Tacking liquidity risk in illiquid power markets

The strong power market growth evident in western Europe is spreading eastwards but with emerging market opportunities come additional risk. Katie Holliday talks to market experts about how best to approach the issue of mitigating liquidity risk

Emerging markets hold unique opportunities for energy and commodities players and many are keen to establish a strong presence in a new product or region before their competitors. But immature markets are high-risk environments and despite potential for huge profit margins, tackling liquidity risk can pose a challenge.

Liquidity defined

Liquidity can be defined as the ease with which a trader can enter or exit a financial position without impacting price. If a trader is not able to move in and out of market positions quickly and easily then the market is illiquid.

"An illiquid market is a market where few quantities are exchanged and large bid-ask spreads persist for long periods of time," says Stefano Fiorenzani, head of risk and middle office at EGL Italia.

According to Vince Kaminski, professor at Jesse H Jones Graduate School of Management at Rice University in Houston and former managing director of research at Enron, one of the biggest challenges of operating in an illiquid market involves the difficulty of exiting positions.

"If you are in a very illiquid market, sometimes it is impossible to exit a position. In the US, this is what we call a 'roach motel', which describes a trap for cockroaches. The halls are coated with a hormone that attracts the bugs, but are also coated with glue. Many emerging markets are 'roach motels', because it is easy to enter but almost impossible to leave," he says.

The electricity markets are well known for being one of the most difficult commodity markets to trade due to their relative immaturity and illiquidity. However, the incentive for trading in such difficult markets is that the opportunity for making profit is much higher than in more liquid commodity markets.

"Illiquid and immature markets are characterised by more risks but also more opportunity. The challenge to me is the good assessment and balance between risk and opportunities," says EGL Italia's Fiorenzani.

Fiorenzani adds that the high-risk environments of illiquid markets attract a particular type of market participant: "Traders in these regions are probably those who have a more aggressive mentality. Pure traders prefer more liquid markets because they want to extract profits from market trends. While in illiquid markets we can extract profits from asymmetric information use – [when there is more information on one side of the trade – usually for the seller]."

Eastern promise

The western European power markets have made significant progress in terms of liquidity and sophistication over the past decade, with European energy companies and investment banks piling in to capitalise on the growth opportunities. The power markets in central and eastern Europe (CEE) have experienced slower growth, but are now beginning to catch up with their western peers. Major European energy companies, such as Belgo-French GDF Suez and Norway's Statoil, are now venturing into eastern Europe, whether to service domestic customers or act as market-makers and try to develop liquidity and transparency in these markets.

Although the CEE power markets are far less liquid than western European markets such as Germany and within the Nordic region, not all countries in eastern Europe can be tarred with the same brush. Liquidity levels vary significantly, with some markets grown significantly in liquidity and sophistication over recent years. Most countries in the region now have a national power exchange and the establishment of several market coupling initiatives has aided market development, such as the coupling of the Slovakian, Hungarian and Czech Republic regions, for example. Together with Poland, these regions trade the largest volumes in eastern Europe. But in the southern eastern European (SEE) region – including Greece, Romania and Bulgaria - liquidity is so low it is sometimes not even possible to see a price.

EGL Italia's Fiorenzani says the progress made in recent years is demonstrative of the CEE power market's potential. "If you compare the volume of power exchanged in the last three to four years in the central and eastern European regions, you will see an almost continuous increase despite the crisis period. Illiquidity niches are still present, in particular for some countries and for some longer-term products, but the tendency is for a clear improvement."

Although illiquidity in the CEE power markets has deterred some foreign players, many are taking a long term view and are keen to help transparency and develop the market so it is easier to trade further down the line. But operating trading activities in less liquid markets presents its own set of challenges, namely negotiating language barriers, country-specific rules and additional credit risk.

Local knowledge

According to Frank Brannvoll, head of illiquid power markets at GDF Suez, local market knowledge is vital as a participant in a new and emerging market. "You need to know the market really well before you enter an illiquid market. It's not like the German power market where you can just come in and out really easily because of the small spread between bid and ask price. This is one of the main challenges of operating in an illiquid market. You cannot just do what you want. Illiquidity constrains what you do," he says.

Brannvoll adds that it would be easy to apply one strategy to all European markets, but one has to respect the limiting factors, such as volume, market length, as well as credit risk in each market.

"An important step in risk management would be to have power exchanges work in a more regional manner. In this way companies would be able to trade more markets on one exchange with less credit risk and easier accessibility. Today we often see exchanges with different rules and even very specific restrictions for who can trade the market," he adds.

EGL Italia's Fiorenzani agrees that the use of local people with knowledge of the market is an important tool when negotiating emerging markets. "Since liquidity goes together with scarce transparency, a very close presence in the market through the use of local people may help reduce liquidity risk," he says.

Participants with physical assets within the CEE power market region will be at an advantage to those without, according to Grzegorz Onichimowski, president of the management board of the Polish Power Exchange (PolPX): "It is good to have some roots and connections and it is, of course good to have the local people and the local traders," he says.

Stumbling blocks

Another hindrance to trading in an illiquid market environment is the difficulties involved with participating on local platforms. Often local governments will enforce complex and time-consuming procedures for trading on national power exchanges.

PolPX's Onichimowski says local rules can discourage participants from trading on the exchange and hamper liquidity growth. "There are still not very friendly regulations concerning exchange participation. For example, a trader has to obtain a licence to trade [in Poland], which seems odd for an experienced over-the-counter commodity trader who is active on other markets and exchanges," he says.

As a solution, Onichimowski proposes exchanges should have the power to distribute licences rather than government regulators. "All those regulations are too complicated. We would like to see changes to legal requirements," he adds.

"You could say regulation can also hinder the development of liquidity in an illiquid market," says GDF Suez's Brannvoll. "If there are too many regulations that enforce companies to set up a local office, take an exam in a local language or provide tremendous amounts of reporting – it makes it difficult for new companies to set up trading and hedging operations."

Fiorenzani points to the Italian market as a key example of the negative impact excessive regulation can have on market growth. "My personal belief is that regulation never helps the development of a market, but in fact does the opposite. For example, in countries like Italy, the excess of regulation has slowed down the development of the power and gas markets," he says.

Zoltán Medveczki, chief executive officer of the Hungarian Power Exchange (HUPX), says one method large energy companies can use to try to mitigate against liquidity risk is to use portfolio optimisation. Portfolio optimisation is the process of using predictions about the asset universe to find a suitable trade to perform. "Using cross-border trading over central countries can help," he says.

According to EGL Italia's Fiorenzani, cross-hedging with other more liquid products is also a useful way of minimising liquidity risk.

Regulatory progress on a European level will be pivotal to helping develop cross-border trading through market coupling initiatives.

"We need more cross-border capacity, more market coupling, we need really to speed up the target model for the electricity market, that's what we need," says PolPX's Onichimowski.

However, Medveczki warns that sometimes the best way to tackle an emerging, illiquid power market is to take a ‘wait-and-see' approach. He advises that western players need to be patient and wait for the right moment before starting to trade on the CEE power markets in the same way they do at home. "Eastern European divisions never used to do real volume trading. Now there are brokers and power exchanges in every country and there is increasing liquidity. This improvement will speed up and we'll see better trading environments. However, the London financial guys are not interested in a local power exchange unless they can close several hundreds of megawatts at once with high probability without physical risks. This is not the case yet – before that we need to wait sometime, a few years perhaps," he says.

Venturing into less liquid markets, as found in the CEE power market region, is a challenging and high-risk procedure. But with local knowledge of domestic rules and regulations combined with portfolio optimisation methods and a well-balanced assessment of the risks involved, European energy players can be well-placed to capitalise on the  huge rewards that emerging markets present.