Analysis: Commodity exchange battleground switches to "swaps"
CHICAGO (Reuters) - Two of the world's top commodity exchange powerhouses are scrambling to turn new regulations to their advantage in an important but largely hidden piece of their business, the trading and clearing of energy swaps.
Chicago-based giant CME Group Inc. (CME.O) has lost ground in the estimated $1.2 billion-a-year business of guaranteeing over-the-counter swaps to arch-rival IntercontinentalExchange Inc. (ICE.N) in recent years, company data show, as the Atlanta-based upstart offered cutting-edge trade technology.
Both companies are now racing to carve a new advantage by recasting many, if not most, cleared energy swaps as futures -- thereby making them exempt from new Commodity Futures Trading Commission rules due to come into effect on October 12. Some of those rules may now be delayed, Bloomberg reported.
The switch to futures is in large part semantic: In most key respects, the newly renamed oil, natural gas or electricity futures contracts are almost identical to the swaps that companies like BP (BP.L) or Glencore (GLEN.L) have been routinely using to hedge for a decade.
But for the energy industry, where clearing has been a mainstay ever since the Enron meltdown over a decade ago, the benefit of switching to futures is huge.
Under the CFTC's new swaps rules, many could face much stricter regulatory requirements, including putting up more capital, if they trade more than $8 billion a year of swaps. Whichever exchange offers the smoothest transition and greatest regulatory security stands to win more volume.
For both ICE and CME, the stakes are substantial. Over-the-counter energy clearing generated about $400 million or 30 percent of ICE's total revenue last year, and about $300 million, or 9 percent of the CME's. CME does not break out revenue from clearing other kinds of swaps.
And even though energy clearing is a smaller piece of the CME's pie, analysts say there is greater pressure on the CME to get it right in the battle for market share, one that is fuelling the biggest energy upheaval in a decade.
Although the regulatory uncertainty continues to cloud the outlook amid questions over what exactly will be counted as a swap, the CME "might not be as well positioned as ICE" for the coming era, says KBW analyst Niamh Alexander.
For at least the past three and a half years -- as far back as CME data is available -- ICE has dominated the business, with volume doubling even as CME's activity has slipped.
Last year ICE handled nearly four times the energy swaps contracts as CME; so far this year ICE's volume is running at five times that at CME.
ENERGY SWAPS IN CROSSFIRE
The change is part of the Dodd-Frank financial reforms meant to drive the over-the-counter derivatives market -- blamed in part for exacerbating the 2007-2008 financial crisis -- into the safety of clearinghouses, which guarantee the trades.
In broad terms the shift means money for clearinghouses, with vast parts of the interest rate and credit swap trading currently done bilaterally over-the-counter. Clearing revenue could reach about $2.1 billion by 2014, says Alexander.
There is less growth for energy swaps, which have been predominantly traded on a centrally cleared basis for years.
Regulators, for their part, say they are merely trying to create a safer world.
"I could care less about any competitive issues between CME and ICE, but I want to ensure that our rules don't roil the markets," CFTC commissioner Bart Chilton told reporters this week in Chicago.
In a swap, the trader on one side of the contract agrees to periodically pay a fixed price for, say, a barrel of oil, and the trader on the other side agrees to pay whatever price the market currently bears.
Like an exchange-traded futures contract, which is a deal to buy or sell a set amount of a commodity at a future date, a swap lets traders lock in prices or bet on price swings. But swaps have historically been traded away from exchanges and were not as heavily policed -- until now.
ICE and CME grew out of very different parts of the energy market. ICE, founded in 2000 by big Wall Street banks, energy companies and electricity merchants, was a power and gas trading platform, while the New York Mercantile Exchange and Clearport, acquired by CME in 2008, had its deepest roots in oil.
Ever since the late 2001 collapse of power-trading giant Enron drove most energy swaps users to seek the safety of clearing, both have grown. The 2008 financial crisis that forced companies to reassess the creditworthiness of the biggest traders gave another boost to clearing activity, years before new rules would make such centralized risk mandatory.
But over the years, offerings by the CME and ICE have increasingly overlapped for both on-exchange futures -- including ICE's successful U.S. crude contract that mimics the Nymex benchmark -- and clearing for off-exchange swaps.
CME and ICE compete most heavily in natural gas swaps, which make up about 57 percent of energy swaps cleared on CME's Clearport and 81 percent of OTC energy volume at ICE, according to data from the exchanges.
Clearport, CME's energy clearing platform, also does a brisk business in oil swaps, which account for about 23 percent of the total, while ICE's second-biggest market is for power swaps, comprising 16 percent of ICE's swaps business, the data show.
"I'd say they're competing head to head on clearing now," says Chris Thorpe, executive director of energy derivatives at broker INTL FC Stone. "The ICE technology and back-end systems seem to be better, and ICE has always had more competitive fees."
ICE seems to be pulling further ahead this year.
ICE cleared about 2 million OTC energy contracts a day in the first six months of the year, up 25 percent from its 2011 average and double 2009, according to its filings. CME handled 440,000 contracts a day this year through August, about the same as last year and down about 10 percent from 2009.
VOILA -- FUTURES!
ICE has set out a relatively straightforward response to the regulatory changes: Over this coming weekend, it will convert all of its cleared energy swaps to futures. CFTC approved the move this week, and allowed it to keep the same margin offsets, which save money for traders, it had when the contracts were swaps.
It is a simple transition for ICE, since its most liquid cleared swaps are already traded on its electronic platform.
"ICE's transition from swaps to futures ensures that markets remain transparent and liquid because they already trade competitively and transparently," an ICE spokeswoman told Reuters.
A CME spokesman declined to comment on liquidity, but said the exchange is "ready to go," pending regulatory approval for some its own rules to ease the transition to futures.
The CME has a more complex path, and will institute a series of rules that will make it easier for traders to replace swaps with futures but retain the benefits of off-exchange deals.
Clearport contracts start life as swaps, and are converted to futures at clearing. Under a new rule filed late last month, CME will allow users to enter into the very same contracts away from the exchange -- a key feature of over-the-counter swaps -- but they will be designated as futures from the get-go.
The problem for CME, however, is that it does not currently have a liquid trading platform for many of its Clearport contracts, making the transition to futures a bit more rocky.
Until early next year, Clearport swaps will not count toward the $8 billion threshold that marks a large swap trader, a CFTC advisory showed this week, giving CME a few months to bring its trading platform up to speed.
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