28 Jul 2010, Sapient Global Markets , Koch Supply & Trading , Energy Risk
New financial regulation is gradually making its way onto the statutes books with sweeping implications for companies worldwide, and energy-related companies in particular. We ask how companies are responding to the prospect of additional requirements and oversight.
Our panellists discuss how to respond to some of the technological and risk management challenges that will be affecting the markets in the the coming year. Topics covered include: making sure a firm’s energy trading risk management system is able to cope with the new demands from market supervisors, allowing continued compliance with regulatory requirements; what will be the likely impact of moves to force more clearing of over-the-counter derivatives and of new reporting and margin requirements? ls this something current systems will be able to cope with or will firms need a full technology rethink? Our panel looks at the various solutions and the role of in-house built systems versus off-the-shelf software, and whether the new regulations will change their relationship with the trading and risk management functions in their firms.
The Q&A provides the reader with a range of opinions and options on these issues, bringing you up to date with the latest thinking on some of the most pertinent challenges that will be affecting the market in the year ahead.
Koch Supply & Trading
Rob Short, Chief information officer
Sapient Global Markets
Jon Davies, Director, business consulting
Tony West, Director, business consulting
What are your company’s technology needs in terms of trading – what specific aspects do you look for/need? Did you build your system in-house or is it an off-the-shelf system?
Rob Short, Chief Information Officer, Koch Supply & Trading: Koch Supply & Trading is a global company with diversified business lines such as commodities trading, supply and structured products. We operate in the physical markets and help customers manage risks, as well as providing liquidity in the paper markets – both over-the-counter (OTC) and on-exchange.
Given the broad scope of activities our companies are involved in, there has been no single energy trading risk management (ETRM) system that handles all of our activities well. The complexities of supplying the physical markets and the wide range of logistics capabilities needed drive very complex system demands across multiple time zones.
We have developed an architecture that allows us the flexibility to use best-of-breed trade management systems, yet still consolidate our data for enterprise-wide risk management. This includes both market and credit risk, which were our first areas of focus. We are enhancing this architecture to help streamline our accounting, tax and finance capabilities.
At Koch Supply & Trading, we buy systems and integrate them instead of building them, and we prefer to buy the things like ETRM systems from vendors with expertise. By focusing on our overall enterprise architecture, we can integrate new trade management systems quickly and cost-effectively. This provides agility to the organisation and enables our experimental style of starting small and growing with success.
How is your company responding to the prospect of additional regulatory requirements and oversight?
Jon Davies, Director, Business Consulting, Sapient Global Markets: For some time now, we have been working with some of the leading industry bodies, such as the International Swaps and Derivatives Association (ISDA), Leadership for Energy Automated Processing (LEAP), and so on, to propose solutions to the regulators and identify areas where standardisation would increase efficiency or reduce operational risk. We have developed metrics that help address some of the concerns the regulators have and show the impact of regulation on a firm’s business. The biggest challenge at the moment is to understand the regulatory boundaries. Until this is clearly understood, it is difficult for companies to plan. While we wait for the details, we are running a series of industry benchmarking surveys to allow firms to compare their compliance framework with their peers.
Rob Short: We are working to proactively understand what is coming so we are better prepared. Our IT capability actually plays a facilitating role in meeting those requirements once they are in place. We believe that some of the systems architecture components that we are working on – mentioned above – are very complementary to enabling continued compliance with relevant regulatory requirements. If an organisation has access to the data it needs in the right format, granularity and timeliness, then responding to new requirements – regulatory or other – isn’t as daunting a task.
Like the rest of the industry, we have already seen a significant move towards more clearing of OTC derivatives. This appears to be driven primarily by a desire to reduce credit risk rather than by the pending legislation. However, it is indicative of the kinds of changes that might be coming. There is a lot of potential capability and systems impact caused by this one change or trend. Depending on where the regulations end up there could be a lot more impacts, some intended and perhaps some unintended. Given the potential change needed to be able to adapt, we clearly have to be proactive about understanding this.
Do you think the current mix of off-the-shelf and in-house systems will be affected as a result of the regulatory changes?
Jon Davies: The push to standardised trade definitions will make it easier to select off-the-shelf systems because the functionality to handle them may have already been built for another market participant. Most large trading organisations already have systems in place so it is not necessarily the case that we will see an increase in the adoption of off-the-shelf systems. However, if liquidity moves to new markets, our clients will want to quickly implement systems that handle these new markets and off the shelf could be the best answer.
Additionally, there will be a need for new reconciliation systems to match the OTC trades in the central repository with trades in the internal trading system. This will most likely require a custom build as there are many different systems and configurations.
What impact could margining requirements have on the energy sector and are companies aware and prepared?
Tony West, Director, Business Consulting, Sapient Global Markets: While most, if not all, players in the energy sector understand the reasoning behind additional margining requirements, there are valid concerns that it could result in a real loss of liquidity and an increase in volatility and cost.
The consequences may have a particularly disproportionate impact on complex physical and asset-backed businesses, especially those in the power and gas markets. Many of these firms do not just hedge cashflow but actively manage their market risk as an alternative to just ‘selling’ the risk to another company. Traders and banks that buy and sell standardised products in the market will be able to offset margin payments for closed positions, but physical players backed by assets may have to maintain margins on one side of the transaction until delivery. If there is some generalised exemption for such ‘offsetting’ physical trades, which might not be just a simple hedge, it will surely dilute the original rationale.
Should there be a reporting mechanism and a central repository that can allow regulators to identify risk concentration?
Jon Davies: Yes, and it is almost inevitable. It is the preferred way for regulators and world governments to gain confidence that the markets operate robustly. It could actually prove to be useful to the market participants even without regulation – for example, adding efficiency in the back office for settlement of standard contracts would allow more time to be spent on processing the more complex, non-standard contracts. The other advantage a trade repository has over the alternatives, such as position limits and margining, is that it doesn’t have an impact on the trading decisions made by a firm. For example, firms with a large physical position will have to adopt hedging strategies that take these into account. This will actually restrict the way a firm manages its exposures and risk, resulting in increased costs.
Sapient believes the industry should take the lead on some standardisation where there would be real benefits and then the regulators would follow (for example, confirm processing and documentation management).
Are you concerned about new requirements in terms of reporting or margin requirements? Is this something your current system can handle or will it necessitate a technology rethink?
Rob Short: We have completed a significant amount of work on our margining capability already. Some of the volatility in the markets in the recent past has highlighted the value of a robust margining capability, and this includes understanding the potential impact of stress events. We don’t see the need for a complete technology rethink, however, we do see the need to continue to invest in this area. We are working to continually improve our capability, as well as looking at possibilities to improve our technology in this area.
Do you plan to reassess your technology needs via a system audit in the near future and is this a regular activity for your company?
Rob Short: We are constantly auditing our capabilities and technology through external and internal audits. Many audits focus on security and controls. However, we also audit functionality and gaps. We have enough humility to know there isn’t much that we do that we can’t still significantly improve upon. For example, we are currently auditing our credit capability and systems. This will include input from outside experts. We have done a lot of work to enhance our credit analytics capabilities and systems over the last 18 months. We have improved our understanding of potential future exposure, for example. We are now looking for the next incremental improvements.
How will the regulatory changes affect hedge accounting and what are the potential implications for energy companies’ technology needs?
Tony West: The bigger problem is that hedge accounting has encouraged asset-backed companies to make non-commercial decisions, particularly around asset optimisation, in order to keep reported earnings volatility down. Existing accounting standards only measure the cash position and not risk, with the consequence that trade decisions are often dictated to by accounting rules rather than the driver to extract maximum value from the asset’s flexibility. Any changes to regulation that impact accounting standards and improve this situation should be welcomed.
In any case, Sapient expects the market to continue responding to hedge accounting complexities. This could manifest itself through an increase in ‘trading services’ offerings from banks to take the risk management and related hedge accounting headaches away. Alternatively, we could see the development of separate systems: one for the day-to-day management of the business – either mark-to-market or asset optimisation profit and loss, depending on the type of business – and one around the financial reporting. This will increase the problem of reconciliation around month and quarter ends that are already major problems for most companies and will further the continued development of auto-generated hedge trades to improve the reconciliation process.
Overall, how would you describe your relationship with the trading and risk management functions at your firm? Has this changed – or will it – in light of the new derivatives regulations?
Rob Short: We are totally integrated. Our risk capability is both a defensive measure and an offensive weapon. The trading groups and the risk groups work very closely together on both fronts. Our risk management challenges are very computationally intensive. IT solutions are almost always a key component. This is one of many technology-intensive areas of opportunity for IT in a trading organisation.
The environment at Koch Supply & Trading is highly collaborative and we value what we call ‘the challenge process’, where every voice in the organisation has the opportunity to be heard. The IT team is in conversations, working sessions and meetings with members of our trading groups and risk management functions on a daily basis.
We have IT-enabled initiatives under way that are sponsored by those areas. This collaboration leads to efficiencies. We constantly work to eliminate waste and be more lean and agile. A very tight communication and feedback loop is critical in that pursuit.
New derivatives regulations will only reinforce the need for such close integration and collaboration.
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