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Commodities on the rebound
Mounting interest in commodities as an asset class opens vast opportunities for exchanges.
The last few years have been a roller coaster ride for commodities markets, but interest in this asset class remains high. While much of the activity is over-the-counter (OTC), exchanges have a tremendous opportunity to launch new products and establish clearing partnerships with OTC firms.
According to Celent, in 2008 the global commodity market stood at US$15.3 trillion, with around 85% of the transactions in the OTC market. From 2002 to 2008 the notional value outstanding of commodity OTC derivatives increased more than 500%, and commodity-derivative trading on exchanges grew more than 200%.
This growth was accelerated by rising demand from emerging economies, capital infusion from non-commercial players seeking alpha, and growth in exchange trading. Oil and metal prices became inflated as the BRIC countries (Brazil, Russia, India and China) increased their consumption to build infrastructure. The demand for corn to produce ethanol, combined with China’s move to repurpose land from agricultural to industrial use, drove “soft” commodity prices higher. Moreover, increased risk in some geographic areas including Iraq and Venezuela added to the inflationary mix.
And then, in mid-2008, came the financial crisis. Energy commodity prices, especially crude oil, were extremely volatile in the summer of 2008. Credit dried up as margins on both bilateral and exchange-traded contracts were increased. Value at Risk (VAR) limits were consumed much faster when crude oil was moving up and down US$10 daily compared to when it was moving US$0.25-0.50.
Moderate volatility sparks the interest of hedgers and speculators, but too much volatility is bad for the market. Market participants, who would typically trade 1,000 units of a commodity to gain the exposure on their book, were only trading 50 units.
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Michael Cosgrove
GFI's Managing Director and Head of Energy and Commodities Brokerage in North America
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“It got to the point where we just had too many shell-shocked traders sitting on the sidelines,” says Michael Cosgrove, GFI’s Managing Director and Head of Energy and Commodities Brokerage in North America. “That hit our businesses pretty hard across the board.”
Statistics from the Bank for International Settlements show that by June 2009, the total notional amounts outstanding in OTC commodity contracts had fallen to US$3.729 trillion. Prices declined as physical demand dropped significantly and speculators de-leveraged.
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Fortunately 2010 is shaping up to be a better year, and commodities could be among the first markets to recover from the economic slump. Energy market volatility has dropped significantly. In addition, several governments are planning to invest in infrastructure and energy projects.
Exchanges have an opportunity to cash in by launching new products such as commodity derivatives and index funds. Growth in index especially in the U.S. Many large institutional investors, including pension funds, are seeking exposure to commodities through managed commodity accounts and even single commodity exchange-traded funds (ETFs or ETCs in the commodities markets) and exchange-traded notes (ETNs).
Commodity Futures Trading Commission Index Investment Data shows that at the end of December 2007 the notional value of futures and OTC contracts outstanding in the U.S. was US$147.1 billion. In December 2008, the notional value had declined to US$82.2 billion, but then climbed to US$159.9 billion in December 2009.
Exchanges also can play a key role in providing transparency and minimizing counterparty risk. “Transparency and risk management varies between commodity types,” notes Fredrik Voss, Vice President of Carbon and Business Development at NASDAQ OMX Commodities. “Markets such as iron ore and wood pulp, for example, are known to lack proper risk management tools.”
To some extent electronic trading improves price transparency and risk management. Market participants can save time accessing prices on a screen, even if they are only indications. But with some transactions, the clients want the broker to provide some “color” or perspective on the market. These deals lend themselves to voice trading.
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Paul Newman
Managing Director of ICAP Energy
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“We might do 1,000 deals a day in short date electricity and natural gas. With these high velocity, low value transactions, it is better to enable clients to execute electronically,” says Paul Newman, Managing Director of ICAP Energy. “In coal derivatives, where we might only do 100 deals a day, the volumes do not justify an electronic-only market.”
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While Cosgrove opposes new legislation that is a mandate for exchange trading, he strongly supports central counterparty clearing, and believes this is a lucrative business for exchanges. “Exchanges can clear all the business we do because that’s not what we want to do or what we’re suited for,” says Cosgrove. “I see tremendous synergy between ourselves and clearinghouses now and going forward.”
NASDAQ OMX is one exchange to have partnered with OTC market participants. After purchasing the North American Energy Credit and Clearing Corp. it launched NASDAQ OMX Commodities Clearing LLC (NOCC), a U.S.-based clearinghouse for the OTC power and gas markets. NASDAQ OMX also owns an 85% equity interest in Agora-X, an electronic communications network for institutional trading in OTC commodity contracts.
Commodities were affected by the recession, but now the market is recovering. Clearly there are opportunities for exchanges to capitalize on the mounting interest in commodities by launching new products and promoting efficiency, cost savings, risk management, transparency and liquidity through central counterparty clearing.
OTC trading goes exchange in U.K. power market
The January 2010 launch of N2EX, a marketplace for physical U.K. power contracts jointly operated by NASDAQ OMX Commodities and Nord Pool Spot, marks the first time that traditional OTC trading will take place in an exchange environment. N2EX also plans to launch a cash-settled derivatives power market with a range of clearing services and cross-commodity netting opportunities. N2EX is the result of a market initiative to inject liquidity back into the U.K. power market in which the Futures and Options Association selected a consortium bid from Nord Pool Spot AS and NASDAQ OMX Commodities to provide market and clearing services for the U.K. wholesale power market.
By Sherree DeCovny
Illustration: Valero Doval
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