Swaps Come of Age

The spread of electronic trade is having a far-reaching impact on the oil and gas business, with the latest developments promising to advance over-the-counter (OTC) products such as swaps as a mainstream hedging tool. The IntercontinentalExchange (ICE) last week confirmed plans to offer clearing services for its OTC contracts from the fourth quarter of this year. With similar moves also planned by the New York Mercantile Exchange (Nymex), OTC contracts such as swaps are fast shedding their former image as the wild cousins of regulated futures contracts. OTC oil and gas contracts were traditionally distinguished by their fuzzy legal status, lack of standardization, and absence of clearing services. Changes in US law and the spread of electronic trade have pretty much eroded the first two differences, and the ICE initiative will deal with the third. The main differences now lie in regulation and settlement. Some traders view swaps as more effective hedging tools. Calendar-month WTI swaps, for example, are widely used to hedge against producer or refiner supply contracts, which use average prices during calendar rather than contract months. ICE’s clearing services will be provided by the London Clearing House -- the clearinghouse for London's International Petroleum Exchange (IPE), which was taken over by ICE. ICE will now be able to offer a one-stop hedging shop for cleared futures and derivative contracts, allowing traders to use a single location to conduct full hedging strategies and to pool their risk (energy network Jan.16, p7). Clearinghouses offer financial risk protection, acting as a central party to shield traders against counterparty default. ICE's initiative in part reflects its increasingly fierce competition with Nymex. But the evolution of swaps is also part of a deeper market trend, which has been actively encouraged by the US government and some big energy companies. The US has been working to give derivatives a stronger legal framework since the late 1990s, after Russia defaulted on its debt and the Long-Term Capital Management hedge fund came to the brink of collapse. That effort culminated in legislation giving derivatives a stronger legal footing (energy network Dec.12, p1 ). The advance of electronic trade has accelerated the change, by encouraging liquid trade in standardized products. This is no accident. In an interview a year ago, John Browne, chief executive of BP -- one of ICE's founders -- said that the platform had been set up in an attempt to create “a real exchange market for swaps, rather than simply one-off, over-the-counter activity.” This would make hedging more transparent and efficient, he said (energy network Jun.23’00, p3 ). By David Pike