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 / 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

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.

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

gives a glimpse on trade volumes of financial derivatives for the last three years.

Derivatives Traded in Overseas Exchanges by Product

(unit: unit contract, thousand dollars) Agricultura Transport l Product Metals Energy Index Total Trade 484,087 1,111,254 586,216 33,377 2,214,934 2010 Volume Traded 14,543,579 76,756,069 41,195,553 920,648 133,415,849 Value Trade 477,780 920,621 613,563 22,525 2,034,489 2011 Volume

Traded 19,078,528 128,190,639 53,952,960 399,461 201,621,588 Value Trade 587,722 1,964,739 1,000,206 18,700 3,571,367 2012 Volume Traded Value 23,263,672 110,496,379 76,319,224 201,144 210,280,419 Source: “Research on Derivatives 2013”, Derivative Research and Development Center of Korea

Domestic Trade Volume of Financial Derivatives (2011-2013)

(unit: trillion won, %) 2011년 2012년 2013년 Growth Rate Total 82,951 60,564 57,121 △3,443(△5.7) Domestic Exchange-Tra 70,011 48,420 45,101 △3,319(△6.9) ded OTC 12,940 12,144 12,020 △124(△1.0)

1. Parentheses indicate year-on-year growth rate 2. Surveyed are banks, foreign currency banks, securities firms, insurance companies, asset management firms, merchant banks, futures companies, and credit card companies. Source: “Financial Derivative Trade 2014”,Financial Supervisory Service of Korea

Korea Energy Economics Institute 9 - Total value of derivative trades from 2011 to 2013 were whopping 82,000 trillion won, 60,000 trillion won, and 57,000 trillion won respectively.

- However, the value of jewelry trades were little as 39.3 trillion, 37.5 trillion, and 32.7 trillion won respectively.

- Energy derivatives incorporated in jewelry trades accounted for 45 percent, 40 percent, and 30 percent from 2011 to 2013.

○ Despite the big scale of domestic derivative trades, domestic energy derivative trades are insignificant compared to the world’s energy derivative markets.

- In general, energy derivatives in Asia are mostly transacted in SGX.

□ Domestic energy industry’s hedge trades

○ For oil companies that are mainly importing businesses, incentives from hedge trade are weak.

[Figure 4-1] Net Future Sales of Shipbuilding and Refinery Businesses

10 Policy Issue Paper 14-18 Energy Investment in the Over-the-Counter Market

Source: “Long-Term Strategic Suggestions to Enhance Risk Managing Ability of the Korean Financial System”, Bank of Korea (2012) Refinery Business Shipbuilding Business

○ There are two major reasons to this background.

- First, an importing business like the energy companies provides products through expected production method. Therefore, by being able to hold small amounts of foreign currency assets for short-terms, there is not a large incentive from hedging.

- Second, companies such as oil refineries that hold domestic market dominance, incentives from hedge trades are even more obsolete.

- And it is because they are able to pass on the cost from not hedging onto the consumers.

□ Analysis of domestic energy industry fund investment cases

○ The Korean government has been active in mission of attracting energy business fund investment, with a view to securing energy resources and helping enhance private investment in overseas energy investment projects. One of its strategy was support to resource development funds.

- To that end, the government launched a research on success factors of Parellel Trust Fund, Ankor Oil Fund, and Ambatovy Nickel Fund, seeking roles of OTC trade to promote profitability and stability of fund investment.

- This research is significant, contributing to encouraging private investors to participate in long-term, high-risk, and high-return projects and providing Korean financial agencies with chances to experience overseas

Korea Energy Economics Institute 11 advanced financial systems.

- However, an issue of accountability can be raised especially when a project causes huge losses to private individual or corporate investors, because the investors relied on promises of state-own companies who lead the project.

○ In order to improve profitability and sustainability of investment through market principles, the authorities should refrain from using public fund to cover risks but instead, promote financially engineered derivative trading or spot and futures derivative trading in exchanges or OTC as risk hedging strategies.

- Especially when it comes to energy product investment, transaction costs are normally higher than other products and investors are very cautious not to leak trade information. This is largely attributed to the nature of the industry, which is a wide variance of purposes of trading contracts. As a result, investors and businesses prefer to confirm hedge strategies through OTC trades rather than through the exchanges.

- As Korean financial experts are less capable of dealing with energy-related derivatives, it is needed to invite a credible matchmaker to reduce transaction costs and to enhance Korea’s capacity at least during the early stage of OTC market.

□ Problems of Korean OTC energy finance investment

○ Cost structure that drives transaction costs high: financial investment climate

12 Policy Issue Paper 14-18 Energy Investment in the Over-the-Counter Market

- Although Korea’s financial industry made a remarkable growth along with economic growth for the last few decades, its role has been no more than a risk taker that supports goods and services markets.

- The obstacles of growth of Korea’s financial investment business include the limited scale of banks and their extreme propensity to avoid risks in asset operation.

- Since the majority of investors have been banks, financial institutions in Korea are rarely exposed to competitive market settings. The major features that Korea’s financial industry exhibit are: excessive pursuit of fund security and real estate-based asset management. They ended up hampering progress of the industry.

- The world’s leading investment banks (IBs) do not confine their business with asset management. They rather expand to high-risk and high-return projects. With extended portfolios, they are able to learn lessons in new businesses and make qualitative growth. To the contrary, Korean IBs tend to settle in managing asset and generating revenues from commission with a strong focus on quantitative growth.

- As Korea becomes one of the fastest aging countries and the economic growth gets slow with low interest rates, the profit structure based on commission is no longer sustainable.

- Moreover, banks compete each other decreasing their commission rates, which aggravates business profitability in general. For example, commission rate of securities firms was 9 percent in 2011, down from 20 percent in 2000.

Korea Energy Economics Institute 13

Financial Market Size Across Countries

(as of 2013, unit: US$ trillion) Capital Financial Capital Financial Region GDP Market Market Market Ratio Market Ratio to GDP to GDP World 74.7 151.6 282.8 2.1 times 3.8 times EU 16.3 39.2 87.6 2.5 times 5.4 times U.S. 16.7 52.0 75.1 3.2 times 4.5 times Japan 4.9 18.2 28.2 3.1 times 4.9 times Korea 1.2 2.5 4.4 2.1 times 3.7 times 1) Financial market = stock market + bond market + bank assets, 2) Stock market = market capitalization, 3) bond market = balance of bonds issued, 4) capital market as of 2012 Source: World Bank, BIS Statistics

- Additionally, a series of regulations, such as net capital ratio (NCR) and limit on foreign exchange dealing range, ended up holding IBs back from growing into capital management-based suppliers. Due to the regulations, IBs find it hard to diversify capital management through foreign investments and have to face increasing OTC trade searching costs.

※ Operational net capital divided by total risk cost equals NCR. NCR serves as an indicator of a bank’s capacity of handling potential losses from its assets without mobilizing additional funds from the outside. In Korea, a bank with NCR under 150 percent is advised to improve its management, if under 120 percent, is required to improve its management, and if under 100 percent, is put through annulation of business license. The Finance Committee recently substituted operational net capital ratio with net capital ratio, which equals operational net

14 Policy Issue Paper 14-18 Energy Investment in the Over-the-Counter Market

capital less total costs divided by necessary equity capital, in order to remove unnecessary obstacles in doing business overseas. This new standard will apply to investment brokers starting in 2016.

International Investment Bank Ranking in Asia (as of 2009, measured in market capitalization)

Market Ran Country Investment Bank Capitalization Total Asset king (US$ billion) (US$ billion) 1 China IND & COMM BK OF CHINA - A 255 1,430 2 China CHINA CONSTRUCTION BANK - H 208 1,107 5 China BANK OF CHINA LTD - H 150 1,018 21 China BANK OF COMMUNICATIONS CO-H 65 393 22 Japan MITSUBISHI UFJ FINANCIAL GRO 62 1,933 34 China CHINA MERCHANTS BANK - A 48 230 42 Japan SUMITONO MITSUI FINANCIAL GR 37 1,121 44 India STATE BANK OF INDIA 34 256 45 China CHINA CITIC BANK - H 33 174 47 Japan MIZUHO FINANCIAL GROUP INC 30 1,546 48 China SHANGHAI PUDONG DEVEL BANK-A 29 192 49 China INDUSTIRIALBANK CO LTD-A 28 150 51 Hong Kong HANG SENG BANK LTD 27 98 52 Hong Kong BOC HONG KONG HOLDINGS LTD 25 148 57 India ICICI BANK LTD 23 121 58 Singapore DBS GROUP HOLDINGS LTD 22 179 60 China CHINA MINSHENG BANKING-A 21 154 62 Korea KB FINANCIAL GROUP INC 20 212 63 Korea SHINHAN FINANCIAL GROUP LTD 20 210 74 China BANK OF BEIJING CO LTD -A 17 61 80 India HDFC BANK LIMITED 16 33 85 Malaysia MALAYAN BANKING BHD 15 82 87 Japan RESONA HOLDING INC 14 400 96 Indonesia BANK CENTRAL ASIA PT 12 22 100 Korea WOORI FINANCE HOLDINGS CO 11 231

Source: Mickinsey Global Institute (November 21, 2013), Jun-haeng Lee (2014)

○ Internal factor of high transaction costs: weak capacity of market players,

Korea Energy Economics Institute 15 - Compared to the leading nation's financial markets, the domestic financial market lacks consultative capacity for energy industries and related product investments, and the ability to evaluate future business value is falling short as well.

- The lack of expertise and skilled traders becomes a large obstacle when it comes to large OTC financial transactions in which the information asymmetry between dealers is large. In other words, the main reason behind lack of energy project investments through OTC financial trades is because of the uncertainty of long-term future profitability for the financial investment institutions when it comes to making a decision to invest upon an energy business.

Ⅲ. Policy Implications

□ It is necessary to reduce OTC search costs by utilizing networks of international investment banks.

○ The best scenario is that Korean investment banks play a role of matchmaker. However, they fall short of capacity.

○ This research focuses and examines upon the strategy of utilizing highly creditable international IBs as a renowned matchmaker and their network for OTC finance trade development. The ultimate role of matchmakers will be to reduce transaction costs.

○ To that end, it is essential not only to invite leading investment banks,

16 Policy Issue Paper 14-18 Energy Investment in the Over-the-Counter Market

such as Goldman Sachs and JP Morgan, into domestic market to bring down transaction costs but also to strengthen Korean investment banks’ capacity.

- The purpose of deploying networks of foreign top-notch investment banks is to mitigate information asymmetries in OTC market and decrease search costs.

□ Possible side effects

○ Monopoly of information by international IBs

- The reason why international IBs’ networks are required in OTC trades is that they have a privileged position in acquiring information leveraging their control power in markets.

- When an information monopolist plays a benign role in markets, liquidity increases in market. On the other hand, when it attempts to take over the entire market, market failure happens.

○ In order to properly utilize the international IBs, an institutional strategy to check up on their monopolistic strength of information is also essential.

- And the reform of OTC trade information disclosure system being made around the world recently seems like the perfect fit as the institutional device in complementing the international IB network strategy.

□ Information disclosure system case study: TRACE

○ The majority of U.S. bond markets use TRACE (Trade Reporting and

Korea Energy Economics Institute 17 Compliance Engine) to report closing prices and minutes of meeting.

- When trade volume of a contract does not go out of the pre-set range, TRACE announces the trade volume, otherwise, announces “override flag.”

- Not publicizing large-scale yields helps easing concerns of large-scale liquidity providers that negotiation parties might take advantage of their contract terms, such as volume and price, before coming to negotiation tables. In addition, it helps prevent stock imbalances caused by large contracts.

○ Bissembinder, Maxwell and Venkataraman (2006) studied TRACE’s role in providing price transparency using empirical evidence.

- The study results indicate that TRACE helped increase market liquidity, contrary to the common belief.

□ That is to say, this research emphasizes that a strategy of utilizing a creditable international IB network to promote OTC energy investments can become a lot more effective when complemented with an institution which reveals all OTC trade information upon the players of the market.

18 Policy Issue Paper 14-18 Energy Investment in the Over-the-Counter Market

Ⅳ. Expected Achievements

□ Korean financial institutions and energy corporations will be able to strengthen their investment capacity through the world’s top IB networks.

○ It is not impossible to do market timing via international IB networks without affecting commodity portfolio.

○ In addition, they can both overcome rigidity caused by long-term contracts and reduce price risks of commodity trades.

○ Partnering with international IBs will surely increase capacity as domestic trader.

□ It is expected that energy finance market climate is formed favorable to market players’ voluntary participation.

○ The authorities are advised to refrain from cover policy, but to create a climate where investors can actively adopt risk hedging strategies, such as financially engineered derivatives and spot and future trading in exchange or OTC market.

○ Consequently, it is anticipated that profitability and stability of energy business investment will increase boosted by market principle.

○ Also, this will pave the way for a stronger market spirit in domestic energy market.

Korea Energy Economics Institute 19 < References >

금융감독원 (2014) 2013년 금융회사 파생상품 거래 현황

금융연구원 (2014) 국내 금융 투자업의 발전방향 및 과제

금융 투자협회(2013) 12월 해외파생상품시장 외신동향 자료집

금융 투자협회 ‘2013 장외파생상품 시장동향

기획재정부 보도 자료 (2014) 파생상품시장 발전방안 (2014 6.17)

한국거래소 파생상품연구센터 (2012) 국내외 석유 현·선물시장 현황 조사

한국거래소 파생상품연구센터 (2013) 일반상품 파생상품시장의 특성과 국내 시 장 현황

한국거래소 (2013) 세계 파생상품시장 동향, 파생상품시장본부 주식파생운영팀

Bessembinder, H., Maxwell, W. and K. Venkataraman (2006) "Market transparency, liquidity externalities, and institutional trading costs in corporate bonds," Journal of Financial Economics, Elsevier, vol. 82(2), 251-288

Duffie, D. (2011) "Dark Markets: Asset Pricing and Information Transmission in Over-the-Counter Markets (Princeton Lectures in Finance)", Princeton University Press

20 Policy Issue Paper 14-18 Policy Issue Paper 14-18 Energy Investment in the Over-the-Counter Market Printed on February 23, 2015 Issued on February 23, 2015

Author：Bong-Seok Choi Publisher：Joo-Heon Park

Published by Korea Energy Economics Institute, (Address) 405-11, Jongga-ro, Jung-gu, Ulsan, 44543, Korea, (Phone) +82-52-714-2114, (Fax) +82-52-714-2028

Registered on December 7, 1992 ⓒ Korea Energy Economics Institute, 2015