Navigating Market Structure: Considerations Beyond Trading Methods

According to Rudolf, Stephen (1994) The most frequently asked question in the area of market structure is whether a new exchange should use upon outcry or electronic trading. This, however, is not the most important issue in market structure or development. Nor will the answer necessarily be the same for all markets, because of the varying abilities of different potential exchanges to meet the capital and technological requirements for electronic trading. More generally, an exchange must be able to survive in the environment in which it is operating.

This environment includes the state of the development of the underlying cash market, the linkages with this market, the type of competition the exchange will face, and the type of market participation anticipated the availability of risk capital, the nature of potential market-makers, and the strength of the financial infrastructure. Issues such as these should be addressed before turning to the question of the appropriate method of trading.

Specific market structure issues include whether derivatives exchange should be part of the exchange for the underlying product (in the case of equity derivatives in particular) or whether it should be a separate entity.

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Most successful derivatives exchanges are separate entities, but there are advantages and disadvantages to both approaches. There is also the question of the type of organization of the exchange. Most exchanges are membership organizations. They are owned and managed by their member, but other forms of organization, such as for-profit corporation, are possible.All futures exchange have had to adapt to a changing environment.

They have had to address such issues as an expanded trading day, growing international participation, and a rapidly changing technology.

Exchanges which continue to rely on open outcry are no exception. Open outcry trading markets today use very different technologies for many functions, such as order transmittal and record-keeping, than they did a few years ago. This is simply one example of a fundamental fact about markets, and financial markets in particular. The efficient market structure is a moving target. It varies from country to country and from market to market within that country. It can also change very quickly. Those planning to enter the market must be prepared to be flexible. Pandey (2008) According to Michael (2016) The study found that the Kenyan Financial market is still in the development stage as characterized by the domination of over the counter financial derivatives like forward contracts, options and swaps and the non-existence of the more sophisticated exchange traded financial derivative instruments like structured notes and credit derivatives.

Usage of financial derivatives in Kenya, was also found to be enabled by the need for firms and financial institutions to hedge risk of losses from volatility of interest rates and the fluctuating value of the Kenyan currency. Support services as described by Peetz and Genreith, (2011) include all the other promotional activities that assist in marketing the derivatives market and growing it through research and development and agitation of its interests. Support service range from marketing services, support from academia, research and development and support from interest groups. Marketing needs should be targeted at all levels of participants whereby intermediaries like brokers need to be sold the idea that derivatives will help their business. The investors need to understand how different tools can help them in their investment objectives. The general public would need to ideally understand what derivatives are and how they work. This is needed to counter the scathing attacks from the media and politicians King & Mallo, (2010).

It also addresses lack of product knowledge amongst both investors and professionals like brokers, exchange personnel and fund managers; which limits the capability and demand for product development. It also includes inadequate competition in the securities industry due to brokers who are unfamiliar with the products hence makes derivatives trading unattractive and absence of affordable, efficient electronic platforms due to a misguided belief that open-outcry trading is more suitable for derivatives! (King, & Rime, 2010). It goes further to address issues touching on liquidity in the underlying market which implies that there should be interest in the asset itself and therefore a demand for investors to use derivatives to hedge their exposure to that asset. It also addresses market inefficiencies like counter-party inflexibility where a buyer of a future might find it difficult to get out of the delivery obligation if he decided he did not wish to deliver.

It also involves complexity of trade execution where for instance an investor who wishes to track a benchmark index may find it impossible to immediately buy or sell the full set of constituent index stocks. Further it addresses stifling trading rules like the ban or restriction on short selling which is enhanced by use of a future or an options contract. If the underlying market is subject to taxation that increases the cost of trading, a derivatives market can provide some relief. Barriers to trade for wanting to protect its own commodity producers can be sorted by a derivatives exchange within that protected territory by allowing an island of liquidity for locals barred from using overseas exchanges (Peetz and Genreith, 2011).

Other issues that ought to be streamlined include fear-based attitude to derivatives that they disrupt the underlying market but this should be countered by the many studies that have indicated that derivatives have either a benign or positive influence on the underlying market. Existing competition from surrogate derivative products should also be countered by the fact that a derivative market addresses inefficiencies which are not met by existing products or services. Introduction of warrants and other structured products can be a useful stepping stone to introduce investors to the concept of leverage and risk management through derivatives. Also if Exchange traded funds are traded on margin, they give something very close to the risk profile of a something very close to the risk profile of a futures contract and could provide competition to index futures. Lastly it may be legitimate for a home market to create a futures market solely to pre-empt foreign competition, regardless of the likelihood of success (Ross et al 2011).

Research and development is the key to innovations in the derivatives market. This should be encouraged internally through establishment of research and development departments within the investors and other users' organization structures. The market research institutions and academic institutions can also be encouraged to do research on derivative instruments. The government can also participate through the capital markets authorities and national research institutions. Support groups include the associations of the derivatives market participants like the dealers associations, brokers associations, data vendors and lobby groups like consumer organizations. These groups have the ability to sway public opinions and affect the derivatives markets. There is need for the derivative market participants to cultivate a good working relationship with the support groups so that they can get positive criticism and support where possible (King & Rime, 2010).

The derivatives market participants can boost trade in the derivatives market if they possess the right set of skills while any shortcomings in the same can be a source of challenges in the usage of financial derivatives. Investors and users in a derivative market include the professional traders, retail investors and institutional investors who engage in the derivatives market with an aim of securing returns on their investments. A truly successful derivatives market should have professional traders, retail investors and institutions all contributing in reasonable proportions and ideally, the type of brokers one targets when trying to secure participation will be ones who can provide a mix of all three types of users. In practice, this rarely happens and the market tends to be dominated by one group or another (Ross et al