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Energy Investment in the Over-The-Counter Market Policy Issue Paper 14-18 Energy Investment in the Over-the-Counter Market B. S. Choi Contents Ⅰ. Research Background / 1 Ⅱ. Research Results / 5 Ⅲ. Policy Implications / 16 Ⅵ. Expected Achievements / 19 <References> / 20 Energy Investment in the Over-the-Counter Market Ⅰ. Research Background 1. Background □ Global over-the-counter markets have recently been growing rapidly. ○ Domestic over-the-counter market (OTC) began with the approval of derivative product business of general goods from commercial banks since 2006 with focus on foreign trade supplies. ○ But Korea’s domestic market, compared to the leading nations such as the United States or the United Kingdom, is lacking in financial infrastructure and expertise. The number and scale of markets are insufficient and a system to manage market risks is not settled yet. - As disputes over OTC derivative, such as ELS, increase, the importance of protection for investors is being emphasized. ○ Meanwhile, countries like Singapore and China are focusing upon investments for developing future markets and institutional support to stimulate energy product trades, and also putting efforts to further develop the corresponding hub for the energy financial market. □ Korean OTC Derivatives Market is on the rise. ○ In alignment with the global trend, the Korean government pushes forward a goal to develop Yeosu-Ulsan oil hub. - Also, several plans to promote energy product trade are in progress Korea Energy Economics Institute 1 with consideration towards the domestic supply and demand situation in order to naturally form a petroleum product price range. For example, Korea Exchange created an electronic trade internet website and plans to establish a future market for petroleum products. - Investment interests towards the energy industry within the domestic OTC market are on the rise but, due to technological limits and other non-commercial risks, investors tend to hesitate to advance into OTC market and the authorities are slow in making efforts to improve relevant financial institutions. - Despite the active efforts, due to comparatively less-advanced financial infrastructure and the rigorous energy market conditions, effects of institutional improvements are being undertoned, and the incentives for market investors are lacking; particularly for the private oil refinery companies that are responsible for the monopolistic oil market. 2. Research Purposes □ Why this research is needed ○ Despite increasing interest in energy investment via OTC, not many studies have been conducted. - Energy investment has been largely based on policy financing. - There is not a market basis for energy investment, on which private investors can willingly take part in. □ Research purposes 2 Policy Issue Paper 14-18 Energy Investment in the Over-the-Counter Market ○ This paper proposes a strategy to revitalize energy investment which fits into the domestic OTC trades while also examining the pending issue of energy and financial product investments through OTC trades based on the advancements of financial markets and related law within the major countries around the world. - Especially this paper focuses upon deriving a strategy to invigorate the OTC market for South Korea's developing financial market through an empirical analysis of syndicate loan trading thereby finding a way to promote domestic energy market price mechanism with invigoration of energy financial investments. □ Reference: definition and features of OTC market ○ OTC market is a market where sellers and buyers individually come to an agreement on trade terms, not via centralize trade mechanism, including limit-order book, in coordinating bids and offers (Duffie 2014). - Sellers and buyers in OTC market are under a relatively greater asymmetric information because they do not know counterparties or other similar price negotiations to refer to. - OTC market prices and trades are influenced in many ways by brokers and dealers and imperfect information in market. ○ Most often, assets traded in OTC market include government or corporate bonds, asset-backed securities, advance against securities, repurchase contracts, derivatives, real estate, and currency. Dealers are in charge of OTC trade in general. Korea Energy Economics Institute 3 ○ When trade transparency is not guaranteed by traded goods, investors tend to prefer OTC market to central clearing. - For example, complicated credit products, such as collateralized debt obligation, are not great in trade volume. Besides, those contract terms are extremely complicated that only a small number of professional investors can assess and understand profit structure. - These financial products have less liquidity and transparency, so the market often fails to attract participation of investors and get the products cleared. As a result, they end up being traded in OTC market. 4 Policy Issue Paper 14-18 Energy Investment in the Over-the-Counter Market Ⅱ. Research Results □ Trades in energy products in global financial markets ○ For the last five years, energy products in the worlds’ domestic financial markets rose 13.2% on average per annum. - Since 2008, energy product trades have made a steady growth. Since 2010, growth rate has been increasing. - In 2013, US$1.27 billion contracts were made globally, marking 36.7% of year-on-year growth, largely contributed by natural gas and electricity derivative trades. - Energy future derivatives rose by 12.5 percent in 2012, largely attributed to a big growth in demand for brent crude and natural gas derivatives. Korea Energy Economics Institute 5 <Table 2-1> Derivative Trade Volume 2011-2013 (unit: thousand contracts, %) 2011 2012 2013 Underlying Asset Trade Trade Growth Rati Trade Growth Rati Volume *Ratio Volume Rate o Volume Rate o Agricultur 996,837 4.0 1,254,416 25.8 5.9 1,213,000 -3.3 5.6 al Product Energy 814,866 3.3 925,683 13.6 4.4 1,266,000 36.7 5.8 Carb 37 0.0 84 125.8 0.0 - - - on Marin e 93 0.0 100 7.1 0.0 - - - Shipp ing Jewelry 342,058 1.4 319,299 -6.7 1.5 Non-Jewe 1,077,000 23.3 5.0 lry 435,113 1.7 554,253 27.4 1.6 Miscellane 229,623 0.9 252,590 10.0 1.2 493,000 95.2 2.3 ous Total 2,818,496 11.3 3,306,240 17.3 15.6 4,049,000 22.5 18,7 Ratio is to underlying asset volume, including index, stocks, currency, short-term and long-term interest Source: “Global Derivative Trends 2013”, Korea Exchange - As brent crude price increases and substitutes WTIFMF as a new benchmark, quantity of brent future contracts of ICE increased 11.6 percent. - 2013 energy futures contract jumped by 36.3 percent in volume compared to the previous year, which is attributable to a tendency of ICE converting OTC derivatives into futures, so-called futurization, and increase in demand for crude derivatives. - Nine of the top ten selling products are traded in ICE and NYMEX, the U.S. major futures exchanges. ○ OTC derivatives markets had been in decline since 2011 until the 6 Policy Issue Paper 14-18 Energy Investment in the Over-the-Counter Market second half of 2013, when nominal price made a turnaround jumping 9.5 percent. - In particular, interest rate products, of which nominal value takes up 81 percent of the total, grew by 14.6 percent, whereas currency products, of which nominal value makes up 10.6 percent of the total, made a 8.6 percent growth. <Table 2-2> Energy Futures Contract Volumes (2012) (unit: 10 thousand, %) 2012 2011 Rankin g Product Exchange Contrac Year-on Ra Contrac (2012) t -Year nki t Volume Growth ng Volume 1 Brent Crude Oil ICE (U.S.) 1,474 11.6 2 1,320 2 Crude Oil (WTI) NYMEX 1,405 △19.7 1 1,750 3 Natural Gas NYMEX 948 23.3 3 769 4 Gasoil ICE 635 △3.5 4 658 5 Natural Gas ICE 602 - - - 6 Crude oil MCX(인도) 578 5.5 5 548 7 Gasoline NYMEX 366 17.6 8 311 8 Heating Oil NYMEX 361 13.3 7 318 9 Crude Oil (WTI) ICE 331 △35.1 6 511 10 Power ICE 331 - - - Global Energy Futures Total 8,279 12,5 7,361 Source: “Global Derivative Trends 2012”, Korea Exchange - The growth rates of commodities and credit derivatives shrunk to 5.0 percent and 2.9 percent, down from 13.6 percent and 6.9 percent of the previous year. □ Trades in energy products in the domestic market ○ Current domestic exchange-traded derivative market's trading volume is Korea Energy Economics Institute 7 8th largest in the world. The domestic exchange-traded market has 15 derivative markets based off of 15 different standards including stock quotes and shares while 90 percent of trades are made up of stock futures and option trades. ○ Banks have been the major participants of trades within the OTC derivatives market. Trading status shows 90 percent are made between banks while Non-Deliverable Forward (NDF) takes up 72.3 percent and Interest Rate Swap (IRS) products at 21.5 percent. - Comparatively, the scale of domestic OTC derivatives market is only 27 percent of exchange-traded market, but the OTC balance is more than 80 times larger than that of the latter. ○ That implies that within the domestic central derivatives markets and OTC markets, energy derivative products are of less importance. - Based on the research results of 2013, the overall global weight taken up by energy derivative products are 4-5 percents of the entire derivative market. - But as for Korea, despite having a larger share of petroleum and petrochemical product exports, there is no market that manages risks related to these products. - Meanwhile, the U.S. CME handles over 1,200 financial trades and China’s Shanghai Futures Exchange, Zhengzhou Commodity Exchange, and Dalian Commodity Exchange deal with energy products in various forms. 8 Policy Issue Paper 14-18 Energy Investment in the Over-the-Counter Market - The following <Table 2-4> gives a glimpse on trade volumes of financial derivatives for the last three years.
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