THE DEVELOPMENT OF THE
BASE METALS OPTION MARKET
Roundtable: 28th May, 1st Floor, Century Hall, International Convention Centre
Speech: PM, 29th May, 2013
Discussion Panel: 17:00, 29th May, 2013
21 May, 2013
INTRODUCTION
Your Speaker
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Mr. Ben Green (38 years old)
17 years trading metals derivatives
Previously at Goldman Sachs, Barclays
Chairman – LME Option Committee
Member – LME User Committee
Member – LME Trading Committee
Promise
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NO MATH in this presentation!
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BACKGROUND
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HISTORY
Options have always existed
“Real Options” examples are numerous - the right, but not the obligation, to
undertake certain business initiatives, such as deferring, abandoning,
expanding, staging, or contracting a capital investment project.
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Example 1: an aluminium smelter which uses a series of inputs (alumina,
power, labour) to produce an output (aluminium) and has the option to
close down when the input costs exceed the output costs.
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Example 2: a power station
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Example 3: A common option that exists is that which allows a mortgage
borrower to repay his loan earlier – this corresponds to a callable bond
option.
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HISTORY OF OPTIONS
Formalisation
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332bc- The earliest recorded option believed to have been used in ancient
Greece by Thales of Miletus who bought the right to use a number of olive
presses in the following Spring in anticipation of a larger than usual olive
crop. We do not know how Thales valued this option!
Standardisation and listing
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17th Century, first listing on an exchange in London – on tulips – outlawed
1733-1860
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Standardisation, trading as we know it today occurred in 1973 on CBOE
(stock options)
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HISTORY OF OPTIONS
There is much literature available on the many types of options
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HISTORY OF OPTIONS
…and on how to value them
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HISTORY OF OPTIONS
…and also plenty on how to risk manage them.
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THIS PRESENTATION
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Discussion pertains to simple listed options (American or European style) on
single assets such as commodity futures
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Factors that need to be considered in the design of an option contract
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USES OF OPTIONS
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THE PURPOSE AND FUNCTIONS OF OPTIONS
Risk Management
Options can be used to:
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Hedge “contingent liabilities” (consumer contract)
Manage underlying price exposure (producer hedging)
Reduce volatility (zero cost collar)
Change risk profiles (limited participation)
Provide portfolio insurance (macro hedge in copper)
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THE PURPOSE AND FUNCTIONS OF OPTIONS
Speculation
Options can be used to:
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Take directional views on markets
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Take views on volatility of markets
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Limit downside in a trade
In general, a universe of pay-out options can
be tailored to specific views (timing, potential
market move, etc)
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OTHER BENEFITS OF OPTIONS
Volatility as an asset class
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The existence of a liquid options market in an underlying asset allows an
independently traded volatility market.
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This attracts additional users of the options contract who will be more
interested in the volatility characteristics of the option as opposed the
directional characteristics) and this will improve liquidity
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OTHER BENEFITS OF OPTIONS
Correlation as an asset class
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Inter product and intra product options (options on timespreads, options on
commodity spreads) allow for an independently traded correlation market
Once again, this will attract liquidity from traders who wish to express views
on the correlations between futures and thus increase overall contract
depth.
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The existence of volatility and correlation as observable, tradable
parameters allows for positive externalities.
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Some assets are simply options (see previous examples) and it is possible to
theoretically model and value these assets as options which means that the
“time value” as well as the “intrinsic value” of the asset can be computed.
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WHY DO OPTIONS NEED SPECIAL ATTENTION?
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WHY DO OPTIONS NEED SPECIAL ATTENTION?
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WHY DO OPTIONS NEED SPECIAL ATTENTION?
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WHY DO OPTIONS NEED SPECIAL ATTENTION?
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CREATING A SUCCESSFUL
OPTION CONTRACT
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CREATING A SUCCESSFUL OPTION CONTRACT
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CREATING A SUCCESSFUL OPTION CONTRACT
INGREDIENTS LIST
Liquid, transparent underlying market in futures and/or an established
benchmark index
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CREATING A SUCCESSFUL OPTION CONTRACT
INGREDIENTS LIST
A diverse pool of potential users of the option contract – you need
buyers and sellers
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Producers
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Consumers
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Traders
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Speculators
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Market makers
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Algorithms (electronic listing)
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CREATING A SUCCESSFUL OPTION CONTRACT
INGREDIENTS LIST
Contract design
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Essential that option contract satisfies
broadest range of market participants and is
not overly specialized (cash settled versus
physically settled, expiry timing, timezone
considerations)
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LME uses monthly options but Asian options
are commonplace in hedging community as
mirror financial mechanics of physical
contracts
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Possible to run several option types but
potential for liquidity
fragmentation/misunderstanding)
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CREATING A SUCCESSFUL OPTION CONTRACT
INGREDIENTS LIST
Strong market architecture
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Valuation (transparency, pre and post trade)
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Margining
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Mechanics (exercise)
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Reporting (compatible with futures reporting)
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Surveillance
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Regulation
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CREATING A SUCCESSFUL OPTION CONTRACT
INGREDIENTS LIST
Essential seasoning:
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Consultation
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Education
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Strong Regulatory Framework
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Culture
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OPERATION OF AN OPTION
MARKET
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MAJOR RISKS IN DAY TO DAY OPERATION
Systematic build-up/concentration of risks
(dominant positions, large pockets of risk)
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Margining
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Monitoring – pre-trade, post-trade
transparency
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Position limits
Operational risks with large adverse financial impacts
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Mistakes upon expiry can be limited through well thought
through expiry process
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End of day “double blind” reconciliation at clearing house
for all positions to eliminate misbooked/unbooked trades
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MAJOR RISKS IN DAY TO DAY OPERATION
Non-linearity of risk can result in rapid
acceleration of counterparty risk intraday
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Stress testing of portfolios
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Position reporting/understanding of
market structure
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MAJOR RISKS IN DAY TO DAY OPERATION
Inappropriate use of contracts
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Over hedging,
Overly large speculation/mismanagement of option risk – especially from
shorts
Shadow banking
Hiding losses
Off-market transactions (in the money options)
Mistimed transactions
Cash movements between accounts
Inappropriate use of credit lines
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Excessive leverage can cause credit line usage to increase rapidly (mitigated
by stress testing, monitoring of risks)
In-the-money options can be used to dramatically increase credit line usage
(pseudo loans)
Ability to identify linked accounts across market
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MAJOR RISKS IN DAY TO DAY OPERATION
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Regulatory
framework
defines
acceptable use of product and
provides a foundation upon which
market structure can be designed,
built and run.
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With
thoughtful
design
of
regulatory framework it should not
be necessary for the regulatory
body to intervene in day to day
running of markets.
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REGULATION OF OPTION
MARKET
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DESIGNING A REGULATORY FRAMEWORK
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Regulator works closely with exchanges to design clear rules, reporting
requirements, sanctions system to:
• Protect end user of derivatives (misselling, inappropriate contract use)
• Protect against market instability (credit events, concentration of risk)
• Protect against market abuse (inappropriate contract use, manipulation
of prices)
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Rulebook can be designed at regulator level to ensure consistency of rules
across exchanges but different markets will require specific rules
(commodity markets versus financial markets) and it is possible that
variants/adaptions on standard regulatory rulebook will be required.
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Exchanges should capture sufficient data to be able to either identify rule
breaches or potential risk issues in real time or historically (patterns)
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Ensure that sanctions can be effectively applied in the case of problems
(clarity of rulebook, clarity of breach) either at Exchange level (minor
breach) or Regulator level (major breach)
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DESIGNING A REGULATORY FRAMEWORK
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Regulation needs to encompass wholesale and retail users of the exchanges:
• Requirement for strong corporate governance – authorisation/signoff at
all levels
• Requirement of accountability throughout corporation
• Requirement of openness – full disclosure of house account, client
accounts and retention of all relevant records
• End user protection (misselling, protection of funds, netting of accounts)
• Remuneration culture (moral hazard)
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Enforcement
• Must be credible, effective and targeted
• Applied by Exchange or Regulator
• Clear sanctions
Fines
Negative publicity
Revoking of licence
Prosecution
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BUILDING A SUCCESSFUL OPTION MARKET
21 May, 2013