Over the last two years, the clearing of energy contracts traded over-the-counter has quietly become a huge new line of business for the futures industry. As of mid-December, New York Mercantile Exchange and IntercontinentalExchange, the two main energy marketplaces in North America, were on track to clear more than 30 million OTC energy contracts. That is more clearing business than the whole of the New York Board of Trade, and about as much as the International Petroleum Exchange.

OTC clearing has not attracted much attention outside the energy sector for the simple reason that very few people had a good grip on just how big the business was. Until now, the volume of cleared OTC contracts was not widely disseminated by either platform. To help publicize the success of this new business, both platforms agreed to share their data with FI.

From January to November, Nymex cleared more than 12 million natural gas, electricity, crude and refined petroleum contracts through ClearPort, its clearing facility for OTC contracts, and exchange officials say they are on track to clear 14 million by year-end. ClearPort is generating almost as much volume as the exchange’s Comex division, and it is growing much more quickly.

At ICE, the year-to-date volume cleared by its partner, LCH.Clearnet, was more than 16 million as of the end of November, and could top 18 million by year-end. Both Nymex and ICE say clearing volumes are currently running at about three times the previous year’s level, and both expect to do even more business in 2005.

The frontiers of OTC energy clearing are still fairly limited. More than 90% of the OTC energy contracts now cleared in North America are based on natural gas, according to ICE and Nymex. The trends in electricity and crude products, the two other areas where OTC clearing is available, are on the upswing, but they are farther back on the adoption curve than natural gas.

That said, this business appears to have passed a critical turning point in 2004. When it was first introduced in 2002, the concept encountered resistance from market participants who for various reasons preferred the old way of doing business, and the volume stayed on a relatively low plateau all through 2003.

That changed dramatically in 2004. Starting in March, the volume of OTC contracts cleared through these two marketplaces took off like a rocket. Clearing is now pervasive in the OTC energy market, and numerous industry sources say more and more traders are coming into the clearing world every day. It’s taken a long time, but OTC clearing seems to have reached the long-awaited tipping point.

Implications for the Futures Industry

For the futures industry, the success of OTC clearing has several important implications. First, it has been a great new line of business for the small number of clearing firms willing to handle this business. There are around 20 futures commission merchants authorized to clear ICE contracts through LCH, and 40 that do this business on Nymex.

Second, OTC energy clearing has created a new linkage between the two worlds of OTC trading and exchange trading. On one level this is simple arbitrage between two sets of similar contracts. On another level it is a cross-fertilization of people and ideas, as each side seeks out better opportunities in newly accessible markets.

Third, clearing is paving the way for greater growth of the energy market as a whole. Clearing not only helped restore liquidity post-Enron, it opened the door to an influx of hedge funds and other professional traders, many of whom come from the financial world. These new entrants are bringing more sophisticated trading techniques into the business and driving other participants towards clearing. OTC clearing also has improved risk management by making the cost of credit more visible and by creating a more reliable benchmark for valuing OTC contracts.

The breakthrough in the energy world raises an interesting question: can it succeed in other OTC markets as well? The answer is: it depends. The success in energy markets clearly had a lot to do with the scale of the credit crisis that hit energy companies after the collapse of Enron. The old way of doing business simply could not continue, so the door was open to clearing.

For this reason, the success of OTC clearing in the crude sector will be especially significant. Most of the leading players in crude still have strong credit ratings, and they have more than enough capital to continue trading on a bilateral basis. Even so, clearing is gaining some traction, mainly because it opens the door to greater participation by speculative traders. These traders often have a financial background, they are familiar with futures markets, and they see clearing as a better way to enter this market and establish trading relationships than the old model of bilateral trading.

Invasion of the Financials

What really drove clearing forward, according to numerous industry sources, was the large number of hedge funds and other financial players who came into the market after Enron collapsed. Up until then, power and gas trading had been dominated by the so-called merchant energy companies such as Enron, Mirant and Dynegy, as well as a few large energy companies and a few large banks. When Enron collapsed, this market lost not just one of the largest trading houses, but also its defacto clearing center. Enron effectively was operating as a central hub, facilitating trades among various counterparties and trading for itself on the information flow.

After the collapse, most of the merchant energy companies were unable to remain in the trading business, but the need for risk management remained as strong as ever. That left the field open for new entrants such as Citadel, the hedge fund group based in Chicago, which snapped up traders laid off by Enron and others and built a sizeable trading operation in power and gas. In some cases, the traders displaced from the merchant energy companies set up their own funds and came back into the business for themselves. A number of banks also came into the business, notably Barclays, Bank of America and Merrill Lynch, while other banks that were already well-established in energy trading, such as Goldman Sachs and Morgan Stanley, expanded their presence. Lastly, a small number of merchant energy players, notably Constellation and Sempra, continued to run a trading desk and embraced clearing as a way to bring liquidity back to the market.

“The OTC energy trading market has changed dramatically over the last several years,” says Jeffrey Sprecher, the chairman and chief executive officer of ICE. “When we started ICE, back during the height of the Enron era, there was a whole raft of merchant energy companies active in our market, and those players have almost all exited the speculative trading business. In their place we are now seeing the entrance of hedge funds, proprietary trading shops, and individual displaced merchant energy traders who are coming back into this market. So the business today is fundamentally different in terms of the types of people trading, and those people are increasingly demanding clearing.”

During the earlier phase, most of the main players in the market had bilateral relationships with each other, so there was little demand for clearing. The new entrants, on the other hand, could enter the trading business more quickly via clearing than by writing ISDA legal agreements with a dozen or more counterparties.

“Going back a few years ago, when someone entered the OTC space, the first thing they did was travel around and sign bilateral trading agreements with the top 50 trading counterparties,” says Sprecher. “Now people are coming back into the space by just opening a clearing account, and they do not have to spend time or energy setting up bilateral agreements. In fact with clearing they can be anonymous, and they don’t have to have any particular reputation. It’s a level playing field.”

“Bo Collins is a good example,” Sprecher continues. “He was a large OTC trader at El Paso in the merchant energy era, and then left to go to into management at Nymex. Now he has come back into the trading space as a principal behind his own fund. With OTC clearing, he can efficiently set up and manage his business without signing individual bilateral agreements and dealing with counterparty credit issues. And there are lots of examples of other people coming into the business in the same way.”

Collins, who quit Nymex in June, decided to form his own hedge fund called MotherRock. After several months of gathering money from high net worth individuals and institutional investors, he jumped back into the energy markets in December and hopes to reach a total of $120 million in assets under management in 2005. He says clearing is a key part of his business strategy and stresses the administrative advantages.

“There is no reason for me right now to do business that is not cleared,” says Collins, whose fund is active on both clearing platforms. “If for no other reason, the operational efficiency is so important. The hardest part of trading is the operational side, and with clearing there is very little possibility of an operational error.”

As these new players came into the market, they put pressure on other participants on the ICE trading platform to move toward clearing. Whenever one of these hedge funds posted a bid or offer on the ICE trading screen, the price was visible to every other participant in that market, whether they had signed up for clearing or not. But if one of those other participants decided to hit that price, the system would reject the trade if they had not signed up for clearing. So very quickly the traders realized that clearing was going to improve their access to liquidity, especially since the hedge funds were making some of the best prices available in the market.

All this took place at a time when many of the established participants were suffering from severe credit problems and were unable to continue trading with their traditional counterparties. In some cases, the company simply could not come up with the necessary cash to meet collateral requirements that were rising as their credit ratings were falling. In other cases, the company was forced to cut off trading with certain counterparties because they had exceeded their credit limits.

On the ICE system, this had the effect of turning the screen red. Any bids or offers posted by eligible counterparties are colored white; those posted by ineligible counterparties are colored red. This preserves anonymity and allows all participants to see the entire order book. Signing up for clearing had an immediate effect—the universe of eligible counterparties expanded and the prices went from red to white.

“The success of this concept has redefined the OTC market for energy products and helped the industry mature,” says Chris Edmonds, the head of ICAP Energy. Clearing allows for the “optimization” of credit risk management, he says, by concentrating it at the clearinghouses and by bringing the futures clearing firms into the picture. “This type of third party credit mitigation has been the right product at the right time for this industry.”

Edmonds, whose firm is one of the leading voice brokers in OTC power and gas, added that clearing has changed the composition of the trading environment by encouraging hedge fund participation. “We wouldn’t have had hedge funds coming into the market without this. In the past, they were only involved with energy futures. Now they have direct access to wholesale market space. They can trade with producers, not just banks, without taking on additional credit risk.”

“The vigorous growth in activity on the ClearPort system clearly indicates that financial security and the mitigation of counterparty credit risk are of high importance to market participants throughout the energy industry,” says Nymex President James Newsome. “The system is attracting new users, more companies are trading and new contracts have been added. The varied slate available through ClearPort now consists of more than 100 contracts.”

The Hedge Fund Perspective

John Arnold, one of Enron’s top traders during the boom years, set out on his own in 2002 and established Centaurus, a Houston-based hedge fund dedicated to trading energy products. His firm has become one of the biggest players in the market, reaching $1 billion in assets under management. Clearing was a central part of his business strategy and now accounts for around 75% of the fund’s trading.

“After Enron collapsed, there was a general revaluation of credit risk among energy companies,” he explains. “The better credits were less willing to take on the lesser credits as counterparties. So the lesser credits found themselves with fewer counterparties willing to trade with them, even though they still needed to hedge the pricing risks in their business. Hedge funds previously had not been involved in the over-the-counter market, except for the very largest, because the other participants were reluctant to grant credit to that type of entity.”

Arnold, whose fund is active mainly in gas and power trading, adds that clearing enabled a tremendous growth in the number of smaller companies active in the OTC energy market. Where there might have been around 10 hedge funds in this market two years ago, he estimates that there are now around 100. Most of these are new shops with relatively low capital, but there is also a lot of interest among the established macro funds such as Citadel, Tudor, and DE Shaw. In effect, he says, clearing allowed the market to move from having a small number of large firms toward having a larger number of small firms.

“Clearing has been fantastic for funds like ours. We are able to access everyone in the market. At first it was the lesser credits who were most interested, but then the better credits realized that they weren’t getting the best prices if they stayed out of the cleared space.”

On the opposite end of the scale are Mark Vonderheide and Rob Harper, who formed their own firm in January to trade over-the-counter energy products. Vonderheide says that when ClearPort was introduced, they decided that there was an opportunity to apply their combined skills to this environment. “Until ClearPort came around, the only OTC market makers were institutions with the balance sheet size and back office and credit support necessary to be in that business. With ClearPort, we were able to set up shop within a few months and trade with all of those same participants.”

Their firm, HPR Commodities, concentrates on crude and refined products and functions very much like a local on the floor. “When our clients call up, they typically need to buy or sell a structure, and we quote a price. They will call around to three or four other houses, and we might be the only one that will do this exclusively as a cleared trade. Most of our customers are trading desks at big firms; they are happy to lay off risk and move on a more interesting part of the transaction.”

Vonderheide says the business is taking off. “We have had a tremendous reception. We have eight people now and there’s way more business than we can handle. The market is embracing cleared transactions as another important means to gain liquidity.”

The Clearing Firm Perspective

When OTC clearing was launched in the spring of 2002, there were some clearing firms that embraced it right from the start, but the community as a whole was somewhat skeptical. One reason was that firms were concerned about the potential risk to the clearinghouses from these products, which were unfamiliar, illiquid and highly volatile. Plus, much of the trading was conducted by firms with weak credit ratings in a sector riven with bankruptcies.

Two years on, clearing firms are now much more comfortable with these products. They understand the underlying better, they can see the open interest building up, they are more confident that they can liquidate the contracts in case of a default, and the credit quality of the sector seems to have stabilized. In fact, the clearing firms are busy signing up more trading firms for clearing accounts and looking forward to the introduction of OTC clearing for additional products based on weather and emissions.

BNP Paribas, for example, has parlayed the strength of its parent’s relationships in the energy sector into a sizeable OTC clearing business. Lou Caiafa, a managing director at the firm’s futures commission merchant subsidiary in New York, says he works with energy marketing and trading groups in different parts of the country. These groups typically are involved in some part of the gas industry—pumping gas out of the ground, owning pipelines or tanks, or moving gas from producing areas to pricing points—and they need basis swaps and other types of OTC contracts to manage pricing risk.

“Initially the FCMs had some concerns, but as we went along, the concerns disappeared,” Caiafa says. “On ClearPort, for example, we can set the level of risk exposure that we are comfortable with, and if the traders see that they are about to exceed the limit, they can call us and we can look at the trade and adjust the limit level if appropriate.”

One of the initial concerns was liquidity, Caiafa explains. “Say a counterparty goes bankrupt, you’re stuck with Waha basis swaps, and you need to liquidate. In the early days, who knew about Waha basis? Now, you can see the open interest, and you know the liquidity is there.”

Richard Schaeffer, a senior executive at ABN AMRO and the vice chairman of Nymex, says clearing has become pervasive in the energy business. “This is a tool that is here to stay. Previously people did not understand how it worked, but now it is being used by everybody—trading groups, producers, hedge funds, even traders on the floor.”

Schaeffer adds that OTC clearing has added a new and profitable line of business for FCMs by allowing them to capture more business from the OTC world. “OTC clearing gives us a new opportunity to work with the treasury groups at oil companies to help mitigate risk. Previously they tended to do all of their business on a bilateral basis, but now they are willing to do clearing, especially if that facilitates a deal with a counterparty with a weak credit rating.”

Why Not Power?

Even though power and gas trading are closely related, clearing has made much less headway in power than in gas. The reasons are complex. For one thing, the power business was deregulated more recently than gas, so the trading mentality is not as well established. Another reason is that electricity cannot be stored and is not easily transported, and the market is fragmented into many regional pools, with no national benchmark like Henry Hub in gas. Still another reason is that the market is still dominated by utilities and other power generation companies that are primarily interested in the underlying physical market and often seek delivery on the OTC contracts that they trade.

In addition, there seems to be some resistance from within the power industry. Some companies prefer bilateral trading because they want to see who they are trading with, according to several industry sources. There is also a perception on some trading desks that cleared trading is more expensive than bilateral trading.

Constellation Energy is one of the nation’s largest wholesale sellers of power and runs a large physical trading operation for managing customer business, hedging its generation portfolio and limited speculative purposes. Constellation’s chief operating officer, Stuart Rubenstein, says his firm has supported clearing right from the start because of the potential efficiencies in the use of capital. Up to now, however, clearing has not yet reached critical mass in power trading, and consequently it is more expensive than bilateral trading.

“Every contract moved from bilateral trading has to be margined, so in the short term the cost of the business goes up,” explains Rubenstein. “But as more people clear, the cost will go down, and the effects on capital efficiency should continue to grow.”

Clearing is gaining traction in power, he says, and cleared volumes are increasing more rapidly than the overall volume of trading. Several other sources agreed with this assessment, adding that the volume of cleared power increased appreciably on the ICE/LCH platform in the second half of 2004. This is particularly the case with PJM contracts, which are based on the price of electricity in one of the major regional pools. PJM contracts are well suited to financial trading because the pool has a daily posting of clearing prices, and financial players such as hedge funds feel that they can participate in this market without having a presence in the physical market for electricity.

The question in Rubenstein’s mind is how long before the overall power trading business gets to the point at which clearing becomes less expensive than bilateral. “Currently about 20% of our bilateral trades are cleared. We would like that to rise to 100%, but others don’t see it that way.” Constellation has an investment grade credit rating, he adds, and much of its bilateral trading can be conducted within existing credit lines. “The lower rated players should really be flocking to this.”

What Is OTC Clearing?

Let’s step back a moment and look at what this business entails. First and foremost, clearing is a mechanism for reducing counterparty credit risk. In the OTC world, every participant is exposed to the risk of default by the other side of the trade, and over time these exposures build up into a complex web of counterparty credit risk. This is not an obstacle when everyone in the market has a good credit rating, but when there is a credit crisis—as in the case of energy post-Enron—this system requires a large injection of collateral.

With OTC clearing, on the other hand, the various trading exposures are netted down to a single exposure, usually much lower, to a central counterparty, namely the clearinghouse. This is accomplished by a process called novation, in which the old bilateral contract is broken up and the trade is re-established in two parts, with the clearinghouse on one end of each part. This allows for multilateral netting, which can reduce credit risk exposures by as much as 90% if the whole marketplace agrees to participate. It also allows for more efficiency on the back end.

To make this work, however, the contracts have to be relatively standardized, or plain vanilla, to use the traders’ term. The more complex products, and the products that extend over a longer time frame, are not well suited for clearing. As a result, most of the volume being cleared is front month trading in a handful of benchmark contracts, although some traders report that increasingly longer strips are coming into ClearPort, with OTC brokers working with locals on the floor to negotiate a price.

There is also the small obstacle of cost. The clearing firms charge fees, the clearinghouses charge fees, and then there is the issue of margin. For traders with experience in futures, the daily margining process is no big deal, but for some of the more traditional energy players, such as utilities and the energy merchants, it was a new concept, and that slowed down the adoption process.

During the boom days of energy trading, before Enron collapsed into bankruptcy, gas and power traders were accustomed to trading on a bilateral basis with minimal if any margin requirements. Typically their firms set up a credit line with the other players in the market, and so long as they stayed under the threshold of that credit line, no margin was required. With clearing, on the other hand, every trade is subject to margin requirements, which requires having the ability to manage daily cash flows to and from the clearinghouse.

Competition in Clearing

As the volume data makes clear, the Nymex and ICE platforms are running neck and neck in terms of the amount of clearing business they are attracting. ICE does not disclose the volume of clearing on an individual contract basis, but ICE officials say that their platform tends to dominate on the small number of contracts that can be cleared into LCH, while Nymex dominates on contracts with less liquidity, and on contracts where the voice brokers are dominant. Nymex officials counter that their platform offers greater regulatory certainty, since contracts are converted into futures, as well as greater liquidity in the back months and more latitude for margin offsets.

Recently the two platforms have begin competing on price as well. ICE has waived its transaction fees on its WTI crude oil swaps, while Nymex waived transaction and clearing fees on all of its electricity contracts. Both fee waivers will last for the whole of 2005. In both cases, the platforms are targeting the areas where the other platform does more volume, according to several industry sources.

Can the success of OTC clearing in energy be repeated in other areas? One obvious lesson from this experience is that the breakthrough in energy had some unique pre-conditions. Power and gas trading first boomed, then collapsed, creating not only the conditions that made clearing necessary but also an environment that required a functioning wholesale market. The credit crisis that hit the U.S. power and gas sector was the equivalent of a 100-year flood. It dislodged old practices, swept away some players, and prepared the ground for sounder practices. Other sectors are not likely to go through such extreme conditions.

On the supply side of the equation, Nymex faced a competitive threat from ICE, and this helped encourage the exchange to take a chance on ClearPort, even though some elements within the membership were concerned that OTC clearing might undermine the floor business. As it turned out, ClearPort has been a great source of additional business for the exchange, and more and more locals are making markets on ClearPort. In other sectors, the incumbent exchanges might not be as aggressive in extending the clearing mechanism into a rival marketplace.

Third, the volatility of crude and gas attracted a lot of financial traders and investment funds into the energy sector, and this in turn helped drive the adoption of clearing. As a contrast, one could look at the difficulties faced by single stock futures, which were launched into a bear market for stocks.

The breakthrough in energy is still just at the beginning of the growth curve, however. Both platforms expect to make many more products available for clearing, not only within the power, gas and crude sectors, but also in new categories such as weather and emissions. Both platforms also are working to extend OTC clearing to European energy markets and deepen their penetration into North American energy markets.

There is also an increasing integration of the futures and OTC trading communities. At Nymex, some locals have begun looking for ways to apply their expertise in making markets to the ClearPort contracts, and view OTC trading as an essential part of their business.

“With the success of OTC clearing, it won’t be as simple to be a local trading at Nymex,” says Collins, the exchange’s former president. “If you want to participate in all the information of the market, you have to participate electronically and OTC. I don’t think there is going to be a dramatic change. Some locals will stick to trading futures and they will do fine. But OTC clearing allows the traders who have a deep knowledge of the floor to have a whole new opportunity to conduct their business in the OTC world.”

ICE for its part has turned to the mainstream futures trading community, working with independent software vendors such as Trading Technologies to improve the distribution of its products. ICE recently held seminars in Chicago and London to introduce its products to futures traders, and Sprecher believes these traders could become a significant source of volume.

“It takes some education to reach this community, but once that takes place and they get active in the markets, we get a lot of positive feedback,” says Sprecher. “So we are cautiously optimistic that we are going to see new market participants from this community and through the ISVs connected to our platform.” 

OTC Energy Clearing: 2004 Volume

ClearPort vs. ICE (number of OTC contracts)