05.28.2012
By Terry Flanagan

Energy Markets Power Up Compliance

With critical decisions from regulators on over-the-counter swaps still pending, energy companies up and down the supply chain—producers, distributors, power generators, utilities and energy trading desks of banks—are turning up the juice on their trading and risk compliance systems.

Although the Commodity Futures Trading Commission has made strides towards providing clarity on some issues, there are still a number of questions unresolved, such as end-sure exceptions and margin requirements.

“There are both practical business transformation issues, as well as regulatory drivers, affecting a sea change in energy trading compliance,” said Glenn Kinser, head of energy trading compliance, SME, at Nice Actimize, a compliance and risk management provider.

“As the energy industry moves through a transformation that parallels the financial industry, it is imperative that the approach to trade compliance changes to meet the complex demands of a range of legislation hitting the energy and commodities market,” Kinser said.

With the imminent implementation of the Dodd-Frank Act, hedge trading will be the litmus test for attaining end user exemptions.

“Companies will be challenged if they try to invoke a sort of ‘hall pass’ for the CFTC class they don’t want to attend if they say that their book of swaps is comprised only of hedges,” said Patrick Woody, senior strategist, regulatory risk compliance at SAS RiskAdvisory, a commodity trading and risk management provider. “End users should expect more regulatory scrutiny and due diligence to assure a hedge is in fact a hedge.”

The CFTC in April issued final rules providing critical definitions of entities subject to Dodd-Frank provisions.

By defining the terms “swap dealer”, “major swap participant” and “eligible contract participant”, the rules provide some much-needed clarity for participants in the OTC markets.

The final rules have significantly relaxed the threshold for firms to engage in hedging without being classified as swap dealers.

Under the final rule, the CFTC raised the threshold to $8 billion over a 12-month period throughout a two-and-a-half year phase-in period, during which time the CFTC will conduct a study of swap data that’s reported to swap data repositories.

Depending on the results of the study, the CFTC could reduce the threshold to $3 billion.
“The industry breathed a huge sigh of relief when [the CFTC] came out with a de minimus threshold,” said Woody. “They have defined most customers to be end users, which means they are not subject to the same draconian rules as swap dealers.”

The JPMorgan Chase fiasco has invigorated arguments for more prescriptive regulatory definitions of hedging in view of Dodd-Frank Act implementation in the coming months, as well as renewed the debate around the adequacy of Value-at-Risk as the tool of choice to measure market risk.

“If VaR didn’t serve up the right alerts for JPMorgan, then which risk metrics can?” said Woody.

“Risk experts are coming to consensus that best practice risk management require a suite of advanced portfolio analytics that properly aggregate and disaggregate risk factors, monitor cross-commodity exposures, basis and spreads,” he said.

Best practices also require employment of stress testing, risk factor sensitivities and constantly re-evaluating a risk model’s predictive power with forms of back testing.

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