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How Mexican regulations work on trading energy as a derivative (futures and swaps) as

well as a physical commodity?

Regulation of trading energy as a derivative

A general law that regulates derivative markets in Mexico is the Securities Market Law

(Ley del Mercado de Valores). The law defines derivative financial instruments as securities,

contracts, or any other legal act the valuation of which is related to one or more underlying

assets, values, rates or indices (art 2 (XIV) of the Securities Market Law). Article 171 (VI) of the

Securities Market Law provides that brokerage firms are entitled to carry out transactions with

derivative financial instruments, on their own behalf or on behalf of third parties. The brokerage

firms that carry out transactions with derivative financial instruments are subject to regulations

issued by the Bank of Mexico (art 176 of the Securities Market Law).

In 1996, the Bank of Mexico issued the Rules for the Participants of the Derivative

Contract Market (hereinafter – Rules). The Rules were last amended in 2014. The Rules define

an underlying asset as an asset, rate or certificate asset, rate, certificate, price, index, financial

derivative instrument, or any variable that determines a subject-matter value of derivative

contract. Such a definition of an underlying asset means that energy sources, such as oil, natural

gas and so on, can be underlying assets.

According to the Rules, derivative contract is a document that sets forth general terms

and conditions of negotiation of the future contracts, option contracts, swaps contracts or a

combination of them and other financial transactions known as derivatives, the valuation of

which is determined by one or more underlying assets. Derivative contracts should be offset and

settled in the Clearing House, the trust entity which conducts recordkeeping of derivative
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contracts and other derivative transactions. Furthermore, the Rules provide a definition of future

contracts, option contracts and swaps contracts. Future contract is an agreement providing for

purchase or sale of an underlying asset with the condition that the settlement of price will take

place on a future date. Future contracts are registered in the Stock Exchange. Option contract is

an agreement, according to which the buyer, by paying the premium, acquires a right (but not an

obligation) to call or put an underlying asset at the price agreed at a future date, and the vendor

commits to sell or to buy the underlying asset at that price. Swaps contract is an agreement by

which the parties agree to exchange cash flows on future dates within a certain period. Here, one

may note the difference: while future contracts are listed in the Stock Exchange, swaps and

option contracts are not.

The Rules place certain restrictions on who can be involved in derivative transactions.

Thus, commercial banks and security firms can execute and settle derivative contracts only if

they have right and authorization to operate with the underlying asset. If one extrapolates this

provision to a situation involving an energy derivative, he or she will conclude that commercial

banks and security firms will be entitled to execute and settle energy derivative contracts only if

they have a right and authorization to operate the underlying energy asset. In other words,

commercial banks and security firms can execute and settle derivative contracts, only if the client

gave them the right and authorization to operate the asset.

Another instrument that regulates derivative market is the General regulations applicable

to issuers of securities and other participants of exchange markets (Disposiciones de carácter

general aplicables a las emisoras y a otros participantes del Mercado de Valores). However,

these regulations are hardly applicable to energy derivatives, since they mainly address

derivatives the underlying asset for which is the company capital (art 50 (3) (e) or derivative the
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underlying asset for which is shares of the issuer (art 83 (IV)). Provisions applicable to derivative

markets are also contained in the General regulations applicable to brokerage houses

(Disposiciones de carácter general aplicables a las cases de Bolsa). According to Article 69 Bls

of the General Regulations, brokerage firms must maintain exclusive subaccounts for

transactions with derivative financial instruments. Operations with derivatives are exempted

from the rule that brokerage houses must refrain from carrying out operations in which they

assign the sale and purchase of the securities simultaneously in one or more contracts, in which

there is identity between one or several holders, or between the different sub-accounts of the

brokerage firm's own account (art 89 of the General Regulations). The General Rules also

contain provisions regulating how brokerage firms must record and count derivative financial

instruments. Thus, when derivative instruments come in packages, each derivative instrument is

counted separately and independently (art 151 (VIII)). The exception from these rules is future

contracts with equivalent terms which concern the same purchase or sale and refer to the same

amount and rate. Such contracts can be counted as swaps (art 151 (VIII)).

The observation of Mexican regulatory regime of derivative markets shows that there is

no special regime for derivatives on energy commodities. Rather derivatives on energy

commodities are regulated in the same manner as derivatives on any other underlying assets.

Such state of affairs contrasts with that one in the United States, where derivatives on energy

commodities are regulated by a special law, the Commodity Exchange Act (hereinafter - CEA).

The CEA adopts a broad definition of commodity which covers energy assets (7 US Code § 1a).

Furthermore, to a certain extent the CEA regulates operations with derivatives on energy

commodities (7 US Code § 6). Although the CEA provisions mainly address futures exchanges,

its antimanipulation and antifraud also apply to other kinds of derivative transactions such as
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swaps. Moreover, there is a specific regulator, the Commodity Futures Trading Commission

(CFTC), which is authorized to oversee trading of derivatives on energy assets (7 US.Code § 2).

It appears also that in the United States, the CFTC may also regulate, although at the very limited

extent, over-the-counter derivatives markets, which are outside the regulated exchange

environment: certain types of off- exchange transactions must comply with antifraud and the

antimanipulation provisions of the CEA (GAO, 2007).

Regulation of trading energy as a physical commodity

Energy is also traded as a physical commodity. Until recently, the Mexican energy market

was monopolized by the state, since only state-owned company were entitled to extract, produce

and own energy sources (Vietor, R. H., & Sheldahl-Thomason, 2017). However, in 2013 a

comprehensive reform was launched to liberalize the Mexican energy sector (Vietor, R. H., &

Sheldahl-Thomason, 2017). Nowadays, the oil and gas trade is regulated by the Hydrocarbons

Law and its regulations. The electricity market is regulated by the Framework of Electricity

Market. The Hydrocarbons Law regulates distribution and retail sale of natural gas, liquefied

petroleum gas, and petroleum products (art 2 of the Hydrocarbons Law). Retail sale is defined as

a direct sale to consumers (art 4 of the Hydrocarbons Law). Permit from the Energy Regulatory

Commission is required to engage in retail sale of the hydrocarbons (art 48 (II) of the

Hydrocarbons Law). The Hydrocarbons Law provides that aircraft fuel cannot be directly sold to

the public and its distribution is subject to control by service providers (art 71 of the

Hydrocarbons Law). The hydrocarbons must be sold with no alternation to their composition (art

72 of the Hydrocarbons Law). The Energy Regulatory Commission sets forth quality

specifications for hydrocarbons (art 73 of the Hydrocarbons Law). Prices and rates on
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hydrocarbons are established by the Energy Regulatory Commission (art 77 of the Hydrocarbons

Law). One may observe that although liberalized, the hydrocarbons market remains heavily

regulated, since the Energy Regulatory Commission is entitled to set prices at which these

commodities must be sold at the market. Such regulation contrasts with a free market regulation

of hydrocarbons market in the United States, where there is no central regulatory regime for oil

and gas industry, but these sectors are regulated by state authorities. Moreover, no federal

regulator sets prices or rates for sale of hydrocarbons in the United States. In a word, compared

to the United States, hydrocarbons market remains to be heavily regulated.

The Framework of Electricity Market lays down the design and operating principles of

the electricity market. According to the Framework, the electricity market consists of : (1) a short

term energy market; (2) power capacity market; (3)clean energy certificate market; (4) market of

financial transmission rights (art 1.3 of the Framework). In addition, the National Center for

Energy Control (CENACE) operates auctions to assign medium and long-term electricity

coverage contracts (art 1.3 of the Framework). According to the Framework, qualified users

(typically industrial companies) which obtained permit from the Energy Regulatory Commission

are entitled to sell electricity to end users (Vietor, R. H., & Sheldahl-Thomason, 2017). These

qualified users can obtain electricity directly at the market, from generators (whether state-

owned or private) or from other qualified electricity retailers (Vietor, R. H., & Sheldahl-

Thomason, 2017). Compared to the United States, the Mexican electricity market remains

heavily regulated. In the United States, the Federal Energy Regulatory Commission (FERC), the

regulator in interstate electricity sale does not conduct auction to assign medium and long-term

electricity coverage contracts as the CENACE does in Mexico. Its role is limited to approval and

review of interstate transmission reliability standards and to detecting manipulations and rule
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violations (Flores-Espino et al, 2016). Electricity is sold at a wholesale spot market which is

coordinated by independent entities (Flores-Espino et al, 2016). To sum up, regulation of trade of

energy assets such as petroleum, gas and electricity, is radically different in Mexico and in the

United States. While in the United States the markets are more free in the sense that their

principles and character are determined mainly by market players, in Mexico the character and

principles of the energy market are defined by regulators.

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References

Flores-Espino, F., Tian, T., Chernyakhovskiy, I., Mercer, M., & Miller, M. (2016). Competitive

Electricity Market Regulation in the United States: A Primer (No. NREL/TP-6A20-

67106). NREL (National Renewable Energy Laboratory (NREL), Golden, CO (United

States)).

Framework of Electricity Market. Retrieved from

http://www.cenace.gob.mx/Docs/MarcoRegulatorio/BasesMercado/Bases%20del

%20Mercado%20El%C3%A9ctrico%20Acdo%20Sener%20DOF

%202015%2009%2008.pdf

GAO (2007). “Trends in Energy Derivatives Markets Raise Questions about CFTC's Oversight”

Retrieved from https://www.gao.gov/assets/270/268177.html

General regulations applicable to brokerage houses (Disposiciones de carácter general aplicables

a las cases de Bolsa). Retrieved from

http://www.cnbv.gob.mx/Normatividad/Disposiciones%20de%20car%C3%A1cter

%20general%20aplicables%20a%20las%20casas%20de%20bolsa.pdf

General regulations applicable to issuers of securities and other participants of exchange markets

(Disposiciones de carácter general aplicables a las emisoras y a otros participantes del

Mercado de Valores). Retrieved from

http://www.cnbv.gob.mx/Normatividad/Disposiciones%20de%20car%C3%A1cter

%20general%20aplicables%20a%20las%20emisoras%20de%20valores%20y%20a

%20otros%20participantes%20del%20mercado%20de%20valores.pdf

https://www.gao.gov/assets/270/268177.html
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Hydrocarbons Law. Retrieved from https://www.tklaw.com/files/Publication/5f93e40d-fc4d-

445c-b7f9-7dc1cc20b56e/Presentation/PublicationAttachment/9b630df7-5e9e-4e9c-a2f6-

80af30e552ff/Mexico-Hydrocarbons-Law-English-Translation.pdf

Rules for the Participants of the Derivative Contract Market. Retrieved from

http://www.banxico.org.mx/disposiciones/normativa/reglas-conjuntas-participantes-del-

mercado-de-cont/%7B7EFEB4D3-621B-D1D5-09C4-0BBC08FDA46D%7D.pdf

Securities Market Law, 2005 (Ley del Mercado de Valores). Retrieved from

https://docs.mexico.justia.com/federales/ley_del_mercado_de_valores.pdf

Vietor, R. H., & Sheldahl-Thomason, H. (2017). Mexico’s Energy Reform. Retrieved from

https://sites.hks.harvard.edu/hepg/Papers/2017/Mexican%20Energy%20Reform%20Draft

%201.23.pdf