Cash Collaterized Futures

   

With the introduction of cash-collateralized futures contracts in the Nordic power market, banks can play a key role by bridging the gap between efficient hedging products and an efficient market place.

 

 

As part of the lobbying efforts for bank guarantees, NAET in 2015 conducted a survey among members to identify preference for forwards/swaps vs futures contracts. The result, which was presented at the annual meeting in London, showed a significant preference among members for forwards/swaps for hedging purposes. This conclusion was not surprising.

 

Nordic power has traditionally been an exchange traded market with Deferred Settlement forward contracts. One of the main reasons for this was the exemption in EMIR which allowed the use of bank guarantees as collateral for cleared power and NatGas derivatives. Under this regime any positive value in the hedge contract was paid at settlement while any negative value was covered by low cost guarantees.

 

With this exemption coming to an end in March 2016 a new regime has been introduced in the Nordic power market. We now have exchange traded futures contracts where any positive or negative market value is settled on a daily basis with cash – or cash-equivalent collateral. This regime introduces new challenges and new costs for hedgers. A key element to consider is that the exercise of hedging market risk introduces a new type of risk: liquidity risk.  

 

Under the new cash-collateral futures regime we anticipate that the Nordic power market will gradually develop towards hedging/trading models that we see in other energy markets.

 

Looking for example to the oil market, there is a well-functioning and liquid exchange traded market for oil futures which is utilized by the largest fundamental players, banks, investors and other financial players. In parallel there is also a well-functioning and liquid bilateral market for swaps/forward contracts.

 

The bilateral market for swaps/forwards is typically utilized by the mid-size fundamental players who don’t want the exposure to the liquidity risk entailed in the daily margined futures contracts. Also, these players often need tailor made hedging solutions that are not easily covered by the standard futures contracts.

 

Banks play an intermediary role as so called swap-dealers between the exchange traded futures contracts and the hedge products (swaps/forwards) required by the fundamental players: Issuing swaps/forwards to clients while hedging this exposure in the exchange traded futures market.

 

The need for tailor made hedging solutions is as big, if not bigger, in the Nordic power market due to factors such as seasonality impacting production profiles, area-price risk etc. Traditional Nordic producers, with large values tied up in illiquid water reservoirs (so-called “dry joke”), will face increased leverage and high capital costs when prices/volatility increase. Hedgers are well aware of this – as reflected in the 2015 NAET survey.

 

The new situation provides opportunities, but also challenges.

 

To avoid cash collateral some hedgers could be tempted to consider physical hedging agreements. We believe this represents several steps backwards for the Nordic power market. For optimal price discovery, a liquid and efficient exchange traded market is in the interest of everyone who is active in this market. Hedgers can’t solve the issue of falling liquidity in the Nordic power market on their own – they need the help of more active, speculative players to do the job, but the hedgers can avoid contributing to the negative trend through the way they engage in the market – by choosing to contribute to the liquidity rather than reducing it. Hedgers should actively promote and trade financial contracts to add to the Open Interest in the market.

 

With the introduction of cash-collateralized futures contracts in the Nordic power market, banks can play a key role by bridging the gap between efficient hedging products and an efficient market place – by issuing swaps to hedgers and hedging this exposure in the exchange traded futures market.

          Andre Rørheim, DNB