Innovation in Listed Derivatives

A Switch in Innovation Strategy
Innovation and the creation of new listed derivative products were once the engines of growth for established exchanges. But with demutualization, exchanges have increasingly focused growth initiatives on well-established successful listed products.

At the current size of these products, a one or two percent increase in volume becomes a significant driver of revenue. By contrast, a new contract, even if moderately successful, would hardly move the revenue needle.

This change in focus by established exchanges offers a unique opportunity for startups to create new listed derivative contracts based on innovative asset classes. Startups by nature understand that the success of their idea is binary; it is either going to work or not and are willing to take that risk.

In recent years, Connamara has seen an increase in entrepreneurial clients looking to create new classes of listed futures and options contracts. Their goal is to bring price transparency, price discovery, and risk transference to markets where these tools do not exist. The asset classes of these products range from freshwater to transportation, from healthcare to hemp, from cryptocurrency to energy, and everything inbetween.

Creating a New Futures Exchange
To create, list, and trade a derivative contract based on a new asset class, the entrepreneur is required to obtain approval by the Commodity Futures Trading Commission (CFTC) as a Designated Contract Market (DCM). This is the same regulatory framework and designation that the largest established futures exchanges follow. The value to the startup of obtaining the DCM status is legitimacy, access to the established marketing channels, and central counterparty clearing.

The DCM approval process can take anywhere from twelve to twenty-four months to complete. This timeframe is reasonable when one considers the impact a failed exchange would have on our industry. The issue for a startup looking to gain approval is more of timing and sequencing of the requirements to gain approval rather than the length of the approval process.

To gain approval, the startup exchange must be completely setup and ready to trade. This means that the technology must be in place (fully redundant) and the exchange staff must be hired and trained (including support staff, compliance staff, and executives). Agreements with the clearing house must be executed, agreements for third party trade practice surveillance must be in place, SLAs and contracts with other third parties must be in place. The funds for post-launch operations must be in the bank.

All this pre-approval preparation requires capital. Capital that an early stage startup finds very dear and hard to justify to investors.

However, from a regulatory point of view this makes a lot of sense if the day after approval the new exchange will indeed commence trading. In our experience, only in the rarest of cases will a startup exchange have customers ready to submit orders on that first day after approval. For a startup exchange there is marketing and education that must be done, FCMs must agree to let their customers trade on the new exchange, changes to the FCM back office systems must be made to book the trades from the exchange, trading platform vendors must become connected to the exchange and be certified by the exchange. In other words, a lot of things must be accomplished post-approval – all with associated costs and uncertainty.

For a startup exchange, having the staff trained and ready, fully deployed technology, and executed, paid-up contracts with service providers in place, prior to gaining CFTC approval (6 months or more), presents quite a funding challenge. Add to this, that many times venture funding rounds are triggered by the crossing of the approval hurdle.

Regulatory and Industry Support
We agree that the above mentioned requirements must be met prior to the startup exchange being allowed to accept and match orders. The regulations in place protect our customers and our industry. However, it seems that if we truly want to promote product innovation, there should be instituted levels of approval or a possibly conditional approval granted that would allow the startup to hire staff, raise funds, complete the technology build-out while carrying out marketing, education, and garnering FCM and industry support for the product.

These entrepreneurs represent a true avenue for industry growth and expansion. They should have both regulatory and industry support to foster the innovation needed to move our industry forward.
To learn more about how Connamara can help startup exchanges click here.

Leave a Reply