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Online Power Trading
by Anne Ku (Nov 2000)
This is the original, unedited article which was submitted to Global Energy Business magazine (Nov/Dec 2000).
The Internet has moved power trading online in different guises: multilateral exchanges, electronic brokers, and online marketmakers. Anne Ku explains the terminology and motivation, following which Dave Ernsberger reports the recent rush of new exchanges in Europe.
Electric power is the perfect commodity. Unlike other physical commodities whose specifications vary in quality, grade, and calorific value, and in addition are logistically more demanding to transport, power differs only in location, period of delivery, and firmness. That is one of the main reasons for the rapid growth of online trading in deregulated markets, especially in Europe. Wholesale power trading on the Internet is a subject loaded with buzz words, bells and whistles, and the rush of press releases about companies launching new platforms.
Online trading in twenty years
The term "online trading" generally refers to any type of buy-sell transaction conducted real time on computer terminals connected to a common electronic network, which can be in the form of private leased lines, Internet, or wireless. The participants do not have to be physically in the same room.
In the eighties, Reuters Dealing System, the predecessor to modern Internet chat rooms and instant messaging systems, enabled traders to communicate with each other point-to-point (one-to-one) or in broadcast (one-to-many) mode. The so-called "multi-contributory page" on Reuters and Telerate monitors displayed the changing bids and offers entered by traders using the same system. Together they formed the online trading platform for foreign exchange and money market traders back then.
To economise physical desk space, the burden of different types of screens and keyboards quickly led to hardware integration on a single type of screen and a single keyboard. Next, software consolidated via multiple windows on a single screen. Throughout the nineties, advances in technology enabled further consolidation and standardisation from digital feeds to web-based displays.
Online trading platforms evolved to bring about improved price transparency, declining transaction costs, and increasing user productivity. The concept of "usability," a term coined by Jakob Nielsen, to mean "ease of use" and cognitive economy, defined as "an individual's desire to reduce transaction costs of the human mind in adjusting to different systems", will push for further standardisation and consolidation. The natural inclination towards ergonomic efficiency and desire for greater compatibility with in-house and other systems will push for standardisation and consolidation. The user, in this case, the trader, may well determine the future.
Over the counter or exchange?
Markets first begin "over the counter" where transactions are bilateral and price discovery is slow. We classify this as the one-to-one model where a trade occurs between a buyer and a seller by way of point-to-point communication, such as phone calls, email, or face-to-face conversation. Deals done in this fashion tend to be longer term and more complex than those done in an exchange.
Products traded in an exchange are standardised to increase liquidity. Bids and offers are displayed for all participants, providing transparent price discovery. Postings may be anonymous or known. The various business models can be categorised by the method of transaction, namely one-to-one, many-to-one, one-to-many, and many-to-many. The table below shows how they are distinguished by bearing of credit risk, taking title of the product transacted, anonymity, ownership, and revenue earning method.
In any market, there will be different types of traders: those looking for good deals but unwilling to commit yet, those having something to buy or sell, and those prepared to buy and sell at any time. The last type of trader "makes the market" and are hence called market makers. EnronOnline was the first energy market maker to go online in November 1999, followed a year later by DynegyDirect. We classify these as the "one-to-many" model, as the market maker always acts as a principal to the transaction.
The traditional delineation between trading over the counter and in an exchange is blurring as electronic marketplaces appear in different forms. Exchanges used to mean "regulated exchanges" such as NYMEX, which acts as a party in the transaction, clears the trade, and bears the credit risk. To participate, one must become a member and pay membership fees. We classify this as the "many-to-one" model.
The new online exchanges are "unregulated" in that they are not party to a transaction, do not bear credit risk, and merely facilitate by matching buyers and sellers. We classify this as the "many-to-many" model, which has several variations from the pure electronic to hybrid voice/electronic broking. Altrade Power and Bloomberg's PowerMatch, for example, match anonymous bids and offers on a purely electronic basis. Several voice brokers, notably GFINET and the Spectron, now compete in this arena with their own hybrid trading platforms. Still others, such as ePower in Norway, encourage trader and broker participation through equity ownership. Finally, traders themselves may elect to form a multilateral consortium such as the Intercontinental Exchange in the US.
In pursuit of liquidity
What determines the success of a market, be it online or offline, is the level of liquidity. Will buyers and sellers will be able to find each other and transact quickly and satisfactorily? The number of active participants and trading volume are good indicators of liquidity. The smaller the bid-offer spread the greater is the liquidity. The much cited Forrester Report listed liquidity as the main reason for companies to transact online.
But how do you create liquidity? No one wants to be the first one on the dance floor. Only after a certain critical mass is reached will momentum take off. Critical mass creates inertia which increases trading velocity. In the words of Frank Getman, CEO, Houstonstreet, "Liquidity begets liquidity." It's a vicious circle where the more liquidity you have, the more liquidity you'll get.
The trader spends a lot of time looking for prices that truly reflect the market and finding a counterparty for the trade. Successful electronic exchanges provide both price discovery and liquidity, enabling a trader to reach a community of buyers and sellers all in a very short time, thus minimising the time to search and process information. In illiquid markets, brokers are often called by traders to "find a bid" or "find an offer." Placed in a position of trust, the broker can anonymously match buyers and sellers, who do not necessarily have to "commit" to the trade. Traders may not necessarily have the "standard" product to trade on an exchange. Similarly, traders may not necessarily have the confidence to participate in an "illiquid" exchange, one which he or she feels does not reflect the market.
Credit risk or credibility risked
The availability of credit becomes a more pressing issue as online trading grows. Credit or counterparty risk refers to the chance that a counterparty will default on the transaction, leaving the other with the physical product or cashflow outlay. Credit rating agencies such as Standard and Poors use a variety of criteria to determine credit risk. Companies themselves have their own trading limits and restrictions.
The specification of who and which product a company can and will trade is a multidimensional one. When collapsed, it becomes a "tree." London-based energy platform developer Trayport's Globalvision uses a credit tree to permission a product hierarchy: each participant specifies which products (defined by time block, location, firmness, etc) can be traded with whom. Redmeteor has a credit preference feature which allows traders to specify the counterparties with which they are willing to trade. Tradecapture maintains corporate structures for counterparties and internal entities and goes further in providing summary and detail credit exposure information via user selected criteria. Espeed's technology provides a range of compliance and credit risk management components that continuously monitor trading activity to ensure that clients are staying within credit limits, automatically prevent further trades once credit limits have been exceeded; and evaluate and calculate positions and risk exposure across various products and credit limits.
If user profiles are not set properly, it is possible for a trader to trade with himself or his own company. If credit risk preferences are not properly permissioned, it is possible to trade with counterparties that are off-limits. In such cases, the broker may find a third counterparty to complete the deal and split the commission. This is called sleeving. When trading activity increases, the risk of trading out of limits increases.
The launch of EnronOnline saw the rapid growth in number of transactions and counterparties. Online trading had a great impact on credit in that counterparties take on more risk, exposures grow, credit volatility increases, credit qualities fall, operational risk grows, and credit risk changes in real time. Brian Seyfried, Vice President, Enron Credit, noted "the traditional credit processes needed to be much quicker. Enron saw the opportunity to set up EnronCredit.com to facilitate real time pricing and management of credit risk for any type of customer This type of service wasn't available in the marketplace." Virtual Credit Services is another company which offers credit risk management solutions.
The Internet for energy trading
The popularisation of the Internet and the development of Internet-based applications coincided with the deregulation and liberalisation of the power industry. Increasingly new trading platforms are going the Internet route instead of costly proprietary software on dedicated private leased line networks. Private lease line has become an option not a requirement. Why? Internet browser-based applications allow access anytime, anywhere, on anything. This kind of standardisation flattens the learning curve, reduces set up cost, and thereby increases user acceptance.
The rapid growth of Internet-based trading in wholesale power is particularly noticeable in Europe. (See Dave Ernberger's article on European power trading.) Riding on their successes in the US, firms like Altra, Automated Power Exchange, and HoustonStreet have recently announced their move to Europe. Will the factors that led to their success in the US carry over to Europe?
Internet vs Web: a difference in terminology
There is a difference between systems that are "Internet based" and "web-based". The usability guru Jakob Nielsen distinguishes the two:
Thus a web-based system is by virtue one that is Internet based, but not vice versa. An Internet but not web-based system, such as ICQ or Yahoo's Instant Messenger, is essentially an application that runs on the Internet but not on a web browser. Some systems are specific browser based, such as running on Internet Explorer 5.0 but not Netscape Navigator. A truly web-based system runs in any browser. Some browsers are platform specific, such as PC but not Macintosh.
Derek Myers, Managing Director, PowerEx, London, claimed theirs to be the only exchange with a centralised server based application, with no client end software or browser plug ins - that is, a true Internet exchange. The advantages include simpler client end IT installation, integration, ongoing management and functionality / product specifications upgrades and version control. It is much more secure as the firewall does not need to be tampered with. This type of server-end application tends to be more reliable as client end software often has problems. PowerEx's target launch date is 27 January 2001.
Internet trading platforms: more than meets the eye
A pure online trading platform, at the minimum, provides a mechanism for posting bids and offers, and a bulletin board-like display to show the latest and best bids and offers. Next, participants should be able to take the prices either online or offline. Nowadays, exchanges seek to differentiate themselves by offering additional functionality such as news and other content, decision support systems including data analysis tools, middle and back office integration.
Because trading itself is not a standalone activity, increasingly software providers such as TradeCapture, Altra, and Truequote are offering end-to-end solutions comprising of front, middle, and back-office integration. Still others, such as Trayport, offer just the trading platform with simple interface for in-house integration. These providers no longer compete only in the trading front, but also in value added services.
What matters further in Internet trading systems are behind the scene: bandwidth, speed, compatibility/integratability with middle and back-office systems, security, reliability, flexibility, and usability.
Standardisation and Consolidation
Just as the 80's dealing rooms eventually got rid of the tangle of hardware and consolidated the information and trading systems into single interfaces displaying prices from different market data providers, so will traders demand other necessary information and functionality on the same platform. They want to be able to pull information seamlessly from different sites. An Internet platform may be accessed from anywhere - the office, home, mobile, car, etc. While these providers (exchanges, brokers alike) all seek to differentiate themselves now, liquidity and trader preferences may force standardisation and consolidation.
The proliferation of different systems has led Houstonstreet, Automated Power Exchange, and other trading exchanges to form the Energy Trading Standards Group (ETSG). The main aim initially is to streamline the deal capture process by developing open standards based on the extensive mark-up language (XML) technology. XML would be used to define any deal by a set of common attributes.
Pure voice brokers or pure electronic exchanges?
While it may seem that everyone's going online, that is, creating websites, moving from bricks to clicks, and transacting on exchanges, is the future only online? Will electronic exchanges replace brokers?
With twenty years of broking experience behind him, Ron Levi, Managing Director, GFI Brokers, London, sees the role of the broker crucial in providing liquidity and information in an uncertain market like European power. "There's no doubt European Power is the place to be for the next 10 years, just like derivatives was in the 90's," he said. More than half of the time, the trader just wants to know about the price. Next come plant outages and problems. People want to know if a plant has gone down or about to go down and how long the outage is expected to last. Brokers' conversations with traders also include speculation about flows, what's happening and why. As such, brokers can condition perceptions.
Only a year ago, brokers were building proprietary online trading systems to compete on technology. They wanted differentiation, but their clients - the traders wanted standardisation for familiarity. The attitude has now changed to that of buy or lease but definitely not build. This allows brokers to concentrate on their core strength: building relationship and liquidity.
Currently brokers are reluctant to share platforms as splitting commissions reduces their overall revenue. However, traders' preference for a uniform look and feel, dictated by stickiness of comfort and ease of use has lured several European power brokers, namely Spectron, GFI, and ePower to adopt Globalvision, a PC-based Internet platform, as a complement to traditional voice broking business. According to Michael Hepburn, Trayport's Business Development Manager, they have issued about five hundred user licenses to their Globalvision platform.
Brokers argue that there will always be a need for the intermediary, a policing function in the posting and matching of bids and offers. After all, said Gunnar Linquist, CEO, ePower, brokers are one of the key ways markets liberalise initially. Traditionally, brokers are distribution channels for regulated exchanges. A trader will speak to all brokers in the market, even after getting prices from electronic trading platforms, said one broker. In fact, traders would always try to get a better price or negotiate a more complex transaction, said another broker.
Elsewhere, Martin Walls, Director Technical Marketing, Convergent Group believes that face to face will not go away. The best communication method, he said, is blended media: face to face, phone, and Internet. One thing is clear, trading is no longer confined in the pit or in the office as mobile phones and laptops take over.
Charts and Tables
Box 1: Chatrooms
Table 1: Online Trading Models
Figure 1: Factors That Will Accelerate Online Trading
Box 2: Key Success Factors
Box 3: Other Features and Functionality
Box 4: Voice Broking vs Electronic Trading
Table 2: Online Whole Power "Exchanges"