The derivatives burden

It was a bit of a waste really. On a sultry mid-June afternoon, at the end of London’s Derivatives Week event, a panel of market experts pondered the future of on- and off-exchange energy derivatives before a torpid audience. “It’s just as well the press aren’t here,” joked one of the panellists in a provocative bid to rouse the audience from its lethargy. Nevertheless, it was one of those days when a potent brew emerges from an eclectic mix of ingredients.

A quick warm-up discussion led by the jovial but sharp moderator, Clive Furness, chief executive of commodities, e-commerce and derivatives consultancy Contango Markets, established the issue for the day: regulation. The spotligh t was particularly on the European variety and on the area where it most affects participants – on the balance sheet, in the form of capital adequacy requirements.

Lynn Johansen, a partner at law firm Clifford Chance, painted an alarming picture. She evoked a Panzer division of directives advancing to crush energy market participants under the weight of capital adequacy requirements actually intended for investment institutions.

Not that she put it quite in those terms of course, but we knew what she meant. I can think of no-one better than Johansen at conveying to a patient that his condition is terminal.

Yet Paul Beynon, head of trading at UK energy firm Innogy, took the view that the energy industry neither knows nor cares what comes from Brussels – participants feel it cannot happen to them. He recorded the sad fact that a recent consultation on the issue by the UK’s Futures & Options Association (FOA) elicited just three responses. That did not do much to change the opinion of the relevant directorate in Brussels that its plans are sound.

The regulatory theme then gained momentum, albeit with fascinating departures into related subjects.

Richard Heyman, director of futures and options clearing at the London Clearing House (LCH), was, like the other participants, under threat of a ‘red card’ if he promoted his own firm, and was therefore unable to promote LCH’s Enclear initiative. Instead, he spoke movingly of the fragmentation of European energy clearing into – but we knew what he was getting at.

There was fairly general agreement as to the absence of any credible cross-border regulation and, furthermore, that end-users clearly want more transparency. Yet while some remarked on the current trend for banks to enter power trading as liquidity providers, no-one pointed out that, for these new entrants at least, transparency is the enemy of profits.

Indeed, an interesting point came up in relation to the desirability of infrastructure providers such as the UK’s BG Group acting as active market participants – namely, how impracticable ‘Chinese walls’ are in this area.

Conflicting purposes
By the conclusion, a theme was emerging, which Brian Harmon de Clare, global head of commodity origination and sales, of investment bank ABN Amro and Innogy’s Beynon came closest to identifying. They felt there is a fundamental and structural discontinuity in regulatory and commercial terms within energy and commodity market architecture, arising out of an underlying conflict between two of the main underlying purposes of derivatives markets.

Simply put, market participants have two key objectives: to secure supply and to secure price.

For a spot contract, the securing of price is merely an issue of credit. Where delivery is set for a point in the future, the time element introduces risk, and derivative contracts have evolved as a means of transferring that risk to intermediaries.

Supply contracts are essentially bilateral in nature – you ‘deal with the people you deal with’, whom you trust to perform the contract, which is a ‘two-way street’. In a rising market, the buyer seeks to ensure performance by the seller – in a falling market, it is the buyer who may be looking for reasons to abandon the contract and buy cheaper elsewhere.

On the other hand, derivative contracts securing price are essentially a matter of ensuring cash payment of the resulting profit or loss and are therefore multilateral in nature – at least once the credit issue is resolved. If the only criterion is the ability to pay, then in that case participants do not care with whom they deal – provided the credit condition is met by insurance or guarantee.

The problem is that the market architecture is such that security of supply and security of price are often merged in ‘hybrid’ contracts traded on hybrid exchanges. The hybrid nature of exchanges such as the New York Mercantile Exchange (Nymex) and the International Petroleum Exchange (IPE) has two main facets:

• deliverable – and therefore ‘hybrid’ – contracts, such as Nymex West Texas Intermediate crude oil or IPE gas oil, are for the most part closed out before delivery; and
• the multilateral relationship between members made possible by a clearing house guarantee ‘back-to-back’ with the bilateral relationship between the member and his client.

However, the objectives of market participants may preclude one of the two elements. Banks, for example, tend to have no interest in securing supply. So they will avoid any involvement in supply or deliveries, being interested in commodity or energy derivatives only in their pure ‘paper’ form – that is, they favour cash-settled contracts.

A regulatory framework has evolved to govern the activities of investment institutions – risk takers, in other words – and this has led to the need for regulatory tools such as capital adequacy requirements.

However, end-users – the counterparties of liquidity providers/market-makers – are in a diametrically opposed position: they wish to secure supply while offloading risk through securing price over time.

Regulators focus on the risks taken on by intermediary liquidity providers such as investment banks. However, the constituency of end-users has an entirely different risk profile from that of liquidity providers, since any derivative contracts are by definition balanced by supply contracts usually backed by capital assets often of monumental scale.

As ABN Amro’s Harmon de Clare asked, what is the relevance of value-at-risk to a power generator hedging forward sales?

But despite their differences, energy market participants are lumped together with investment institutions, because there has been no way to exclude them that would not allow banks to find major loopholes.

As we have seen, the fundamental problem lies in the hybrid structure of contracts and the markets in which they are traded.

Already legal protocols, such as the International Swaps and Derivatives Association (Isda) agreement, are having to be re-examined in the light of commercial developments. Innogy’s Beynon cites as an example the likely unenforceability of the ‘material adverse change’ clause.

Another problem is that the requirement for risk capital to back derivative contracts securing price is getting caught up with the entirely separate issue of the provision of credit in a supply contract: credit support annexes are now a fact of life.

Seeking segregation
What can be done to segregate the security of supply from the security of price and thus address such conflicts?

Existing market models, coupled with the development of standardised vanilla Isda terms over the past 10 years, may point to a solution.

Some market observers may recall a press release from Credit Suisse about three years ago during its acquisition of a seat on the London Bullion Market Fix – the traditional process that occurs twice a day whereby five men fix the price of gold.

It was to the effect that the London Bullion Fix methodology of an iterative auction offered the most efficient price-setting/benchmarking mechanism available – namely, the price at which most spot bullion will trade at that moment in time. Forward bullion, the physical market and derivative prices may then all be calculated by reference to this arguably optimally ‘discovered’ price.

The fact that Credit Suisse then pulled out of the bullion market last year just in time to miss all the Iraq-related excitement did not make their analysis wrong – merely their timing.

The London Bullion Fix and its London sister Fix in Precious Metals forms the basis for virtually all off-exchange trading in those commodities. Although there is significant trading on-exchange in New York and Tokyo in both bullion and precious metals, it plays a minimal role in the global price-setting mechanism.

A close cousin of the bullion fix is the London Metal Exchange (LME), with its multilaterally trading price-setting ‘rings’ – which set both spot and three-month prices – and bilateral telephone trading for the rest of the day.

However, the LME’s coupling of central LCH clearing with the provision of credit by members to clients for margins is possibly unique in the way it meets client requirements. As a result, it has been constantly attacked by US exchanges unable to compete for regulatory reasons.

More to the point, LME members have been fighting a rearguard action on the European capital adequacy front for more than a decade. They have been drawn into the capital adequacy regime due to their acting as principals and offering credit to clients and counterparties for margins.

Meanwhile, many observers believe the principal reason for the IPE's Brent crude oil contract's success in recent years has been the fact that it is cash-settled against an index and is therefore not hybrid in nature.

Reform
Yet the opportunity has not been taken to carry out a root-and-branch reform of the global trading mechanism, such as the introduction of two or three geographic Fix-style physical auctions perhaps integrated with either or both Platt’s assessment and a Baltic Exchange-type panel of brokers. Some market participants have observed that while you may embellish what you tell Platt’s, you tend to tell your broker the truth…

Participants could then use the prices – discovered by these price-setting mechanisms based on physical supply – as the basis of vanilla swap contracts or cash-settled futures contracts.

As a result, we would see:

• bilaterally traded spot and forward contracts securing supply with one or more daily Fix auctions broadcast – perhaps literally, as there is simple, cheap technology capable of doing so – to the market; and


• multilaterally traded cash-settled derivatives securing price and traded either on-or off-exchange.

Both sets of contracts would be subject to credit enhancement either by insurance or central counterparty intermediation. Such segregation could enable the market to overcome the current regulatory dog’s dinner outlined by our panel.

Chris Cook, a freelance consultant, was formerly director of compliance and market supervision at London’s International Petroleum Exchange.
email: cojock@hotmail.com