8583 Summary

The futures exchanges provide financial integrity to the commodity markets and guarantee the performance of their contracts. This is not an unimportant point, for, in the U.S., no energy futures contract has ever defaulted. Performance is guaranteed by brokers, the clearinghouse, and the exchange. All transactions are matched and offset at settlement. Although there is a perception among the public that futures exchanges exist primarily for speculation, hedging is their true function. The creditworthiness of the exchanges and their standardized, fungible contracts is essential to off-exchange trading, where counter-party performance is a key component of swaps agreements. In off-exchange transactions, the market maker assumes the functions of an exchange. If a transaction unravels, the market maker must perform. Large banks, major oil companies, and large traders not only can make a market, but because of their creditworthiness and performance capability, their customers have confidence in their ability to stand behind their transactions. In the evolving electricity markets, electric utilities are starting to assume the market-making function.

Cash settlement, rather than physical delivery, is an obvious advantage of OTC markets over physical or forward markets for electricity in terms of performance. No one can squeeze a cash-settled contract, as sometimes occurs in the physical market. Cash settlement also offers a better hedging vehicle, since physical delivery alters supply and demand. Physical delivery at contract expiration can be a recurring problem. These problems do not exist in derivative products because they are cash settled, which enhances their performance function.

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