Keys to unlocking a booming exchange: Is it the exchange model or the battle for liquidity?

By Roxane Richter, Contributing Editor

As dust settles on several folding and flopped trading platforms (the likes of Red Meteor, HoustonStreet and such) there’s a new rivalry growing in town, namely a head-to-head duel between consortiums, independents, brokers and proprietary systems. Call it the future battlefront of the dueling exchange models.

And if the model and the battle for liquidity are the proverbial keys to the e-market kingdom, what can be gleaned from past e-market experiences, counterparty credit risk botches and high-tech, high-dollar exchange failures of the past? “Although we knew it at the beginning, the market has learned through the Enron experience that the “Ëœprivate’ or “Ëœproprietary’ exchange is merely an e-transformation of a trading floor and is a flawed model. It aggregates risk with one counterparty while dispensing valuable counterparty information. The true independent model remains the best in theory, but has the greatest problem developing liquidity

Peter Fusaro, President of New York-based Global Change Associates Inc., commented on the variety of e-bombs and boons: “Altra had a good model, but then they went crazy and bought QuickTrade, and TransEnergy. HoustonStreet’s model was never viable. They were never big; big pizzazz but a total failure. Tradespark has Williams and some others but they’re just there. Now ICE [IntercontinentalExchange] has the market-making power, they’ve got 13 members who are powerhouses in trading.”

But at the end of the high-tech day, technology has become an almost negligible factor of market success as functionality and features from competing systems are assembled into a “working platform” of best-of-breed functions. In the end, it seems as though liquidity remains as the trump card for the ultimate victor.

Where’s the love? The loyalty?

What’s been the most successful market and why? Well, that depends on the market area, apparently. Continuous bid-offer markets lead our nation’s markets while regulated exchanges in Europe–like International Petroleum Exchange of London (IPE)–and Scandinavia (Nordpool) use auctions to set spot prices and continuous markets to trade forward markets.

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Hanson also explained that in North America, the consortium model has proven the most successful as it has accumulated the most liquidity from its members, but there are exceptions, namely Altra Energy Transaction’s liquids system and NGX in Canada. But the question there is: “Can these later two maintain the liquidity when there is very little “Ëœexchange loyalty’?” he wondered. “In Europe, the NordPool market is by far the most successful using the auction method to set spot electricity prices. Success tends to be fleeting, as energy markets are still not commoditized enough to behave like financial products,” Hanson noted.

The exchange vs. consortium showdown: ICE/IPE vs. NYMEX

Grinding through the current rumor gristmill is the story of two mega-stars on the exchange constellation: a showdown between ICE [IntercontinentalExchange]/ IPE and the 500-pound regulated exchange gorilla, New York Mercantile Exchange (NYMEX). In case you haven’t kept up with this particular sell/buy saga, here’s the quickie rundown: Atlanta-based ICE is a consortium owned by more than 100 energy and metals traders, brokers and bankers. ICE was formed in May 2000 and by July of 2001, ICE nudged out a rumored NYMEX offer to buy IPE, a European energy futures and options exchange that provided regulated open outcry and e-markets (Brent Crude futures and options, natural gas futures and electricity futures).

“ICE is doing fantastic in natural gas, but nothing substantial in North American oil and has some server problems. But ICE and NYMEX are going at it head to head,” Fusaro said.

But why would IPE hang their hat with ICE rather than NYMEX, you might ask? Well, insider sources revealed that NYMEX may have played IPE and its acquisition a bit heavy-handedly, in the end, insulting IPE with a reputed $35 million (or so) offer. Expert sources say that ICE hit NYMEX right where it hurt–in power. “They found the one crack in the NYMEX wall, OTC gas and power,” a futures insider said, “But since Enron’s debacle, both have been rumored to have hit a 20-30 percent increase in volumes.”

As for IPE’s current progress, “We understand the economics on that hasn’t worked out so well, that’s one of the reasons they’re moving from open outcry to electronic,” said Bob Levin, NYMEX Senior Vice President of planning and development.

To that Hanson added that IPE is “not doing well on the electricity side and the rumor is they will drop trading electricity contracts and just leave it to ICE. ICE is making some inroads over here [Europe], but Europeans in general prefer to deal with an exchange rather than a consortium. And they definitely are not keen on proprietary systems. Therefore NYMEX should win any battle but NYMEX has never proved to very nimble or inventive–so don’t bet against ICE.”

In a nimble race of Euro-bound brokers and exchanges, GFI, PowerITS and ICE are all attempting to get clearing systems for OTC power trades in Europe. So while the U.S. may be in a state of e-ho-hum, there are plenty of fireworks overseas to watch. The big-boy players to watch, though, will be the regulators and what trump cards they might deal in the high-stakes game of e-markets.

The future: More regulation

The e-market future two to three years from now may look very different, with loads of new financial disclosure and federal regulation. “If the energy markets can truly commoditize the products, which is a big if, the financial players will dominate the future exchange business,” Hanson noted, “They have the funding, the infrastructure and the know-how. The true commodities will be traded on platforms provided by the financial players and the consortiums may end up members, but with a diminishing role as market makers. The OTC brokers will remain a major force with hybrid voice-assisted platforms, with more voice assists for the less commoditized products… As the business matures, expect to see some regulation of this “Ëœfinancial’ marketplace.”

And while the battle between exchanges will surely continue to rage on unabated, the new “sheriff in town” on the e-market forefront–stricter regulation–is far more threatening than any new competitor.

Richter is a veteran energy journalist specializing in new technologies, deregulation, risk management and energy marketing. She can be reached at roxrich@flash.net.

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