Algorithmic trading in energy

Algorithmic trading has made slow progress in energy markets. Ned Molloy looks at the reasons for the limited uptake and at the market’s prospects

The turtle and the hare

Most buying and selling of shares is not done by humans any more. Algorithms, designed to sift through vast amounts of market data and detect subtle patterns, don't just suggest appropriate trades to their owner, but can execute trades themselves within milliseconds of finding an opportunity.

They are also used to slice up large trades into many smaller ones to conceal the trade from the rest of the market, a technique known as iceberging. But while such strategies are well established in equities and fixed income, energy markets lag several years behind in the uptake of algorithmic trading. And it remains unclear to many market participants whether this is more because of the inherent qualities of energy derivatives, or entrenched interests and inertia.

Algorithmic trading has its natural home on the exchanges, where there is the order flow in futures for day traders to enter and exit the market at a suitable price. "On the futures side, and the options on the futures to a lesser extent, the algorithmic trading is extremely high," says Paul Zubulake, senior analyst at Aite Group. "You could be confident of about 20-30% of the futures-related flow in energy, the West Texas Intermediate (WTI), the Brent, the gasoil, the gasoline, coming from that algo-driven world."

According to CME Group's latest figures from fourth-quarter 2010, in energy products 32% of the electronic volume and 54% of the message traffic was from algorithmic traders. This is a smaller share than in interest rates, where algorithmic trading constituted 42% of electronic volume and 61% of message traffic, and foreign exchange, with figures of 58% and 77% respectively.

Within the energy bracket, there are vast differences between products. The most popular exchange-traded energy product, crude oil futures, hosts a higher volume of algorithmically executed trades than any other contract, with 31.51% of the vast turnover of WTI crude oil futures on CME and 25.33% of crude oil options traded algorithmically.

The other major exchange for energy products, Ice Futures Europe, doesn't release figures for levels of algorithmic trading, but here also oil derivatives are the dominant contracts for algo trading, according to David Peniket, Ice Futures Europe president and chief operating officer. "Participants in the oil markets understand that markets are electronic. They can see that the behaviour of the market has changed and evolved since they traded on an open-outcry trading floor, and one of those changes has been that there are algorithmic traders. But they understand that and they know how to operate in a market where the other side of their trade may be a computer," he says.

The basic reason for oil's popularity with algo traders is liquidity. Ice Brent Crude futures have traded between approximately 200,000 and 800,000 times a day since the start of the year. WTI and gasoil futures also trade several hundred thousand times a day, but all other energy contracts on Ice trade in the low tens of thousands, or even in the hundreds. This puts off algorithmic traders, who need to have confidence they can enter and exit the market easily at short notice. As Peniket explains: "Normally you would want to be certainly in the tens of thousands and probably in the hundreds of thousands before the algorithmic traders are interested and come into the marketplace. When they do, they can significantly affect market liquidity and help the market grow" (www.risk.net/2028049).

The exchanges are not simply waiting for liquidity to build up, however, but are investing heavily to attract algorithmic traders, including high-frequency traders, to their energy derivatives markets. Co-location services have long been offered by the major exchanges, allowing auto-execution and algorithmic engines to operate without the delays to trade execution inherent in even the fastest internet connections. This option has been taken up enthusiastically by hedge funds and proprietary trading firms, seen as the innovators in algo trading. Prop traders such as Arctos Capital in New York can boast of algorithmic trading, market-making and statistical arbitrage strategies not only in crude oil but also in natural gas, refined products and electricity.

Physical market participants contribute to the algorithmic flow as well, according to Aite Group's Zubulake. "If you're looking at a player in the physical market who's using futures as a hedge, even though they might be calling that order in or sending it via Bloomberg or instant messenger, the chances of the actual executing broker using an algorithm is probably pretty high."

Despite the hype around the increasing importance of algorithmic trading in energy markets, the figures don't always back this story up. On CME, algo trading as a share of volume in energy products declined from 37% in second-quarter 2010 to 32% in fourth-quarter 2010. In specific product categories, algo trading as a share of crude oil futures trading declined from 37.56% in second-quarter 2010 to 31.51% in fourth-quarter 2010, while algo trading in crude oil options declined from 29.47% to 25.33% over the same period. CME spokesmen did not want to comment, "due to competitive issues". There is certainly not an inevitable shift under way, and algorithmic trading will wax and wane depending on market conditions.

Nevertheless, the potential is there for massive further growth from real-money investors, according to Stephen Bruel, analyst at TowerGroup. "I think energy's going to be a huge alternative asset class because it has a lot of the attributes that institutional investors like. A lot of the products are liquid, they have volatility, and they can provide uncorrelated returns," he says. These investors are learning from the technology of those already in the market, according to Bruel. "Black box trading is moving from hedge funds and quant shops to more fundamental investors such as the pension plans. If you're not using the most advanced technologies, you're not going to get the best price, and best price is a fiduciary obligation. So, it is absolutely worthwhile to make the investment in algorithmic trading tools if you're going to take a position in the energy markets."

Regulatory pressure

But with more and more people's investments and savings tied indirectly to an algorithm they possibly have no knowledge of, regulators are paying increased attention to this area. Exchanges are expected to come under increasing pressure with regard to the monitoring and control of high-frequency trading in particular. Regulators in Europe and the US have been spurred on by the desire to prevent another ‘flash crash', a market crash on May 6, 2010 that saw the Dow Jones industrial average fall roughly 700 points and then rebound within a few minutes. A joint Commodity Futures Trading Commission (CFTC) and Securities and Exchange Commission advisory committee formed in the wake of the crash made 14 recommendations on February 18 this year, including that "the CFTC use its rule-making authority to impose strict supervisory requirements on designated contract markets or futures commission merchants that employ or sponsor firms implementing algorithmic order routing strategies".

Christine Cochran, president of the Commodity Markets Council, the Washington, DC-based trade association for commodity futures exchanges, believes the exchanges already have in place much of what the CFTC will ask for. "CME requires all traders using an automated trading system to register. They also have quantity restrictions, price banding and stop price logic triggers in place to give the market pause when it is needed. It also has systems in place to identify connected entities. This allows the exchange to see who the clearing firm is as well as the client," she says.

On the other side of the Atlantic, Peniket of Ice Futures Europe is also confident that his exchange has appropriate safeguards in place to handle algorithmic trading. "We operate reasonability limits that mean that prices can only move within a certain range of the last traded price. We have a compliance process that any algorithmic trader has to go through when they bring their system on to the exchange so that we can monitor what's going on and ensure that they comply with exchange standards. And we offer to our participants controls including controls over volume and daily position so that traders are limited as to how far they can go in terms of the trading activity on any one day," he says.

OTC oil still voice-traded

The world of over-the-counter energy derivatives is very different, with oil and oil products still almost exclusively voice-traded. The failure of OTC oil trading to move to electronic trading - let alone algorithmic - in any significant way, is more down to the interests of market participants rather than the fundamental characteristics of oil markets, according to James Davis, head of sales and client services at IT company Trayport. "Momentum is probably the biggest impediment that we have. The world of oil changes very slowly. There are a lot of protected interests in it, the brokers are getting good margins, and I think there are quite a lot of people in it who like a lack of transparency." Another market participant, who spoke on condition of anonymity, agrees. "Some of the bigger oil houses, which make money by having information that other people don't, may prefer not to put their prices on a screen," he says. Others in the market point simply to demographic change as the key factor, with the younger traders who grew up using technology a minority, although a growing one, in the OTC oil world.

Nevertheless, Michael Anderson, head of energy Europe at Tradition, is confident about the eventual outcome. "I feel it's inevitable that oil swaps will migrate to electronic systems. That will be in a hybrid format where voice broking still plays a very important part. The speed and timescale of the migration is still uncertain, and it's still uncertain which platform, portal or software will capture that business. It's still open."

In this gradual migration, some oil products categories will be more amenable than others to electronic trading, and Trayport's Davis expects some specific progress this year. "We've been talking a lot to some fuel oil groups, and we expect to make some breakthroughs in fuel oil over the next six to nine months," he says.

Oil issues aside, power, gas, coal, freight and emissions are all commonly traded electronically on a screen, the prerequisite for some level of automation to creep in. (Automated trading is usually taken to mean that the trade is still controlled by the trader, who can click to execute a certain pre-defined strategy. Algorithmic trading is generally used to refer to software that, once activated, enters and withdraws trades based on pre-defined criteria, often at very high frequencies, without human intervention.) But automated strategies still remain at low levels in these products, up to 10% at most, according to Trayport's Davis.

What next

Some market observers think there is no fundamental reason for the slow uptake of automated trading apart from inertia. "There are no inherent barriers to expanded automated trading in agriculture and energy," says the Commodity Markets Council's Cochran. Others believe there are two major obstacles to the further take-up of automated execution in OTC energy markets.

First, many physical players have a defined quantity of gas, oil or electricity that they want to hedge, and so they often post ‘all-or-nothing' trades that can only be taken up in their entirety, to make sure they exactly match that quantity. This distinctive feature of energy markets makes it much harder to transfer algorithms over from asset classes such as equities where they are more deeply established, according to Richard Everett, product manager at Trayport. However, Everett expects this issue to subside in the face of more liquidity. "If you look at exchanges, as the products becomes more liquid the minimum clip size and the all-or-none aspect of orders does disappear. If you can be guaranteed that there will be the liquidity to get the order you want at a good market price, then you don't need to request a large all-or-none that's going to sit with your broker
all day until you find another side of the deal," he says.

Second, there is a lack of adequate prime brokerage services in energy, according to some market participants. "I think there is definitely a big space for an increased role in the prime broking market," says Paul Newman, managing director at Icap Energy. This means that every trading company wishing to enter into energy derivatives contracts must have bilateral credit agreements in place with its counterparties. (Prime brokers provide central securities clearing for hedge funds, with the fund's collateral requirements netted across all transactions handled by the prime broker.) With the large banks and utilities dominating trading, this poses no problem as the counterparty risk is deemed to be low. However, according to market participants, many of the incumbent utilities and banks would be reluctant to sign credit agreements with dozens of small players with higher counterparty risk, hindering the entrance of hedge funds and prop traders - the standard bearers of algo trading - into the energy space.

But this state of affairs is beginning to change, according to Mark Holt, Trayport's head of planning. "If you're a hedge fund and you use a general clearing member or a bank to clear with LCH for example, then you can now begin to play in those brokered markets without needing individual credit agreements," he says. Trayport itself stands to benefit from more participants and increased automation in OTC energy markets, and so is also trying to address the prime broking issue. "We have a prime brokerage system now that we're testing with BHF Bank, and we're talking to all the other prime brokers about how we can enable the development of these energy markets, by bringing in more players," says Trayport's Holt. "If we can get prime brokers in place, with the prime broker holding the bilateral agreements, then we expect to see smaller players come in, players who are more used to algorithmic trading."

If this happens, the broader range of participants in OTC energy markets would boost liquidity to new levels. This will erode the difference between brokers and exchanges, according to Trayport's Holt. "We expect that over the next few years the model for OTC markets and brokers, certainly for front-month trading, will become almost identical to an exchange. But as you go further down the curve you'll still have the voice component involved."

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