Wednesday, April 15, 2009

Over the counter vs. Exchange Traded

It appears that the bankers would like carbon trading to be over the counter in addition to being exchange traded. Over-the-counter refers to the trading done through market makers where the buyer and seller are trading directly without an intermediary such as an exchange. The argument is as follows:
"Granville Martin, vice-president for environmental affairs at JP Morgan, said access to OTC contracts was critical for bank financing. “You can’t scale up carbon finance without OTC markets,” he said.

For example, a utility wanting to build a power plant would only get a loan if it could hedge its long-term carbon and fuel risks. In many cases, he said, an appropriate contract is not available and, moreover, the utility would have to tie up a huge chunk of capital with the exchange as collateral.

For such contracts, investment banks would often be the only counterparty, and they could manage the risk by, for instance, taking a second lien in the power plant rather than upfront cash.

Forcing such trades through exchanges would add a significant hurdle to low-carbon development, and would be pointless if the reason was just to ensure transparency, Martin said.

“If the concern is ‘dark corners’ you can come up with solutions. You can have disclosure and preserve OTC,” he said."

I agree that financial innovation is likely to foster the rapid growth of the carbon markets. Unfortunately, the rapid growth of CDS and CDOs, and the pain they brought, as well as the financial innovations of Enron are too fresh in memory to believe that the different players will opt for transparency and full-disclosure. Setting up appropriate regulatory structure is going to be critical in determining not only the growth of the carbon finance industry, but also its ability to withstand systemic shocks.

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