What is an Alice Market?
An Alice Market is an innovative, end-user-driven venue for the creation, administration and settlement of derivatives.
Derivatives are financial contracts, settled at some point in the future, where the contract’s value at settlement depends on the value of another financial instrument or economic index, called the “underlying”. For example, the contract settlement value may be tied to an underlying interest rate, a stock market index, a credit market index, a climate value (such as monthly temperature), or a currency value. A derivative contract may be established to settle a week hence or years hence but those that are electronically traded are typically tied to fixed periods such as three months ending in a particular month.
An Alice Market enables end-users and investors to create flexible contracts that meet their hedging and investment needs in a real-time, secure and anonymous electronic market. It also ensures that participants are not exposed to the possible failure of the parties with whom they contract.
Frequently Asked Questions
What is an Alice Contract?
An Alice Contract is a special type of derivatives contract. In an Alice Contract, the underlying is segmented into discrete elements which may vary in size and number but must not overlap and must collectively cover all possible outcomes. Only underlyings that are amenable to this segmentation can be the basis of an Alice Contract. The segmentation of the underlying is chosen by the operator of the Alice Market with a view to how the contract might be most often used.
An Alice participant, called an Ordering Party, assigns financial amounts to each element of the underlying according to their desired payoff profile. An assigned amount must be a fixed number, even if the element represents the “tail” of an underlying, that is, the set of outcomes at the extremes of the underlying.
Payoff amounts assigned to elements in an Alice Contract can be negative. These represent an offer by the Ordering Party to pay the amount rather than receive it, for example because a business expects to save money if the final outcome falls within that element. Offering to pay on an element would typically reduce the overall price of the contract.
The following example shows the payoff profile for an Alice Contract in the underlying “Total Snowfall in the Australian Alps”. Such a profile might be used by a snow clearing firm to hedge its potential costs for snow clearing.
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What types of products can be created in an Alice Market?
Because of the ability to specify varying element structures and the ability to assign varying positive and negative payoff amounts to the elements, Alice Contracts can approximate the payoff profile of a wide range of cash-settled products, including options and swaps. The Alice Contract may not be a perfect match to a traditional product but it may suffice for the purposes of hedging business risk. Below is how an Alice Contract might emulate a call option. In this example, the element “R” in the Alice Contract represents the “tail” element covering all outcomes larger than the value R.
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How are Alice Contracts priced?
Alice participants called Counterparties maintain unit prices in the Alice system for each element in the underlying. Their function is similar to market makers in other markets however any Alice participant can be an Alice Counterparty. Counterparties base their unit prices on, amongst other things, their own estimate of where the underlying will fall at settlement and the cost of hedging the risk they take on. For example, in the Snowfall example, they may require $50 per $10K for the element “Snowfall 350 to <375 cm” but $100 per $10K for the element “Snowfall ≥ 425 cm” because it may be harder to hedge an exposure in that element.
The Alice Market uses these unit Counterparty prices to calculate an overall weighted price (called the Premium) for the payoff profile entered by the Ordering Party. The Counterparty with the set of unit prices that results in the lowest Premium for a profile is automatically matched with the Ordering Party.
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What does it mean to split or slice in the Alice Market?
An Ordering Party can slice the payoff profile horizontally or split it vertically which may result in the overall profile being fulfilled by multiple contracts with different Counterparties, each with a different Premium price. Splitting or slicing may be necessary if Counterparties place limits on the net exposure they will take in a given element or if no single Counterparty offers an attractive overall price. Some Counterparties may specialize in pricing certain elements and an Ordering Party can take advantage of this by splitting off those elements for separate pricing. The following example shows how the profile for the Snowfall contract might be split and sliced.
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How are Alice Contracts traded?
Ordering parties have screens on which to enter their payoff profiles and may also use a computer interface to generate the profile. Counterparties have screens and computer interfaces that enable them to enter and continually adjust unit prices for elements and to set limits on the exposure they may assume. The profiles and prices are submitted to the Alice trading engine which determines which Counterparty’s set of prices yield the lowest Premium price for a profile. If the Ordering Party has specified the profile submission is for “price discovery”, then the Premium price is displayed to the Ordering Party but the contract is not executed. Otherwise, provided both parties have the funds available and limits are not exceeded, a contract is automatically established between the participant who is acting as the Ordering Party and the Counterparty providing the lowest Premium for the submitted profile.
Trading in the Alice Market is completely anonymous and secure. Both the Ordering Party and the Counterparty can see the range of unit prices being quoted for each element in the underlying and the unit prices at which completed trades were made but not who made them. The Counterparty never sees the full profile entered by an Ordering Party so cannot adjust unit prices based on the shape of the profile or “game” an Ordering Party based on a price discovery request.
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How can liquidity be supported in an Alice Market?
Counterparties take on the obligation to pay out on the customized payoff profiles of Ordering Parties and need to hedge the risk they assume. One way they do this is to act as Ordering Parties themselves. However, instead of requesting a multi-element payoff profile, they may hedge their risks by using multiple, elemental contracts. Elemental contracts are simple Alice Contracts with payoffs of a standard size requested for only one element in an underlying. For example, to hedge the Snowfall example, a Counterparty may take out multiple $10K contracts for the element “Snowfall ≥ 425 cm” and multiple $10K contracts for the element “Snowfall 325 to <350 cm” and so on. These elemental contracts are more likely to be liquid, meaning they are frequently traded and competitively priced so a participant can expect to execute a contract at a reasonable price whenever they need to. Depending on the type of underlying, a Counterparty may also hedge their Alice Market exposures in a non-Alice exchange-traded market.
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How does the post-trade process work in an Alice Market?
All Alice participants are required to have Alice accounts at Alice’s designated custodian bank, which is bankruptcy remote from both the Alice Market and Alice participants. Ideally the custodian bank is a central bank. The Alice Market has an integrated central counterparty (Alice CCP) which also holds the funds it collects with the same custodian bank.
Before it executes the trade, the Alice Market confirms that the Ordering Party has the funds in their Alice account to immediately pay the premium for the contract and that the Counterparty has the funds (the collateral) to pay out the worst-case payoff amount at settlement (that would be $70K in the Snowfall example). If the Ordering Party has offered to pay out on any elements, funds will be collected from them to cover the worst case payout. The Alice CCP becomes the party to both sides of the contract at the point of execution and immediately transfers the collateral for the worst-case amount from the participant’s Alice account to a sub-account for the participant at Alice CCP.
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How does an Alice Market manage netting and collateral?
Alice CCP allows participants to net their collateral obligations only across contracts of the same duration and underlying. It further requires the collateral for the worst-case payout be in cash in the currency of the contract. These restrictions mean the Alice CCP is “fully collateralized”, meaning it always has the necessary collateral to pay out on all contracts at all times. Provided it is not forced to prematurely close out a contract, it is never exposed to the failure of a participant. The Alice CCP is a relatively simple operation and does not require complex risk calculations, margining or a default fund.
If a larger CCP decided to support an Alice Market, it might allow netting of obligations for other markets it supports against Alice CCP collateral. However, it must still keep the required Alice collateral safely segregated within the Alice CCP at all times. The fundamental Alice principle of full collateralization at all times cannot be compromised.
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Does a participant need an intermediary to trade on the Alice Market?
By pre-funding their Alice trading account at Alice’s custodian bank, a participant can trade on an Alice Market and participate in the Alice CCP without an intermediary. They need only satisfy Alice’s “Know Your Customer” checks.
If a participant wishes to take advantage of credit to fund their trading, they can establish a separate credit agreement with an Alice lending bank to support their trading account. Alice lending banks keep funds available at Alice’s designated custodian to support this function. If a participant’s own account cannot fund the collateral required for a trade, funds can be provided by the Alice lending bank up to a limit set by that bank for the participant. The lending bank has the ability to dynamically monitor and change the participant’s limits within the Alice CCP. Alice CCP itself never has a credit agreement with a participant or a lending bank. It requires immediate cash payment for price and collateral at point of trade whether the funds are from the participant’s account or the lending bank’s account.
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What are the advantages of an Alice Market over traditional derivatives markets?
A wide range of derivatives, including futures, options and swaps, are traded in markets globally now. Current derivatives markets have several inherent issues.
First, current derivatives markets allow open-ended contracts where the settlement amount is extreme because the underlying at the time of settlement turns out to have a value at the tail end of its possible range, an outcome which parties to the contract may not anticipate. This “tail risk” was evident during the financial crisis, for example, where AIG contracted to pay out if structured products based on home mortgages experienced losses and clearly did not anticipate the actual level of loss. In an Alice Market, a large amount may be assigned to the tail element but it cannot be open-ended and is always known. This does mean that a participant using an Alice Contract to hedge must always retain some extreme risk but it does not concentrate the tail risk in a central place.
Second, current derivatives markets deal with the so-called counterparty risk that one party will not pay out on its contract at settlement by margining. A down-payment, called the initial margin, is collected when the contract is made and then additional variation margin is collected depending on how the daily change in the underlying affects the ultimate settlement amount. Margining requires complex, daily risk calculations and daily collection of margin payments, payments which rarely cover the full potential loss at any instant but only an informed estimate of it. Margining may be suitable when the underlying stays within predictable bounds but when the underlying behaves unpredictably, as happens in times of crisis, the party collecting the margin will demand large amounts quickly to cover the increased counterparty risk, causing cash flow problems for the owing party and potential loss for the collecting party.
If the collecting party is a central counterparty (CCP), such as a clearing house, it may need to use other parties’ collateral, a default fund contributed to by members, or its own equity to cover the failure of one of its members. The result can be instability in the financial market as a whole and a possible need for government bailouts. By contrast, an Alice CCP always has the required collateral to pay out, does not need to continually margin and does not need a default fund.
Third, in current derivatives markets, calculating exposures and collecting margin daily is time critical and imposes strict payment deadlines on CCP members. The CCP must further protect itself against potential failure by requiring members to contribute substantial amounts to a default fund. The time-critical margin collection process and the requirement for a default fund mean only well-capitalized institutions can be direct clearing members of a traditional CCP. All other participants have no choice but use clearing members to process their trades. The clearing firms pay the margin to the clearing house on a participant’s behalf but will in turn require the participant to maintain excess funds with them to cover any likely variation margin. Some clearing firms have failed, resulting in the loss of these excess funds, MF Global being a notable recent case. All participants, including retail participants, who meet basic “Know Your Customer” checks, can trade on an Alice Market and participate in Alice CCP.
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How will current derivatives regulation affect an Alice Market?
Alice believes the underlying invention is even more relevant today in the wake of the financial crisis in 2007. The Company has met with industry experts in the United States and elsewhere to determine how changes in the industry structure affect the prospects for an Alice Market and has received considerable positive feedback. Alice has monitored the recent regulatory developments in Australia, the United States and Europe to ensure they would not preclude an Alice Market being established.
Recent submissions to regulators include:
United States
Australia
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