Personal Project Blog 2 - Making Progress

Since my last personal project update, I’ve met with several contacts in finance-related job functions in order to get a better understanding of derivatives markets and market making in general.  It was my goal to apply the knowledge obtained through these meetings directly to a financial model of a carbon derivatives exchange.  However, things did not proceed exactly as I had planned and instead of helping me to move forward on my original derivatives exchange plan, these conversations helped to illustrate several obstacles within my plan that would limit its economic feasibility.  The good news is these meetings have led me in some new directions that are more feasible than my original plan.

The first person that I spoke with was a finance professor of mine, Professor Shockley. The reason that I wanted to speak with Professor Shockley was because I wanted to confirm that my hypothetical derivatives contract, of which I know of no currently existing equivalents, was mathematically sound.  I explained to Professor Shockley that even though my contract was based on an underlying asset which had no spot price, I believed that the spot price could be derived through price discovery in the futures market.  Professor Shockley confirmed that the contract made sense and recommended that I talk with the CME Group in Chicago in order to figure out why nobody else was pursing such a contract.

So that’s what I did.  During my meeting with a member of the Research and Product Development Team at the CME Group, I learned about potential methods in which I could partner with their exchange in order to launch my Carbon contract.  By working within an already established exchange, I would instantly have access to a liquid market and a credible clearing house.  In exchange for these services, I would have to pay a launch fee and I would receive only a portion of the commission generated by each trade.

After talking with the CME Group, the next person that I talked with was Michael Greenberg, the founder of the Plastics Exchange in Chicago.  The Plastics Exchange is one of a few, if not the only, truly new markets that has successfully been established in the last thirty years.  Mr. Greenberg told me that I had a clever idea but that a carbon exchange, organized in the way in which I had imagined, would be almost impossible to turn into a viable business.  The reason for this is because the commissions on futures contracts average out to be only about eight cents per contract.  This commission structure is appropriate for contracts like S&P 500 futures, which trade millions of contracts every day.  However, by launching my own exchange, even if I managed to create a market with thousands of contracts in open interest, a number which is similar to that of the Plastics Exchange, I would still be earning very little revenue in the process.  Mr. Greenberg thought that the option of working with the CME group was more realistic.

After hearing this critique, I spoke with another professor of mine in the business school, John Succo, who until recently ran his own hedge fund.  John explained that the lucrative part of making markets was the actual act of matching buyers and sellers.  In this business model, a broker earns a large fee for their match-matching efforts.  The only problem with this model is that it is much less transparent, and as a result, I do not know if such contracts/brokers currently exist.  John suggested that in order to find out, I get touch with the players who would be involved in a carbon market.

So that is the next step.  I need to get in touch with utility companies in order to find out if/how they hedge their carbon risk.