systems

Sep 01, 2000 9:30 PM  By

Derivative Solutions First it was “disintermediation,” then it was “reintermediation.” The e-supply chain can’t seem to figure out which way it wants to go. But in a virtual marketplace, does “intermediation” really matter?

Probably not, because the supply “chain” isn’t really a chain at all in the virtual marketplace. The e-market is truly a worldwide web of interconnected affiliations – or at least it has the potential to be. Partners, affiliates, enablers, and yes, intermediaries, can proliferate in myriad ways to facilitate an infinite variety of deals and transactions. A commercial exchange or portal site doesn’t have to take responsibility for managing them, either. It must merely facilitate them.

Going for brokers The intermediaries in real markets often perform some type of broker role. Instead of taking ownership of a product, they may own only the risk (and the benefit), or leverage the capital investment, or invest in derivative contracts for products to be delivered in the future. Indeed, such brokers play a vital role in making markets work. The supply chain would rust without them.

We are now beginning to see these kinds of futures brokers in the e-marketplace. onExchange.com, Inc., in Waltham, MA, is a hybrid commodities market and software company, providing online markets with a comprehensive derivatives trading capability. The company, which started in February 2000, plans to offer digital derivatives on everything from plastic pellets to newsprint. If it has its way, it will become the one-stop shop for risk-reduction strategies on e-commerce exchanges.

A word about derivatives: Derivatives are financial instruments whose value is based on another instrument, such as a commodity or a stock. They can protect businesses with fixed-cost contracts when those prices fluctuate. For example, a company locks in oil at a certain price, but owns a derivative that gains value if the price of oil goes down. While agricultural products and oil have long been traded as commodities, products of the new economy are not widely traded. But there is a demand for this in the e-market, says Richard Jaycobs, onExchange’s co-founder and CEO.

“If I want to buy 100,000 widgets from you next summer – and have you commit some of your factory’s capacity now – I’m going to need to determine a price for those widgets now,” says Jaycobs. “Where do I get that price? We create a whole new cast of market participants, people who are experts at trying to price out the forward-risk management contracts.”

Derivatives are a “very useful risk management tool available in a small set of industries,” said Peter Kollock, the company’s co-founder and executive vice president of research and development. “We want to offer it to other industries that want to lock in future prices.”

Indeed, the company has applied to become a fully regulated commodity futures and options exchange to offer an array of derivatives products comprising both regulated and unregulated instruments that can be tailored to meet dynamic market requirements.

Digital trading onExchange is building a fully Web-based derivatives exchange where online marketplace customers can trade derivatives with maximum flexibility and minimum cost. The company’s “digitalDerivatives” framework combines elements of conventional futures and options exchanges and other derivatives markets with innovations optimized for Internet-based transactions. These innovations include:

Embedded derivatives. onExchange’s Web technology supports listing of derivatives products side-by-side with cash products on B2B exchanges.

Direct market access. As they do in the cash market, B2B exchange customers will be able to trade derivatives without going through a broker intermediary (but those market participants who choose to use a broker will also be accommodated).

On-demand product creation. As one of its most impressive innovations, onExchange is building an authoring tool to enable rapid design and deployment of new derivative instruments as well as the instantaneous modification of existing products.

Granular markets. onExchange’s Web-based system can support markets and instruments of any size, driven by customer demand, not the minimum-size restraints imposed by private network systems (this is what will extend the derivatives marketplace outside of its traditional niches).

Regulatory certainty. Regulated derivatives, including futures, provide advantages over other alternatives in many risk management and trading applications. As a regulated commodity exchange, onExchange will enable its business-to-business exchange partners to offer regulated derivatives.

Flexible clearing: onClear – onExchange’s clearing system – supports bilateral and multilateral clearing models found in online exchanges and futures clearing houses respectively. To streamline credit management for online exchanges and their customers, onClear will enable clearing methods and collateral types that are consistent with commercial and financial practices in the related vertical markets.

Financial infrastructure. To ensure the highest possible financial security of onExchange transactions, onExchange coordinates the activities of an infrastructure of banks and other financial institutions that provide credit support, enhancements, and guarantees at the customer and exchange/clearing levels.

Trading technology At its core, onExchange.com provides a trade-matching engine for derivatives products that can be modularly integrated with matching engines used by B2B exchanges. However, the matching engine is only part of the technology platform. onExchange’s trading system and onClear clearing system also include real-time risk management and credit/collateral accounting, position management, clearing and settlement, banking, data reporting, foreign currency, and product design tools.

At the moment onExchange.com is one of only a few companies looking to set up public Internet commodities exchanges. Are they on the right track? Says Heather Ashton, director of business strategies for Framingham, MA-based Hurwitz Group Inc., “They’re early to market and there’s a need.”

In short, onExchange hopes to drive liquidity in the B2B exchange arena by offering creative tools for risk management in online marketplaces. This is the kind of innovative company that can truly redefine the dynamics of the e-marketplace to take full advantage of its fluidity. Fluidity . . . liquidity: kind of makes sense, doesn’t it?