I don\’t know whether it\’s the journo not making it clear or something deeper and more disturbing that is wrong here:
The EU has moved to pass a directive, the Emir, or European Market Infrastructure Regulation, to regulate the trading of complicated financial instruments that many blamed for causing the global financial crisis. The legislation aims to standardise all derivatives products not traded on a regulated exchange.
The point of having derivatives that are not traded on an exchange is to have derivatives that are not standardised.
Think about it for a minute: so, imagine, you want to play about with 3 month, 6 month aviation fuel prices. You\’re an airline, you\’re taking money from people now for flights that aren\’t going to happen for another 5 months. You need to hedge your exposure to possible changes in fuel prices: don\’t forget, you\’re charging people a fixed price now and you\’ve a variable fuel cost in the future.
I\’m pretty sure there are aviation fuel futures (and or options?) over in the US but even without those you can get a pretty good synthetic cover by playing around with crude oil futures and options. The link between oil prices and aviation fuel prices is pretty direct: the refining margins tend not to move around very much.
Excellent, there are deep and liquid exchange traded futures and options so off you go and hedge your exposure. In exchange traded products.
As just such an airline you\’ll also probably have a little flutter on currencies as well: you\’re collecting money (as a European airline, say, Ryanjet) in euro and pounds, maybe a little in Danish Krone, Czech Crowns and so on. But aviation fuel is (normally) priced in $ so you want cover there as well.
Deep and liquid exchange traded markets here as well.
So, why would you want an OTC derivative?
Well, let\’s say that these exchange traded products only extend out to 9 months (don\’t know whether that is still true but it used to be, for both options and futures). But you\’re buying planes on 20 year leases: perhaps also you\’ve got some worried about what fuel prices are going to be in 3 or 5 years time. You are, recall, making 20 year bets with your aricraft leases.
You probably don\’t want to be playing with futures here (a future insists that you trade at the relevant time at the agreed price) but options will do very nicely (an option allows you to trade at the agreed price at the relevant time). It\’s an insurance policy really: you work out what $/€ rate will bankrupt you on your lease payments, work out what aviation fuel cost will bankrupt you, shave a little bit off those prices then purchase options. So, if either price moves to where it will bankrupt you you can exercise the option and just about stay in business, getting your $ or your fuel at a price that allows you to do so.
Options out 3 or 5 years can be expensive, which is why you set your option price at the most extreme price that allows you to stay in business: rather than paying a higher premium that will ensure profit but that higher price might unacceptably bite into current profits.
(Umm, do please note that all of this is made up, it\’s an example. An example of the logic, not a precise description of what airlines actually do: that I\’m not privy to. The basic effects are right, if not the precise actions.)
But there are no exchange traded products which go out to 3 or 5 years. If you are limited to exchange traded products then you can\’t actually hedge your risks. Thus you go to Mr. Global Megacorp Bank and make up an OTC option which will cover you.
It might well be that their bright young things will then go and hedge this option in the exchange traded markets, using a mixture of shorter dated exchange traded options to cover their longer term risk but you as an airline don\’t care about that. You\’re covered which means you can get on with working out how to charge people for having a pee while airborne.
And that\’s why OTC markets exist: because there are people out there who need hedges which can\’t be done with the standardised products on the exchanges. Which means that the desire to standardise OTC products is doomed to failure: the whole point of them is that they are not standardised.
As I said at the beginning, I\’m not sure whether it\’s just the journo who has made a casual error here or whether the EU really is trying to do this impossible and highly undesirable thing.
Neither, frankly, would surprise me.