How to ‘futurise’ swaps may not be the only lesson that the energy markets have for OTC derivatives market participants, according to US clearers attending last week’s Mondo Visione Exchange Forum in London.
“OTC energy went through the epiphany in 2002 that the credit and other markets experienced in 2008,” said Paul Swann, chief operating officer at ICE Clear Europe, the European clearing arm of the Intercontinental Exchange (ICE), the Atlanta-headquartered derivatives exchange group. Speaking in a panel session on post-trade issues in OTC derivatives market, Swann noted the collapse of giant US energy producer and trader Enron revolutionised clearing in that market.
ICE and CME Group both hit the headlines recently by positioning themselves to offer listed futures products that will have much the same characteristics as swaps traded on newly-created swap execution facilities (SEFs) in the US but will be cheaper to use and will have the benefit of running on tried and trusted rails.
Both ICE and CME are well-placed to used their experience in the US energy markets, where central clearing has become the norm in the decade since Enron, to steal a march on SEFs, the exchange-like venues established by the Dodd-Frank Act, but subject to slightly different rules depending on whether they are regulated by the Securities and Exchange Commission (for equity-based derivatives) or the Commodity Futures Trading Commission (most of the rest). Moreover, the growing London-based presence of ICE and CME implies quite a battle for trading and clearing volumes in Europe once the European Securities and Markets Authority begins to approve instruments suitable for exchange-like trading, central clearing and reporting.
Over the weekend of 13-14 October, ICE transitioned all existing open interest in cleared OTC energy swaps and options positions to become exchange-listed futures and options. All North American natural gas, electric power and physical environmental contracts are now listed on ICE Futures US, with all global oil products, freight, iron ore, and natural liquid gas contracts listed on ICE Futures Europe. ICE had traded swaps alongside energy futures on ICE for more than a decade. All ICE energy contracts will continue to be eligible for cross-margining via ICE Clear Europe. ICE will continue to operate an electronic OTC energy market via ICE OTC Markets, which offers OTC physical markets and will register as a SEF under Dodd-Frank. ICE anticipates registration in accordance with the CFTC’s current deadline of early-to-mid 2013.
The exchange brought forward its initial migration plan from January 2013 on the basis that clients “have expressed a preference for a timely transition to gain operational and regulatory certainty”. Following approval from the CFTC, CME Group has until the end of the year to transition its energy, metals and agricultural swaps into futures contracts, which will allow many non-financial firms to avoid being regulated as ‘swap dealers’ under Dodd-Frank. If repeated across the OTC derivatives landscape, ‘futurised swaps’ may replace the centrally cleared swaps that are due to be traded on SEFs from next year.
According to Swann, reforms to reduce the scale of the swaps market and increase organised trading were aimed at improving price formation. “The question has always been around bearing the risk of a difference in valuation between the mark-to-market price and the booked price,” he said, adding that the energy markets had addressed the issue without recourse to regulation. “Since Enron, a large part of the OTC energy market has become cleared naturally. Roughly 95-96% of OTC energy products are cleared. That wasn’t done through regulatory mandate. It was done because the sell-side and the buy-side perceived a value to introducing credit intermediation into that market,” said Swann.
Protect and serve
Speaking on the same panel, Michael McClain, executive vice president, business operations group, at the Options Clearing Corporation (OCC), which clears options across 14 US markets, said client clearing and segregation of client funds were very well established in US listed derivatives markets, but noted an increased desire for buy-side protection.
“After 2008 clients wanted a service that was already working really well, in most situations, to become more stringent, with more segregation,” he said. “Buy-side firms have made enquiries about direct access to clearing but they soon back away when they consider the mutualisation of loss and deposits into the clearing fund. They accept that the agency model does work, more or less, but they are looking to establish multiple prime brokers, greater portability, and sub-accounts.”
McClain predicted that clearing houses in the US and beyond would increasingly offer choice to clearing members over whether they continue to clear for clients via omnibus accounts or more segregated customer accounts that offer more portability. “It remains to be seen whether their clients would be willing to pay for that,” he said.