The news has been dominated lately by COP26. There have been major announcements amongst others on deforestation, methane reduction, phasing out of coal and of course how countries intend to become carbon neutral. So, what is the impact of sustainable trading on margin?

This focus on climate change has led many exchanges to list related products, whilst existing contracts that support sustainability have seen increased interest. Although many of these are standard products, there are some that have particular properties that will impact the way in which margin is calculated, or may differ from those that firms are used to trading.

Two-fifths of the world’s financial assets of $130 trillion are under the management of a group of banks, insurers and pension funds who have agreed to adjust their trading to help achieve various net-zero goals, including limiting global warming to 1.5C by 2050.

This means that they will be looking to invest in products that support this ambition. Given the size of the firms involved it is likely that they will drive liquidity towards sustainable contracts.

This in turn is likely to result in trading venues listing more “green” products. This shift in the contracts traded is going to impact firms who are used to trading particular markets or derivatives, with liquidity waning in some products and driving them towards new contracts.

ESG (or Environmental, Social and Governance) defines how a company’s business model relates to its sustainability, and how the products and services that it provides contribute to sustainable development. Regulation is expected to provide clarity on areas such as corporate climate reporting, data structures and company disclosures, but the bigger issue will be how firms embed these ESG guidelines into their businesses. Countries are introducing packages of sustainability disclosure requirements that are designed to prevent firms from “greenwashing” and increase the speed of the transition to net-zero.

This regulatory push provides a trading opportunity. Many exchanges are listing ESG related products, for example index futures and options based on companies with a specified ESG rating.

With the number of exchanges looking to participate in these products, the decision for firms will be where to trade. This choice needs to take into account a number of factors. Fragmentation, design and definition challenges mean that many of these exchange traded products will remain illiquid. However, if the liquidity is available then the choice may come down to cost, including the level of margin requirements.

With the number of margin algorithms involved, covering the various OCC methodologies, Eurex Prisma as well as SPAN, then an analytical solution will be required that can support all of these.

Transport is one of the big drivers of carbon emissions. This has led to the push to convert to electric vehicles, which in turn has resulted in the listing of new derivative products covering the materials required to produce these. The particular area of focus has been the manufacture of batteries and the commodities that support this.

The London Metal Exchange has been particularly active in this area.  For example they have listed Lithium Futures, joining other products within their contract suite for electric vehicles and batteries.

The particular thing to note here is that these new products are generally cash settled futures, rather than the traditional LME deliverable forwards. This has a big impact on the margin calculations. The Lithium Futures will be subject to daily realised variation margin, unlike the discount contingent variation margin applied to the existing LME products such as Aluminium.

Emissions trading is an obvious focus of sustainable markets, often in conjunction with power trading. There are many different trading venues, and the choice for firms will depend on the jurisdiction, the style of the contract and also the impact on margin. Currently this is largely a bilateral market, but exchanges such as Nodal and ICE are competing to move this business on exchange.

Trading on exchange means that it will be centrally cleared, and apart from enhanced risk management firms would also save cash by avoiding the upfront payments of trading bilaterally. In the forward market you pay 100% upfront for delivery of emission rights in the future, whereas when trading listed contracts you only pay margin which is probably closer to 10% of the value.

Life is likely to become difficult for those firms that trade solely fossil fuel derivatives. Some banks are off-boarding commodity firms, and this will be further driven by their agreement to work towards net-zero.

For the commodity firms themselves this is going to lead to credit lines being squeezed and the cost of borrowing increasing. They will need to diversify, both to make themselves more acceptable to brokers as well as to continue to achieve the required level of returns from their investments. As the use of fossil fuels reduces then the liquidity in the derivatives market would be expected to fall too. Commodity trading firms will need to start looking at some of the products described above, such as emissions or green power related contracts.

With this change in portfolio composition firms are potentially going to find themselves having to support and understand additional margin methodologies. Being able to do this will be key if they are to continue to achieve a good return on capital in a difficult market.

A focus on sustainability is leading to markets listing new products and firms adapting their trading strategies. This in turn is exposing them to additional complexity in the margin calculations that they need to understand.

Products that are currently traded bilaterally are now being listed on exchanges, whilst similar products are being developed by multiple exchanges. The combination of these contracts covers the majority of the currently implemented CCP margin algorithms, with a combination of scenario and VaR based methodologies.

Firms need to make sure that they are ready for sustainable trading, especially the impact it may have on any solutions used to support their margin management. With new products and markets to consider it is going to be harder to optimise margin to help maximise returns.