Derivatives

Delivered January 18th, 2018. Contributors: Nitin P., Brian S., Michael D., Becca R. and

Part

of four

Part

Derivatives Market Trends

Overall, weather-based derivatives have little trading volume currently, although recent innovations could restore this market. At this time, companies no longer prefer weather-based derivatives to hedge against loss of earnings due to unfortunate weather. Conversely, the energy derivative market is growing. 

Despite thorough research, only limited sources could be found for both the derivatives. However, the trends project an in-depth picture of the present and the future market potential of the derivatives. A deep dive on the research is presented below.
Weather-based derivatives trends1. In 2017, the Chicago Mercantile Exchange (CME) stopped offering snow-based derivatives, owing to the fact that there was little to no trading volume of the contract. The exchange delisted them along with all other products that were not attracting traders.

2. According to Jean Boeing, the head of weather derivatives at EDF Trading in Britain, weather risk management is strategically important in Europe. However, the weather-based derivative market is still in the initial stages and the profitability of this segment is meager at the moment. 

3. In Germany, the surge in awareness regarding climate change is drawing attention from the large utilities, like EEX, towards the business of hedging against the risks around gas, power and water supplies due to the uneven pattern of wind, sunshine, and rainfall. For example, in Germany wind energy contributes to 12% of total power generation and hence the power production in this segment involves risks of gain or loss owing to the calm or turbulent wind conditions.

4. Catastrophe bonds or cat bonds — which provide risk coverage against wildfires, solar flares, hurricanes and other natural calamities — are gaining popularity at the moment, although these bonds have been in the market for more than a decade. Investment in these bonds is profitable; of the 300 recent investments in the cat bonds only 10 cases have resulted in losses by September 2017.  According to Wall Street Journal, cat bonds which covered hurricane risks and amounted to $26 million have recently been purchased in Florida.

5. According to Aon Benfield’s 2016 Global Insurance Market Opportunities report, "data and analytics can stimulate a new wave of innovation for the insurance industry." The insurance companies are using predictive analytics to better price weather-based derivatives and customize the risk coverage as per business requirements. These predictive weather-based derivatives are useful for agriculture, breweries, airlines and many other weather-dependent industries.
Energy Derivatives trends1. According to CME group, owing to the uncertainty in the international oil prices there is demand in the energy-derivative segment, which is attracting huge trade volumes. The CME group draws 85% of its revenue from transaction based processes of which energy-derivatives play an important part. CME's energy derivative revenues increased by more than 35% over the last two years.

2. According to Risk.net, the commodity derivative market (including the energy-derivative market) has been in recovery mode after experiencing uncertainty for the past few years. To be more precise, the derivative market for energy — including oil, petroleum, LPG, among many others — has been drawing greater attention in the recent months. 

3. This surge in the energy-derivative market has also given rise to non-banks that are fast developing their innovative market strategies to offer better market plans to their potential clients specifically in the Greek and Italian energy markets.

4. The active players in the hedge market include large banks like Citi Group, brokers, and energy traders which make up a large portion of the energy-derivative market. However, there are smaller banks as well which take more risks in developing their derivative products than the larger banks.

5. According to a recent survey by PwC, most corporates need customized or tailor-made energy-derivatives to suit their needs ("on bespoke terms"), so the future of the energy-derivative market is more dependent on the over-the-counter (OTC) trade rather than the standardized market. However, standardization is necessary for the development of the energy-derivative market. Thus, more tailor-made or bespoken products are likely to emerge in the future to cater the needs of the diverse "hedge seekers" mitigating their energy risks.
ConclusionTo wrap it up, the weather-based derivative segment is in demand in weather dependent industries including agriculture, breweries, and airlines; however this segment has lost trading value over the past few years. Insurance companies are using cutting edge data and analytics to customize their derivatives, with the hope that increased innovation will restore market value to the weather-based derivative segment. The energy-derivative segment, which was uncertain in the past few years, is now attracting huge trading volume. However, the majority of the demand for energy-products is through OTC trading and in bespoken terms, to suit the corporate needs.

Part

of four

Part

Derivatives Regulations

An overview of the regulatory apparatus surrounding derivatives trading suggests that the rules governing the industry are complicated and highly specific.  However, some governing guidelines can be deduced from the web of highly-targeted regulations.

 Most of the specific rules on derivative buying and selling relate to the traders themselves.  For those holding the derivatives, there are a number of reporting and tax-related regulations to keep in mind.  

There are rules limiting the amount and type of derivatives that a company can hold.  The main goal of these regulations is to force companies to keep their risk profile from becoming dangerous.  Many of these were put in place following the 2008 financial crisis.

Taking a broad view of regulatory environment as presented in the sources reviewed, the specific regulations for derivatives differ based on the type of derivative and the company holding it.  While most of the limits on derivative trading are related to the overall impact on a company's financial health, the impression given from this research is that any company considering derivative trading should look into the specific regulations governing those particular derivative positions.

Overview
Derivatives and options trading is a key activity for financial companies, both for financial service firms, like banks and hedge funds, and for those involved in the insurance or reinsurance business. Derivatives can be used for hedging risk and for trading and investment profit.  

A majority of derivative trading in the insurance business are used for hedging risks.  For example, a study by the National Association of Insurance Commissioners conducted in 2010 suggested that 90.8% of the insurance industry's total exposure to derivatives was for the purposes for hedging.

Most of the regulations related to derivatives trading have to do with reporting and tax purposes.  In terms of regulating when a company can purchase or hold a derivative, regulations are largely focused on the company's underlying liquidity.  In short, regulations are in place to ensure that a company can only hold derivatives in proportion to its underlying financial strength, in order to avoid risky over-exposure to the market, as happened in the 2008 financial crisis.

While the scope of this review was explicitly limited to national U.S. regulations, it should be noted that there are regulations that operate on the state level and laws concerning options trading vary somewhat from state to state.

There is a web of regulatory bodies that are at least in part tasked with regulation of derivative trading.  Regulations vary somewhat depending on the type of derivatives being traded, who is trading them and the purpose of those trades.  Any specific company looking to make a specific transaction should look into the particular regulations related to that specific derivative market.

Background To Current Regulatory Framework
Regulation in derivatives trading was stepped up in the aftermath of the 2008 financial crisis.  That severe economic calamity was started by a bubble in the sub-prime mortgage market and spread through the economy via under-regulated derivative markets, where options related to securities backed by home mortgages were exchanged.  The risks of these securities were vastly underappreciated and eventually the bursting of the subprime bubble saw several large U.S. firms, such as Wall Street bank Lehman Brothers and insurance giant AIG, pushed toward collapse by their exposure.

Eventually the government was forced to step in, bailing out AIG and setting up a series of of other supports for financial institutions aimed at avoiding a near-total economic collapse.  The bailout avoided the worst potential outcomes of the crisis, but a major economic downturn did result.

In the aftermath of the crisis and subsequent recession, new regulations on derivative markets were passed.  The main pillar of these new regulations was known as the Dodd-Frank Act.  This package of regulatory reforms was signed into law in 2010, specifically for the purpose of reining in the excesses that led to the financial crisis.

Dodd-Frank updated the regulatory infrastructure for the financial industry, particularly as it came to derivative trading.  It included trade requirements for standardized derivative products and expanded the record-keeping requirements related to the market.  The law also further empowered governmental regulatory bodies to create rules for the market and provided those agencies with enhanced enforcement powers.

Main Regulatory Bodies
As noted above, there is a web of regulatory bodies that are at least in part tasked with regulation of derivative trading:

SEC
The Securities and Exchange Commission, or SEC, governs most of the securities trading in the U.S. It was set up in 1934 in the aftermath of the stock market crash that helped initiate the Great Depression.  As the main regulatory body for the securities industry, it can set trading rules, including rules related to derivatives.

CFTC
The Commodity Futures Trading Commission, or CFTC, is another governmental agency involved with the regulation of options.  It monitors various exchanges involved in the trading of futures for sectors like agriculture, energy and environmental markets.  It has primary responsibility for the regulation of swaps, a type of derivative.  The agency shares responsibility with the SEC for other matters.

FINRA
 Financial Industry Regulatory Authority, or FINRA, is a relatively new regulatory body.  It was founded in 2007 and is a self-regulating body for the industry.  It is not a governmental agency, though it was authorized by Congress.  It oversees activity in the broker-dealer industry, creating and enforcing compliance and ethics rules related to trading activities.

Exchanges
There is a large market for derivative trading that takes place off exchanges.  These so-called Over-The-Counter derivatives take the form of contracts between parties.  However, there is also widespread trading on exchanges, and there exchanges have their own internal regulatory framework.  Some examples of exchanges that participate in derivative exchange include the Chicago Board Of Trade, the Chicago Mercantile Exchange and the New York Mercantile Exchange.

ConclusionWhile there is a wide and intricate set of rules for traders involved in the derivatives market, the broad regulations in the U.S. related to financial companies, like insurance and reinsurance companies, are largely aimed at the firms' risk profiles. There are capital and liquidity requirements that limit the amount of derivatives a company can hold.  These are meant to prevent another economic contagion such as the one that led to the 2008 financial crisis.  

However, there are various individual regulations that govern how derivatives need to be reported and accounted for.  Meanwhile, there are also specific limitations that vary according to the type of derivative and the type of company involved.  These rules are highly targeted to the specific situation.  As such, any company looking to make a derivative trade should review the regulations surrounding that particular transaction.

Part

of four

Part

Derivatives Market Size

According to the U.S. Treasury Department, the notional value of the derivatives market in the United States was $200 trillion in October 2017. There are over 3,500 publicly-traded companies and over 4,000 broker-dealers potentially involved in derivatives market.
TrendsThere are a number of trends projected to impact the U.S. derivative markets in the near future. These trends include:

Transition to ETFs — Exchange traded funds are increasingly seen as an alternative to derivatives, according a report by Greenwich Associates. Around 50% of asset managers planned to replace some of their derivative investments with ETFs during 2017. This could lead to a decline in the size of the market.

Trans-Atlantice Regulation — The U.S. Commodity Futures Trading Commission (CFTC) and the European Commission agreed in 2016 to recognize each other's rules on derivative clearinghouses. This had made it easier for European banks to enter the U.S. derivative market by lowering capital requirements and is expected to drive growth.

Brexit — Uncertainty over the terms of Britain's exit from the European Union have raised doubts about the long-term health of the financial sector in the U.K. American firms have seen this as an opportunity and expect continued doubts to contribute to a growth in American business.

Cryptocurrency — The CFTC recently gave approval for the CME Group and Cboe Futures Exchange to begin offer bitcoin derivative contracts. The attention surrounding cryptocurrencies is expected to contribute to growth.

Fragmentation — The number of options exchanges in the U.S. expanded to 14 in 2017, requiring firms expand their presence in order to keep in touch with markets. This fragmentation of exchanges has not driven up volume, but nonetheless is presenting difficulties for firms who need to devote resources to them. These resources might put a small drain on firms, eating into profits from the derivatives market. 
ConclusionThe derivatives market in the United States is currently valued at approximately $200 trillion. It is expected to grow in the coming year due to increasing European participation, easing of restrictions of cryptocurrency, and uncertainties over Brexit. Market fragmentation and a transition to ETFs might slow this growth somewhat.

Part

of four

Part

Derivatives Competitors

Key competitors within the weather-based derivatives industry include: the CME Group, eWeatherRisk, Cantor Exchange, Sompo International, MSI Guaranteed Weather, and Compagnie Financière Tradition. These companies each sell weather-based derivatives and are among the top selling companies in the country. 

The CME Group The CME Group is the world's leading company in this industry and is the largest vendor of weather derivatives in the United States. It offers the most diverse derivative products within the market including agriculture, energy, equity Index, FX, interest rates, metals, options, OTC, and real estate.

e Weather Risk eWeatherRisk a leading company in the industry and a leading provider of weather derivative products.  The company offers products within the market including energy, agriculture, construction, and transportation.  

Cantor Exchange The Cantor Exchange is a CFTC approved and designated contract market. CFTC is otherwise known as the Commodity Futures Trading Commission and is a government run agency. The exchange provides an enlarging variety of products covering FOREX, Tropical Storms, and inclement weather.  

Sompo International Sompo International offers global weather reinsurance products. These  include WeatherLock® financial products and CommodityFlex® products. The company is a provider of weather indices, based on temperature, rainfall, snowfall, humidity, solar radiation and wind speed. The company also offers commodity indices including natural gas, power, and agricultural. These products can be delivered on a global basis as either derivatives, insurance, or reinsurance.  

MSI Guaranteed Weather MSI Guaranteed Weather is a company based in the United States that offers weather based risk management products. These products alleviate the adverse effects of weather on business revenues and expenses. They offer products in the energy, agriculture, construction, entertainment, food/beverage, and transportation industries.  

Compagnie Financière Tradition Compagnie Financière Tradition is one of the world’s top interdealer broking firms, with a branches in 28 countries around the world. "Acting as a marketplace and an intermediary, CFT facilitates transactions between financial institutions and other professional traders in the capital markets. These transactions vary in scale and liquidity, from the simplest to the most sophisticated, the most liquid to the most illiquid." The company offers products within the capital markets, money markets, and FX and equities industries. 

ConclusionSix key players within the weather-based derivatives industry are the CME Group, eWeatherRisk, Cantor Exchange, Sompo International, MSI Guaranteed Weather, and Compagnie Financière Tradition. Each of these companies is based in the United States, but most possess a presence in other countries. Each of these companies trade derivatives based on the weather, but also offers a wide variety of products relating to the weather as well, including energy, agriculture, and transportation.