There is potential to revive over-the-counter (OTC) gas and power markets through more effective management of credit, but the industry is slow to adopt operational changes, according to delegates at Equias' annual conference in Brussels this week.
The combined volume of OTC and exchange trades dropped in 2022, as spikes in gas and power prices exhausted market participants' cash and credit facilities. And there was a migration to exchanges, because of a shortage of available bilateral credit between wholesale counterparties, and because of the attractiveness of concentrating trading in clearing houses, where firms can net positions taken across different commodities to reduce their overall exposure.
But a surge in margin calls — collateral that traders have to put up to clearing houses in case of counterparty default — has made exchange trading more difficult, too. "Exchange trading has soaked up the industry's credit risk, but also drained it of cash", according to Hugh Brunswick, chief executive of technology firm Equias which provides software to standardise and automate OTC trade.
The recent drop in gas and power prices — which have moved to their lowest since mid-2021 — has only led to a partial recovery in liquidity.
OTC trading can be rebuilt through operational changes to bring about faster settlement periods and a move to bilateral daily margining, making processes more standardised and paving the way for greater automation, industry representatives said.
The key to unlocking greater OTC liquidity is a much shorter settlement cycle, operations committee secretary at European energy traders' association Efet, Stuart Beeston, said.
Market practice is to settle invoices on the 20th day of the calendar month for European OTC gas and power trades, with any associated collateral held returned the following day. Hundreds of millions of pounds of value is left on the table because of long settlement periods, which is "obscene", Beeston said.
A study conducted by Efet and PwC last year concluded that earlier settlement should help to enhance liquidity by reducing the financial and operational risks to which it is exposed, including credit default.
A prerequisite for the implementation of earlier settlements is a standardisation of the settlement process. Efet is pushing for greater adoption of electronic settlement matching (eSM), provided through third-party software offered by Equias and Fidectus.
But while many energy companies have implemented eSM, there is a general reluctance to invest in operational efficiency, particularly in a high-priced and volatile market, Beeston said.
The use of eSM involves changes to internal systems. Implementation costs for a medium-sized trader are €200,000-€300,000, and a move to daily settlement would require a similar further spend, according to the Efet-PwC study.
Besides daily settlements, market participants suggested other forms of standardisation and automation to rebuild liquidity in the OTC market.
Spanish firm Endesa's head of contracts and credit risk, Juan Moya, called for the automation of credit support annexes (CSAs) — documents that define the terms and conditions under which collateral is posted to mitigate counterparty risk. The automation of CSAs, which are highly manual and time-consuming at the moment, would allow firms to trade more on the OTC market, Moya said.
But other industry representatives were sceptical that energy firms would find enough common ground to enable the automation of processes such as CSAs. Credit risks are difficult to standardise as companies have varied risk appetite, Jan Haizmann, chief executive of regulatory consulting firm Correggio Consulting, said, while expressing a hope that energy utilities could find common ground if they met to work on it.
Broader adoption of electronic invoicing would be another way of increasing efficiency, and would provide a mechanism that could be easily extended to automate bilateral daily margining, market participants said.
Shorter settlement cycles and the automation of CSAs has potential to bring parity between OTC and exchange trading, Equias said — and the OTC market could become the preferred destination for trading once again owing to the flexibility it offers when calibrating credit or margining, alongside the contract-side flexibility, the firm said.
