Abstract
In this paper we refer to the requirement for industrialized countries to reach a domestic target for greenhouse emissions, as ratified in the Kyoto Protocol, and propose a market-consistent model of futures price dynamics for cap-and-trade schemes designed in the spirit of the European Union Emissions Trading Scheme (EU ETS). Historical price dynamics for the EU ETS suggest that both European emission allowance (EUA) and certified emission reduction (CER) certificates, generated by a nondomestic offset mechanism, are significantly related. We use an equilibrium framework to demonstrate that compliance regulation singles out special price dynamics. Based on this result, we propose an arbitrage-free model and apply it to the pricing of spread options between EUAs and CERs.
Highlights
Over-the-counter (OTC) markets played a central role during the global financial crisis (GFC)
We show how the size and structure of these markets can undergo rapid and extensive changes when participants engage in portfolio compression, which is an optimization technology that exploits multilateral netting opportunities
We introduce a framework that empirically supports the large effects attributed to a marketwide adoption of portfolio compression
Summary
Over-the-counter (OTC) markets played a central role during the global financial crisis (GFC). Several jurisdictions mandated major regulatory reforms including central clearing, increased capital requirements and enhanced trading transparency. Underpinning these initiatives was the need to curb counterparty risk stemming from excessive leverage and the lack of transparency in the mutual positions of financial institutions.. OTC markets are characterized by their large aggregate size in terms of notional obligations, to the level of hundreds of trillions of dollars. The market for credit default swaps (CDS) featured a remarkable reduction in size: from USD 61.2 trillion outstanding at the end of 2007 to USD 8.3 trillion outstanding at mid-2018.2 In principle, this 86% reduction could be seen as a mere reflection of lower trading activity. Several sources have instead attributed its origin to the global adoption of a posttrade risk management technique prompted by the new regulation, namely portfolio compression (Vause 2010, ISDA 2015, Schrimpf 2015, Aldasoro and Ehlers 2018)
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