Taking the screen test

Volume2/No12 October 2005 Cover story: brokers Taking the screen test Screen trading is spreading faster than ever in the energy markets and market dynamics are changing as a result. Do interdealer brokers in the market see this advance as a threat or an opportunity? Stella Farrington finds out This year may well be remembered as the year the energy markets finally embraced electronic trading. Not only did the International Petroleum Exchange make its high-profile move from floor trading to screen trading, but in the over-the-counter energy markets, screen trading began to spread as never before. Between January 2004 and July 2005 there was a 56% rise in the number of OTC trading screens installed by Trayport, the world s leading provider of energy trading technology. Some 6,100 Trayport trading screens were in use by July this year, compared with 3,900 in January 2004. The fact that more people than ever now have direct access to the market is changing market dynamics and has far-reaching implications for the intermediary interdealer brokers who connect these participants. It has often been said that the advance of electronic trading sounds a slow death knell for interdealer brokers. But perhaps surprisingly, rather than feel threatened by this new energy world, today s interdealer brokers are often the first to extol the virtues of the electronic marketplace. There s a real explosion of players entering the energy markets now because of screen trading and the possibilities of OTC clearing, says Paul Newman, the London-based managing director of interdealer broker Icap Energy. Screen trading also leads to the collection of price data, which in turn can allow more sophisticated, index-derivative trading to develop. And brokers agree this is what s happening. There s more sophistication entering energy trading, with interregional spreads, exchange-for-physical and index trades becoming more common across the product range, notes Andrew Polydor, managing director of interdealer broker Tullett Prebon Energy. New participants have flocked to the energy markets this year. Some are driven in by the need to manage their carbon risk under the EU emissions trading scheme, others want a hedge against high energy costs, and still others, such as banks and hedge funds, want exposure to rising oil and gas prices and see arbitrage possibilities no longer present in the saturated financial markets This explosion of new players coupled with the spread of 1 of 1

technology furthering market sophistication, is an exciting mix, participants say. In the 24 years that I have been in the energy markets, this is without a doubt the most interesting time, enthuses Michael Cosgrove, chief executive of North American operations for independent broker Amerex. And that enthusiasm is felt on both sides of the Atlantic. European energy markets this year have finally come of age, says Ron Levi, head of European markets at USheadquartered interdealer brokers GFI. The UK and European gas and power markets have become proper pools of liquidity, oil has come to the fore once again, as have freight derivatives; coal is becoming a properly traded market, and carbon brings everything together. Indeed, the new EU emissions market which links the energy markets and promotes cross-product trading is predominantly screen-traded, and is shaping this new energy market landscape. Most of the interdealer brokers report that screen volumes are growing faster than voice-brokered-only volumes, but it s worth noting that definitions can be blurred. The EU emissions market, for example, is described as almost 100% screen traded, because most orders end up on the International Petroleum Exchange/European Climate Exchange (IPE/ECX) electronic screen. But as most players want clearing, brokers give up contracts to LCH.Clearnet, which puts them through the IPE/ECX where they are registered as futures contracts. However, the origin of many of the contracts may have been voice-brokered. Additionally, customers may phone for advice on a market and will end up wanting part of their trade to go straight onto the screen, and part to be voice-brokered. More and more customers are requesting that voice-brokered deals be entered on a screen for administrative efficiency. And of course, the ratio between screen and voice-brokered trade also alters radically from market to market. Brokers report markets such as European power and gas as between 50% 70% screen traded. But even in these markets, it s only the liquid front end of the curve that works well being traded electronically. Markets further out along the time curve, for example, are often very illiquid and it will remain difficult for a company always to show its best bid or offer, notes Chris Edmonds, president of the US-based Energy Brokers Association, who is also a senior vice-president at Icap in the US. It s more like a structured product that far out. You don t want to show your position, so you d use a broker to gain the colour of the market. This structured product feel to the market may well mean energy markets will never migrate as fully to the screen as financial markets, experts believe. Because commodity derivatives are tied to underlying physical products, there are different settlements and individual peculiarities. So standardising contracts is a lot more complicated due to their unique characteristics than it is in financial markets. A cargo of oil just about to offload at a refinery in the UK is not wholly fungible with one about to offload the other side of the Atlantic, for instance, notes Ian Stevenson, chief executive of the London Energy Brokers Association (Leba). As markets become more liquid contracts can be more easily standardised and what starts off as an exotic 2 of 2

contract needing voice broking may become more suited to screen trading over time. However, as markets are always developing, there will always be new contracts springing up, and the first few times of trading them, people are likely to require brokers, not only for advice on the trade, but to help connect two interested parties. But even when a trader is comfortable with a trade, he/she may still want to use a broker for time and efficiency reasons, especially for a multi-legged trade. And one of the most compelling reasons for using brokers might be to spread a large order around the market without revealing a large position. For this reason, customers prefer to have at least four to five large brokers in any one market. The big interdealer brokers also bring expertise to the energy markets gained from their experience in financial markets. Tullet Prebon, for example, has recently transferred several staff from the financial markets into energy markets. We are beginning to offer our brokers the analytics and systems gleaned from the fixed income and interest-rate derivatives market into energy markets, says Stephen Duckworth, chief operating officer for EMEA at Tullet Prebon. Duckworth has just overseen the relocation of Collins Stewart Tullet s trading floor to new premises in London s Bishopgate. The move also brings Tullet Prebon Energy s team onto the large broking floor. Clearing But as well as screen trading, there s another development that is having a profound affect on the market, and that s the growth of clearing in OTC markets. While exchanges have always offered clearing as part of the trading set-up, OTC trade had tended to be largely uncleared. The spread of technology is facilitating clearing and there are now several large clearing providers offering clearing across OTC markets, including Nymex ClearPort, Ice, LCH.Clearnet, Nordpool, EEX and Nos, which offers specialised clearing in freight derivatives. Clearing is opening up the market to exponential growth as new players who have no credit knowledge of each other are able to trade together without so many credit restrictions. Clearing and screen trading is also blurring the definition between exchanges and OTC markets by greatly reducing the credit risk that OTC trading previously carried. For the customer, trading electronically on a broker s screen with clearing has many of the same benefits as trading on an exchange. So, rather than shut the interdealer brokers out of the markets, screen trading has in many ways enabled them to compete better with exchanges. The two largest energy exchanges, Nymex and Ice, are generally perceived to have taken very different approaches to brokers in their bids to move in on the OTC markets. Nymex ClearPort, the clearing arm of Nymex, has proved more broker-friendly. ClearPort has changed OTC energy trading forever, says Amerex s Cosgrove. It used to take a new market entrant six months or more to establish sufficient liquidity to begin trading. Now you can put margin into an account and access the US OTC natural gas and electrical power markets the same day, he says. I would guess that in excess of 90% of all ClearPort business is done by OTC brokers 3 of 3

In addition, some of the larger Nymex locals are now using OTC brokers in conjunction with ClearPort to trade OTC markets they couldn t enter before, he adds. However, the European market is lagging the US in terms of clearing. Despite an offering of European contracts on Nymex ClearPort, there has been relatively little interest from Europe. The European market isn t ready to clear yet but the products are out there, says Joe Raia, Nymex s senior vice-president of marketing. However, it looks set to take off in Asia, he notes. China Aviation Oil really opened people s eyes to the benefits of clearing, and Singapore is really jumping on the bandwagon now, he says. Ice, on the other hand, is usually perceived as less broker-friendly. As a US-based OTC marketplace, Ice s markets come under the remit of the US regulator, the Commodity Futures Trading Commission (CFTC). Ice comes under the remit of the Commodity Futures Modernisation Act (CFMA) of 2000, which stipulates that OTC markets pursuant to this act must be principal-only exchanges. As such, brokers and intermediaries are not permitted to execute within this market structure. However, separately, Ice received an exemption for registered exchange locals (whether registered with the CFTC or the UK s Financial Services Authority) to trade in Ice s OTC markets. Ice s clearing system, though, is widely used by brokers who can give up trades to Ice for clearing only. These trades, known as blocks, are shown on the Ice ticker and submitted for clearing to LCH.Clearnet where they are cross-netted against other positions. Most of the interdealers, though, see Ice as a competitor. We re in competition with Ice, as we are with all electronic and voice brokers, every single day, notes David Pinchin, co-chief executive of TFS in New York. But more cooperation could be good for both sides, believes Cosgrove. We understand Ice s fear of revealing their prices to OTC brokers, but we believe that Ice would do well to open their business to them. Enron Online did that and experienced a significant uplift in turnover and profitability, he notes. However, Enron Online gained an exemption to the CFMA, eliminating restrictions on market participant requirements, which market watchers say would be exceedingly difficult, and perhaps unwise, for an OTC exchange to do today. GFI s Levi feels brokers and exchanges will always be in competition, but believes brokers offer some advantages over exchanges. We are de facto exchanges and are judged so by rating agencies, notes Levi. Brokers can move quicker though there s less red-tape. There s no exchange contract in the world that didn t start with voice-broking. Oil the exception Although screen trading is undoubtedly increasing across OTC energy markets, it s with one very notable exception the oil markets. Interestingly, despite the high-profile move of the IPE from open outcry to electronic trade there is no one successful electronic platform for trading OTC oil and Trayport hasn t developed one for oil 4 of 4

So far, there appears to be little demand for screen trading in the OTC oil market. London-based PVM, the largest independent broker devoted solely to oil and petroleum products broking, took the decision not to invest in a screen when the interdealer brokers were rolling out screens for other markets. We wanted to focus on our core business, and were not convinced of the value of investing huge sums on IT, explains PVM s managing director David Hufton. In the OTC oil markets the technological revolution found its form in instant messaging around 2002. Instant communication with the rest of the market at the touch of a button transformed broking and trading in the OTC oil markets. Bar the point of execution, instant messaging is practically an electronic market, but with the advantage that traders can be selective in who they show their bids and offers to. For brokers it meant if they heard an important piece of information that people might want to trade on, they could let all their customers know instantly, rather than having to phone through a list. Instant messaging revolutionised the business and contributed to our growth, notes PVM director Philip Wiper. Demand for clearing has also been slow to enter the OTC oil markets. Wiper believes this could have historical reasons. Companies who didn t have good credit ratings with the market in general were able to trade on the IPE where clearing was mandatory, thereby leaving the traders in the OTC markets very comfortable with trading with each other. Nevertheless, he believes the potential for OTC volume growth is enormous as clearing allows new entrants. Even in the area where oil trading has gone electronic IPE Brent and gas oil futures markets brokers have been surprised at the market share they ve retained. We feared with the IPE going electronic that our services would be dispensed with, but we ve been pleasantly surprised, says Hufton. He believes PVM is now the leading electronic oil futures broker. The company comes consistently in the top three in the IPE s monthly report on execution volume, rubbing shoulders with much bigger principals. Most of the interdealer brokers have no current plans to enter the oil futures markets. Outside the oil market, though, where screen trading is flourishing, do the brokers pose a threat to exchanges? Most market watchers believe not. It s felt that in most markets no single broker will capture over 50% of the OTC business, and certainly not across markets as a whole, and therefore clients will always need to buy several brokers screens. Rather than viewing their screens as a potential way of gaining market domination, most of the interdealers see them simply as a service they offer to customers. Even Spectron, which has always been out in front when it comes to screen trading, believes screens are just a service to go alongside voice broking. Electronic broking won t take over the whole space, says Spectron director John Evans The hybrid model works well 5 of 5

The birth of electronic trading Electronic trading in the over-the-counter energy markets gained its first real footing with the creation of theatlanta-based Intercontinental Exchange (Ice) in March 2000. A partnership of BP, Deutsche Bank, GoldmanSachs, Morgan Stanley Dean Witter, Royal Dutch/Shell Group, SG Investment Banking, Totalfina Elf, andcontinental Power Exchange (who provided the trading technology), Ice went head to head with Enron Onlinein 2001 before the infamous collapse of Enron at the end of that year.at the time, Enron s demise, coupled with the burst of the tech bubble, seemed proof to many that onlinetrading in energy was not the way forward. But the interdealer brokers continued to offer screens.spectron was the first interdealer broker to develop an online trading screen for the coal market in NorthAmerica in 1999, which was then adapted and launched for the European gas and power markets at the startof 2000, just a month after Enron Online went live. GFI followed with a Trayport screen in 2000, and Icap and TFS rolled out Trayport screens in 2001. Consolidation Experts believe it s unlikely that there will be any more consolidation of the big interdealers in energy, butconsolidation will continue among the boutiques. In particular, more acquisition of boutiques by theinterdealers is almost certain, as it is the interdealers preferred method of entering new markets. The large independent brokerages are also being eyed. Amerex has had about half a dozen unsolicitedoffers of interest from potential buyers in the past year, says chief executive Michael Cosgrove. We renot opposed to being bought, but so far none of the offers has made good enough sense, he adds. Unlike others, PVM has displayed a distinct reluctance to entering into acquisition discussions withinterdealer brokers. The culture of PVM is very different to the money brokers, says Hufton. Our beliefis that if you are going to be a successful oil intermediary, you need to be a specialist, he says. 6 of 6 The company prides itself on its very low staff turnover with, for instance, seven of its 22 London crude oilbrokers clocking up more than 10 years service with the company. The one area it would like to gain a

$1 trillion, 50% of which is electronic. Icap Energy was formed in1990 to broker oil and moved into electricity and gas markets from 1995. In October 2002Icap acquired Kentucky-based APB Energy and in June 2003 it bought London-based Inter-continental Energy Brokers. In 2004 it launched options trading on the US petroleum statis-tics, and freight derivatives trading with shipping broker JE Hyde. In August this year itannounced the acquisition of US brokerage United Fuels International. Icap Energy hasaround 90 brokers in Europe, Asia and Australia and around 120 in the US. Prebon Tullett started in the energy markets in 1990 with gas in the US. In 2003 it beganramping up its presence in the energy markets, hiring a European gasoline team from TFS.In 2005 it invested heavily in emissions and freight. It now has 150 brokers globally. Established in 1988, initially in the crude oil market, Spectronis solely dedicated toenergy. Following a management buy-in/buy-out in 1999, the group developed into adiversified provider of services to the energy trading industry. The group has approximately100 energy brokers globally and three LME metals brokers. Founded in 1985, Tradition Financial Services(TFS) is a market leader in brokering financial and non-financial products. TFS Energy was established in 1989 to specialise inderivatives across the whole energy spectrum and exchange-traded futures and options.today, it employs around 125 voice brokers, and has dedicated Nymex floor clerks in natural gas and crude oil. Amerex, the largest independent energy broker, began as a broker of heating oil, fueloil and gasoline in 1978. It now has 148 brokers worldwide, and specialises in US electricityand natural gas, particularly swing swaps and natural gas options, European fuel oil, NorthAmerican emission, coal and freight.? PVMwas founded in 1971, beginning in the refined products markets and moving intocrude oil broking in 1974. It is the only large independent brokerage dedicated solely tothe oil and oil products markets, and now has around 60 brokers worldwide. 7 of 7