Energy markets have transformed over the last 15 years to offer diversified and sophisticated asset classes in constantly evolving market structures. The three layers of energy market, including the physical assets, soft trading and regulation/international treaties, interact to provide creative and financially safe ways of managing market and credit risks.
The historical emphasis on bilateral trading in energy markets has meant that they have long resisted automation. However, the growth in energy trading and the increase in complexity of governing regulation have meant a speedy transition to e-trading in the past decade.
An energy e-trading survey conducted by Lab49 in collaboration with Commodities Now discovered ICE (Intercontinental Exchange) to be the e-trading platform of choice among survey participants.
The integration of energy markets in recent years has meant that market participants want all energy trading to be on a single platform in order to compare trade decisions. Respondents of the energy e-trading survey were clearly dissatisfied with the inability of any one platform to fulfill this requirement. Deep liquidity and tight spreads were rated as the most desirable features on a platform.
The survey summarized that there was a lot of untapped potential in energy as an asset class. The adaption of e-trading in energy has long lagged the adaption of e-trading in other markets. It is a matter of debate whether recent regulations would slow down or speed up this process.
From the crash of Enron to the financial crisis of 2008 to the current market state, regulators have recognized the need to maintain market integrity by limiting the freedom of trading. In times of financial crisis, market participants themselves revert to organized markets to execute their risk management strategies.
OTC energy contracts have recently been restricted by the Dodd-Frank Act of 2010 in an effort to curb the unregulated trading of swaps and derivatives, which is largely felt to be responsible for the credit crisis of 2008. Under this limitation, traders would be required to post collateral on the exchange (usually between 5-25%) and submit trade data on swap transactions to Swap Data Depositories (SDRs). While Dodd-Frank rules will reduce systematic default risk and improve market transparency, they will also require a lot of background work in converting the systems.
ICE is to transition cleared swap contracts into futures starting with the January 2013 contracts. This would severely reduce the liquidity and increase the cost of energy trading. Futures are often seen as a less precise hedging instrument than OTC products because of the liquidity costs involved. However, with the new rules, futures may be an easier choice for market participants due to the similarity with other asset classes
However, the Commodity Futures Trading Commission (CFTC) announced an exemption of renewable energy products such as Renewable Energy Credits (RECs), emissions allowances and carbon offsets from the Dodd-Frank rule. Market participants breathed a sigh of relief as this prevented disastrous consequences of market slowdown.
Following the confirmation of Dodd-Frank, OpenLink Financial LLC issued its regulatory compliance suite and has plans to expand it with ICE Trade Vault SDR reporting capabilities. ‘The combination of ICE Trade Vault and OpenLink will allow global market participants to benefit from our functionality and compliance tools, helping them manage new reporting requirements through a well-designed, cost-effective solution,’ said Bruce Tupper, President of ICE Trade Vault.
More e-trading solutions for adopting Dodd-Frank are being developed and one was launched by Allegro Development Corporation in early July. Allegro Derivative Regulation is a component of Allegro 8 platform and supports regulatory reporting, position limit monitoring, and data retention requirement functions. The platform also intends to launch components that support European Market Infrastructure Regulations (EMIR) and other regulatory initiatives in the future.
Despite the many offerings by energy platforms to ease the market into the future, agencies are struggling to meet the end of 2012 deadline to transition current trading into organized asset classes in 2013. It appears that all energy market participants will be burning the midnight oil to develop and implement new systems.