link, or key elements of the Stockholm server-cluster are out of order, the market is closed. That has happened on several occasions, but there was no unscheduled downtime in 1993.
Recovery procedures ensure that the market can re-open in an orderly manner after an interruption of service. This involves intervention by the Market Place Support staff to remove members' positions, particularly for market-makers. The market can then be 'pre-opened', to allow members to create, vary or delete orders, but without order execution or matching being undertaken. It can then be re-opened for business. The complete cycle generally requires 20 minutes to an hour, depending on the circumstances. It is only occasionally necessary to use these procedures.
OM uses Digital Equipment Corporation (DEC) VAX equipment running the VMS operating system, including multiple loosely-coupled servers in Stockholm. A fully fault-tolerant configuration is considered to be too expensive to justify the investment. For client workstations, DEC Workstations are used almost exclusively. In principle, however, it is possible to use alternative clients, such as IBM-compatible PCs running MS Windows, or equipment running OS/2 or Unix.
The network comprises leased telephone lines, within London at 64KB, and between London and Stockholm at 128KB. The nodes are from the U.S. company Vitalink, which was the only offering available at the time of the purchasing decision in late 1990 which provided security features considered by OMSI's development team to be satisfactory. The communications software comprises Ethernet at the lower layers (with some internal Appletalk and LAT - check the latter). Above that there are a proprietary broadcast protocol called OMDU used for distributing price information, DECNet (or TCP/IP where customers request it), and DEC's Reliable Transaction Router (RTR). With the growth in volumes and the subsequent improvements in telecommunications technology, the network will soon be due for enhancement. For the time being, however, it is providing sufficiently fast transmission of transactions, and refresh rates for displays.
The application software is primarily in C, with some remnant Pascal, and some new components in C++. The presentation layer uses C together with the Motif library of X-Windows compliant routines. There is a single version of the Click Trading software, and the login-id determines which functions are available to each particular user. CIBOIS is only available to Market Place Support staff.
All market-makers have OM workstations on their premises, and use them in their operations. A dozen other members have OM workstations, but only 3 of them trade on-line at present, preferring to use their workstations only as an information source and information management tool. Like the remaining 30 members without workstations, they telephone their orders through to OMLX's Market Place Support staff.
The 'Click Trading' software has been operational in its current form since December 1991. New releases are implemented about every three months, but these have predominantly delivered refinements rather than significantly new functionality.
A service which offers risk-management opportunities to its members is itself a risky business. Successive layers of regulation are in place.
Members enters into a contract with OMLX which specifies the requirement that they comply with the Rule Book. OMLX is responsible for ensuring that the Rules are complied with.
Within member-firms, individual traders must be nominated, they are issued with their own login-id and password, and they are required to use them at all times, and protect against their use by others. Typically a member has 6-7 traders.
Market-makers have an obligation to maintain both bid and ask offers for all series to which they are designated. OMLX Market Place Support staff monitor the market to ensure that this requirement is complied with.
In conformance with the requirements of the Securities and Investments Commission, members who wish to trade as both agent and principal are issued with two ids, must sustain separation between the two operations, including use of the ids for the designated purpose only.
[Presumably the OMLX Rule Book precludes orders being 'closed' within a member-firm, whether between two client orders, or between a client order and the member's own order book?].
[Are there some other critical control mechanisms at this level?]
OM guarantees the performance of contracts exchanged using its services. It claims to have one of the highest ratios of capital to exposure of any clearing house in the world. In the event of default by any member, OM therefore incurs liabilities, and it carries insurance against this risk. During 1993, one member of OM Stockholm defaulted. OM fulfilled its guarantee (Annual Report, 1993, p.12).
The Securities and Futures Association (SFA) is a professional association of principals and brokers active in options and futures trading. Members of OMLX must be members of SFA, which sets entry standards, and exercises control over its members' behaviour.
[Needs a brief assessment as to what degree of impact this self-regulation entails].
The Securities and Investments Commission has statutory responsibility relating to, and powers over, Recognised Investment Exchanges, including OMLX.
[Needs an outline of what that entails].
OM claims to have been one of the first exchanges in the world to clear 'OTC' (i.e. 'over-the counter' or off-market) derivatives transactions.
A new service is 'Tailor Made Clearing', marketed as Flex Contracts. This enables contract parameters (particularly duration and exercise price) to be tailored to suit the needs of individual members. In effect, OMLX advertises the desire of a member to trade in a new, special-purpose series. This capability was introduced in several U.S. exchanges in 1992, and OM was the first in Europe to introduce them, late in 1993.
It is intended that additional series of options and futures be released progressively. Rather than offering series identical to those offered by other Exchanges (such as LIFFE, the LSE and the Swedish Stock Exchange), and hence directly attacking the market-share of an established player, new products tend to be created on the basis of a newly perceived market demand.
Through its subsidiary OM Systems International (OMSI), OM has generated software and services revenue in many countries beyond Sweden and the United Kingdom. It is a shareholder in exchanges in Finland, Norway, Slovakia and the Czech Republic. Its technology has been, or is currently being exported, to Austria, Finland, France, Norway, Slovakia (the first of its kind in Eastern Europe, in 1993), Spain and the Czech Republic, and a prototype has been developed for the American Stock Exchange (AMEX).
OMLX is electronically linked with its parent OM Stockholm, providing a single orderbook and shared liquidity. This may have been the first instance in the world of such a linkage. OM looks to further expand its operations within Europe, and perhaps beyond. This is being achieved in three different ways:
The First European Exchanges (FEX) alliance was established in 1992. This comprised the two OM exchanges, EOE of Amsterdam and SOFFEX of Zürich. It has since been joined by ÖTOB of Vienna. Under this arrangement, members of each participating exchange are to have access to all of the affiliated markets without the need for additional membership or clearing arrangements. Progress to date has been very limited, but the intention remains, at least among some of the original members.
The Österreichische Termin- und Optionsbörse (ÖTOB - Austrian Futures and Options Exchange) was established in 1989, and on-line trading launched in October 1991. It uses OM's 'Click Trading' system, with minor variations from the base version.
Although Vienna was an active capital market until early this century, activity on the Vienna Stock Exchange was muted by the country's turbulent history between 1914 and 1950, and its role as a frontline cold war state until the 1980s. Since the mid-1980s, however, there has been a considerable resurgence of capitalism in Austria, and a plan to develop the marketplace's sophistication has been in place since 1989. There is fairly close association between the Austrian and German capital markets, a considerable proportion of the new capital raised has come from Germany (especially in the case of several very large privatisation exercises in recent years), and the Austrian Schilling is tied to the Deutschmark. Attachment 4 contains an outline of the history from the viewpoint of ÖTOB's Chief Executive, and published in May 1994.
Austria inherited strong links with Eastern Europe from the times of the Hapsburg empire, and these were reinforced by the politics of the Kreisky era. As a result, Austria has benefited more than any other country from the recent construction activity in Eastern Europe, and during the recent recession its growth and particularly its unemployment rates have been amongst the best in the world.
ÖTOB is a company which was established by 5 major Austrian banks, and is now owned by 37 Austrian banks and 1 Austrian securities dealer. It has entered into a contractual relationship with the Vienna Stock Exchange (Wiener Börsekammer), which exercises some degree of control over its activities. It is also subject to the Österreichische Kontrollbank, which is an organisation owned by the Austrian banks, and which performs central banking functions. (The remainder of the functions of central banks such as the Bank of England, U.S. Federal Reserve and the Reserve Bank of Australia, such as monetary policy, are performed by the Austrian National Bank). The KontrollBank, and hence ÖTOB, are subject to regulation by the Finance Ministry, although there is a stated intention by the government to establish a separate organisation to exercise that function.
ÖTOB's growth has been very brisk, and is summarised in Attachment 5. There are 11 dealers, almost all of whom are banks, almost all of whom act as both principals and agents, and almost all of whom are market-makers in at least some of the series traded. All are Austrian companies (although one is the local subsidiary of a major German bank). With Austria's impending entry into the European Union, an increased degree of openness to companies from fellow EU members is anticipated. The proportion of deals traded by members as principals was initially about 90%. This has gradually fallen as more trading has been stimulated, averaging only 80% over 1993, and appearing to be about 65% by the end of that year.
The series traded are:
ÖTOB claims that its activities have resulted in a 25% increase in the volume of trading in the underlying markets, as a result of the hedging possibilities it offers, and the stimulation provided by market-makers, which increases the likelihood of a price being on offer. This represents a claim that about half of the total increase in share transaction volumes during the last few years is the result of increased activity brought about by futures and options trading. In addition, the introduction of bond futures has been claimed by traders to have resulted in a halving of spreads.
ÖTOB operates entirely electronically. This involved an investment of ATS107 million (about $US17). OM's software was selected "because the OM system offers advatnages regarding flexibility, the possibility of expanding the installed system due to a modern programming language amnd modular structure, the possibility of being integrated into international networks as well as its extremely low failure rate" (ÖTOB booklet of May 1994).
All members have workstations (between 2 and 10 per member) with a total of 80 workstations in use. All members use them for trading, not just as an information source, and there is no Market Place Support service as is the case at OMLX. The network is based on 64KB links, all within the city area. The prices of the underlying stocks are provided within the 'Click Trading' information windows. During 1993, the system was unavailable for only one hour of the scheduled (c. 1,000) trading hours. A manual fallback arrangement is in place. Reflecting the importance of continuous trading, a backup system is due to be installed in 1994.
ÖTOB has considerable prospects for further growth. The Austrian market is highly visible to, and trusted by, Eastern European countries. Following the very strong result in the referendum of 12 June 1994, Austria will be increasingly visible to other members of the European Union. Existing regulation on investment funds was eased in January 1994, removing futures and options from the gaming and betting provisions, and enabling funds to trade in derivatives. Pension funds have been to date almost entirely controlled by companies, and the bulk of their funds reinvested in the company, and placed in government bonds. This situation may also change in the direction of professional pension fund management conventional in English-speaking countries, which would further increase the demand for hedging opportunities.
Additional products are intended. Long-term options on the ATX index are scheduled to commence trading in late June 1994, and medium-term government bond futures and interest-rate futures are also under serious consideration. ÖTOB enjoys an effective monopoly in derivatives trading in Austria, and is working in concert with the Vienna Stock Exchange to increase the sophistication of Austrian capital markets. At present the Exchange only supports continuous trading in the 20 most liquid stocks, but it plans to launch the Equity Quote Order System (EQOS) in October 1995, to provide electronic trading for the most liquid stocks and shares, and this should give further impetus to both Exchanges.
ÖTOB anticipates growth in international activities. On the one hand, it has an eye to developments in Eastern European markets. On the other, it is a member of FEX, and has plans to link on-line with SOFFEX in Zürich. Those plans have been deferred due to SOFFEX's desire to focus first on implementing foreign currency products.
Whereas ÖTOB operates entirely electronically, OMLX continues to provide a manual arrangement. It remains to be seen whether brokers and principals will all embrace on-line trading, or continue to use the services of OM's Market Place Support staff.
It appears that direct competition in options and futures trading, in the sense of providing the opportunity to trade in the same instruments, tends to occur only in the initial stages of development of a market (cf. OM's original trial of strength against the Stockholm Stock Exchange). Once an Exchange has established its position, competition is less direct, and involves the search for new products to exchange, rather than the exchange of existing ones.
OM Stockholm and OMLX operate as a single marketplace. This is a breakthrough, but has been achieved through a 'computer heirarchy', i.e. a within-company arrangement. The FEX alliance has been been formed, but has not to date delivered on the promise of integrated international trading across Exchanges. Similarly, the linkage between the Frankfurt Exchange owned by the banks, DTB, and its Paris counterpart, has yet to come to fruition. It therefore remains to be seen whether this or other international alliances will flourish or peter out, and whether alliances will be extended beyond Europe, and into additional time-zones.
The information in this document about OM, OMSI, OM Stockholm and OMSI is based on interviews with Peter Cox, Business Development Director, OMLX, London, and Peter Fagerberg Technical Manager, OMSI, Stockholm, in London, on 2 June 1994, plus a demonstration and explanation of the Click Trading software provided by Debbie [I don't have Debbie's surname!], Market Support Manager, OMLX, London, and written materials provided by the company.
The information in this document about ÖTOB is based on an interview with Christoph Oberrauch, Trading Support Manager, in Vienna, on 14 June 1994, and written materials provided by the company.
This version of the document is a draft, which has not yet been checked by OMLX or ÖTOB.
I express my appreciation to OMLX, OMSI, ÖTOB and their staff for their assistance in preparing this case study.
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