Energy Futures: Traders Requirements of Tomorrow

Transcription

1 Energy Futures: Traders Requirements of Tomorrow New opportunities are emerging in energy futures markets. Until the introduction of Dodd Frank, the choice between trading swaps and futures was not a question asked by market participants, but rather was a simple evolution of two separate and distinct markets. Today, trading is increasingly occurring in listed futures instruments. This is a dramatic structural shift sure to force market participants to change longstanding practices. Firms accustomed to an OTC trading environment face new challenges, while others see opportunities and are quickly expanding their presence in both futures and lookalike, swap-futures markets. Tools to support the transformation, especially those designed for automated trading and price determination, including analytics, will become progressively more important. As new firms enter the market, success will be increasingly dependent on improved capabilities for managing market data, accessing markets and trading efficiently. The new trading landscape includes new and more nimble participants. Meanwhile, faster trading velocities and how energy products will be traded favors the firms that are able to leverage automation to become successful. Matt Simon V11:026 June

2 The Transition of Bilateral to Listed Energy markets have historically traded over the counter (OTC) through off-exchange bilateral transactions effected through brokers. This is partly a result of the specialized nature of the transactions, which often include non-standardized terms including delivery locations and variable pricing terms, but it also relates to the large transaction sizes which are characteristic of the marketplace. Under the current regulatory climate, a new set of drivers is pushing firms to consider moving towards listed instruments. These drivers include a more open and transparent market with reduced levels of counterparty risks enabled by centralized pools of liquidity, mandatory clearing, and more standardized reporting. In addition, energy futures rather than bilaterally traded swaps draw investor attention due to their lower cost structure for margin and collateral requirements. In this regard, the mindset of firms wanting to avoid burdensome and costly swap dealer registration mandates changes. Futures exchanges cognizant to these changing market variables remain eager to accommodate their evolving customer base. Intercontinental Exchange (ICE) was the first out of the gate when it transitioned all of its cleared energy swaps and options (cashsettled) positions to exchange listed futures. A deeper pool of energy futures results in over 30 million of additional contracts cleared in the energy futures markets per month (see Exhibit 1). Exhibit 1 Gas and Power Contracts on ICE Exchange *Starting October 2012, volume includes ICE Futures U.S. energy conversion. Historical energy volume has been adjusted to include energy futures contracts previously traded over the counter (OTC) as cleared swaps. Source: ICE Exchange, TABB Group 2013 The Tabb Group, LLC. All Rights Reserved. May not be reproduced by any means without expressed permission. 1

3 As the transition from swaps to futures occurs, futures traders already participating in the listed markets become exposed to new sources of liquidity. This participation attracts more market participants, builds liquidity and sets the stage for greater automation. Thus, any further transition by market participants from swaps to futures requires new tools and services to help traders effectively compete in a futures market that is dominated by electronic trading. TABB Group also expects the role of energy OTC brokers to diminish over time as firms make the shift to listed futures markets. As this transition occurs, it will provide significant opportunities for exchanges, clearinghouses, and FCMs that can support the listed energy markets. It will also benefit technology providers supporting the needs of OTC market participants as they transition to the listed markets (see Exhibits 2 & 3). Exhibits 2 & 3 Energy Futures Markets Trading, 2013 & 2015 Estimates Source: CME Group, ICE, TABB Group Meanwhile, there are many traders and compliance groups at energy trading firms reluctant to make a switch from swaps to futures, claiming their large transactions occur in bespoke and illiquid contracts for a reason. Thousands of futures contracts are required in order to match trading objectives, potentially driving up execution costs and the risks required to hedge a position. Conversations with inter-dealer brokers (IDBs) suggest that voice brokering will not completely disappear; they also quickly point out how automation does not benefit all end users. The big four energy market IDBs, ICAP, GFI, Tullet Prebon, and Tradition, say that customers transacting in massive size will continue to benefit from the anonymity of their services. Customers appreciate the market color IDBs are able to provide by maintaining meaningful relationships The Tabb Group, LLC. All Rights Reserved. May not be reproduced by any means without expressed permission. 2

4 Yet, a knowledge of recent market history, along with conversations with other nonconflicted market participants, suggest IDB business models are in jeopardy and that their services will be replaced by screens and traders self-directing orders. Similar to cash equity markets, the opportunity for algos and experienced sales traders to slice and dice orders over time and prevent traders from getting run over seems like a reasonable alternative. They point to the short end of the curve becoming increasingly electronic as a sign of where the market is headed. For example, Henry Hub near term futures contracts are executed mainly by traders using electronic trading tools to access the market. Trading Tools: Data Collection & Making Decisions The transition from OTC to listed products requires traders to change their trading habits and evolve with marketplace developments. In this regard, they will require fast and accurate market data in order to feed models and make trading decisions. Connectivity with exchanges and brokers will be required for direct market access. And electronic trading solutions, such as algos and transaction cost analysis (TCA), will be important to supporting efficient trading and validating trading costs. Pre-trade needs will be met by market data providers that provide a broad range of services. As most firms subscribe to a single provider for pricing, news, and analytical/charting functionality, the choice of provider should not just be a vendor with whom they are familiar, but rather one with services that are easy to use, cost friendly, rich in content, and able to provide great customer support. Even better, firms that can support trading capabilities in addition to data, analytics, and social media become logical choices for firms that want to make an easy transition from research to execution. While a data vendor may have comprehensive market data and content related to financial markets, the needs of energy futures traders can be very specialized. This includes having the need to calculate notional value for illiquid products and find unique, but material information for energy and commodity markets that are often times regionally and locally focused. In this regard, vendors that focus on energy markets gain clout. Items such as global calendars of events that impact pricing or headline news stories which are displayed in an aggregated, but easily processed manner become differentiators that separate vendors from their competitors. Front-end platforms that provide an efficient means to access markets and order/execution management capabilities also remain an important technology in a 23/6 marketplace. The functionality to connect with multiple brokers and fulfill trader needs through different types of broker services fed into a single system remains critical to firms expanding their investment strategies. On the other hand, less active firms will rely on brokers because watching their books each second of the day will not generate returns. Instead, firms such as CTAs and less active hedge funds will use brokers to faciliate trading since making a fat finger error or doing something harmful impacts profits more than the marginal return of working orders on their own The Tabb Group, LLC. All Rights Reserved. May not be reproduced by any means without expressed permission. 3

5 Lastly, solutions and firms that alleviate or bridge the operational differences between swaps and futures trading is desirable. At the most basic level, energy futures traders require the establishment of both initial and variation margin accounts. Moreover, some buyside firms will be responsible for managing their own margin if brokers do not have a margin facility, a process that today could be unfamiliar to them. While this is just one example, technology solutions and firms that can make the swaps to futures transition more easily stand to gain traction. Market Potential Energy futures markets consist of a few main entities, primarily fuel (Brent crude oil/gas) and power (electricity). While other contracts exist (coal), most of the trading activity occurs in these products. Electricity is highly regionalized based on where company outputs occur, such as PJM (Pennsylvania, Jersey, Maryland), New York, or Texas. On the other hand, natural gas is country-specific with Henry Hub futures the most commonly used proxy by US traders. Similarly, crude oil is a worldwide benchmark tracked primarily by US traders through the West Texas Intermediate (WTI) or Brent Crude Oil contracts. Throughout 2012, energy futures global market volume totaled million contracts, or 40% more than 2009 (see Exhibit 4). The US energy futures market represents just over half of global volume, with ICE Futures US and CME Group the largest two exchanges. Outside the US, ICE Futures Europe is the next largest exchange, accounting for 32% of global activity. The only other significant energy futures activity occurs at the Multi Commodity Exchange of India, which accounts for 10% of global volume. Relative growth of the energy futures markets continues to outpace the two major asset types: fixed income and equity, as investors speculate and hedge on prices that remain uncorrelated with other asset types. Exhibit 4: Millions of Energy Futures Contracts Traded on Global Exchanges *Starting October 2012, volume includes ICE Futures U.S. energy conversion. Historical energy volume has been adjusted to include energy futures contracts previously traded OTC. Source: FIA, TABB Group 2013 The Tabb Group, LLC. All Rights Reserved. May not be reproduced by any means without expressed permission. 4

6 TABB Group expects overall energy futures markets volumes to increase again in Assuming money managers and hedge funds continue to incorporate energy futures as part of their investment strategies, the additional volume should continue to outpace other markets. Many market participants say each large player is very important, citing the exiting of Centaurus in 2012 as a major hit to the industry; yet, recent decisions by proprietary trading firms like Infinium trading in Chicago to shift from equity linked futures to energy and commodity products is a positive market signal. The next logical question is how large the energy futures markets will become. In many ways, a market wide transition from swaps to futures has become a catalyst to a market that had already been experiencing steady growth over the past 10 years. If potential firms classify for end user exemptions, they will remain consistent with their trading practices and will try to avoid listed markets due to the added volatility that electronically traded products present. That said, a number of end users are in the evaluation mode of futures trading as Category 2 mandatory swaps clearing rules are expected June 11, Thus, it is not unreasonable to again project 40% volume growth over the next 3 years. Current and Future Participation TABB Group estimates current energy futures market participation is split amongst trading firms (long-only institutions, hedge funds, proprietary trading firms), utility companies (or end users ), and banks, although the line between banks and asset holders can be blurry. At times, financing desks at investment banks will structure deals to provide funding to companies that produce energy and banks have the control to turn on or off their own holdings (see Exhibit 5). Individuals may also participate in markets directly, but are a relatively insignificant portion of the daily trading activity and are limited to those with sufficient wealth and expertise. Exhibit 5 Energy Market Participants Market Firm Type Example Purpose Outlook Commercial End User Hedge Funds Energy Producer (eg. Utility Company) Global Macro Hedge gas/oil price fluctuations Directional strategy with uncorrelated assets High Medium Prop Trading Firm Market making Arbitrage High Money Manager/CTAs Long only Hedge underlying cash positions Medium Investment Bank Financing desk Fund project Low Individual Wealthy person Speculate Low Source: TABB Group 2013 The Tabb Group, LLC. All Rights Reserved. May not be reproduced by any means without expressed permission. 5

7 Going forward, greater activity in the energy futures markets will help to draw new market participants. Specifically, the transparency of the market and added liquidity will draw market attention via new types of trading accounts. Commercial end users, prop trading firms, and large hedge funds represent the largest opportunity for trading energy futures. Energy companies, such as ConEd or Shell, trade billions of dollars in the OTC markets to hedge market exposures, and even just a sliver of this amount would translate into significant volume. By the same token, large hedge funds also present a big upside, as firms are more interested in trading energy futures as liquidity becomes easier to source. With oil and gas prices often times moving based on geopolitical activities, hedge funds and institutions are eager to participate in markets that have a great deal of speculation and alpha opportunities. Introduction of the Volcker Rule also means traders at banks could form their own funds and will be eager to participate in markets where they have expertise. At the same time, prop trading firms will emerge as volumes increase and market-making becomes a more profitable activity. Lastly, the additional market participation will be important to technology providers and brokers alike. Many firms will require elements such as operational, trading, and infrastructure support. Additional trading produced by faster markets, in addition to new players in the marketplace, will translate into new data sets and disparate forms of information that will need to be processed in order to make the best trading decisions The Tabb Group, LLC. All Rights Reserved. May not be reproduced by any means without expressed permission. 6

8 TABB Group About TABB Group is a financial markets research and strategic advisory firm focused exclusively on capital markets. Founded in 2003 and based on the methodology of first-person knowledge, TABB Group analyzes and quantifies the investing value chain, from the fiduciary and investment manager to the broker, exchange, and custodian. Our goal is to help senior business leaders gain a clearer understanding of financial markets issues and trends so they can better grow their businesses. TABB Group members are regularly cited in the press and speak at industry conferences. For more information about TABB Group, visit The Author Matt Simon Matt is a Senior Analyst at TABB Group. He joined the company in November 2005, following four years with T. Rowe Price Associates at its corporate headquarters in Baltimore. Most recently, Matt authored US Futures Markets: State of the Industry 2013, US FCM Business: The Listed Part of the Equation, Malaysian Derivatives Trading: Opportunities and Growth Ahead, US Hedge Fund Equity Trading: The Challenge Is the Opportunity, US Equity Trading 2010/11: Outflows, Outrage, and Balance, and US Hedge Fund Equity Trading 2010: Commissions, Volumes and Traders. He earned a B.S. degree from the University of Maryland and holds an M.B.A. from the Fordham University Graduate School of Business. Limitations Any views or opinions presented in this report are solely those of the author and do not necessarily represent those of Interactive Data Corporation and/or its affiliates ( Interactive Data ). The information contained herein ( Information ) is provided for informational purposes only. The Information is subject to change without notice and does not constitute any form of warranty, representation, or undertaking. In no event shall any user of the Information publish, retransmit, redistribute or otherwise reproduce any Information in any format to anyone, and no user shall use any Information in or in connection with any business purpose or commercial enterprise The Tabb Group, LLC. All Rights Reserved. May not be reproduced by any means without expressed permission. 7

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