High energy

Deregulation in financial markets is often a case of regulators playing catch-up with the real world – an acknowledgement of the new status quo. But the December 15 enactment by Congress of the US Commodity Futures Modernization Act of 2000 could turn out to be a seismic shift.

It means that derivatives exchanges in the US can now offer clearing services and an open market-place for over-the-counter derivative products. The exchanges believe they can offer their customers the key advantage of being able to offer net margining. That means dealers will be able, for example, to trade swaps and futures in the same place and their margin exposure will be the net. 

Marty Chavez believes that, for commodities dealers, this could mean the end of any real distinction between exchange-traded and OTC derivatives. Chavez is co-founder and chief executive of Kiodex, a New York-based trading and risk management solutions provider for the commodities markets. Kiodex has struck a deal to provide the order-matching system for the New York Mercantile Exchange’s (Nymex) new electronic trading and clearing platform – enymex – beating off stiff competition from rivals as large as exchange technology specialist OM Group and Microsoft. In addition to offering the order-matching system, Kiodex is an application service provider (ASP) supplying trading technology and risk management via the internet. Its portfolio management tool, Risk Workbench, will be co-marketed with Nymex.

Enymex launches in the second quarter of this year, and Nymex has plans for a plethora of new derivative contracts that were previously limited to the OTC markets, initially for energy and metals markets, and later for a range of new markets, such as steel, chemicals and even telecommunications bandwidth. Nymex is already the largest physical commodities exchange in the world, trading futures and options on oil, gas and metals. With electronic trading, Nymex says it wants to reach deep into the B2B market for commodities.

The Kiodex office, opposite the Staten Island ferry terminal in Manhattan, buzzes with the sense of potential. It’s like the dotcom bubble never burst. Many of the staff are former colleagues of Chavez from Credit Suisse First Boston (CSFB), where he was head of energy derivatives. They are IT specialists who have traded good jobs for a start-up they believe will fly.

Kiodex began life last February in true dotcom style when Chavez e-mailed a four-page business plan to all his investment contacts, and quickly raised $8.16 million of seed capital. His plan is that Kiodex’s revenues will exceed costs in 2002.

A computer sciences graduate, Chavez started his career in commodities at Goldman Sachs in 1993. At that time, Goldman was still in the early phase of building its J Aron subsidiary, a coffee trading specialist, into a major player in forex and metals markets. Chavez’s main task over the next couple of years was to implement Goldman Sachs’s firm-wide trading risk system, SecDB, at J Aron.

The system allowed J Aron to run a global commodities trading book of tens of thousands of positions, and that meant it could sell a range of new exotic hedging products to clients. “This was a business fraught with peril in the early days. Increasingly our competitors were mispricing options, but Goldman Sachs dedicated the resources and had the strategies to make it work,” recalls Chavez.

In 1997, Chavez joined what was then Credit Suisse Financial Products. CSFP had a different approach to modelling risk. “At Goldman Sachs everyone had their own product line. The CSFP structure was that the derivatives marketers each had a regional focus. They could cross-market credit derivatives or asset swaps, for example,” says Chavez. “The task of the modelling group was to create one options calculator to cover all the different asset classes, whereas Goldman might have used a thousand variations on Black-Scholes across the firm... I saw the value of a uniform approach to modelling.”

Pooling
It also became clear to Chavez while he was at CSFB, he says, that all kinds of trading were heading for the Web. By pooling customers, the Web will offer the chance to tap into order flows of a scale previously available only to major banks, with their thousands of credit lines.

Chavez cites the example of Enron Online, the electronic trading platform launched in November 1999 by Enron, the Houston-based energy giant, which now trades around 850 different products, as evidence of opportunity.

What this huge new market will lack though, is the ability to calculate risk. “When I started Kiodex, I knew that no-one in the business had the risk technology apart from Enron, J Aron and CSFB,” says Chavez. “Furthermore, it’s not just a case of buying risk management software. You can spend a million dollars and that’s just the start of your problems – you need the people who can cajole and nurture it. The customers don’t want software, they want answers. They want mark-to-market and P&L reports in Adobe and Excel.”

There are three big winners in the new regulatory and technological environment, according to Chavez’s vision of the future: the exchanges that can provide the unglamorous but lucrative clearing services; electronic market-makers such as Enron Online; and the ASPs that can offer the growing army of end-buyers independent risk calculation on a “pay-as-you-go” basis.

Nymex is only Kiodex’s first partner in the distribution of its risk technology. Chavez also plans to sell and market his products through other exchanges and through dealers. That’s the real beauty of the ASP model: “We can go everywhere,” he says.