Carbon Trading Designing the Canadian Market

Presented by Lon Bitton, VP R&D Montreal Exchange Winnipeg, March 14th, 2003
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Montral Exchange (MX)

Sole Financial Derivative Exchange in Canada
Bourse Trades all $CDN Interest Rate Derivatives Bourse Trades all Canadian Equity Derivatives
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Dimension of The Montreal Exchange Market

$ Traded / Notional value 2002

Interest Rate Derivatives : 5 $ trillion

Equity Derivatives : 143 $ billion

MX Volumes Growth by Asset Class 2002

60 000

Daily average

50 000 40 000 30 000 20 000 10 000

+9%

+24% +20%

2002 2001 02 / 01 Interest-rate futures

*Open Interest: +31% Equity Index Futures

Equity options

Total

Variation 2002 vs 2001

5

+15%

MX Highlights
Restructuring program
MX TSE Vancouver Alberta Senior equities

Derivatives

CDNX

CDCC 100%

TSX
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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
MONTRAL
VANCOUVER WINNIPEG CALGARY
Broker Dealer FCMs, Proprietary Firms

TORONTO

LONDON

NEW YORK CHICAGO

Authorized Persons

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

The Trading Process

Access Trading
SAM
Order & Quote

Post trading

Data Dissemination And Clearing

Market Data (HSVF protocol)

Participants

Independant Service Vendor (ISV) using MMTP protocol (SLE screen) ISV using FIX protocol ISV and Order Flow Provider (OFP) using STAMP protocol

Trade & Market Data

Communication (HUB) Gateways

Mind Trade Management

Database Data Dissemination Surveillance Tools

Data Vendors Participants & ISVs (SLC Screen)

Order & Quote

Trade information

Montreal Exchange Internet Site

Market Data

Canadian Press

Trading Engine (NSC)

Trade confirmation

Automated Trade Reporting to Participants (ATR)

TSX

Market Data for underlying

Trade Trade & Allocation information

CDCC

Participants Back Office 10

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

CDCC
Manages a nominal risk of approximately 600 billion $ AA rating from Standard & Poors

Members

33 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
Futures Forwards Swaps

Price Limiting Instruments

Options

Two distinct markets for execution Exchange based Off Exchange

bilateral OTC
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Total Worldwide Exchange Derivatives volume by Asset Class*

Interest 13% Gov Debt 15% Currency 1% Metals 2% Individual Stock 27%

Equity Index 35%

Energy 4%

AG 3%

* Source: IOMA 2001

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Dimension of Derivatives Market Global notional outstanding in OTC derivatives markets

End June 2001: $99.7 trillion
Commodities 0,7%

Equities 2,0% Forex 20,5%

Credit-linked 0,7% Interest rate 76,1%

* Source : BIS

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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 and maturity A structured market (exchanges are regulated) Limited risk of default Clearing House Marked to market daily Margin is mandatory Customized Traded in OTC markets Subject to counterparty risk Generally settled at maturity 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):

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:

Surplus

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. Shortage

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 (cont)

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 (Outright, arbitrageur) Companies involved in the carbon market Undertakes emission-reduction projects

Environment Canada

Emissions trading registry

Sellers Allowances

The Exchange Electronic Carbon emission and derivatives market Clearing House

Buyers

Independent Compliance and Monitoring Self-governing structure Provides confidence to the market Must meet minimum requirements to be an Approved participant or a clearing member

Registry,Trading, Clearing & Settlement Centralised price discovery Market liquidity Market Anonymity Reduced transaction costs Central counterparty risk

Allowances Distribution & Market Access Canada U.S.A. U. K. Etc.

$ Cash

$ Cash

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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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spot and derivatives cost-effective solution

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MX Value proposition: An integrated

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Central credit Counterparty

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For more information

Bourse de Montral www.m-x.ca Derivatives Institute www.derivatives-institute.com Lon Bitton lbitton@m-x.ca
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