Carbon Trading

Designing the
Canadian Market
Presented by
Léon Bitton, VP R&D
Montreal Exchange
Winnipeg, March 14th, 2003

2
Montréal Exchange (MX)
Sole Financial Derivative
Exchange in Canada

• Bourse Trades all $CDN Interest

Rate Derivatives

• Bourse Trades all Canadian Equity

Derivatives

3
Dimension of The Montreal
Exchange Market
$ Traded / Notional value 2002

Interest Rate Derivatives : 5 $ trillion

Equity Derivatives : 143 $ billion

4
 MX Volumes
Growth by Asset Class 2002

+15%

Variation 2002 vs 2001

60 000
+24% +20%
Daily average

50 000 +9%
40 000

30 000

20 000

10 000

2002
Interest-rate Equity Equity Total
2001
futures Index options
02 / 01 Futures
*Open Interest: +31%
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 MX Highlights
• Restructuring program

MX TSE Vancouver Alberta

Senior
Derivatives CDNX
equities

CDCC 100% TSX

6
 MX Highlights
• Demutualization

• First North American Traditional

Derivative exchange to be fully electronic

• Creation of an on-line Training Institute

• Remote Access USA / UK

• BOX – New US option Exchange

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 Why an electronic
exchange?
Direct access
MONTRÉAL

VANCOUVER
LONDON
TORONTO
WINNIPEG
NEW YORK CHICAGO
CALGARY
Authorized
Broker
FCMs, Persons
Dealer
Proprietary
Firms
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 MX Electronic Trading
Platform
An open electronic trading platform
using the following main components:
• NSC trading system used by several exchanges
around the world

• Open architecture allowing firms to connect

using their own proprietary front end solutions
or one developed by an Independent Software
Vendor (ISV)

• Internet based connection – Under review

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 The Trading Process
Data
Access Trading Post trading Dissemination
SAM And Clearing
Market Data
Order &
(HSVF protocol)
• Independant Quote
Service Vendor
(ISV) using
Mind Trade
MMTP protocol Communication Management Data Vendors
Participants
(SLE screen) (HUB)
Gateways Database Participants & ISVs
• ISV using FIX Data (SLC Screen)
protocol Dissemination
Surveillance
• ISV and Order Tools
Flow Provider
Montreal Exchange
(OFP) using Trade Internet Site
STAMP protocol information
Market
Data Canadian Press
Trading
Engine
(NSC)
Automated Trade
Trade
confirmation Reporting to
Participants (ATR)

Trade
Market Data CDCC
for underlying
TSX Trade &
Allocation
information Participants
Back Office
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A Unique Market Model
Key characteristics:
• Price transparency
• Fairness
• Expanded access
• Rapid order execution
• Straight through processing for execution
• Flexibility of trading hours
• Enhanced liquidity
• Security

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 The Canadian Derivatives
Clearing Corporation (CDCC)
Clearing House carries out three
main functions:
• Registers and manages commitments
resulting from market transactions
(back-office function)
• Provides protection against counterparty
credit risk (netting function)
• Ensures the financial integrity of the market

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 CDCC – A factor of
competitiveness
• Manages a nominal risk of
approximately 600 billion $
CDCC
• “AA” rating from Standard &
Poor’s

• 33 members
Members
• Major financial institutions
• Contribution to Clearing fund
and margin: 1,9 billion $

Client Client

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 Derivative Instruments

Two kinds of hedging instruments

• Price fixing Instruments • Price Limiting Instruments

– Futures – Options
– Forwards
– Swaps

Two distinct markets for execution

Exchange based Off Exchange –

bilateral OTC

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 Total Worldwide Exchange
Derivatives volume by Asset Class*
Interest Metals
13% 2%
Gov Debt
Individual
15%
Stock
27%
Currency
1%

AG
3%
Energy
Equity Index 4%
35%
* Source: IOMA 2001 15
Dimension of Derivatives Market
Global notional outstanding in
OTC derivatives markets

-
End June 2001: $99.7 trillion

Commodities
0,7%
Equities Credit-linked
2,0% 0,7%
Forex Interest rate
20,5% 76,1%

* Source : BIS 16
Dimensions of Derivatives Market
The Global Cash and Derivative Market/Equity

$17.28
(in $Trillions)
$4.93

$28.03

$39.75

Cash Exchange-Traded Index Futures

Exchange-Traded Index Options Exchange-Traded Stock Options
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 Significance of Being
Exchange Traded
• Standardization facilitates market
liquidity
 Futures are price transparent, ensuring fair
prices
 Anonymity

• Clearing corporations reduce

counterparty risk
 Margin
 S&P rating

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Comparison of Markets
Exchange-Traded Over-the-counter
•Standardized as to size •Customized
and maturity
•A structured market •Traded in OTC markets
(exchanges are regulated)
•Limited risk of default – •Subject to counterparty
Clearing House risk
•Marked to market daily •Generally settled at
maturity
•Margin is mandatory •No margin requirements
(or optional)

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Prerequisite for an efficient Market –
Diversity of users and
concentration of liquidity
• Hedger is managing risk, either through a
price fixing process (futures) or by taking out
insurance (options).

• Speculator is taking risk - using investment

decision as primary source of income

• Arbitrageur is special - exploiting variations

in market conditions
– credit, tax treatments, liquidity

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 An illustration of emission
allowances and futures trading

 At the beginning of 2003, a coal-fired power

plant receives allowances matching its carbon
dioxide (CO2) emissions cap, say 20,000
emission allowances
(hypothesis: 1 emission allowance equals 1 ton
of CO2 emissions):

0 5,000 10,000 15,000 20,000 emission allowances

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First situation: surplus of emission
allowances ‣ ‣ ‣ Selling futures.
 In December, the CO2 emissions of the plant equal only 15,000 tons
thanks to the implementation of new CO2 filters:

Surplu
s

0 5,000 10,000 15,000 20,000 emission allowances

 Alternative 1:
If the treasurer of the plant knows that the implementation of new
CO2 filters will lower its C02 emissions below 20,000 and if he plans to
sell the surplus, selling a Dec 03 futures contract on 5,000
allowances @12 will place a floor to the December 2003 market
price.
 Alternative 2:
The plant may keep the surplus for use against its target in future
years or sell it to a trader at the market price.
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Second situation: shortage of emission
allowances ‣ ‣ ‣ Buying futures
 In December, the CO2 emissions of the plant reach 25,000
tons, it is a shortage of 5,000 allowances.

Shortag
e

0 5,000 10,000 15,000 20,000 25,000 emission

allowances

 Alternative 1:
If the treasurer of the plant anticipates an increase in the
C02 emissions, buying a Dec 03 futures contract on
5,000 allowances @12 will cap the December 2003
price.
 Alternative 2:
The treasurer of the plant will buy 5,000 allowances at the
market price to fill up the shortage in allowances.

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Benefits of the futures market

• The futures market improves risk

transfer by enhancing the ability of
investors to hedge or assume risk.

• The futures market contributes to the

overall efficiency and liquidity of the
cash market.

• The futures market improves the

transparency of the market.

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 Using Derivatives =
Good Business Practice
• Flexible
• Cost-Effective
• Maximize Returns
• Manage Risk

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 Prerequisites for an Efficient
Emissions Trading Market
• Liquidity
Need:
• Sizeable market volume and sufficiently high number of market players
• One-stop shopping for spot and derivatives contracts
• Economic efficiency/minimized infrastructure cost

• Diversity of market players

Need:
• Different market participants with different background and different
targets (power generators/industries/traders/financial institutions)
• Cross-border activity

• Standardization
Need:
• Standardised underlyings because they reduce market fragmentation,
facilitate risk management and reduce transaction costs

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 Prerequisites for an Efficient
Emissions Trading Market (con’t)
• Risk management tools / Certainty
Need:
• Improved risk management through Derivatives Market.

• Sound Exchange and Clearing House

Need:
• A centralised market place through which buyers and sellers trade
carbon emissions and futures with reduced credit risk exposure.
• An Exchange with a market - Neutral position and good reputation
for fairness and transparency in the conduct of trading
• Trade facilitation: electronic access and transparent model.

• Legal Framework
Need:
• Establishment of the framework and rules governing the market.

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Carbon Trading Market Design
Investors Companies involved
(Outright, in the
arbitrageur) carbon market

Undertakes
Environment
emission-reduction
Canada
projects

Emissions
trading
registry

The
Sellers Exchange Buyers
Allowances

Allowances
Electronic
$ Cash

$ Cash
Carbon emission
and derivatives market

Clearing
House

Independent Compliance Registry,Trading, Distribution &

and Monitoring Clearing & Settlement Market Access
• Self-governing structure • Centralised price discovery • Canada
• Provides confidence to the market • Market liquidity • U.S.A.
• Must meet minimum requirements • Market Anonymity • U. K.
to be an Approved participant • Reduced transaction costs • Etc.
or a clearing member • Central counterparty risk

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The Mission of a Carbon Exchange

• To provide a one stop shopping for spot

and derivative contracts on Canadian
environment products.

• Early launch to enable Canadian business

to gain practical experience of emissions
trading ahead of the implementation of
the Kyoto Protocol (2008-2012).

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Benefits of an Exchange
• Trading emission allowances is no different
from trading any other commodity. Anyone
who holds an account in a central registry will
be able to buy and sell allowances.

• An electronic emission trading system will

provide industry, governments and other
organizations in Canada with the opportunity
to buy and sell emission reductions at a
reduced overall cost.

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 MX Value proposition: An integrated
spot and derivatives cost-effective solution

Central credit
Counterparty

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For more information

• Bourse de Montréal
• www.m-x.ca
• Derivatives Institute
• www.derivatives-institute.com

• Léon Bitton
• lbitton@m-x.ca

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