Plugging New Products into Exchange Power
— Unleashing the flow of power to entrepreneurs —

by Richard Friesen

Regulated exchanges have a new opportunity to tap into entrepreneurial energy, creativity and capital. The staid and conservative exchange environment is bursting with change and potential as regulatory changes, upstart exchanges and electronic trading roar onto the scene.

We are going to examine a critical factor in the ability of regulated exchanges to respond to these changes by examining the relationship between flexibility and structure. We will propose moving a single function from the structure side of the ledger to the flexibility side. This single change could unleash currently undiscovered and highly profitable entrepreneurial activity leading to a new wave of increased trading volume.

The best way to understand the tension between flexibility and structure is to look at the straight forward example of our electrical grid. Behind the wall sockets in our homes, we want a stable system supplying electricity to meet our needs. We will make the trade-offs necessary to have a structure that delivers 120 volts of power (or 220 for our high voltage overseas friends) without interruption; scalable, reliable and secure. Behind the wall socket, we want to avoid risk.

On the front side of the wall socket, we have the opposite story. No one wants the local power company to design computer monitors or decide what electrical appliances and features we should have. Here, we want to see the full force of our entrepreneurial economy producing new products and services that improve our lives. In short, we want Adam Smith's invisible hand plugging in the newest model.

Historically, our regulated exchanges have used this model to create liquidity. Just as you could not determine what appliances would be invented by studying the electrical grid alone, exchange rules could never describe the actual activities on an exchange floor. Trading floors are complex adaptive systems that are dynamic, creative and flexible.

The combination of a trusted environment (structure) and the trading floor (flexibility) produces pools of liquidity that can handle a wide variety of order types, sizes and complexity. We have regulated exchange structure behind the wall socket and entrepreneurial trading activity on the front side of the wall. So far, so good.

However if we examine the new product development efforts of existing exchanges, we see a very different picture. As a former chairman of the new products committee at the Pacific Exchange, I know from experience that most products, industry wide, have failed. The CME and the CBOT's new product success rate is under 5%. The problem is that we are asking a non-entrepreneurial, risk-averse structure to willingly tackle risk, over and over again.

The current rate of innovation in this industry is stifled because the whole ground of being of a regulated institution is at variance with entrepreneurial spirit. The people who excel at running complex operations don't want to see their pictures in the newspaper, ever. For the entrepreneur, such publicity is the stuff of life. Behind the face plate, the natural flow of capital is toward creating a more robust infrastructure. In front of the face plate, entrepreneurial companies will consistently choose to funnel all available money into developing new and untested products. Behind the wall, command and control is the name of the game. In front of face plate, we look for visionary commitment to the products of the future. It is no wonder that the OTC marketplace, with its emphasis on flexibility, has grown faster than the regulated market place in spite of the higher capital requirements, greater overhead and increased credit risk associated with peer-to-peer clearing.

In the past, and in spite of the stretch, exchanges have been able to straddle both sides of the face plate because the rate of change has been restricted by regulation and legacy technology. Now however, with the presence of new technology, global competition and regulatory relief, the pace of change is accelerating. The wall plaster around the electrical socket is starting to crack with the stress.

What is an established institution to do? I propose that we move new product development to the front side of the exchange face plate. Market makers make markets. Brokers broker trades. ISVs provide trading software. Why not allow an innovative class of New Product Entrepreneurs (NPEs) to develop new products?

New Product Entrepreneurs (NPEs) are developers of new derivative products who come to the party with domain expertise, sales ability, new capital and fresh ideas. A NPE could be a start-up or large hedge fund. It could be a bank or an association. The point is, these entrepreneurs can arrive at the exchange doorstep with an understanding of existing customer needs, or a vision of needs not yet felt. The creativity of the entire financial community can be channeled into new products and subsequently tested in the marketplace.

Here is the deal. The exchanges provide the infrastructure, including all the technology, data centers, and communications. They also provide the regulatory and compliance functions. Once approved by the exchange, the NPEs develop products, arrange for liquidity providers, and take responsibility for marketing and sales costs. In this model, it is the NPE that takes the new product risk, not the exchange. Because NPEs are providing their own risk capital, they are motivated to succeed. Both the exchange and the NPE can share the exchange fees creating a win for both with a successful product.

The exchanges get to do what they do best; the entrepreneurs get to do what they do best. With electronic markets, a whole new world of niche products and auction types can grow and thrive under the care of the NPE. These new products might look very different than conventional derivatives. They might include seasonal trading, one week out of the year, or topic products that grow and die in a few weeks. They might include more complex semi-fungible products. They might include a mix of continuous and auction markets to create liquidity on several levels.

It might help to look at the Silicon Valley model that has produced incredible value over the last 30 years. The law firms, venture capitalists and accountants created the infrastructure. The entrepreneurs created the products. Just as we could not predict the invention of computers from looking at the electrical grid, we will not be able to predict what products will be developed for our regulated exchanges if we unleash our entrepreneurial friends.

Oh, and let me tell you about this great idea I have for an option product …

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