Newman: why commodities will stay OTC

Post-crisis derivatives regulation has failed to shift commodity trading from over-the-counter markets to exchanges and is unlikely to achieve this key aim any time soon, if ever, says recently retired Icap Energy founder Paul Newman.

Regulations such as the 2010 US Dodd-Frank Act and the 2013 European Market Infrastructure Regulation (Emir) encourage firms to move trading out of OTC markets on to exchanges by mandating and favouring clearing. However, despite years of regulatory effort, Newman believes there are still really only five liquid exchange-traded energy futures contracts. Four of these – CME’s West Texas Intermediate crude future and US heating oil contract, and Ice’s Brent crude future and European gasoline future – were launched between 1978 and 1988. The fifth, CME’s RBOB gasoline contract – which stands for reformulated blended stock for oxygenate blending – took over from an older gasoline contract in 2007.

“After all this time those five contracts are the only liquid energy contracts that are true futures contracts,” he says. “The regulatory drive to move markets towards exchanges has created contracts that look like futures but aren’t. They are over-the-counter forwards given up for clearing, not executed futures.”

European coal derivatives are a good example of this. In 2017, out of all exchange-cleared volumes of European coal, only 28% were exchange-executed while 72% were executed in the OTC market and given up for clearing, according to data from trading platform Trayport. European Union emissions allowances are another market that has always been dominated by clearing, but with a large percentage of execution carried out OTC. In 2017, 97% of EUA trades were cleared, but a hefty 33% of total volumes were executed OTC and given up for clearing.

While Newman believes OTC and exchange contracts will continue to converge and look more and more alike post-trade, he does not believe many OTC contracts will ever be executed as futures, as the underlying markets are simply not big enough. “I think most OTC energy markets are always going to require voice intervention,” he says.

Through his 26 years at the helm of Icap Energy, Newman was instrumental in getting various energy markets off the ground, introducing derivatives to parts of the industry that had never used them before.

“Pretty much everything we did [at Icap Energy] in energy commodities was new to the industry at the time and we were alongside a handful of others, effectively developing new markets,” Newman says.

Newman founded the commodity brokerage in 1990 as a joint venture – Intercapital Commodity Swaps – with Michael Spencer, now chief executive of electronic markets and post-trade services company Nex Group. At the time, Spencer was running the world’s first OTC interest rate derivatives business, Intercapital, later rebranded to Icap. In 1999, Icap bought out the commodity brokerage and it became Icap Energy. Newman was Icap Energy’s executive managing director until 2014 when he was made chairman, a position he retained until Icap offloaded all its voice-broking operations to Tullett in 2016.

From his first trade in 1990 – a jet fuel swap between an airline and an oil trading company – Newman grew the business in line with the expansion of the energy markets through a series of carefully timed market entries. “For most of the 1990s, oil and products was the only game in town, but I always had an eye open for new business,” he says. 

That opportunity came in the second half of the 1990s with the deregulation of gas and power markets in the US and Europe which brought a need for new hedging instruments. This expansion continued into coal markets, and was followed in 2005 with the launch of the EU Emissions Trading Scheme, which created a carbon market. Most recently the firm became involved in iron ore.

As stepping into new markets is costly and time-consuming, avoiding the traps is almost as key as entering the right markets at an early stage, Newman says, noting that he’s pleased to have avoided the overhyped bandwidth market in 1999, and the still-niche weather derivatives space.

Five-point test

His successful track record on emerging markets was underpinned by a five-part test, Newman says. For an OTC derivatives market to take off it needs to fulfil five criteria: there must be a range of different reasons why firms come to the market; there must be a sufficient underlying spot market; there must be enough volatility; there must be a credible index; and it must be big enough.

Many markets that initially captured attention but never got off the ground failed one of these tests, says Newman. “Property derivatives never got off the ground as they fail test four. There’s never been a credible index. Weather derivatives fail test one as most firms are broadly protecting against bad weather and there aren’t enough natural players on the other side of the contracts. Industrial polished diamonds is an example of a market that wasn’t big enough.”

One market he feels might now pass all the tests is liquefied natural gas (LNG) derivatives.

“LNG derivatives are starting to tick all the boxes,” he says. “In the past it was weak on test one as there were very few suppliers and a lot of buyers. That’s changed as new players are coming in now.”

As well as being consistent in how it decided which new markets to enter, Icap Energy’s success is attributable to the longevity of its staff, Newman says. “Many of the senior staff running the desks had been with the company for 10 to 20 years. This was unheard of in our industry,” he says. “Achieving this level of continuity was something I particularly prioritised because in the end it enables a better level of service for the customer.”

But he admits there have been disappointments along the way. “The biggest disappointment I’ve had is that we were never able to deliver a proprietary OTC screen for oil product markets. We had two very expensive and resource-intensive attempts at it but it never took off as it had in other markets,” he recalls.

The first attempt was a platform called SwapNet launched in Singapore in 1999 as a joint venture between Icap and an individual developer. It was heralded as the first secure internet-based platform for OTC commodities swaps and enabled trading as well as providing automated risk management and credit controls. However, it failed to gain sufficient traction to keep going. Over a decade later, Icap Energy tried again, launching trading screen TrueQuote in 2010, hoping to capitalise on the regulatory push to move commodities trading on to screens and exchanges. However, again, the oil products industry appeared not to be ready for a screen-based solution, Newman says.

“The markets were not ready to accept a one-firm-only screen. It was seen as a fragmentation of liquidity,” he says. In a market that is already highly granular, people were wary of any further splitting of liquidity, he says. “We talk about an oil products market, but in reality there isn’t one, but around 20. The ones that are fully liquid went to futures decades ago.”

Of course distributed ledger technology is going to impact on our industry soon but it’s a post-trade event not pre-trade

Paul Newman

Newman describes the swathe of post-crisis financial regulation brought in since 2008 as one of the most difficult things he has had to navigate. For brokers, regulation such as Emir and the second Markets in Financial Instruments Directive and Regulation brought a host of new rules around transaction and order reporting, platform offerings, voice broking and other pre- and post-trade transparency requirements. “Certainly one of the biggest challenges of my career was leading our charge into the uncharted territory of increased regulation from 2008 onwards,” says Newman.

His biggest bone of contention with regulation is that it has caused a drop in liquidity. “An unexpected outcome of the first phase of regulation has been a drop in liquidity, particularly in the back end of the curve which is where people want to access liquidity for risk management,” he says. “As a result, bid/offer spreads at the back end of the curve have definitely widened. In the end that’s a real cost to the end-user because a wide bid/offer spread is a hidden cost.”

The other enormous cost has been that of compliance, which is now particularly onerous for banks. “Compliance is now the biggest activity and cost there is for some banks,” he says. While he believes financial regulation will continue to place this burden on banks, he believes the banks will adapt in how they manage it. Rather than keeping it in-house where it is not a core competency like lending and credit, it’s likely to be outsourced, he says: “I think what will happen is we’ll see independent centres of compliance excellence emerging just like we did in audit decades ago.”

Another trend he predicts is the increased use of blockchain technology in commodities markets, but he’s sceptical that it will be a platform for trade and execution. “Of course distributed ledger technology is going to impact on our industry soon but it’s a post-trade event not pre-trade,” he says. “In my opinion blockchain will not play a role in trade execution. Attempts to move liquidity away from the most liquid contracts are very unlikely to work and the other less liquid contracts all need voice intervention.”

He sees blockchain technology as posing the biggest threat to clearers, many of which are enjoying a boom period in today’s regulatory environment. “Regulation has been good for clearers but distributed ledger technology does perhaps threaten their role. However, they are agile and will be quick to adjust their business models as required.”

This article was edited on July 9 to clarify the criteria for a successful OTC derivatives market.