dominant consideration, and customization is relatively unimportant; these users can opt to trade on exchanges. For other users, liquidity is less important than the ability to enter a contract tailored to meet a specic objective. ese users choose customized OTC products.
For instance, a power plant is a very long-lived asset that will face carbon price risk exposure for its entire existence, many decades in dura- tion. Moreover, the nature of this risk exposure is likely to be quite complicated and non-linear, and may depend not just on the price of carbon, but on other prices—and other economic variables.
e decision to operate a power plant in a car-
bon capped environment will depend on, among other things, the price of carbon, the price of fuel, and the price of power. Under some combinations of these prices, it is optimal not to operate the power plant, and in this event, the rm needs to purchase no carbon permits. Under other combi- nations of these prices, the plant may operate, but its output—and hence its need for emissions per- mits—will depend on other factors. e ability to turn a plant on and o creates a non-linearity in the exposure to price risks, extending over many years. Simple vanilla carbon derivatives with maturities in months (the kind of products that would likely trade on exchange) would be com- pletely inadequate to manage these risks.
Nor are these challenges limited to power plants alone. Other carbon intensive businesses, nota- bly rening and cement manufacture, would also have to confront similar problems.
Moreover, there is a symbiotic relation between exchange and OTC markets. Some rms, typi- cally large nancial institutions, specialize in of- fering customized products to their customers. When they enter these contracts, these inter- mediaries take on risk exposure. Since it is di- cult to nd another customer with the desire to take an exactly osetting position in an identical
customized product, the intermediaries frequent- ly lay o the risk on an exchange. ese rms spe- cialize in (a) designing (usually dynamic) trading strategies using standardized derivatives to hedge the risk embedded in customized derivatives, and (b) bearing the risks arising from hedging errors and mismatches. us, the existence of exchange- traded products facilitates the creation of cus- tomized products, and specialized intermediaries bridge these two markets.
is analysis implies that parallel exchange and
OTC markets oers derivatives users a larger range of choices, thereby leading to a more dis- criminating match between the instruments they trade and their trading objectives. Forcing all trading onto exchanges imposes costs on those who prefer the benets of a customized con- tract to the liquidity oered by a standardized exchange-traded product. Revealed preference— the fact that many rms choose to trade OTC instruments rather than on exchanges—demon- strates that these costs are real.
Against this it might be argued that many of the products traded in the OTC market are in fact highly standardized. is is true, but two points should be kept in mind. First, these highly stan- dardized OTC contracts are oen highly liquid, with trading costs on a par with, and sometimes lower, than trading costs on exchanges. Second, these OTC contracts, although standardized in many respects, still oer exibility that exchange traded instruments do not, and this exibility can be quite benecial to market users.
Perhaps the most important source of exibility re- lates to the management of contract performance risk. Exchanges utilize central clearing. Part of the clearing process is rigorous collateralization. Traders must post collateral—margins—to initiate positions; this collateral serves as a performance bond. Moreover, their margins are adjusted on a daily basis as market prices change in the so-called
E N E R G Y S E C U R I T Y I N I T I AT I V E