Exchanges eye weather

New exchanges are entering the weather risk arena despite Liffe’s failure to successfully market its European weather futures. But while the US exchanges appear bullish, European entrants are treading cautiously. Paul Lyon reports

Last year, Eurex, the Swiss-German derivatives exchange, started publishing temperature indexes for 30 European cities as a prelude to its entrance into the exchange-traded weather derivatives market. But it soon changed its plans. “Weather derivatives are a cute and nice idea,” a Eurex spokesman said, “but there is no customer demand for the product.”

Now it has made another dramatic U-turn. Eurex is again considering launching exchange-traded weather derivatives, although it still has reservations about the feasibility of such products and has no timeframe for launch.

Some market participants speculate that Eurex has reviewed its position as weather derivatives players hailed the Chicago Mercantile Exchange (CME) weather futures as one of the market’s success stories this year. And Atlanta-based IntercontinentalExchange (ICE) is also talking up its US weather risk contracts.

But Eurex’s rival, the London International Financial Futures and Options Exchange (Liffe), has been struggling. Its exchange-traded weather futures contracts are settled against the monthly and winter season indexes based on daily average temperatures in London, Paris and Berlin. Although US energy firm Aquila traded one contract of five lots on the London indexes, Paris and Berlin have still not been traded – over six months since Liffe launched the contracts.

As a result of Liffe’s failure to kick-start its weather futures offering, some market participants have questioned whether the $4.3 billion weather risk market is ready for an exchange-traded product – Eurex was just one doubting Thomas. But this sense of confusion, typified by Eurex, hasn’t deterred possible new entrants, including three European exchanges (Eurex, Euronext and the Helsinki securities and derivatives exchange (Hex) and one US exchange (the Weather Board of Trade). Meanwhile, the CME and the ICE look set to push their products as aggressively as ever.

Holger Sturtz, Eurex’s Frankfurt-based product development manager, whose remit includes weather derivatives, says he is not bullish on the prospect for exchange-traded weather derivatives. And if Eurex does ever commit to offering weather derivatives, Sturtz admits there is no plan for what form the contracts might take.

Meanwhile, the Hex is preparing to launch exchange-traded weather derivatives by the end of the third quarter. But, surprisingly, Jyrki Kiviniemi, Hex project manager for weather derivatives, says the exchange’s weather risk contracts will take a similar form to those offered by Liffe – presently the only market for exchange-traded weather derivatives in Europe.

“We have not been discouraged from developing the exchange-traded product, despite Liffe’s failure to trade more than one contract since its December launch,” Kiviniemi says. “Although our index is similar, we have a very different market structure to Liffe. If an energy company wants to buy Liffe weather futures, it has to go through a market-maker. But Hex will allow energy companies direct trading member status, which avoids unnecessary third-party complication.”

Hex will initially offer monthly contracts based on one location – Helsinki – although it may expand to other locations across the Nordic region, depending on client demand. The exchange will start publishing its index, based on the monthly mean daily average temperature, once trading starts. This index is calculated by taking the mid-point between the minimum and maximum temperature of the day, which, when combined with the averages for the month to date, form a cumulative average for the month.

Hex says it focused on average temperature, rather than the usual heating degree-day (HDD)/cooling degree-day (CDD) format, because it believes average temperature has the benefit of consistency all year round. Although targeted initially at energy companies, the index is likely to prove relevant to a wide range of other market sectors, Kiviniemi says.

Like other exchanges, Hex’s entrance has been a long time in the making – 18 months to be exact. While it now has the go-ahead from Finland’s financial regulators, the exchange initially encountered regulatory difficulties, as the authorities had little knowledge of the products, Kiviniemi adds.

In January, meanwhile, Euronext launched six weather indexes for France as a first step to offering exchange-traded weather derivatives. Derivatives contracts based on the temperature indexes are planned for launch next year. But this is conditional on the indexes’ successful performance in the coming months. Like Eurex, Euronext is treading cautiously.

Euronext joined forces with French weather service Météo-France to calculate six French weather indexes for the pan-European exchange’s online NextWeather service. The indicators – five regional and one nationwide – are designed as a daily reference for business sectors dependent on weather conditions to factor the impact of weather into their operations. Euronext also plans to extend the indexes in September, first to the Netherlands and Belgium, then to more of Europe.

Like all exchanges and over-the-counter players, Euronext wants to woo the usual suspects – energy, insurance and reinsurance companies. And as a regulated market, Euronext would guarantee full completion of transactions in the event of default by a participant through its clearing entity, Clearnet.

Standardisation
But why should Hex or Euronext bother if Liffe has so spectacularly failed to make its weather futures work? “There is a real need for standardised weather products, since OTC weather risk players can’t take all the risk in the market, so they have to hedge their own exposures,” Kiviniemi explains. “And for these purposes exchange-traded contracts are a good basic tool.”

Stephane Fourneaux, head of derivatives marketing at Euronext in Paris, agrees: “At the moment, we are in a kind of testing phase for our index, and I think the most encouraging sign we can hope for will be when an OTC contract is traded based on our measurements,” he says. “There is no magic formula for attracting liquidity. Although we haven’t decided anything concrete, we may well structure different contracts for different industries. But Liffe only has one contract it hopes will appeal to a multitude of sectors, from energy companies to ski resorts.”

Fourneaux is hopeful that exchange-traded weather derivatives may one day become the benchmark for the OTC market, but he is also aware the weather risk market is not yet mature enough for this. He also points out that the nature of the European weather risk market hinders exchange-traded development. “Europe doesn’t have a standardised approach to presenting weather data, necessary for structuring all contracts, whereas in the US, standardisation of meteorological data was present well before the inception of the weather risk market.”

Euronext is aware of the constraints surrounding the development of European exchange-traded weather contracts, as it only has to look at the failure of its subsidiary, Liffe, to market the products. But Fourneaux says the exchange-traded and OTC market will complement each other. “People will need exchanges with clearing houses to hedge on a more secure market. Post-Enron, people are becoming increasingly aware of the costs and credit problems inherent in OTC trades.”

Maybe so, but the nature of the weather risk market necessitates highly structured and complex OTC needs, says Steffan Roggenkamp, head of alternative risk transfer and commodities at HypoVereinsbank in Munich. “It’s good to see a commitment to the European weather derivatives market from Liffe and others, and it should help boost liquidity,” Roggenkamp says. “But end-users need an explanation of weather derivatives that is only really available to them if they opt for the
tailored OTC product.”

The CME disagrees. It trumpets the success of its exchange-traded offerings, arguing that it provides a model for European exchanges considering weather contracts. June volume totals for the CME’s HDD contract, traded as futures or options across 10 city locations, reached 50, whereas CDD hit 255, with year-to-date totals, as of July 9, at 137 for HDD and 818 for CDD. Although the CME launched weather derivatives back in 1999, the products took off when it brought Wolverine Trading aboard as lead market-maker. Several other participants also make markets at times on an unofficial basis, according to Felix Carabello, the CME’s head of weather derivatives marketing.

“We believe the futures and OTC markets will complement each other as they grow,” Carabello says. “We are constantly seeking feedback from current and potential market users, and we will adjust our existing products and introduce new products to meet the market’s needs.”

But how does the CME distinguish itself from the upstart exchanges looking to enter the weather risk market? “The CME offers a complete package of products and services for weather trading. We design and develop products to meet the market’s needs, we offer the products on Globex, the CME’s global electronic platform, and we provide complete transparency and growing liquidity, eliminating credit risk through our financial safeguard system and wholly owned clearing house,” Carabello adds.

But there are detractors of the CME model. “The HDD and CDD model that the CME uses is energy industry biased,” says Dan Parker, managing director at the Atlanta-based Weather Board of Trade (WBOT), which obtained US Commodity Futures Trading Commission approval in May and should begin trading weather derivatives by October. “Our contracts, however, will appeal to a cross-section of industries because they are not just based on temperature, and they can also be based on regional baskets as well as specific weather stations.”

The WBOT has developed the Normal-Departure Index (Nordix), its US weather index, to structure trades. This will be geared to trading temperature and precipitation measures, with sunlight and wind speed measures to be added later. The US government’s National Climate Data Center will supply weather data and, since Nordix will be the first weather index to be marked-to-market on a daily basis, Parker says this could encourage speculators to dabble in the weather risk market. “Hedge funds, for example, will be eager to use this index because it provides a liquid market unconnected to other risks they may have, which makes it an ideal hedge,” Parker adds. “Ours is a better product than what the CME offers – simply because Nordix can appeal to more end-users. We will of course co-exist with the CME, but one day we hope to become the benchmark for the OTC market.”

The WBOT is signing up 12 charter members, which will include a mixture of brokers and market-makers, as well as trading firms. Although Parker will not say which exchange the WBOT will use for clearing services, he says he has approached the Kansas Board of Trade and the CME, as well as brokers Cantor Fitzgerald and Brokertec to see if they will list Nordix.

The WBOT also plans to launch in the Canadian market at the start of next year. “We do have plans for Europe but we want to establish ourselves in the US and Canadian markets first,” Parker says.

Tellingly, the ICE is also holding off launching European weather derivatives. The OTC commodities market, which increasingly resembles a traditional exchange complete with clearing for certain products, launched US weather derivatives in November 2001 under the guidance of US energy firm Aquila. The ICE discussed launching a European contract with troubled energy trader Aquila in April, but Stephanie Trabia, chief executive of the ICE’s London office, says the ICE is too busy with its other product offerings to consider launching a European weather contract.