What is OTC trading?
OTC Spot and Futures Trading
OTC trades are executed on spot and futures markets. Trading takes place directly on OTC platforms, through brokerage firms that carry out the transactions on behalf of their customers, or – even in the age of the internet – with a phone call. In such cases, the two parties agree to terms in a recorded telephone conversation and finalize the contract verbally. A confirmation of the transaction can be sent after the conversation. OTC business transactions are often initiated on publicly-available instant messaging programs.
OTC spot market
On the OTC spot market, short-term trades are carried out bilaterally and tend to involve daily and weekly products. Only the two contracting parties know the specifics of the price.
OTC futures market
The OTC futures market processes all long-term transactions, which includes any deal longer than 24 hours up to several years. Electricity traders distinguish between a sub-market that includes a physical fulfilment obligation, and a sub-market that includes a financial fulfilment obligation. Forward contracts with a physical settlement obligation are more common.
Buyers and sellers in the long-term futures market are looking for the best price for certain quantities of electricity in a defined period, regardless of pricing on the volatile spot markets. This strategy, also known as hedging, secures OTC spot market transactions with a significantly shorter time period, making them comparatively riskier.
Large-scale power plant operators frequently use long-term OTC futures to hedge against price fluctuations or events such as maintenance work.
OTC electricity trading - advantages and disadvantages compared to exchange trading
In regular exchange-based trading, trading prices and volumes are public knowledge. In OTC trading, this information is only available to the contracting parties. However, the price transparency of exchange trading does influence OTC trading, since spot market prices serve as benchmarks for OTC pricing.
Although OTC trading has the advantage of potentially lower fees and transaction costs, the barriers for market-entry are higher than on the exchange. On the stock exchange, securities must only be deposited once, while in OTC trading, securities must be deposited for each individual trading partner. This makes the entry into OTC trading more difficult for smaller trading companies, while big trading companies stand to save money on the OTC market.
OTC trading is significantly more expensive, which inhibits participation by smaller market players.
OTC trading also lacks fixed standards. Compared to exchange trading, this increases the flexibility of OTC trading, but also increases the risk. Default and loss risks stemming from poor decisions or business misunderstandings increase the likelihood of entering a bad contract, which can carry serious consequences.
In addition, OTC trading no longer has the advantage of short-notice contracts since spot exchange deadlines have become much shorter. On the EPEX Spot, for example, electricity can be traded up to five minutes before physical delivery.
"Standardized" OTC contracts
In order to lower the risks associated with free OTC trading and to simplify trading transactions, some exchanges such as the European Energy Exchange (EEX) in Leipzig now offer standardized OTC contracts. If desired, these can be settled using European Commodity Clearing (ECC). These standardized contracts, such as the EFET framework contract, are usually templates that are adapted by the contracting parties.
Manipulation risks of OTC trading
Due to the lack of regulation and transparency, manipulation of the electricity market is an inherent risk of OTC trading. By automatically linking electricity exchange prices with OTC trading platforms, electricity traders can manipulate the exchange price through targeted purchases and yield high OTC trade profits. This is illegal, and such manipulation is difficult to detect.
In response, the European Union has created an effective instrument against this and other forms of manipulation with the Regulation on wholesale Energy Market Integrity and Transparency (REMIT). REMIT seeks to increase market transparency and to prevent manipulation and insider trading through a legally-binding reporting obligation. In Germany, the Federal Network Agency (Bundesnetzagentur) monitors compliance with REMIT through its market transparency unit.
Conclusion: OTC trading in the electricity market of the future
It is difficult to predict if the significance of OTC trading on the electricity market will increase or decrease over time. One aspect is clear, however: large power plants will continue to minimize their price risks through long-term OTC trading contracts. Furthermore, there are currently no signs that long-term trading will become fully institutionalized and render long-term OTC contracts obsolete. For short-term trades, however, OTC trading has become less attractive; shorter trading and delivery periods make exchange trading an attractive option.
In the long term, it is possible that renewable energy trades could shift to the OTC market with the pending expiration of subsidies. Without subsidies, OTC is a better option for long-term, price-securing forward transactions ("Power Purchase Agreement” or “PPA”). In the long term, it is likely that trading renewably-sourced electricity will shift from short to long trading periods, which have so far been defined individually in bilateral agreements.