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5 Table of Contents

006 Central Counterparties . . . . . . . . . . . . . . . . . . . . .Jon Gregory

Chapter 2: Exchanges, OTC Derivatives,DPCs and SPVs

023 Managing Energy Risk . . . . . . . . . . . . . . . . . . . . . .Markus Burger, Bernhard Graeber, Gero Schindlmayr

Chapter 1: Energy Markets

078 The Liquidity Risk Management Guide . . . . . . . .Gudni Adalsteinsson

Chapter 1: International Financial Reporting In Context

100 Markets for Managers . . . . . . . . . . . . . . . . . . . . . .Anthony J. Evans

Introduction/Chapter 1: Incentives Matter

121 Understanding Bitcoin . . . . . . . . . . . . . . . . . . . . . .Pedro Franco

Forward and Instroduction

136 Bonds without Borders . . . . . . . . . . . . . . . . . . . . .Chris OMalley

Chapter 1: Before the Beginning

157 The Monetary System . . . . . . . . . . . . . . . . . . . . . .Jean-Franois Serval, Jean-Pascal Tranie

Forward & Chapter 1: From Antiquity to Modern Times; Monetary Development Over 5000 Years . What History Explains and Comparison within New Contexts

177 The Handbook of Hybrid Securities . . . . . . . . . . .Jan De Spiegeleer, Wim Schoutens, Cynthia Van Hulle

Chapter 11: Constant Elasticity of Variance

Some of these chapters are from advance uncorrected first proofs and are subject to change .All information and references must be checked against final bound books .

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Central Counterparties: Mandatory Central Clearing and Initial Margin Requirements for OTC Derivatives

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72Exchanges, OTC Derivatives,

DPCs and SPVs

economy would face severe adverse consequences.Ben Bernanke (1953)

2.1 EXCHANGES2.1.1 What is an exchange?

centre where parties can trade standardised contracts such as futures and options at a speci-

can be thought of as a long journey where a critical trading volume, standardisation and

-tral counterparties (CCPs) date back to futures exchanges, which can be traced back to the 19th century (and even further). A future is an agreement by two parties to buy or sell a

be able to hedge their exposure to price movements. An exchange was essentially a market where standardised contracts such as futures could be traded. Originally, exchanges were simply trading forums without any settlement or counterparty risk management functions. Transactions were still done on a bilateral basis and trading through the exchange simply

exchange.An exchange performs a number of functions:

Product standardisation: An exchange designs contracts that can be traded where most of the terms (e.g. maturity dates, minimum price quotation increments, deliverable grade of the underlying, delivery location and mechanism) are standardised.

Trading venue: Exchanges provide either a physical or an electronic trading facility for the underlying products they list, which provides a central venue for trading and hedging.

8rules of the exchange. This centralised trading venue provides an opportunity for price discovery.1

Reporting services: Exchanges provide various reporting services of transaction prices to trading participants, data vendors and subscribers. This creates a greater transparency of prices.

2.1.2 The need for clearing

In addition to their functions as described above, exchanges have also provided methods for improving clearing and therefore mitigating counterparty risk. Clearing is the term that describes the reconciling and resolving of contracts between counterparties, and takes place between trade execution and trade settlement (when all legal obligations have been made). A buyer or seller suffering a large loss on a contract may be unable or unwilling to settle the underlying position and two methods have developed for reducing this risk, namely margin-ing and netting.

Margining involves exchange members receiving and paying cash or other assets against gains and losses in their positions (variation margin) and providing extra coverage against losses in case they default (initial margin). Exchange rules developed to specify and enforce the mechanics of margin exchange.

Netting involves the offsetting of contracts, which is useful to reduce the exposure of counterparties and the underlying network to which they are exposed. It therefore reduces the costs of maintaining open positions such as via the margins needing to be posted. Histori-cally, netting can be seen in all of the three forms of clearing that have developed, namely direct clearing, ring clearing and complete clearing, which are described next.

2.1.3 Direct clearing

Direct clearing refers to a bilateral reconciliation of commitments between the original two

may deliver the underlying contractual amount of an asset to the other in exchange for the

they can reduce obligations as illustrated in Figure 2.1. Here, counterparties A and B have offsetting positions with each other in the same contracts: A has an agreement to buy 100 contracts from B at a price of $105 at a later date, whilst B has the exact reverse position with A but at a lower price of $102. Clearly, standardisation of terms facilitates such offset by making contracts fungible. Rather than A and B physically exchanging 100 contracts worth of the underlying and making associated payments of $10,500 and $10,200 to one another they can use payment of difference. Payment of difference, rather than delivery, became common in futures markets to reduce problems associated with creditworthiness. In Figure 2.1, this would involve counterparty A paying counterparty B the difference in the value of the contracts of $300. This could occur at the settlement date of the contract or at any time before. In the OTC derivatives market, this form of direct clearing is now generally called netting.

1 This is the process of determining the price of an asset in a marketplace through the interactions of buyers and sellers.

12 Central Counterparties

9Obviously, in direct clearing original counterparties still have exposure to one another, albeit potentially reduced by methods such as payment of differences. Although exchanges

limited additional roles to play in such a structure, potentially just as mediators in any ensu-ing dispute.

2.1.4 Clearing rings

The fungibility created by standardisation means that direct clearing can be extended to more than two counterparties. Historically, the development of clearing rings was a means of utilising standardisation to ease aspects such as closing out positions and enhancing liquidity. For instance, prior to the adoption of complete clearing at the Chicago Board of Trade, groups of three or more market participants would ring out offsetting positions. Clearing rings were relatively informal means of reducing exposure via a ring of three or more mem-

substitutes for their original counterparties. Rings were voluntary but once joining a ring, exchange rules bound participants to the ensuing settlements. Some members would choose not to join a ring whereas others might participate in multiple rings. In a clearing ring, groups of exchange members agree to accept each others contracts and allow counterparties to be interchanged. This can be useful for reducing bilateral exposure as illustrated in Figure 2.2. Irrespective of the nature of the other positions, the positions between C and D, and D and B can allow a ringing out where D is removed from the ring and two obligations are replaced with a single one from C to B.

Clearing rings clearly reduce counterparty risk. They also simplify the dependencies of a members open positions and allow them to close out contracts more easily, increasing liquidity. Clearly, all members of the ring must agree a price for settling contracts, which may be facilitated by the exchange. Historically, exchanges (and courts) have generally upheld the contractual features of ringing. For example, if (via a ring) a counterparty had their original counterparty replaced via another that subsequently defaulted, then they could not challenge the clearing ring reassignment that led to this.

-

readily the transactions with C and B, A is indifferent to the formation of the ring since

BA100 contracts @ $102

100 contracts @ $105

BA $300

Figure 2.1 Illustration of direct clearing.

Exchanges, OTC Derivatives, DPCs and SPVs 13

10

its positions are not changed. Furthermore, the positions of B and C have changed only in terms of the replacement counterparty they have been given. Clearly, if this counterparty is

-

participants. A member at the end of a ring with only a long or short position and therefore

with members refusing to participate in rings because, for example, they preferred larger exposures to certain counterparties rather than smaller exposures to other counterparties.

In the current OTC derivative market, compression (section 5.2.3) offers a similar mecha-nism to the historical role of clearing rings.

2.1.5 Complete clearing

contracts and the resulting risk in the event of counterparty failure. Members are still exposed to the failure of their counterparties. Furthermore, like dominoes, contract failures can create a cascading effect and lead a string of seemingly unrelated counterparties to fail. A good historical example of this is the 1902 bankruptcy of George Phillips, which affected hundreds of clearing members of the Chicago Board of Trade representing almost half of the total

complete clearing where a CCP or clearinghouse becomes counterparty to all transactions.

other. By interposing itself between two counterparties,2 which are clearing members, a CCP assumes all such contractual rights and responsibilities as illustrated in Figure 2.3. This fa-cilitates the offsetting of transactions as in clearing rings but also reduces counterparty risk further, as a member no longer needs to be concerned about the credit quality of its counter-party. Indeed, the counterparty to all intents and purposes is the CCP.

2 Sometimes CCPs do not interpose themselves but rather guarantee the performance of the trade. This has historically been the case in US markets compared to Europe. Nevertheless, the end result is similar.

D

B

C

A B

C

A

100

100 100

Figure 2.2 Illustration of a clearing ring. The equivalent obligations between C and D and between D and B are replaced with a single obligation between C and B.


11

Complete clearing originated in Europe and was adopted in the US by the end of the 19th century (although full novation of contracts did not occur until the early 20th century). Following the development of central clearing, as new futures exchanges were established, central counterparty clearing was often the chosen structure from the start.

Faced with counterparty risk, CCPs adopted rules to limit their exposures. In addition to the offset that this clearing structure facilitated, they used already developed margining rules to protect themselves from the risk of insolvency of one of their members. Margin gener-

variation margin initial margin to cover the potential

close out cost of positions that a CCP could experience when a member defaulted. Additional to margin requirements, CCPs developed a loss sharing model. All clearing members had to make share purchases, which entitled them to use the exchange. In the event of a clearing member failure, the clearing members were at risk of losing their equity investment (but not

Adoption of central clearing has not been completely without resistance: the Chicago Board of Trade (CBOT) did not have a CCP function for around 30 years until 1925 (and then partly as a result of government pressure). One of the last futures exchanges to adopt a CCP was the London Metal Exchange in 1986 (again with regulatory pressure being a key factor). An obvious and often cited reason for these resistances is the fact that clearing homogenises counterparty risk and therefore would lead to strong credit quality members of the exchange suffering under central clearing compared to the weaker members. The reluctance to adopt clearing voluntarily certainly raises the possibility that the costs of clearing exceed the ben-

Nevertheless, all exchange-traded contracts are currently subject to central clearing. The CCP function may either be operated by the exchange or provided to the exchange as a service by an independent company. All derivatives exchanges have adopted some form of a CCP and central counterparty clearing was therefore the standard practice for derivatives markets clearing until the arrival of the OTC derivatives market in the last quarter of the 20th century.

D

B

C

A

100

100

D

B

C

A50

125

75

25

50

CCP

Figure 2.3 Illustration of complete clearing. The CCP assumes all contractual responsibilities as counterparty to all contracts.


12

2.2 OTC DERIVATIVES2.2.1 OTC vs. exchange-traded

Exchange-traded derivatives are standardised contracts (e.g. futures and options) and are actively traded in the secondary markets. It is easy to buy a contract and sell the equivalent contract to close the position, which can be done via one or more derivative exchanges. Prices are transparent and accessible to a wide range of market participants.

OTC markets work very differently compared to exchange-traded ones, as outlined in Table 2.1. OTC derivatives are traditionally privately negotiated and traded directly between two

to trade and price negotiation is purely a bilateral process. OTC derivatives have traditionally been negotiated between a dealer and end user or between two dealers. OTC markets did not

without activity being visible on any exchange. Documentation is also bilaterally negotiated between the two parties, although certain standards have been developed. In bilateral OTC markets, each party takes counterparty risk to the other and must manage it themselves.

tailor contracts more precisely to client needs, for example by offering a particular maturity date. Exchange-traded products by their nature do not offer customisation. Key players in the OTC market are banks and other highly sophisticated parties, such as hedge funds. Inter-dealer brokers also play a role in intermediating OTC derivatives transactions. Prior to 2007, whilst the OTC market was the largest market for derivatives, it was largely unregulated.

It is important not to confuse customised with exotic OTC derivatives. For example, a

may do so through a customised OTC derivative. Such a hedge may not be available on an exchange, where the underlying contracts will only allow certain standard contractual terms (e.g. maturity dates) to be used. A customised OTC derivative may be considered more useful for risk management than an exchange-traded derivative, which would give rise to additional basis risk (in this example, the mismatch of maturity dates). It has been reported that the

-cial risks.3 Due to the idiosyncratic hedging needs of such companies, OTC derivatives are commonly used instead of their exchange-traded equivalents.

Customised OTC derivatives are not without their disadvantages, of course. A customer wanting to unwind a transaction must do it with the original counterparty, who may quote

3 Over 94% of the Worlds Largest Companies Use Derivatives to Help Manage Their Risks, According to ISDA Survey, ISDA Press Release, 23 April 2009, http://www.isda.org/press/press042309der.pdf.

Table 2.1 Comparison between exchange-traded and OTC derivatives.

Exchange-traded Over-the-counter (OTC)

Terms of contract Standardised (maturity, size, strike, etc.) Flexible and negotiableMaturity Standard maturities, typically at most a

few months Negotiable and non-standard Often many years

Liquidity Very good Limited and sometimes very poor for non-standard or complex products

Credit risk Guaranteed by CCP Bilateral


13

unfavourable terms due to their privileged position. Even assigning or novating the transac-tion to another counterparty typically cannot be done without the permission of the original counterparty. This lack of fungibility in OTC transactions can also be problematic. This aside, there is nothing wrong with customising derivatives to the precise needs of clients as long as this is the sole intention. However, this is not the only use of OTC derivatives: some are contracted for regulatory arbitrage or even (arguably) misleading a client. Such products are clearly not socially useful and generally fall into the (relatively small) category of exotic OTC derivatives which in turn generate much of the criticism of OTC derivatives in general.

OTC derivatives markets remained relatively small until the 1980s, in part due to regu-

-ing and technology together with favourable regulation led to the rapid growth of OTC derivatives as illustrated in Figure 2.4. The strong expansion of OTC derivatives against exchange-traded derivatives is also partly due to exotic contracts and new markets such as credit derivatives (the credit default swap market increased by a factor of 10 between the end of 2003 and end of 2008). OTC derivatives have in recent years dominated their exchange-traded equivalents in notional value4 by something close to an order to magnitude.

Another important aspect of OTC derivatives is their concentration with respect to a rela-tively small number of commercial banks, often referred to as dealers. For example, in the US, four large commercial banks represent 90% of the total OTC derivative notional amounts.5

4 Not by number of transactions, as OTC derivatives trades tend to be much larger.5 -

dq113.pdf.

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Figure 2.4 Total outstanding notional of OTC and exchange-traded derivatives transactions. The

that notional amounts outstanding are not directly comparable to those for exchange-traded derivatives, which refer to open interest or net positions whereas the amounts outstanding for OTC markets refer to gross positions, i.e. without netting. Centrally cleared trades also increase the total notional outstanding due to a double counting effect since clearing involves book two separate transactions. Source: BIS.


14

2.2.2 Market development

The total notional amount of all derivatives outstanding was $761 trillion in mid-2013. The curtailed growth towards the end of the history in Figure 2.4 can be clearly attributed to the

-ital, and clients have been less interested in derivatives, particularly as structured products. However, the reduction in recent years is also partially due to compression exercises that seek to reduce counterparty risk by removing offsetting and redundant positions (discussed in more detail in the next chapter).

rate derivatives, foreign exchange derivatives, equity derivatives, commodity derivatives and credit derivatives. The split of OTC derivatives by product type is shown in Figure 2.5. Inter-est rate products contribute the majority of the outstanding notional, with foreign exchange and credit default swaps seemingly less important. However, this gives a somewhat mislead-ing view of the importance of counterparty risk in other asset classes, especially foreign exchange and credit default swaps. Whilst most foreign exchange products are short-dated, the long-dated nature and exchange of notional in cross-currency swaps means they carry a lot of counterparty risk. Credit default swaps not only have a large volatility component but

other important (and sometimes more subtle) contributions from other products.A key aspect of derivatives products is that their exposure is substantially smaller than that

of an equivalent loan or bond. Consider an interest rate swap as an example: this contract

net payment will be

0

100

200

300

400

500

600

InterestRate

Foreignexchange

Creditdefaultswaps

Equity Commodity Other

Notio

nal o

utst

andi

ng ($

trill

ions

)

Figure 2.5 Split of OTC derivative gross outstanding notional by product type as of June 2013. Note that centrally cleared products are double counted since a single trade is novated into two trades in a CCP. This is particularly relevant for interest rate products, for which a large outstanding notional is already centrally cleared. Source: BIS.


15

exchanged. If a counterparty fails to perform then an institution will have no obligation to continue to make coupon payments. Instead, the swap will be unwound based on (for exam-ple) independent quotations as to its current market value. If the swap has a negative value for an institution then they may stand to lose nothing if their counterparty defaults.6 For this reason, when we compare the actual total market of derivatives against their total notional amount outstanding, we see a massive reduction as illustrated in Table 2.2. For example, the total market value of interest rate contracts is only 2.7% of the total notional outstanding.

Derivatives contracts have, in many cases, become more standardised over the years through industry initiatives. This standardisation has come about as a result of a natural lifecycle where a product moves gradually from non-standard and complex to becoming more standard and potentially less exotic. Nevertheless, OTC derivative markets remain decentralised and more heterogeneous, and are consequently less transparent than their ex-change-traded equivalents. This leads to potentially challenging counterparty risk problems. OTC derivatives markets have historically managed this counterparty risk through the use of netting agreements, margin requirements, periodic cash resettlement, and other forms of bilateral credit mitigation.

2.2.3 OTC derivatives and clearing

An OTC derivatives contract obliges its counterparties to make certain payments over the life of the contract (or until an early termination of the contract). Clearing is the process

and settlement is the process by which those obligations are effected. The means by which payments on OTC derivatives are cleared and settled affect how the credit risk borne by counterparties in the transaction is managed. A key feature of many OTC derivatives is that they are not settled for a long time since they generally have long maturities. This is in con-trast to exchange-traded products, which often settle in days or, at the most, months. Clearing

OTC and exchange-traded derivatives generally have two distinct mechanisms for clear-ing and settlement: bilateral for OTC derivatives and central for exchange-traded structures. Risk-management practices, such as margining, are dealt with bilaterally by the counterpar-ties to each OTC contract, whereas for exchange-traded derivatives the risk management functions are typically carried out by the associated CCP. However, an OTC derivative does

6 Assuming the swap can be replaced without any additional cost.

Table 2.2 Comparison of the total notional outstanding and the market value of OTC derivatives (in $ trillions) for different asset classes as of June 2013. Source: BIS.

Gross notional outstanding Gross market value* Ratio

Interest rate 561.3 15.2 2.7%Foreign exchange 73.1 2.4 3.3%Credit default swaps 24.3 0.7 3.0%Equity 6.8 0.7 10.2%Commodity 2.4 0.4 15.7%

* This is calculated as the sum of the absolute value of gross positive and gross negative market values, corrected for double counting.


16

years operated as separate entities to control counterparty risk by mutualising it amongst the CCP members. Prior to any clearing mandate, almost half the (OTC) interest-rate swap mar-ket was centrally cleared by LCH.Clearnets SwapClear service (although almost all other OTC derivatives were still bilaterally traded).

An important aspect for CCPs is the heterogeneity of the OTC market, since clearing re-quires a degree of homogeneity between its members. Historically, the large OTC derivatives players have had much stronger credit quality than the other participants. However, some small players such as sovereigns and insurance companies have had very strong (triple-A) credit quality, and have used this to obtain favourable terms such as one-way margin agreements.

Banks have historically dealt with counterparty risk in a variety of ways. For instance, a bank may not require a counterparty to post any margin at the initiation of a transaction as long as the amount it owes remains below a pre-established credit limit. Counterparty risk is now commonly priced into transactions via credit value adjustment (CVA), as discussed in more detail in Chapter 7. Before we discuss central clearing in more detail in the next

in the OTC market prior to 2007.

2.3 COUNTERPARTY RISK MITIGATION IN OTC MARKETS2.3.1 Systemic risk

A major concern with respect to OTC derivatives is systemic risk. A major systemic risk episode would likely involve an initial spark followed by a proceeding chain reaction, po-

systemic risk, one can either minimise the chance of the initial spark, attempt to ensure that the chain reaction does not occur, or simply plan that the explosion is controlled and the resulting damage limited.

Historically, most OTC risk mitigants focused on reducing the possibility of the initial spark mentioned above. Reducing the default risk of large, important market participants is an obvious route. Capital requirements, regulation and prudential supervision can contribute

to grow and prosper.OTC derivatives markets have netting, margining and other methods to minimise coun-

terparty and systemic risk. However, such aspects create more complexity and may catalyse growth to a level that would never have otherwise been possible. Hence it can be argued

catalyst (such as many large exposures supported by a complex web of margining) to cause the explosion.

The OTC derivative market also developed other mechanisms for potentially controlling the inherent counterparty and systemic risks they create. Examples of these mechanisms are SPVs, DPCs, monolines and CDPCs, which are discussed next. Although these methods have been largely deemed irrelevant in todays market, they share some common features with CCPs and a historical overview of their development is therefore useful.

However, without the correct management and regulation, ultimately even seemingly

be simply to have the means in place to manage periodic failures in a controlled manner,


17

which is one role of a CCP. If there is a default of a key market participant, then the CCP will guarantee all the contracts that this counterparty has executed through them as a clearing member. This will mitigate concerns faced by institutions and prevent any extreme actions by those institutions that could worsen the crisis. Any unexpected losses7 caused by the failure of one or more counterparties would be shared amongst all members of the CCP (just as insurance losses are essentially shared by all policyholders) rather than being concentrated within a smaller number of institutions that may be heavily exposed to the failing counter-party. This loss mutualisation is a key component as it mitigates systemic risk and prevents a domino effect.

2.3.2 Special purpose vehicles

A Special Purpose Vehicle (SPV) or Special Purpose Entity (SPE) is a legal entity (e.g. a

have been used in the OTC derivatives market to protect from counterparty risk. A company

is not owned by the entity on whose behalf it is being set up.SPVs aim essentially to change bankruptcy rules so that, if a derivative counterparty is

insolvent, a client can still receive their full investment prior to any other claims being paid out. SPVs are most commonly used in structured notes, where they use this mechanism to guarantee the counterparty risk on the principal of the note to a very high level (triple-A typically), better than that of the issuer. The creditworthiness of the SPV is assessed by rating

SPVs aim to shift priorities so that in a bankruptcy, certain parties can receive a favourable treatment. Clearly, such a favourable treatment can only be achieved by imposing a less favourable environment on other parties. More generally, such a mechanism may then reduce risk in one area but increase it in another. CCPs also create a similar shift in priorities, which may move, rather than reduce, systemic risk.

An SPV transforms counterparty risk into legal risk. The obvious legal risk is that of con-solidation, which is the power of a bankruptcy court to combine the SPV assets with those of the originator. The basis of consolidation is that the SPV is essentially the same as the originator and means that the isolation of the SPV becomes irrelevant. Consolidation may depend on many aspects such as jurisdictions. US courts have a history of consolidation rul-ings, whereas UK courts have been less keen to do so, except in extreme cases such as fraud.

Another lesson is that legal documentation often evolves through experience, and the enforceability of the legal structure of SPVs was not tested for many years. When it was tested in the case of Lehman Brothers, there were problems (although this depended on juris-diction). Lehman essentially used SPVs to shield investors in complex transactions such as Collateralised Debt Obligations (CDOs) from Lehmans own counterparty risk (in retrospect

--

7 Meaning those above a certain level that will be discussed later.


18

SPV was a sound legal structure, many cases have been settled out of court.8 Risk mitigation that relies on very sound legal foundations may fail dramatically if any of these foundations prove to be unstable. This is also a potential lesson for CCPs, who must be certain of their legal authorities in a situation such as a default of one of their members.

2.3.3 Derivatives product companies

Long before the GFC of 2007 onwards, whilst no major derivatives dealer had failed, the bilaterally cleared dealer-dominated OTC market was perceived as being inherently more vulnerable to counterparty risk than the exchange-traded market. The derivatives product company (or corporation) evolved as a means for OTC derivative markets to mitigate coun-terparty risk (e.g. see Kroszner 1999). DPCs are generally triple-A rated entities set up by one or more banks as a bankruptcy-remote subsidiary of a major dealer, which, unlike an SPV, is separately capitalised to obtain a triple-A credit rating.9 The DPC structure provides external counterparties with a degree of protection against counterparty risk by protecting against the

-

Morgan Stanley Derivative Products and Lehman Brothers Financial Products.The ability of a sponsor to create their own mini derivatives exchange via a DPC was

partially a result of improvements in risk management models and the development of credit rating agencies. DPCs maintained a triple-A rating by a combination of capital, margin and activity restrictions. Each DPC had its own quantitative risk assessment model to quantify their current credit risk. This was benchmarked against that required for a triple-A rating. Most DPCs use a dynamic capital allocation to keep within the triple-A credit risk require-ments. The triple-A rating of a DPC typically depends on:

Minimising market risk: In terms of market risk, DPCs can attempt to be close to mar-ket-neutral via trading offsetting contracts. Ideally, they would be on both sides of every trade as these mirror trades lead to an overall matched book. Normally the mirror trade exists with the DPC parent.

Support from a parent: The DPC is supported by a parent with the DPC being bankruptcy-remote (like an SPV) with respect to the parent to achieve a better rating. If the parent were to default, then the DPC would either pass to another well-capitalised institution or be terminated, with trades settled at mid-market.

Credit risk management and operational guidelines (limits, margin terms, etc.): Restric-tions are also imposed on (external) counterparty credit quality and activities (position limits, margin, etc.). The management of counterparty risk is achieved by having daily mark-to-market and margin posting.

8

9 Most DPCs derived their credit quality structurally via capital, but some simply did so more trivially from the sponsors rating.


19

downgrade of parent, for example) and how the resulting workout process would work. The resulting pre-packaged bankruptcy was therefore supposedly simpler (as well as less likely) than the standard bankruptcy of an OTC derivative counterparty. Broadly speaking, two bankruptcy approaches existed, namely a continuation and termination structure. In either case, a manager was responsible for managing and hedging existing positions (continuation structure) or terminating transactions (termination structure).

There was nothing apparently wrong with the DPC idea, which worked well since its crea-tion in the early 1990s. DPCs were created in the early stages of the OTC derivative market to facilitate trading of long-dated derivatives by counterparties having less than triple-A credit quality. However, was such a triple-A entity of a double-A or worse bank really a better counterparty than the bank itself? In the early years, DPCs experienced steady growth in notional volumes, with business peaking in the mid-to-late 1990s. However, the increased use of margin in the market, and the existence of alternative triple-A entities led to a lessen-ing demand for DPCs.

The GFC essentially killed the already declining world of DPCs. After their parents de-cline and rescue, the Bear Stearns DPCs were wound down by J.P. Morgan, with clients

by two Lehman Brothers DPCs, a strategic effort to protect the DPCs assets, seems to link a DPCs fate inextricably with that of its parent. Not surprisingly, the perceived lack of au-tonomy of DPCs has led to a reaction from rating agencies, who have withdrawn ratings.10

Whilst DPCs have not been responsible for any catastrophic events, they have become

perceived triple-A ratings of DPCs had little credibility as the counterparty being faced was really the DPC parent, generally with a worse credit rating. Therefore, DPCs again illustrate

as in the case of SPVs but also market and operational risks) may be ineffective.

2.3.4 Monolines and CDPCs

As described above, the creation of DPCs was largely driven by the need for high-quality counterparties when trading OTC derivatives. However, this need was taken to another level by the birth and exponential growth of the credit derivatives market from around 1998 on-

The CDS represents an unusual challenge since its mark-to-market is driven by credit spread changes whilst its payoff is linked solely to one or more credit events (e.g. default). The so-called wrong-way risk in CDS (for example, when buying protection on a bank from another bank) meant that the credit quality of the counterparty became even more important than it would be for other OTC derivatives. Beyond single name credit default swaps, senior

stronger need for a default remote entity.Monoline insurance companies (and similar companies such as AIG)11

guarantee companies with strong credit ratings that they utilised to provide credit wraps

10 For example, see Fitch withdraws Citi Swapcos ratings http://www.businesswire.com/news/home/20110610005841/en/Fitch-Withdraws-Citi-Swapcos-Ratings.

11 For the purposes of this analysis, we will categorise monoline insurers and AIG as the same type of entity, which, based on their activities in the credit derivatives market, is fair.


20

better returns. Credit derivative product companies (CDPCs) were an extension of the DPC concept discussed in the last section that had business models similar to those of monolines.

In order to achieve good ratings (e.g. triple-A), monolines/CDPCs had capital require-ments driven by the possible losses on the structures they provide protection on. Capital requirements were also dynamically related to the portfolio of assets they wrapped, which is similar to the workings of the DPC structure. Monolines and CDPCs typically did not have to post margin (at least in normal times) against a decline in the mark-to-market value of their contracts (due to their excellent credit rating).

From November 2007 onwards, a number of monolines (for example, XL Financial As-surance Ltd, AMBAC Insurance Corporation and MBIA Insurance Corporation) essentially failed. In 2008, AIG was bailed out by the US government to the tune of approximately US$182 billion (the reason why AIG was bailed out and the monoline insurers were not was the size of AIGs exposures12 and the timing of their problems close to the Lehman Brothers bankruptcy). These failures were due to a subtle combination of rating downgrades, required margin postings and mark-to-market losses leading to a downwards spiral. Many banks found themselves heavily exposed to monolines due to the massive increase in the value of the protection they had purchased. For example, as of June 2008, UBS was estimated to have

Merrill Lynch were US$4.8 billion and US$3 billion respectively.13CDPCs, like monolines, were highly leveraged and typically did not post margin. They

fared somewhat better during the GFC but only for timing reasons. Many CDPCs were not fully operational until after the beginning of the GFC in July 2007. They therefore missed at

senior)14. Nevertheless, the fact that the CDPC business model is close to that of monolines has not been ignored. For example, in October 2008, Fitch Ratings withdrew ratings on the

15

2.3.5 Lessons for central clearing

The aforementioned concepts of SPVs, DPCs, monolines and CDPCs have all been shown to lead to certain issues. Indeed, it could be argued that as risk mitigation methods they all have

which does share certain characteristics of these structures.

priorities from one party to another really helps the system as a whole. CCPs will effectively give priority to OTC derivative counterparties and in doing so may reduce the risk in this market. However, this will make other parties (e.g. bondholders) worse off and may therefore

12 Whilst the monolines together had approximately the same amount of credit derivatives exposure as AIG, their failures were at least partially spaced out.

13 See Banks face $10bn monolines charges, Financial Times, 10 June 2008, http://www.ft.com/cms/s/0/8051c0c4-3715-11dd-bc1c-0000779fd2ac.html#axzz2qH4m4ZLD.

14 The widening in super senior spreads was on a relative basis much greater than credit spreads in general during late 2007.

15 See, for example, Fitch withdraws CDPC ratings, Business Wire, 2008.


21

increase risks in other markets (see sections 5.1.6 and 6.4.1 for further detail). Second, a

a framework. This is especially important, as in a large bankruptcy there will likely be par-

expose them to bankruptcy regimes and regulatory frameworks in multiple regions.CCPs also share some similarities with monolines and CDPCs as strong credit quality

entities set up to take and manage counterparty risk. However, two very important differ-ences must be emphasised. First, CCPs have a matched book and do not take any residual market risk (except when members default). This is a critical difference since monolines and CDPCs had very large, mostly one-way, exposure to credit markets. Second, a related point is that CCPs require variation and initial margin in all situations whereas monolines and CDPCs would essentially post only variation margin and would often only do this in extreme situations (e.g. in the event of their ratings being downgraded). Many monolines and CDPCs posted no margin at all at the inception of trades. Nevertheless, CCPs are similar to these entities in essentially insuring against systemic risk. However, the term systemic risk

insurers or bailout of AIG, there are clearly lessons to be learnt with respect to the centrali-sation of counterparty risk in a single large and potentially too-big-to-fail entity. One spe-

period. CCPs could conceivably create the same dynamic with respect to variation and initial margins, which will be discussed later.

Furthermore, it is possibly unhelpful that some commentators have argued that CCPs would have helped prevent the GFC, for example in relation to AIG. It is true that central clearing would have prevented AIG from building up the enormous exposures that it did. However, AIGs trades would not have been eligible for clearing as they were too non-standard and

-tors and politicians believed that AIG had excellent credit quality and would be unlikely to fail, it is a huge leap of faith to suggest that a CCP would have had a vastly superior insight or intellectual ability to see otherwise.

2.3.6 Clearing in OTC derivatives markets

From the late 1990s, several major CCPs began to provide clearing and settlement services for OTC derivatives and other non-exchange-traded products. This was to help market partic-

These OTC transactions are still negotiated privately and off-exchange but are then novated into a CCP on a post-trade basis.

In 1999, LCH.Clearnet set up two OTC CCPs to clear and settle repurchase agreements (RepoClear) and plain vanilla interest rate swaps (SwapClear). Commercial interest in OTC-cleared derivatives grew substantially in the energy derivatives market following the bank-ruptcy of Enron in late 2001. InterContinentalExchange (ICE) responded to this demand by offering cleared OTC energy derivatives solutions beginning in 2002. ICE now offers OTC clearing for credit default swaps (CDSs) also.


22

Although CCP clearing and settlement of OTC derivatives did develop in the years prior

are both positives and negatives associated with using CCPs and, in some market situations, the positives may not outweigh the negatives. As mentioned in the last chapter, the distinction between securities and OTC clearing is important, with the latter being far less straightfor-ward. For this reason, the major focus of this book is OTC CCPs.

2.4 SUMMARYMost CCPs were originally created by the members of futures exchanges to manage default

understand the historical development of central clearing and compare it to other forms of counterparty risk mitigation used in derivatives markets such as SPVs, DPCs and monolines. This can provide a good basis for understanding some of the consequences that central clear-ing will have in the future and some of the associated risks that may be created.

The next chapter will explain the operation of a CCP in more detail.


Managing Energy Risk: An Integrated View on Power and Other Energy Markets, 2nd Edition

Markus Burger, Bernhard Graeber, Gero Schindlmayr9781118618639 448 pages August 2014 Buy Now!

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JWBK624-c01 JWBK624-Buger Printer: Yet to Come April 11, 2014 22:23 Trim: 244mm 170mm

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Energy Markets

Despite a global sustainability trend including climate protection and more efficient use ofenergy, worldwide energy consumption will continue to grow over the coming decades (seeFigure 1.1). Besides future economic growth, an important driver of global energy demand ispolicy commitments, such as renewable energy or efficiency targets. Depending on scenarioassumptions, the average annual growth rate in energy consumption is estimated to be between0.5% and 1.5% (International Energy Agency, 2012) until 2035, with significant regionaldifferences.Most of the energy demand growth is expected to come from non-OECD countries,with China and India being the largest single contributors.The main primary energy source worldwide is oil, covering 32% of worldwide energy con-

sumption (see Figure 1.2). Second are coal and natural gas, with a share of 27% (respectively22%). Nuclear energy (6%) and renewables (13%) have a much smaller share. To meet thegrowing worldwide demand for energy, there will need to be an increase in energy consump-tion from all primary energy sources (Figure 1.2). However, depending on the scenario, theshare of oil and coal will diminish in favour of gas and renewable energy sources.Not all of the primary sources of energy are used directly for consumption; they may first

be transformed into secondary forms of energy, such as electricity or heat. Since part of theprimary energy is used within the transformation process, the final consumption is below theprimary energy demand. A breakdown of the final consumption into different sectors is givenin Figure 1.3.The current trends by sector are as follows (International Energy Agency, 2012.

Industry: The industrial sector accounts for 28% of the total energy consumption and has thehighest growth rate among the sectors. The main energy sources are coal (28%), electricity(26%), gas (19%) and oil (13%). It is expected that electricity and gas will gain importanceat the expense of coal and oil.

Transport: The transport sector, which makes up 27% of the energy demand, is stronglydominated by oil (93%). On a worldwide scale, biofuels (2%) and electricity (1%) still playa minor role, but are expected to increase their share to 2% (respectively 6%) in the refer-ence scenario. The actual development will be strongly influenced by future governmentalpolicies.

Buildings: This sector includes heating, air conditioning, cooking and lighting. It accountsfor 34% of the total energy consumption. The energy is delivered mainly in the form ofelectricity (29%), bioenergy (29%), gas (21%) and oil (11%). There is a clear trend towardsa higher share of electricity and gas at the expense of bioenergy and oil.

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2 Managing Energy Risk

Figure 1.1 World energy demand. Source: International Energy Agency (2012).

1.1 ENERGY TRADING

With the development of a global oil market in the 1980s, energy has become a tradablecommodity. In the early 1990s, deregulation of the natural gas market in the United Statesled to a liquid and competitive gas market. In Europe, liberalisation of gas and electricitymarkets started in the UK in the late 1980s. In the late 1990s, the EU Commission adoptedfirst directives making energy market liberalisation a mandatory target for EU member statesalong different steps of implementation. Whereas a wholesale market for electricity developedsuccessfully in the early 2000s in some countries (e.g., Germany), a liquid gas wholesale

Figure 1.2 World primary energy sources. Source: International Energy Agency (2012).

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Energy Markets 3

Figure 1.3 World final energy consumption. Source: International Energy Agency (2012).

market only existed in the UK. Gas markets in Continental Europe still remained fragmentedand dominated by oil-indexed supply contracts. Further consolidation of market areas, easiermarket access and declining gas demand following the financial crisis in 2008 increasedcompetition and finally led to growing market liquidity for gas markets in Continental Europeand a decoupling of gas and oil prices in the early 2010s.Besides the commodities of coal, oil, gas and electricity carrying energy directly, the EU

introduced carbon emission certificates (European Emission Allowance or EUA) in the year2005 as part of the EU climate policy. The certificates were designed as tradable instrumentsfor which a liquid market quickly developed. Since carbon certificates are closely related toenergy commodities and electricity generation, they will be treated here along with the otherenergy commodities. Before describing the specific markets for each commodity, the generalstructure and basic products of commodity markets in general will be introduced. A moredetailed description of commodity derivatives products will be given in Chapter 5.We generally distinguish between over-the-counter (OTC) and exchange-traded markets.

The OTC market consists of bilateral agreements, which are concluded over the phone orthrough Internet-based broker platforms. Such transactions are most flexible since the partiesare free to agree individual contract terms. As a main disadvantage, OTC transactions maycontain credit risk, meaning that one of the counterparties may not deliver on his contract (e.g.,in case of insolvency). As a mitigation, collaterals may be defined to protect the counterpartiesfrom losses in such a case. Exchanges provide organised markets for commodities in the formof standardised contracts. In particular, they became popular for derivatives products (futures,options), where the exchange also eliminates credit risk for the market participants.

1.1.1 Spot Market

The spot market is the market for immediate (or nearby) delivery of the respective commodityfor cash. The exact definition depends on the commodity. As an example, the spot market forelectricity often refers to delivery on the next day or on the next working day. For coal markets,

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contracts delivering within the next several weeks ahead are typically still considered as spottransactions. Spot markets can either be bilateral OTC transactions or organised by exchanges.For electricity, gas and EUAs, energy exchanges typically offer spot market products.A particular form of spot market is the auction market, where buyers submit their bids and

sellers their offers at the same time. In most cases a uniform price, the market clearing price,is determined which balances supply and demand. Such a uniform price auction is popularfor electricity spot markets; traded products are typically single-hour (or even half-hour)deliveries.Spot prices represent the final price of the physical commodity in the prevailing situation

of supply and demand, and are therefore the underlying of the derivatives market, which islargely driven by expectations regarding the future situation on spot markets. There are variouspublished spot price indices available for the different commodities that provide transparencyfor market participants and also serve as official references for the financial settlement offutures contracts.

1.1.2 Forwards and Futures

Forward and futures contracts are contractual agreements to purchase or sell a certain amount ofcommodity on a fixed future date (delivery date) at a predetermined contract price. The contractneeds to be fulfilled regardless of the commodity price development between conclusion ofthe contract and delivery date. In case the spot price has increased, the seller needs to sellbelow the prevailing spot price at delivery and therefore incurs an opportunity loss, whereasthe buyer makes an (opportunity) profit. In case prices decline, the situation is reversed. Thebuyer of a forward or future is said to hold a long position in the commodity (he profits froma price increase until delivery), the seller is said to hold a short position (he takes a loss froma price increase).The final profit or loss for the buyer of a forward contract (long position) at delivery date T

is the value of the commodity at delivery S(T) minus the contract price K (i.e., S(T) K). SeeFigure 1.4, similarly, the profit or loss for the seller (short position) is K S(T).

Figure 1.4 Profit or loss of a commodity forward contract.

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Forwards and futures are the most basic hedging instruments. If a producer of a commodityenters into a forward or futures contract as a seller, he fixes his revenues and is indemnifiedfrom further price changes. On the contrary, a market participant who is dependent on thecommodity for consumption may enter into a forward or futures contract as a buyer to fix hispurchasing costs for the commodity in advance.The term futures contract is used for a standardised forward contract which is traded via

an exchange. Often, futures contracts are financially settled, whichmeans that only the value ofthe commodity at the delivery date is paid instead of a true physical delivery. Futures contractsopen up the commodity market for participants who do not want to get involved in the physicalhandling of the commodity. Since the exchange serves as a central counterparty for futurescontracts, market participants do not have to deal with multiple individual counterpartiesand their associated credit risk. This also makes it easier to unwind a position entered intopreviously.The market size and liquidity of the futures market is often much higher than the actual

physical (spot) market. A list of exchanges with global significance offering energy-relatedcommodity derivatives products is given below.

CME Group (Chicago Mercantile Exchange): The CME Group is the worlds largest com-modity futures exchange. The wide array of products offered by the CME Group includesfutures and options contracts for energy (electricity, oil products, coal, natural gas), but alsometals, agriculture, foreign exchange, equities and interest rates. The CMEGroup originatedfrom a merger between the Chicago Mercantile Exchange (CME) and the Chicago Boardof Trade (CBOT) in 2007. In 2008, the CME Group acquired the New York MercantileExchange (NYMEX). The NYMEX light sweet crude oil futures contract introduced in 1983and the NYMEX Henry Hub natural gas futures contract introduced in 1990 are the mostpopular energy benchmarks in the United States.

IntercontinentalExchange (ICE): The ICE was founded in May 2000 with the objective ofproviding an electronic trading platform for OTC energy commodity trading. ICE expandedits business into futures trading by acquiring the International Petroleum Exchange (IPE)in 2001. ICEs products include derivative contracts based on the key energy commoditiesof crude oil, refined oil products, natural gas and electricity. The ICE Brent futures contractserves as an important international benchmark for pricing oil cargos (see Section 1.2) inEurope. In 2010, ICE acquired the European Climate Exchange (ECX), which is the leadingexchange for emission certificates under the European Trading Scheme.

NASDAQ OMX Commodities Europe: NASDAQ OMX Commodities Europe is part ofthe NASDAQ OMX Group and originates from the acquisition of the financial tradingpart of the Nord Pool exchange in 2008. Nord Pool was founded in 1993 in Norway andbecame the leading electricity market place for the Nordic and Baltic countries. Meanwhile,NASDAQ OMX Commodities Europe also offers electricity products for ContinentalEuropean countries, electricity and gas contracts for the UK and emission certificates.

European Energy Exchange (EEX): The EEX was founded at the beginning of the 2000swith origins in the German electricity market and has become one of the leading Europeanenergy exchanges with a focus on electricity, gas and emissions. EEX and the French energyexchange Powernext both hold a 50% share of the EPEX Spot exchange, which operatespower spot markets for Germany, France, Austria and Switzerland.

There are several other energy exchanges with a focus on specific local markets for electricityor natural gas. Descriptions of these exchanges are included in the subsequent sections.

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Figure 1.5 Profit or loss at maturity for an option holder.

1.1.3 Commodity Swaps

A commodity swap exchanges a fixed cashflow specified by a fixed commodity price againsta varying cashflow calculated from a published commodity price index at the respectivefixing dates. The risk profile of a commodity swap is similar to that of a forward, whichis financially settled (i.e., paying the commodity price index) instead of a physical delivery.Often, commodity swaps cover multiple payment periods, so that the swap is equivalent to aseries of financially settled forward contracts with different delivery dates T1, ,Tn. On eachpayment date Ti, one counterparty (the holder of the long position) receives the floating priceindex S(Ti) and pays the fixed price K whereas the other counterparty (the holder of the shortposition) pays the price index and receives the fixed price. The net amount the holder of thelong position receives on the payment date S(Ti) is therefore S(Ti) K. For more details andexamples, see Section 5.1.3.

1.1.4 Options

An option holder has the right but not the obligation to purchase (call option) or sell (put option)a certain commodity at a predetermined strike price from the option seller. See Figure 1.5. Inexchange, the option holder pays an option premium to the seller of the option.A call option will only be exercised at the options maturity date T if the spot price at time

T is above the strike price, as otherwise purchasing from the market is cheaper. If the optionpremium is P, then the profit or loss for the holder of a call option is max(S(T) K, 0) P.A put option will only be exercised if the spot price at time T is below the strike price, as

otherwise selling in the market generates higher value. If the option premium is P, then theprofit or loss for the holder of a put option is max(K S(T), 0) P.For more details and examples, see Section 5.3.

1.1.5 Delivery Terms

Unlike in financial markets, the point of delivery plays an important role in commoditytrading, since transportation can be costly (coal, oil) or dependent on access to a grid (power,gas). Therefore, commodity prices are usually quoted with reference to the delivery point.Typical delivery points depend on the type of commodity, for example Richards Bay in South

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Africa for coal orAmsterdamRotterdamAntwerp (ARA) for oil or coal. Another importantspecification for physical commodity trades are the Incoterms (international commerce terms)dealing with the clearance responsibilities and transaction costs. Themost important Incotermsfor energy markets are as follows.

Free-On-Board (FOB):The seller pays for transportation of the goods to the port of shipmentand for loading costs. The buyer pays for freight, insurance, unloading costs and furthertransportation to the destination. The transfer of risk is at the ships rail.

Cost, Insurance and Freight (CIF): The selling price includes the cost of the goods, thefreight or transport costs and also the cost of marine insurance. However, the transfer of risktakes place at the ships rail.

Delivered-At-Place (DAP): The seller pays for transport similar to CIF, but also assumesall risks up to the point that the vessel has arrived at the port and the goods are ready forunloading.

Delivered-ex-Ship (DES): Similar to DAP (eliminated from Incoterms 2010).

1.2 THE OIL MARKET

The oil market is certainly the most prominent among the energy markets. Crude oil (orpetroleum) is found in reserves spread across particular regions of the Earth, where it can beaccessed from the surface. Even though petroleum has been known and used for thousands ofyears, it became increasingly important during the second half of the 19th century as a primaryenergy source and as a raw material for chemical products. The main advantages of oil as anenergy carrier compared with other primary energy sources is its high energy density and theease of handling for storage and transport. Today, crude oil is still the predominant source ofenergy in the transportation sector and is often taken as a benchmark for the price of energy ingeneral. Chemically, crude oil is a mixture of hydrocarbons with different molecular weights.For actual usage, crude oil is transformed via a refinery process into different petroleumproducts, such as fuel oil or gasoline.Because of oils great economic importance historically, oil markets have always been

subject to political regulations and interventions. Figure 1.6 shows the historical spot pricesfor Brent crude oil. Clearly, the oil price is influenced by political or military events (especiallyin oil-exporting countries), which explains, for example, the price spike during the First GulfWar of 1990/91. In addition, there are economic developments, such as the increase of energydemand in Asia or the financial crisis following the bankruptcy of Lehman Brothers in 2008,which have an impact on the oil price.

1.2.1 Consumption, Production and Reserves

Oil consumption and oil production are unevenly distributed accross the world. The majorityof the worlds oil consumption is located in North America, Europe & Eurasia and Asia &Pacific (see Figure 1.7), whereas the majority of the reserves are located in the Middle Eastand South & Central America (see Figure 1.8).Historically, the OECD countries clearly dominated oil demand, but over the last decades

the share of non-OECD countries increased to nearly 50% (see Figure 1.9), largely driven by

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Figure 1.6 Brent historical spot prices. Source: Energy Information Administration.

Figure 1.7 World oil consumption 2012 by region. Source: BP (2013).

Figure 1.8 World oil production 2012 by region. Source: BP (2013).

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Energy Markets 9

Figure 1.9 Historical oil demand. Source: BP (2013).

increased demand fromChina and India. Themain driver for oil demand is the transport sector,accounting for more than 50% of the overall oil demand. Other drivers for oil demand includethe buildings, industry and power generation sectors. Forecasts for oil demand over the nextdecades depend strongly on assumptions for the worlds economic growth and governmentpolicies to curb oil demand. Different scenarios (see International Energy Agency, 2012) leadto an average annual growth rate between 0.5% and 1.80% in the period 2011 to 2035.On the supply side, the OPEC member countries1 control over 40% of the worlds oil

production and over 70%of all known conventional oil reserves (see Figure 1.10).An indicationof the future production potential can be given by the reserves-to-production ratio describingthe number of years that known reserves are estimated to last at the current rate of production.The worldwide reserves-to-production ratio as for 2012 was approximately 53 years, withgreat differences among the regions. For OPEC members the reserves-to-production ratiowas 89 years, whereas for non-OPEC countries the ratio was only 26 years (see BP, 2013).However, this indication may be misleading due to changes in production, revised estimatesfor existing reserves and discoveries of new reserves. A major unknown is the future roleof unconventional oil, which comprises extra heavy oils, oil sands, kerogen oil and lighttight oil. Producing or extracting unconventional oil requires techniques that are usually morecostly than conventional oil production and become profitable only if oil prices are sufficientlyhigh. On the contrary, there may still be substantial learning curve effects leading to moreefficient production processes. An example is the production of light tight oil, which onlyrecently emerged with substantial production volumes using the same technology as for shalegas production (see Section 1.3).Depending on its origin, oil can be of different quality. Themain characteristics are viscosity

and sulphur content. Fluid crude oils with low viscosity have a lower specific weight andare called light crudes. With increasing viscosity and specific weight the crudes are calledintermediate and then heavy. Lighter crude oils are more valuable, since they yield more

1 Iran, Iraq, Kuwait, Qatar, Saudi Arabia, United Arab Emirates, Algeria, Libya, Angola, Nigeria, Ecuador, Venezuela.

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Figure 1.10 World oil reserves 2012 by region. Source: BP (2013).

marketable products. Crude oils with low sulphur content are called sweet, otherwise they arecalled sour. Since a high sulphur content causes additional costs in the refinery process, sweetcrude oils are priced at a premium.

1.2.2 Crude Oil Trading

The physical crude oil market has to deal with a large variety of different oil qualities (viscosity,sulphur content) and with different means of transportation (pipeline, shipping). All of thesecharacteristics influence the oil price. Nevertheless, a liquid oil market has developed, usingreference oil qualities as benchmarks for pricing individual oil qualities. Depending on thequality, a certain price differential will be added to the benchmark price. Long-term supplycontracts typically use such price formulas to price their individual cargos. The most popularbenchmark oils are as follows.

West Texas Intermediate (WTI): Quality sweet and light, main reference for the US market(delivery in Cushing/Oklahoma).

Brent: Quality also sweet and light (slightly less than WTI), main reference for North Seaoil.

Dubai: Reference for the Middle East and Far East with higher sulphur content (sour). ASCI: Argus Sour Crude Index representing the price of medium sour crude oil of the USGulf coast.

The benchmark price used in contracts is typically a spot price index for physical deliverypublished by an oil pricing reporting agency, such as Platts or Argus. Price assessmentsare carried out on the basis of information on concluded transactions or bids and offers inthe market. The exact methodology varies between different reporting agencies. Also thebenchmark itself may evolve over time, for example as the original Brent crude stream hasdeclined over recent decades, the Brent benchmark now includes theNorth Sea streams Forties,

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Energy Markets 11

Oseberg and Ekofisk (BFOE). The benchmark prices above also serve as an underlying for theoil derivatives market, such as futures and swaps.The structure of the physical market for BFOE crude oil is connected to its nomination pro-

cedure. In case of a 25-day2 forward contract, the sellers are obliged to tell their counterparties25 days in advance the first day of the three-day loading window when the cargo will actuallybe loaded. The final loading schedule is then published by the terminal operator. A contractwith already nominated loading window less than 25 days ahead is called Dated Brent. The25-day forward market trades contracts for delivery up to multiple months ahead. A typicalcrude oil cargo has a size of about 600 000 bbl.The need for producers and consumers to financially hedge oil price risks and the growing

importance of oil derivatives for asset managers and speculators gave rise to a very largemarketof financial instruments related to oil. The most important commodity exchanges offering oilfutures and options are the CME Group (formerly NYMEX) for WTI contracts and the ICEfor Brent contracts. Both theWTI and the Brent contracts are monthly futures contracts quotedin USD per barrel with a contract size of 1000 bbl. The Light Sweet Crude Oil (WTI) Futurescontract was introduced by NYMEX 1983 and soon became a global reference for the priceof crude oil. The ICE Brent Crude Futures Contract was launched in 1988 by the formerIPE (International Petroleum Exchange) and also reached global importance next to WTI aspricing reference.

WTI Future Brent Future

Exchange CME Group ICEContracts monthly monthlyContract size 1000 bbl 1000 bblPrice quotation USD/bbl USD/bblExpiration date 3rd business day prior to the 25th

calendar day of the month precedingthe delivery month

15th day before the first day of thedelivery month

Settlement physical physical or financial

In addition to the futures contracts described above there is a wide range of related productsfor specific purposes, such as different option products, contracts-for-differences (CFDs) tomanage the price differential between Dated Brent and forward contracts or spreads betweendifferent oil benchmarks (e.g., WTI vs. Brent).The long-term forward market for crude oil (up to 10 years) is dominated by Brent andWTI

swaps exchanging a fixed monthly payment against a floating payment, which is the monthlyaverage of the front month futures price. Such swaps are typically traded OTC, but exchanges(e.g., CME Group and ICE) meanwhile offer a clearing service for swaps that is increasinglyused by market participants.

1.2.3 Refined Oil Products

As mentioned earlier, crude oil can be of various qualities concerning its density and sulphurcontent. To becomemarketable to consumers, refineries convert crude oil into various products.

2 Before 2012, a 21-day nomination period was typically used.

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The refining process in its basic form is a distillation process, where crude oil is heated in adistillation column. The lightest components can now be extracted at the top of the columnwhereas the heaviest components come out of the bottom. To increase the yield of the morevaluable lighter products, a cracking process is used to break up the longer hydrocarbonmolecules. Other processes are needed to remove the sulphur content. Ordered by increasingdensity, the most important oil products are

Light distillates: Liquefied petroleum gases (LPG), naphtha, gasoline. Middle distillates: Kerosine, gasoil or heating oil and diesel. Fuel oil. Others: For example lubricating oils, paraffin wax, petroleum coke, bitumen.LPG (propane or butane) are hydrocarbon gases that are liquid under pressure or low tem-perature. They are used mainly for heating appliances or vehicles. Naphtha is used mainly inthe chemical industry. Middle distillates are the largest group of oil products, accounting foraround 50% of refinery output. Besides its use for domestic heating, middle distillates (diesel)is used for transportation. Improvements in diesel engine technology and tax incentives haveled to a strong growth of diesel consumption in Europe. Being more polluting and more diffi-cult to process, fuel oil is less valuable and used mainly as bunker fuel in ships and to a limitedextent for power generation (e.g., as a backup for gas).Worldwide there are approximately 700 refineries to match the demand for the different oil

distillates. Since building new refineries is a complex project involving very large investments,refining capacities react slowly to changes in demand. Owing to the combined productionprocess, the prices of different oil products are usually tightly related to each other and can beexpressed in terms of price spreads against crude oil. The lighter and more valuable productshave higher spreads against crude oil than the heavier products. In special circumstances, suchas a military crisis, prices for certain products (e.g., jet fuel) can spike upwards in relation tocrude oil because of the limited refining capacities and the limited flexibility of refineries tochange the production ratios among the different products.The European market for refined oil products is divided into ARA and Mediterranean

(Genova). Typical lot sizes for these contracts are barges that correspond to 1000 to 5000(metric) tonnes.Typical financial instruments for European gasoil are

1. Gasoil swaps:Gasoil swaps are tradedOTCand typically refer to themonthly average gasoilprice (ARA or Mediterranean) as published by Platts for setting the floating payments.

2. ICE gasoil futures: The ICE offers monthly gasoil futures contracts FOB Rotterdam.

In addition, there are local oil prices indices available. In Germany, typical reference pricesfor HEL (gasoil) and HSL (fuel oil) are published monthly by the Statistisches Bundesamt.They include certain taxes and transportation costs within Germany.

1.3 THE NATURAL GAS MARKET

Next to oil and coal, natural gas is one of the most important primary energy sources, coveringabout 22% of worldwide energy consumption. It is used primarily as a fuel for electricity

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generation, transportation and domestic heating. Natural gas consists mainly of methane(CH4), which is the shortest and lightest in the family of hydrocarbon molecules. Othercomponents are heavier hydrocarbons such as ethane, propane and butane and contaminantssuch as sulphur. Natural gas volume is usually measured in cubic metres or cubic feet (1 m3 =35.3 ft3). For larger quantities of natural gas the units bcm (billion cubic metres) or bcf (billioncubic feet) are used. The combustion heat stored in one cubic metre of natural gas at normalatmospheric pressure is about 10.8 kWh (0.0368 MMBtu), but can vary depending on thespecific quality. This section gives a general overview of the natural gas market. For economicmodelling approaches, see Section 7.6.

1.3.1 Consumption, Production and Reserves

Among the fossil fuels there is a global trend in favour of natural gas. On the one hand, naturalgas is the fossil fuel with lowest carbon intensity, therefore it is considered to contribute leastto the greenhouse effect. On the other hand, due to the shale gas boom in the USA andan expanding infrastructure for liquefied natural gas (LNG), there is a stable outlook for gassupply.Natural gas and oil are often found in the same deposits. Depending on which of the two

dominates, it is called either a natural gas or oil field. Unlike oil, because of its low density, gasis difficult to store and transport. In the past, gas found as a by-product in oil fieldswas thereforesimply burned without any economic use. With growing demand for primary energy sources,gas prices have risen and large investments have been made to build up an infrastructurefor gas transportation, either in the form of pipelines or in the form of LNG terminals (seeSection 1.3.3). Because of the required transportation infrastructure, which historically wasmainly pipelines, the regional distribution of natural gas consumption and production is morebalanced between continents than the regional distribution for oil (see Figures 1.11 and 1.12).The countries with the highest gas production are the United States and Russia (between 600and 650 bcm/a), followed by Canada, Iran and Qatar with around 150 bcm/a and Norway,Saudi Arabia and China with around 100 bcm/a.

Figure 1.11 World gas consumption 2012 by regions. Source: BP (2013).

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Figure 1.12 World gas production 2012 by regions. Source: BP (2013).

The distribution of natural gas reserves is less balanced, since gas production in manyOECD countries (e.g., Europe) is in decline. Russia has a long history as a natural gas supplierto Western Europe and the reserves are well connected via pipelines. The large reserves in theMiddle East (see Figure 1.13), however, could not be utilised fully in the past since efficienttransportation to consumers was not available. Over the last decade a growing infrastructurefor LNG has been established, allowing us to transport increasing volumes of natural gasbetween continents, leading to increased export volumes from the Middle East (e.g., Qatar).As of 2012, 90% of natural gas reserves are in non-OECD countries, mainly Russia and theMiddle East.At the current production rate, the proved natural gas reserves as of 2012 are estimated to last

for 56 years (= reserves-to-production ratio). For OECD members, the reserves-to-production

Figure 1.13 World gas reserves 2012 by regions. Source: BP (2013).

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ratio is only 15 years as of 2012, whereas for non-OECD countries the ratio is 78 years (seeBP, 2013). As for oil, the future development of the reserves-to-production ratio will dependheavily on production growth and revised estimates for gas reserves.A major role for the future of gas supply will be played by unconventional gas, which

comprises tight gas shale gas and coalbed methane. Extracting tight gas and shale gas requireshydraulic fracturing. Coalbedmethane is gas extracted fromcoal beds,with significant reservesbeing in the USA, Canada and Australia. Tight gas and coalbed methane have been producedfor many decades; the extraction of shale gas is technologically more intricate and began tobecome profitable only at the beginning of the 21st century. Since then a shale gas boomhas emerged in the USA, able to overcompensate declining conventional gas production andleading to decreased gas prices in the USA (see Section 1.3.2). The global potential of shalegas is still disputed, since outside the USA there is uncertainty around resources and there arealso environmental concerns in many countries regarding the hydraulic fracturing process, forexample with respect to potential contamination of groundwater.

1.3.2 Natural Gas Trading

Compared with oil, the natural gas market is more regional due to the higher costs of gastransportation. The following main gas markets can be distinguished:

North America Europe Asia-PacificHistorically, those regional markets have had little interaction, since LNG played a significantrole only for the Asian market. Owing to a growing LNG infrastructure, market interaction hasincreased significantly during recent years. However, due to the shale gas boom in the USAand increasing demand in Asia, the price differentials between gas prices in North America,Europe and Asia-Pacific have first of all increased substantially (see Figure 1.14). These pricedifferentials may attract additional investments in LNG infrastructure, which could lead againto convergence of prices to some extent in the future.

The North American Market

The United States is an importer of natural gas, with the main imports via pipeline fromCanada. Before the shale gas boom in the mid-2000s there was the expectation that substantialLNG imports would be required to replace declining conventional domestic gas productionand therefore infrastructure for importing LNG was built. The additional shale gas supply hasreversed this picture and the United States may even become an exporter of natural gas around2020 (see Figure 1.15). The extent of exports will depend on infrastructure investments andalso regulatory approval for export licences.TheUSwholesale market for natural gas is liberalised and competitive. The highest liquidity

is found at Henry Hub (Lousiana) in the Gulf of Mexico. Besides a liquid spot market there isalso a very liquid futures market introduced by NYMEX (now the CME Group) in 1990. Therange of products offered by NYMEX includes options on gas futures and spreads betweenHenry Hub and other US gas hubs. As can be seen from Figure 1.16, wholesale prices in theUSA deteriorated after 2008 along with the financial crisis and increasing shale gas supply. A

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Figure 1.14 Global natural gas prices. Source: BP (2013).

recovery of prices will, among other factors, depend on future export volumes to higher-pricedmarkets.The monthly CME Natural Gas Futures contract has the following specification.

Trading unit: 10 000 million British thermal units (mmBtu). Price quotation: USD and cents per mmBtu. Trading months: The current year and the following 12 years (Globex: 8 years). Last trading day: Three business days prior to the first calendar day of the delivery month. Settlement type: Physical delivery at Henry Hub.

Figure 1.15 Projected US natural gas production and consumption. Source: EIA (2013).

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Figure 1.16 Natural gas US wholesale prices (Henry Hub, front-month contract). Source: EIA.

The European Market

As domestic gas production in Western Europe has been in decline for many years, an exten-sive infrastructure for gas imports was established. The main exporters to serve the WesternEuropean demand are Russia, Norway, the Netherlands, Algeria via pipelines and Qatar viaLNG. The UK gas market was liberalised in 1996. The National Balancing Point (NBP) soongained acceptance as a universal delivery point and trading hub in the UK. In 1997 theIPE (now ICE) launched a futures market for UK natural gas, which became the first liquidgas futures market in Europe. The natural gas market in Continental Europe was for a longtime still dominated by long-term supply contracts indexed to oil prices. Fragmented marketzones did not attract sufficient liquidity for a competitive wholesale gas market independentof oil-indexed supply contracts. This situation changed towards the end of the 2000s due todifferent developments:

Downturn in gas demand caused by the global recession after 2008. Growth in global LNG supply. Consolidation of market zones, simplification of market access (e.g., in Germany).

Meanwhile, the liquidity of gas trading hubs has increased also in Continental Europe andcorresponding futures markets were established. The most important natural gas hubs fortrading in Europe are:

National Balancing Point (NBP) in the UK; Title Transfer Facility (TTF) in the Netherlands; Zeebrugge Hub (ZEE) in Belgium; NetConnect Germany (NCG); Gaspool Hub (GPL) in Germany.

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The Continental European market and the UK market are linked by the Interconnectorpipeline that began operation in 1998. The Interconnector has a length of 235 km and connectsBacton, UK with Zeebrugge, Belgium. The pipline has a capacity of 20 billion cubic metresof gas per year to transport gas from Bacton to Zeebrugge (forward flow) and a capacityof 25.5 billion cubic metres in the reverse direction (reverse flow). Since the Interconnec-tor enables arbitrage trading between the UK and Continental Europe (within the technicalrestrictions of the Interconnector), the gas spot prices at NBP and TTF are closely connected.However, the spread may become significant when the Interconnector is shut down due tomaintenance work. The hubs in Continental Europe (TTF, ZEE, GPL, NCG) are well con-nected by pipelines, therefore prices are closely coupled.