E-commerce: Commodites Trading – Open all hours

By Douglas J. Smith, Contributing Editor, Asia/Pacific

Until recently, over-the-counter (OTC) commodities trading might have been described as over-the-phone trading because it has historically been conducted in this way. While the telephone is tried and true, it is not the most efficient way to conduct business in a global economy or the digital world. The internet is changing the face of trading and accelerating the migration from traditional analogue practices to digital. OTC energy products are no exception to this trend. In fact, buying and selling in the OTC energy space was inefficient until the recent creation of electronic trading systems, which reduce error rates, open a paper-less back office, streamline the ability to process orders and trades, and allow for real-time risk management.

As an owner of interests in a number of electric power plants, Jeffrey Sprecher, CEO of IntercontinentalExchange, became intrigued with the idea of building a digital marketplace that would become a forum for trade as the electron became a deregulated commodity. Given the interrelationship of electricity with other energy commodities, there seemed no reason why one centralized commodities marketplace for all traded products should not be developed. After investigating alternatives to secure the technology, Sprecher decided to purchase a firm that owned specialized software for the spot market exchange of wholesale electric power and transmission services, called Continental Power Exchange.

Building the future

Beginning with Continental’s basic software engine and a talented group of managers and software engineers, the group initiated the in-house development of an electronic trading system for the real-time purchase and sale of a large array of commodities and derivative products. The group completed the initial work on this proprietary software in early 2000, and approached a number of major commodities firms to provide initial liquidity. At that time, key participants in the international energy and metals businesses were interested in capturing the efficiency of business-to-business e-commerce – and were receptive to Continental’s ideas.

In March 2000, a leading consortium of international financial, energy and natural resource firms agreed to provide the initial liquidity to implement an electronic marketplace for oil, precious metals, power and natural gas.

The internet-based electronic trading platform, now known as Intercontinental-Exchange, set out to reshape the trading of these OTC products. The initial liquidity providers included BP, Deutsche Bank, Goldman Sachs, Morgan Stanley Dean Witter, Royal Dutch/Shell Group, Société Générale and Totalfina Elf. IntercontinentalExchange is now based in Atlanta, GA in the USA, with offices in London, New York and Houston.

In July 2000, the list of liquidity providers was expanded to include a consortium known as the Energy Trading Platform Holding Company (see PEi August 2000, Analysis, p13). This group consisted of six leading US energy and natural gas trading companies – American Electric Power, Aquila Energy, Duke Energy, Reliant Energy, and Southern Energy Inc. As a result of the expanded partnership, IntercontinentalExchange was able to include significant price depth for the full OTC energy complex.

Figure 1. IntercontinentalExchange is open to any commercial participant in the OTC commodity market
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IntercontinentalExchange began its launch by starting with precious metal trading on 25 August 2000, global crude and refined oil trading on 12 October 2000, and natural gas and power trading on 19 October 2000. Since the company has been open for business, it has seen rapidly growing participation and trading volumes in all product categories traded on the “ICE”. In the first four months of trading, the ICE traded over 400 million barrels of crude and refined oil derivatives, 250 billion m3 of natural gas and 1200 billion m3 of natural gas swaps, 85 million MWh of power and 25 million gold equivalent ounces of precious metals, as of close of trading on 7 February 2001.

Business operations

Each liquidity participant is committed to a significant level of volume participation in the exchange. This initial liquidity enables IntercontinentalExchange to provide its customers with depth of market and price transparency, which it believes are the key drivers to a successful on-line trading business.

IntercontinentalExchange is open to any commercial participant in the OTC commodity market. Customers can connect to its system via the public internet or through its global private network, after downloading client software from IntercontinentalExchange’s website. ICE provides global support from its international field offices, a 24-hour help desk and web-based trading, product and user help guides.

There is no membership in the exchange and there are no dues or fees beyond those incurred in the process of trading. Commissions are charged on each transaction, and all participants pay the same rates – including the initial liquidity providers. IntercontinentalExchange’s commissions are published and are competitively priced at or below the current analogue market rates.

The OTC commodity products traded on the ICE include oil swaps consisting of crude oil, fuel oil, gas/heating oil, jet fuel, gasoline, and naphtha. Natural gas and power products include physically delivered gas at fixed and indexed prices, natural gas basis and swing swaps and firm power. Precious metals products include swaps, options and forwards for gold and silver.

Trading system

Today, technology is creating significant shifts in the global commodity markets as it has in the global financial markets. The technology behind IntercontinentalExchange’s enterprise is the backbone of its entire operation. The ICE is a robust and scalable trading system that facilitates fast real-time execution of swaps and options. ICE was designed to establish a new standard for electronic trading in the OTC commodity market.

ICE offers innovative features such as:

  • Robust management capabilities that allow users to dynamically tailor execution based on their assessment of credit and other counterpart issues
  • A complete picture of the market depth
  • Sophisticated support tools for strategies such as synthetic spread trading.

Trading operates on a bid/ask system in which customers see not only the best bids and offers, but all bids and offers in the market, showing its entire depth. Prices are displayed anonymously.

The OTC commodities market is a business-to-business market, where counterparties accept and manage each other’s credit – unlike the exchange traded commodities and futures business. The ICE incorporates comprehensive, automated credit management capabilities that enable participants to maintain the terms, or master agreements, under which they transact with one another. Each participant can manage its counterparty relationships dynamically, and they are visible on a colour-coded graphic filter located on the trading screen.

IntercontinentalExchange also offers the opportunity to implement straight-through processing of trades and trade information. The ICE was designed to be an open platform, enabling customers to write their own interfaces. Once a transaction is executed, information can flow electronically to accounting and risk management systems.

With the ICE system available on over 3000 screens, IntercontinentalExchange has quickly become one of the most widely distributed online professional marketplaces in the world. ICE participation continues to expand at a rapid rate and currently includes over 150 of the world’s largest energy and financial commodity firms. Another 30-50 companies are currently in the sign-up process.

Furthermore, IntercontinentalExchange’s advanced trading platform offers market participants the opportunity for increased price transparency and liquidity. In markets where similar electronic systems have already been implemented, market prices have improved and operational costs have been significantly lowered for customers.

Power industry trading

Figure 2. Jeffrey Sprecher from IntercontinentalExchange
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Sprechers’ own experiences in the natural gas and electricity markets and his understanding of other established and emerging commodity markets suggest that growth for digital commodity trading will be exponential. Forrester Research reported that of the approximate 2.7 billion MWh and 4.3 billion m3 of natural gas traded in North America in 1999, only 0.2 per cent of electricity trades and two per cent of natural gas trades were conducted on-line. In the same report, Forrester predicted these numbers to increase up to 25 per cent and 11 per cent respectively by 2004.

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