2

Carbon TradingCarbon Trading

Presented byLéon Bitton, VP R&D Montreal Exchange

Winnipeg, March 14th, 2003

Designing the Designing the Canadian MarketCanadian Market

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Montréal Exchange Montréal Exchange (MX)(MX)

Sole Financial Derivative Sole Financial Derivative Exchange in CanadaExchange in Canada

• Bourse Trades all $CDN Interest Rate Derivatives

• Bourse Trades all Canadian Equity Derivatives

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Dimension of The Montreal Dimension of The Montreal Exchange MarketExchange Market

$ Traded / Notional value 2002

Interest Rate Derivatives : 5 $ trillion

Equity Derivatives : 143 $ billion

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MX VolumesMX VolumesGrowth by Asset Class 2002Growth by Asset Class 2002

+20%+20%+9%+9%

10 000

20 000

30 000

40 000

50 000

60 000

Interest-rate futures

EquityIndex

Futures

Equity options

Total

Dai

ly a

vera

ge

Var

iati

on

200

2 vs

200

1

2002

2001

02 / 01

+24%+24%+15%+15%

*Open Interest: +31%

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MX HighlightsMX Highlights

• Restructuring program

MX

Derivatives

CDCC 100%

TSE Vancouver Alberta

CDNXSenior equities

TSX

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• 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

MX HighlightsMX Highlights

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Why an electronic Why an electronic exchange?exchange?

Direct accessDirect access

MONTRÉALMONTRÉAL

NEW YORK CHICAGO

LONDON

FCMs,Proprietary

Firms

AuthorizedPersons

TORONTO

BrokerDealer

CALGARY

VANCOUVER

WINNIPEG

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MX Electronic Trading MX Electronic Trading PlatformPlatform

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 ProcessThe Trading Process

Participants Communication (HUB)

Gateways

Data Vendors

Participants & ISVs(SLC Screen)

• Independant Service Vendor (ISV) using MMTP protocol (SLE screen)

• ISV using FIX protocol

• ISV and Order Flow Provider (OFP) using STAMP protocol

Mind TradeManagement

DatabaseData

DisseminationSurveillance

Tools

TradingEngine(NSC)

Order & Quote

Trade information

Montreal Exchange Internet Site

Canadian Press

Automated TradeReporting to

Participants (ATR)

Participants Back Office

C D C C

Ord

er &

Q

uote

MarketData

Trade confirmation

Trade &Allocation

information

Trade

Market Data(HSVF protocol)

Market Datafor underlying

Tra

de

&M

ark

et

Da

ta

T S X

AccessAccess Post tradingPost tradingDataData

DisseminationDisseminationAnd ClearingAnd Clearing

TradingTrading

SAM

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A Unique Market ModelA Unique Market Model

Key characteristics: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 DerivativesThe Canadian DerivativesClearing Corporation Clearing Corporation (CDCC)(CDCC)

• 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

Clearing House carries out three main functions:

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CDCC – A factor ofCDCC – A factor ofcompetitivenesscompetitiveness

• Manages a nominal risk of approximately 600 billion $

• “AA” rating from Standard & Poor’s

• 33 members

• Major financial institutions

• Contribution to Clearing fund and margin: 1,9 billion $

CDCCCDCC

MembersMembers

ClientClient ClientClient

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Derivative InstrumentsDerivative Instruments

• Price fixing Instruments– Futures– Forwards– Swaps

• Price Limiting Instruments– Options

Two kinds of hedging instruments

Exchange based Off Exchange – bilateral OTC

Two distinct markets for execution

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Equity Index35%

Currency1%

Gov Debt15%

Interest13%

Metals2%

Individual Stock27%

Energy4%

AG3%

Total Worldwide Exchange Total Worldwide Exchange Derivatives volume by Asset ClassDerivatives volume by Asset Class**

* Source: IOMA 2001

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-End J une 2001: $99.7 trillion

Forex20,5%

Interest rate76,1%

Equities2,0%

Commodities0,7%

Credit-linked0,7%

Dimension of Derivatives Market Dimension of Derivatives Market Global notional outstanding in Global notional outstanding in

OTC derivatives marketsOTC derivatives markets

* Source : BIS

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(in $Trillions)

$39.75

$28.03

$17.28$4.93

Cash Exchange-Traded Index FuturesExchange-Traded Index Options Exchange-Traded Stock Options

Dimensions of Derivatives Dimensions of Derivatives

MarketMarket The Global Cash and Derivative Market/Equity

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• Standardization facilitates market liquidity

Futures are price transparent, ensuring fair prices

Anonymity

• Clearing corporations reduce counterparty risk

Margin S&P rating

Significance of Being Significance of Being Exchange TradedExchange Traded

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Comparison of MarketsComparison of Markets

Exchange-Traded Over-the-counter•Standardized as to size and maturity

•Customized

•A structured market (exchanges are regulated)

•Traded in OTC markets

•Limited risk of default – Clearing House

•Subject to counterparty 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 – Prerequisite for an efficient Market – Diversity of users and Diversity of users and

concentration of liquidityconcentration 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 An illustration of emission allowances and futures tradingallowances 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 First situation: surplus of emission allowances allowances ‣ ‣ ‣ ‣ ‣ ‣ Selling futures.Selling futures.

In December, the CO2 emissions of the plant equal only 15,000 tons thanks to the implementation of new CO2 filters:

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

Surplus

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 Second situation: shortage of emission allowances emission allowances ‣ ‣ ‣ ‣ ‣ ‣ Buying Buying

futuresfutures In December, the CO2 emissions of the plant reach 25,000

tons, it is a shortage of 5,000 allowances.

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

Shortage

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 marketBenefits 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 =Using Derivatives =Good Business PracticeGood Business Practice

• Flexible

• Cost-Effective

• Maximize Returns

• Manage Risk

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Prerequisites for an Efficient Prerequisites for an Efficient Emissions Trading MarketEmissions Trading Market

• LiquidityNeed:

• 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 playersNeed:

• Different market participants with different background and different targets (power generators/industries/traders/financial institutions)

• Cross-border activity

• StandardizationNeed:

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

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Prerequisites for an Efficient Prerequisites for an Efficient Emissions Trading Market Emissions Trading Market (con’t)(con’t)

• Risk management tools / CertaintyNeed:

• Improved risk management through Derivatives Market.

• Sound Exchange and Clearing HouseNeed:

• 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 FrameworkNeed:

• Establishment of the framework and rules governing the market.

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Carbon Trading Market DesignCarbon Trading Market DesignCompanies involved

in the carbon market

Undertakes emission-reduction

projects

Investors(Outright,

arbitrageur)

Emissions trading registry

Environment Canada

Independent Complianceand Monitoring

• Self-governing structure• Provides confidence to the market• Must meet minimum requirements

to be an Approved participantor a clearing member

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

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

TheExchangeSellers Buyers

ClearingHouse

$ C

ash

Allo

wan

ces

$ C

ashElectronic

Carbon emissionand derivatives market

Allo

wan

ces

TheExchangeSellers Buyers

TheExchange

TheExchangeSellersSellersSellers BuyersBuyersBuyers

ClearingHouse

$ C

ash

Allo

wan

ces

$ C

ashElectronic

Carbon emissionand derivatives market

Allo

wan

ces

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The Mission of a Carbon ExchangeThe 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 ExchangeBenefits 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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Training

Institute

Exp

erti

se«k

no

w-h

ow

»

Clearing and

Settlement

Service

Central creditCounterparty

Self

regulatory

authority

R

eal t

ime

pri

cedi

ssem

inat

ion

Remote

Access

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

ElectronicTrading Platform (open architecture)

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For more informationFor more information

• Bourse de Montréal

• www.m-x.ca

• Derivatives Institute

• www.derivatives-institute.com

• Léon Bitton

• lbitton@m-x.ca