Montreal exchange Inc. sees huge growth potential in equity options because it believes equity options are risk-mitigating tools that retail investors should be using. The stumbling block is getting advisors to take the training required to sell them.

Currently, options account for about one-third of the MX’s transaction volumes and revenue, and president Luc Bertrand thinks that could easily rise by 50%.

Futures, the MX’s other derivatives business, is strong. The exchange already has 30 of the 40 biggest international players registered and expects to have the other 10 signed up within 18 months. These “foreign approved participants” are connected directly to the MX trading platform and account for more than 50% of the open or current futures contracts on the MX.

Expansion of its product lineup is part of the MX’s strategy. It plans to increase its options coverage to 125 Canadian stocks from 85, and add five- and 30-year bond futures to its current 10-year contracts. MX is also considering issuing a variety of single-stock futures, contracts on individual stocks. The MX launched one on Nortel Networks Corp. in January 2001, but it wasn’t very successful because of Nortel’s accounting issues and was discontinued in 2003.

Transactions accounted for about 44% of the MX’s $19.1 million in revenue in the first quarter of 2006. Other major revenue sources:

> Clearing And Option Exercise. This brought in $3 million, or 16% of total revenue in the first quarter of 2006. The revenue comes from fees charged for processing and guaranteeing contractual commitments made by participants.

> Information Systems Services. This generated $4.1 million, or 21% of revenue in the first three months of this year. This comes from fees for running the operations of Boston Options Exchange LLC, an options exchange (known as BOX) launched with three U.S. partners in 2004. The MX is the first foreign-based exchange allowed to run a U.S. exchange.

> Equity Income. The MX owns 31.4% of BOX; the MX’s share of profit is accounted for as equity income. In the first quarter, this was $631,000.

> Market Data. Sales were $2.5 million, or 13% of revenue in the first quarter of 2006. The MX disseminates to subscribers, through about 24,000 terminals worldwide, information on the Canadian financial derivatives market, including quotations (bid and ask prices), number of trades and number of contracts running at any given time (referred to as “open interest”).

The MX’s growth has been very strong since 2000, the year it demutualized and started to specialize in derivatives. Revenue, at $63.1 million in 2005, was up 81% from 2001, the year the exchange became fully electronic, while net income has soared, to $15.1 million from a loss of $2.7 million. First-quarter earnings were $4.9 million vs $3.2 million for the same period a year earlier, excluding non-recurring items.

The MX normally generates a lot of cash — $25.1 million after net change in non-cash working balances in 2005. There was an aberration in the first quarter of 2006, when cash flow turned negative due to an increase in income taxes payable as tax-loss carry-forwards ran out.

Assets were $153.5 million, with virtually no long-term debt. Shareholders’ equity was $67 million, or $7.70 for each of the 8.7 million common shares.

The MX is not publicly listed. Shareholders are mostly financial institutions that had been members of the former Montreal Exchange that received their shares at the time of demutualization. These shares can change hands privately.

Bertrand is pleased with the financial results and with progress in the strategy of expanding trading volumes, expanding the product lineup and leveraging off of core competencies in financial markets, clearing services and IT. He is, though, frustrated by Canadian attitudes toward derivatives, particularly among regulators.

Bertrand believes Canadian financial advisors need to have derivatives, particularly equity options, in their toolbox in order to mitigate risk. “As the population ages, people are not just looking for a good return; they also become risk-averse,” says Bertrand. “Derivatives are a good tool for this, but they are complicated so advisors need to be sophisticated.”

Bertrand estimates that only 10%-15% of brokers have taken the separate course required to become licensed for options and futures. In the U.S., derivatives are part of the equivalent to the Canadian securities course there, so everyone is automatically licensed for them.

@page_break@“We’ve been arguing for years for mandatory derivatives training at the Canadian Securities Advisory Council but have gotten no support,” says Bertrand. (The CSAC, which meets quarterly, includes the Toronto Stock Exchange and the soon-to-be-merged Investment Dealers Association of Canada and Market Regulation Services Inc., as well as the MX.)

One problem is that derivatives are perceived as risky, speculative investments and not as risk mitigators. However, Bertrand is encouraged by the move last fall by the federal government to allow put options in RRSPs.

The MX is doing what it can. Its training arm, launched in 2001, offers 50 courses online. In 2005, some 5,000 individuals took at least one of these courses. The exchange was also encouraged when the Université du Québec à Montréal started a one-year master’s-level diploma in derivative products in early 2005. There were 63 students registered in the program as of March 2006. Graduates most often become risk managers, analysts or sophisticated portfolio managers.

The MX is unusual in that it is a diversified exchange that offers both options and futures; most countries have separate exchanges for these. It also owns its clearing corporation, develops its trading technology in-house and is an IT service provider. This gives it both diversification in its revenue stream and a larger number of transactions and activities over which to spread costs. It also makes the MX particularly desirable as an acquisition. Certainly the TSX, which has a non-compete agreement with the MX to stay out of options and futures until 2009, would like to acquire the MX.

However, Bertrand has other plans: “We are focused on building our business, not on selling it. The MX’s intention is to continue to lead the derivatives market to its full potential. The MX was first to introduce derivatives in Canada more than 20 years ago. We have key expertise and have just developed a next-generation trading technology that gives the MX an edge in the global exchange market. The MX is the largest shareholder and the operator of an options exchange in the U.S. — the most dynamic market — and our impression is that we are just starting to build momentum.”

Here’s a closer look at the MX’s key operations:

> Equity options. Besides stock options, the MX offers a U.S.-dollar product that allows investors to hedge their currency exposures to fluctuations in the Canadian/US$ exchange rate.

In the U.S., the MX, through BOX, is the only one of the six options exchanges using a competitive market model, in which market-makers compete to fill client orders, rather than the traditional specialist model, in which one specialist on the floor fills the orders without competition. This gives BOX an advantage, given the concern in the U.S. about abuses by specialists, says Bertrand. BOX is also one of only two options exchanges that is fully electronic. BOX will add to its 500 listed option classes once it has moved to the MX’s new trading system, SOLA (see below for description), scheduled for September; there are 2,200 possible listings. BOX has doubled its market share in 2005 to 7%, and Bertrand believes there is huge potential in the growing U.S. options market.

The challenge in the U.S. market is keeping up with the technology to manage the ever-increasing number of electronic messages to and from the trading system. That’s no problem for BOX because the SOLA platform is scalable, says Bertrand.

> Futures. This is mainly an institutional global business because the contracts are so large. For example, one three-month bankers’ acceptance contract has a notional value of $1 million, while you can buy an option contract for a single share. Expansion depends on organic growth and expanding geographically, which requires regulatory approval in the countries in question. The MX has been approved in the U.S. and Britain since 2002, and got approval in France in January. Although the MX does not rule out getting approval in other countries, its immediate strategy is to focus on the main liquidity centres for derivatives — New York, Chicago, London and now Paris — signing on and connecting FAPs to the MX market.

> Clearing. The MX owns 100% of Canadian Derivatives Clearing Corp. , which is rated AA by U.S. rating agency Standard & Poor’s Corp. CDCC is a critical part of the derivatives business because it reduces investor risk by guaranteeing all the contractual commitments made on futures and option contracts purchased on the MX.

CDCC has just completed the regulatory rule changes that will allow it to offer clearing services to the over-the-counter market. The MX believes it has a competitive advantage in this business because CDCC is offering a multilateral environment with 33 large financial institution clearing members, while the OTC market currently operates bilaterally. The potential is huge, given the size of the OTC market. Bank of Canada estimated the Canadian OTC business at US$6.1 trillion in notional value in June 2004, while the MX currently handles about $500 billion in notional value.

> Systems. The MX has developed a new trading system called SOLA, which it has been using since October. SOLA is very strong, very fast and very transparent, says Bertrand, adding that some say its ability to handle 200,000 messages a second per machine makes it the fastest in the world. The MX’s expertise in developing and running trading systems has been recognized in the U.S. The MX is also interested in selling SOLA.

> Other Growth Initiatives. The MX is also working with the Chicago Climate Exchange to create the Montreal Climate Exchange, the first organized market in Canada for environmental products. The plan is to develop trading, clearing, and registry services for Canadian environmental products, the first of which would target the Canadian carbon market. The MX has been pursuing discussions with the CCX and “has high hopes and confidence that it will play a leadership role in building this market of the future,” says Bertrand. However, he adds, this depends on the climate change policy adopted by Canada’s new Conservative federal government. IE