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June 4, 2007

Derivatives Markets Lack Liquidity

By Peter Chapman

Finding liquidity on derivatives exchanges is no easy job.

Despite record trading volume, buyside traders, according to a recent study, say their No. 1 problem is getting filled. Their frustration comes at a time when involvement in derivatives markets by money managers is on the upswing.

A new report from the TABB Group on the use of futures and options by institutions notes that traders looking to buy or sell contracts tied to large-cap stocks or popular indices fare well. But those who need to trade less mainstream contracts suffer.

"Strategies that employ out-of-the-money or long-dated derivatives cannot depend on the listed markets for size," according to TABB. Traders must instead "rely on dealers to commit capital." The problem is especially acute for smaller money managers, says TABB, because they're more likely to trade less conventional products and lack strong relationships with dealers.

The dissatisfaction with the dearth of liquidity comes as both hedge funds and traditional money managers step up their derivatives trading.

TABB reports that derivatives constitute 19 percent of the value of hedge funds' balance sheets and 8 percent of that of traditional money managers.