Fast Reading:

  • OMIP is the Iberian Energy Derivatives Exchange. Apart from derivative products, it allows clearing through OMIClear of OTC deals and bilateral agreements.
  • A Derivative is a contract between a buyer and a seller entered into today regarding a transaction to be fulfilled at a future point in time where the value is derived from the underlying asset. There are four types: forwards, futures, swaps and options.
  • In OMIP, Trading Members can buy energy in base load, or spot charge, with only financial settlement or with physical delivery as well, with maturities ranging from days to years for themselves or third parties.
  • Recently OMIP announced it will enlist both French and German Power Derivatives as well as enlarge listings to six months, seven quarters and four years.

OMIP – the Iberian Energy Derivatives Exchange – was created on June 16th 2003 and, according to itself: “ensures the management of the market jointly with OMIClear, a company constituted and totally owned by OMIP, which executes the role of Clearing House and Central Counterparty of operations carried out on the market”. At the end of 2015 it already had 71 registered members and any agent operating in the Iberian Energy Market has heard of this Lisbon-based institution and, most likely, follows or uses its indexes in some way or another.

Roughly 1 week ago, in a statement, OMIP mentioned that “the current set of derivatives products – futures, options, swaps and forwards along with the organization of several auctions (…) will now be complemented with French and German power futures available for exchange trading, OTC registration and clearing” and here is where things get sticky.

It’s easy to guess that OMIP is the “place” where energy deals are brokered in advance, but how exactly is this performed? What are all these products? Who operates in this market? What’s required to do so? What does the addition of these new “French and German power futures” mean?

Let’s see what lies under the hood.

DERIVATIVES – WHAT ARE THEY?

OK. So the agents which are allowed to operate in the market sell and buy things between themselves under the market’s predefined rules and supervision. But what things exactly?

Many associate the financial market to the best know “security” (basically any tradable financial product): the equity market (i.e. stocks). Nevertheless, financial markets encompass far more “products” such as bonds, currencies, real estate, commodities and, of course, derivatives (forwards, futures, options and swaps).

A derivative is a contract between a buyer and a seller entered into today regarding a transaction to be fulfilled at a future point in time. As the name implies, the price of the derivative derives from something, which means it fluctuates with the price of the so-called “underlying” of the contract (the asset one trades on). These contracts have a “life”, i.e. the time between entering into the contract and the ultimate fulfilment or termination of the contract (which can reach very long time spans) making derivatives a great risk management tool.

Derivatives make future risks tradable: whether it’s by exchanging market risks – commonly known as hedging – which decreases uncertainty and stabilizes companies’ cash flows, or by being used as an investment. This last part is particularly interesting, because this means one can invest directly on an asset without buying (or even holding) the asset itself, i.e. one can buy the equivalent of a barrel of oil but never even smell it, or one can invest directly in risk (such as the 2008 infamous Credit Default Swap or evenWeather Derivatives – which compensate the buyer in case of extreme weather events).

But let’s look into each product in particular:

FORWARDS – A forward contract on an asset (underlying) is an agreement between the buyer and seller to exchange cash for the asset at a predetermined price (the forward price) at a predetermined date (the settlement date). Important: No money changes hands until the settlement date.

FUTURES – Forward and futures contracts are essentially the same (and their values usually do not differ that much). Nevertheless, there are important fundamental differences:

· Unlike forwards, you can close the futures contract position whenever you want before the expiration date, i.e. you do not need to wait until the futures contract reaches the expiration date. In another words, you may not really want the asset, you can just speculate with it. Important: the more liquid a market is, i.e. the more traders trade in it, the higher the probability of finding a buyer or seller.

· Unlike forwards, which are settled at the end, futures have daily resettlement, in a process called mark-to-market. At the end of each trading day, the Exchange sets a settlement price based on the day’s closing price range for each contract. Periodically, each trading account is credited or debited based on that day’s profits or losses and checked to ensure that the trading account maintains the appropriate margin for all open positions.

Let’s see an example:

A seller enters into a contract with a buyer for 1000 units of a commodity, at a price of €10/unit, to be settled in 3 months. If the next day the price is €11, the seller has lost €1 and the buyer has profited €1 but, more importantly – unlike securities where you only know your capital gains or losses when you sell the asset – the account of the seller with the exchange is debited €1000 and the buyer’s is credited €1000 and so on, every day. Since these accounts are adjusted every day, usually in the settlement date the contracts are settled in cash and the buyer, if he actually wants the asset, will buy it on the spot market.

Nevertheless, financially speaking, the buyer’s futures’ profits go towards his purchase, therefore, if he has to pay €11.000 on the spot market for his goods and he received €1.000 from the seller, he only paid €10.000. From the seller’s point of view, yes he may have lost €1.000 in the futures market, but he’ll sell at €11.000 in the spot market, therefore he has offset his position to 10.000€. This guarantees the seller a predicted amount in advance and the buyer a cheaper price at the end.

But, since there’s actually no obligation to deliver, this means that a futures contract can be only a financial position, with both agents being speculators – one who won and another who lost.

OPTIONS – Well, since a futures contract is usually a large financial position, it allows for a bit more of “gymnastics”, both on term and value. An option contract gives the buyer the right, though not the obligation, to take a long (price goes up, a.k.a. call) or short position (price goes down, a.k.a. put) in a specific futures contract at a fixed price (a.k.a. strike price) on or before the expiration date. For this right granted by the option contract the buyer pays a sum of money or premium to the option seller. The option seller (a.k.a.writer) keeps the premium whether the option is exercised or not. The seller must fulfil the obligation of the contract if and when the option is exercised by the buyer. Important: calls and puts are not opposites, for every call or put buyer there’s a call or put seller. The usefulness of this? Well, there’s a great example using houses and ghosts and Elvis here.

SWAPS – These are agreements, between two parties, to interchange (swap) two future streams of cash-flows (usually a variable one by a fixed one). Important: payments are made periodically, not at term, which makes the drafting of the contract’s conditions of vital important. In example: let’s say a company needs to draft a budget for next year and a great part of that budget is set by a commodity, for instance, gas. It’s not the company’s core business, so they won’t buy at a lower price and sell at a higher price – they just need it. Since the price of that commodity fluctuates, so does the company’s budget – not interesting. The manager then decides to enter in a swap contract with an investment bank to fix the price of this commodity, if the underlying price rises it becomes valuable for the company, but if it decreases it becomes valuable for the counterparty, i.e. effectively decreasing exposure for the company.

THE EXCHANGE

As any other business deal one can perform it can be done in two ways: with or without a safety net. In the first case you negotiate directly with a salesman and you may, or may not, know the name of (or have the security of) the provider, while in the second case you deal directly with a provider or, particularly, a pool of providers.

The first case, the direct brokerage model, is known as OTC (or over-the-counter). Clients request brokers to find a buyer or a seller of a determined asset, whether it’s on an exchange or for a bilateral agreement between two parties. Brokers are generally active participants in several exchanges. This model is usually very prominent in markets with very little liquidity (see above for the definition), in very complex transactions or simply when exchanges are not operating.

The second case represents a regulated marketplace where assets are sold and bought under specific rules of conduct. To ensure that there are no nuances, all contracts are standardized and there are no special clients. Nevertheless, the most characteristic element of an exchange is the presence of a clearing house – a financially sound institution that ensures all steps of a transaction (from the initial commitment to the settlement) are possible. In another words, it stands between parties to ensure they both honour its trade agreement, even if one party is insolvent before the agreement reaches its term.

It does this by offsetting transactions between multiple counterparties, by requiring collateral deposits (a.k.a. “margin deposits“), by providing independent valuation of trades and collateral, by monitoring credit worthiness, and in many cases, by providing a guarantee fund that can be used to cover losses.

Apart from clearing and settlement services, an exchange provides traders other range of benefits such as: anonymity, faster and securer transactions, they are regulated to avoid and/or punish misconduct of al involved, they enhance liquidity by concentrating counterparties and they offset risk.

Both models are not mutually exclusive nor necessarily competitive as many brokered deals often are executed in part and cleared using an exchange’s clearing service.

OMIP AS AN EXCHANGE

Now that it’s clear what a derivatives exchange is, let’s look at OMIP. OMIP allows the trading in the following indexes around Spanish and Portuguese electricity:

· 24h base load (SPEL Base and PTEL Base)

· 12h spot charge (SPEL Peak and PTEL Peak)

· Financial Transmission Rights auction between Spain and Portugal, in both directions (IFTR E-P Base and IFTR P-E Base)

These products may have physical settlement or just financial settlement, and maturities ranging from days to years. Also, it backs OTC transactions through OMIClear, allowing for forward and swap trades with the same maturities as the futures market.

Let’s consider the example of a contract with physical delivery, for any 30-day month-ahead with a nominal of 1MW and a price of 40,11€/MW.

In the case of physical deliveries, the contracts predict the supply of electricity at a constant power of 1MW during all the hours of the delivery period. For instance, a contract for a 30-day month with this price would have a nominal value of €28.879,20. Upon maturity both the physical component and the financial component are settled: physically on the spot market, i.e. OMIE, and financially similarly to the situation explained above (with daily mark-to-market).

The agents operating in OMIP fall into three categories:

· Clients

· Trading members (Clearing Members)

· OTC Brokers

Clients participate on the Market through Trading Members authorised to trade on behalf of third parties or by registering direct bilateral agreements with Clearing Members. To be a Client, apart from having an agreement with an eligible Trading Member, only a proof of capacity has to be shown. In the case of bilateral agreements, an account has to be opened with a Clearing Member.

The Trading Members are direct participants of the market, intervening in several ways: exclusively taking positions on their own account or on behalf of entities with each they have direct relationship, taking positions exclusively for Clients or both. To be a Trading Member, the requesting party must satisfy the conditions specified in article 16 and 18 of the Trading Rulebook (for instance show proof of capacity for physical settlement if this is an option it wants to pursue or demonstrate human and technical conditions to act in the market). Different accounts must exist for financial and physical settling.

If a Trading Member wants to operate on the behalf of third parties or have the capacity to register Bilateral Transactions is also has to be a Clearing Member, i.e. it has to register in OMIClear. A Trading Member can also access the status of OTC Broker.

OTC Brokers are allowed to do Bilateral Transactions and the registration process (and its conditions) are defined by Notice and Instruction.

At the date of this article, the membership fees required to access the market (which can be found in theOMIP Price List) ranged from €0 (in the case of OTC Brokers) to €12.000/year for full Trading Members. To these costs, one has to add other operative ones, such as user licenses or real time market information.

There’s also a fee per MWh transacted in each of the products ranging (at the date of this article) from €0,0025 to €0,0075.

Each trading session (Trading Day) in OMIP follows a pattern: after opening and before closing there’s a stage where Participants can perform certain administrative tasks to prepare for the following session and in the middle there’s the Trading Phase, during which transactions can be performed. Trading can happen in one of two ways: continuously or by auction. In the first case, priority is given to certain orders, initially by price and then chronologically, in the second case a single price is generated.

As mentioned before, OMIP has the responsibility to actively supervise the market. For that it has an arsenal of sanctions available which range from simple warnings to financial penalties going from €500 to €100.000 and obviously partial or full expulsion.

THE NEW CHANGES

If you managed to read so far and not get bored to death, than you might be interested in knowing that OMIP has enlisted both French and German Power Derivatives as well. Expanding the portfolio of products transacted in the exchange is very important for OMIP, not only due to their obligation of exploring new ways to maintain/increase market liquidity, but also because Trading Members will be able to, for instance, negotiate spreads involving new areas without any additional costs or requirements.

Also the futures listing curve has been enlarged to six months, seven quarters and four years.

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Hugo Martins | Analyst

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