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Carbon Trading Designing the Canadian Market
Presented by Léon Bitton, VP R&D Montreal Exchange Winnipeg, March 14th, 2003

Montréal Exchange (MX)
Sole Financial Derivative Exchange in Canada
• Bourse Trades all $CDN Interest Rate Derivatives • Bourse Trades all Canadian Equity Derivatives

Dimension of The Montreal Exchange Market $ Traded / Notional value 2002 Interest Rate Derivatives : 5 $ trillion Equity Derivatives : 143 $ billion 4 .

MX Volumes Growth by Asset Class 2002 60 000 Daily average 50 000 40 000 30 000 20 000 10 000 +9% +24% +20% 2002 2001 02 / 01 Interest-rate futures *Open Interest: +31% Equity Index Futures Equity options Total Variation 2002 vs 2001 5 +15% .

MX Highlights • Restructuring program MX TSE Vancouver Alberta Senior equities Derivatives CDNX CDCC 100% TSX 6 .

MX Highlights • 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 7 .

Proprietary Firms TORONTO LONDON NEW YORK CHICAGO Authorized Persons 8 .Why an electronic exchange? Direct access MONTRÉAL VANCOUVER WINNIPEG CALGARY Broker Dealer FCMs.

MX Electronic Trading Platform 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 9 .

The Trading Process Access Trading SAM Order & Quote Post trading Data Dissemination And Clearing Market Data (HSVF protocol) Participants • Independant Service Vendor (ISV) using MMTP protocol (SLE screen) • ISV using FIX protocol • ISV and Order Flow Provider (OFP) using STAMP protocol Trade & Market Data Communication (HUB) Gateways Mind Trade Management Database Data Dissemination Surveillance Tools Data Vendors Participants & ISVs (SLC Screen) Order & Quote Trade information Montreal Exchange Internet Site Market Data Canadian Press Trading Engine (NSC) Trade confirmation Automated Trade Reporting to Participants (ATR) TSX Market Data for underlying Trade Trade & Allocation information CDCC Participants Back Office 10 .

A Unique Market Model Key characteristics: • Price transparency • Fairness • Expanded access • Rapid order execution • Straight through processing for execution • Flexibility of trading hours • Enhanced liquidity • Security 11 .

The Canadian Derivatives Clearing Corporation (CDCC) Clearing House carries out three main functions: • 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 12 .

9 billion $ Client Client 13 .CDCC – A factor of competitiveness CDCC • Manages a nominal risk of approximately 600 billion $ • “AA” rating from Standard & Poor’s Members • 33 members • Major financial institutions • Contribution to Clearing fund and margin: 1.

Derivative Instruments Two kinds of hedging instruments • Price fixing Instruments – Futures – Forwards – Swaps • Price Limiting Instruments – Options Two distinct markets for execution Exchange based Off Exchange – bilateral OTC 14 .

Total Worldwide Exchange Derivatives volume by Asset Class* Interest 13% Gov Debt 15% Currency 1% Metals 2% Individual Stock 27% Equity Index 35% Energy 4% AG 3% * Source: IOMA 2001 15 .

1% * Source : BIS 16 .5% Credit-linked 0.0% Forex 20.7 trillion Commodities 0.7% Equities 2.7% Interest rate 76.Dimension of Derivatives Market Global notional outstanding in OTC derivatives markets End June 2001: $99.

75 Cash Exchange-Traded Index Futures Exchange-Traded Index Options Exchange-Traded Stock Options 17 .28 (in $Trillions) $4.03 $39.Dimensions of Derivatives Market The Global Cash and Derivative Market/Equity $17.93 $28.

ensuring fair prices Anonymity • Clearing corporations reduce counterparty risk   Margin S&P rating 18 .Significance of Being Exchange Traded • Standardization facilitates market liquidity   Futures are price transparent.

Comparison of Markets Exchange-Traded Over-the-counter •Standardized as to size and maturity •A structured market (exchanges are regulated) •Limited risk of default – Clearing House •Marked to market daily •Margin is mandatory •Customized •Traded in OTC markets •Subject to counterparty risk •Generally settled at maturity •No margin requirements (or optional) 19 .

• Speculator is taking risk . liquidity 20 . either through a price fixing process (futures) or by taking out insurance (options).Prerequisite for an efficient Market – Diversity of users and concentration of liquidity • Hedger is managing risk. tax treatments.using investment decision as primary source of income • Arbitrageur is special .exploiting variations in market conditions – credit.

say 20.000 10.000 15.000 emission allowances (hypothesis: 1 emission allowance equals 1 ton of CO2 emissions): 0 5. a coal-fired power plant receives allowances matching its carbon dioxide (CO2) emissions cap.An illustration of emission allowances and futures trading  At the beginning of 2003.000 emission allowances 21 .000 20.

000 tons thanks to the implementation of new CO2 filters: Surplus 0 5.000 10.000 15.  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. selling a Dec 03 futures contract on 5.First situation: surplus of emission allowances ‣ ‣ ‣ Selling futures.000 and if he plans to sell the surplus. 22 .000 20.  In December. the CO2 emissions of the plant equal only 15.000 allowances @12 will place a floor to the December 2003 market price.000 emission allowances  Alternative 1: If the treasurer of the plant knows that the implementation of new CO2 filters will lower its C02 emissions below 20.

000 allowances.000 tons.000 25. Shortage 0 5. it is a shortage of 5.000 15.000 allowances @12 will cap the December 2003 price. 23 .  Alternative 2: The treasurer of the plant will buy 5.000 10.000 20. buying a Dec 03 futures contract on 5.000 emission allowances  Alternative 1: If the treasurer of the plant anticipates an increase in the C02 emissions.Second situation: shortage of emission allowances ‣ ‣ ‣ Buying futures  In December.000 allowances at the market price to fill up the shortage in allowances. the CO2 emissions of the plant reach 25.

Benefits 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. 24 .

Using Derivatives = Good Business Practice • Flexible • Cost-Effective • Maximize Returns • Manage Risk 25 .

Prerequisites for an Efficient Emissions Trading Market • Liquidity Need: • 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 players Need: • Different market participants with different background and different targets (power generators/industries/traders/financial institutions) • Cross-border activity • Standardization Need: • Standardised underlyings because they reduce market fragmentation. facilitate risk management and reduce transaction costs 26 .

27 .Neutral position and good reputation for fairness and transparency in the conduct of trading • Trade facilitation: electronic access and transparent model. • Sound Exchange and Clearing House Need: • A centralised market place through which buyers and sellers trade carbon emissions and futures with reduced credit risk exposure. • Legal Framework Need: • Establishment of the framework and rules governing the market.Prerequisites for an Efficient Emissions Trading Market (con’t) • Risk management tools / Certainty Need: • Improved risk management through Derivatives Market. • An Exchange with a market .

Clearing & Settlement • Centralised price discovery • Market liquidity • Market Anonymity • Reduced transaction costs • Central counterparty risk Allowances Distribution & Market Access • Canada • U.Carbon Trading Market Design Investors (Outright.A. • Etc.S. $ Cash $ Cash 28 . arbitrageur) Companies involved in the carbon market Undertakes emission-reduction projects Environment Canada Emissions trading registry Sellers Allowances The Exchange Electronic Carbon emission and derivatives market Clearing House Buyers Independent Compliance and Monitoring • Self-governing structure • Provides confidence to the market • Must meet minimum requirements to be an Approved participant or a clearing member Registry. K.Trading. • U.

• Early launch to enable Canadian business to gain practical experience of emissions trading ahead of the implementation of the Kyoto Protocol (2008-2012).The Mission of a Carbon Exchange • To provide a one stop shopping for spot and derivative contracts on Canadian environment products. 29 .

30 . governments and other organizations in Canada with the opportunity to buy and sell emission reductions at a reduced overall cost.Benefits of an Exchange • Trading emission allowances is no different from trading any other commodity. • An electronic emission trading system will provide industry. Anyone who holds an account in a central registry will be able to buy and sell allowances.

spot and derivatives cost-effective solution ng ini te Tra titu Ins Exp «kn ertise owhow » Elec Tradin tronic g Plat fo rm (ope archit n ecture ) MX Value proposition: An integrated Re Ac mo ce te ss Central credit Counterparty lf Se tory la gu ority r e th au 31 Re al t dis pric ime sem e ina tio n d an g nt rin me ea le ice Cl tt v Se Ser . • Derivatives Institute • 32 .For more information • Bourse de Montréal • • Léon Bitton • lbitton@m-x.