Can technology rescue hedging strategies in energy trading?

By James Brown

allegro
allegro

Plenty of ink has been shed on the topic of global legislation in energy commodities trading. In the U.S., Dodd-Frank marked the first major salvo to enhance accountability in energy trading, followed by EMIR and REMIT in the European Union. But as the months have unfolded, little clarity has been established. Deadlines shift, details change and the traders affected wonder what to do next to prepare for the impending requirements, restrictions, regulations and penalties for non-compliance.

To improve transparency in over-the-counter derivative markets following the global financial crisis, the G20 agreed a series of reforms in 2009 to improve transparency in OTC derivative markets. A central feature of these was to mandate reporting of trade activities to trade repositories. Since then, ambiguity in the timing and details of new rules has caused energy traders on both sides of the Atlantic much anxiety over their next steps toward compliance.

It’s easy to understand why. Lack of agreement on data formats, complicated by privacy laws and further confused by the growing number of active repositories participating in the reporting scheme, has made the rollout of new rules a stop-start affair. Regulators have pressed on regardless, holding companies accountable for changes the regulators themselves don’t fully understand.

Most companies have hesitated to act for fear of investing in solutions that turn out to be expensive dead-ends. The alternative of abandoning hedging strategies altogether and capitulating to higher prices has almost seemed the lesser of two evils.

In a recent survey conducted by Chatham Financial, 74 per cent of European and US treasury and risk management officials said they were not prepared for EMIR or Dodd-Frank compliance.

No wonder then that 13 per cent of the Chatham Financial respondents said they expected to hedge less or stop hedging altogether; or that 47 per cent said that they simply plan to pay higher prices; or that 40 per cent said that they would seek alternative ways of managing risk.

What we know today
Despite the ambiguity, some things are clear. The emerging EU regulatory regimes for OTC derivatives will affect any firm dealing in:

  • Options, futures and swaps on interest rates, securities, credit and indices
  • Commodity derivatives and derivatives on underlyings; including rates, freight rates, emission allowances and climatic variables
  • Contracts for gas and electricity, as well as transportation derivatives

All energy market participants now need to register with national regulators. In the particular case of non-financial counterparties, only companies that exceed a “clearing threshold” will be required to have their contracts centrally cleared. That means having an active monitoring capability in place, in order to know when the threshold is looming.
To continue operating under a hedging strategy, traders will need a proper means of reporting, clearing and demonstrating risk mitigation in order to comply with new rules. Furthermore, if a company’s operations cross regulatory borders, specialised processes will need to be in place, as in most cases, harmony among the various regulatory bodies is unlikely.

Amid ambiguity, a way forward

Despite the lack of clarity, there are alternatives in terms of what companies can do now to prepare. Managing the process manually is not one of them. There are electronic reporting and data storage requirements involved in each set of regulations that will quickly overwhelm any approach based on spreadsheets, economically and technically.
Outsourcing may be an option, but one with its own costs and risks. There is the added overhead of an ongoing contract to manage, and how active you are in the energy trading arena will determine your breakpoints financially. It’s worth bearing in mind that a third party provider would most likely not be held responsible for paying fines should any errors or missed deadlines occur.

That leaves accepting higher prices by abandoning a hedging strategy altogether – not a good thing for your bottom line – or automating the process. From my perspective the best business decisions rests with automation.

Automating regulatory processes requires a basic energy trading and risk management (ETRM) system. A regulatory solution for commodity trading and corporate financial compliance is generally not a stand-alone application. Contract data, hedge accounting, revenue allocation in line with regulatory reporting requirements and other special functions do not happen in a vacuum.

allegro_technology
allegro_technology

A good ETRM should be able to:

  • Efficiently execute trades
  • Ensure trade compliance
  • Enhance market intelligence
  • Improve decision-making

There are software vendors with long tenures in the business of risk managing large energy purchases. In light of the evolving standards for EMIR, REMIT and Dodd-Frank, you will want to choose a solution that allows you to upgrade and manage your regulatory compliance process quickly. Another qualifier to consider is the ability to install software on a captive system and maintain it internally, or purchase a software-as-a-service (SaaS) contract and maintain it virtually in the cloud. Implementing this option could affect your overall total cost of ownership as you integrate the system into other areas of the business.

Direct connectivity to trade repositories should also be a core capability, including all required regulatory identifiers and formats. The system should be able to simplify your threshold monitoring (as discussed above) and facilitate your risk mitigation obligations, including periodic portfolio reconciliations under the new rules.

Despite delays, deadlines are looming
As the regulation clock continues to tick, market participants face an uphill battle to understand and meet the obligation that new rules will impose. When the current ambiguities are cleared up and firm deadlines re-set, everyone will be expected to switch on quickly. Failure to comply will be met with stiff penalties.

Energy traders planning to maintain a hedging strategy to mitigate risk will need to address the compliance conundrum. An automated solution offers the best alternative to meeting the requirements, given the evolving standards and timelines that define today’s regulatory environment.

– James Brown is Senior Energy Consultant, EMEA for Allegro Development Corporation

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