Energy and commodity markets are adjusting to the new realities of regulation to the OTC derivatives markets.
Energy companies up and down the supply chain—producers, distributors, power generators, utilities and energy trading desks of banks—are ratcheting up their trading and risk compliance systems.
For example, entities that participate in the hedging of energy commodities have to deal with the accounting and reporting of those transactions. Similar compliance processes exist for entities that deal with trading in the growing emissions and renewable energy markets.
“There are a variety of regulatory hurdles that companies deal with, including Dodd-Frank,” said Stephen Schwarz, senior vice-president of product development, energy and commodities, at SunGard, a trading and technology firm.
In addition, the Federal Energy Regulatory Commission (Ferc) regulates the interstate transmission of electricity, natural gas and oil, which creates additional complexity for companies that have physical trading operations in any of those commodities.
“The first major pain point is the wide variety of additional data that must be captured for certain deals, such as OTC and exchange-traded deals that are subject to daily limits,” said Schwarz. “The second is the need to monitor position limits in real time.”
On July 10, the Commodity Futures Trading Commission (CFTC), the U.S. regulator, passed the final rule on end-user exception to the clearing requirement for swaps (“end-user clearing exception”) and final rules and interpretations further defining “swap”, “security-based swap” and “security-based swap agreement”; regarding “mixed swaps”; and governing books and record for security-based swap agreements (“definition of a swap”).
While the final rules bring much-needed clarity to the energy markets in terms of Dodd-Frank compliance, there are still important issues remaining to be sorted out, which stem from the fact that energy derivatives are backed by physical commodities like crude oil and natural gas.
“Energy is a very physical business, and as much as the physical aspect is excluded from most compliance calculations, there are unanswered questions such as, ‘will physical trades with volumetric optionality be in or out of scope?’” said Patrick Woody, senior strategist for regulatory risk compliance at SAS RiskAdvisory, a commodity trading risk management provider. “It is these types of uncertainties that create hesitation in the energy business about the mathematics for monitoring and calculating position limits and de minimis thresholds.”
Real-Time Monitoring and Reporting
The Dodd-Frank Act requires submission of trade and valuation data to centralized warehouses called Swap Data Repositories (SDRs) that the CFTC wants to use for surveillance of trades and monitoring of systemic risks.
Dodd-Frank also requires companies to take proactive steps internally for trade surveillance.
“Formulating a response to these data gathering and reporting mandates, and doing so in near real-time, is largely a new challenge for the industry, and it’s appropriate for them to search out technology that can help achieve these goals,” said Woody. “What’s driving companies to seek out solutions like RiskAdvisory’s are a lack of capability to easily aggregate disparate data and perform the appropriate analytics.”
Dodd-Frank compliance requires the submission of very comprehensive sets of data that currently are scattered across the enterprise and is mostly inaccessible in a timely fashion as required by regulators.
Establishing best practices for correct compliance will be a gradual and evolving process, but the companies’ ultimate goal is to achieve automation of this process.
“Automating as much of the reporting and compliance as possible has two important functions: it minimizes human error that can result in penalties, and it also minimizes the amount of disruption that compliance efforts will have on their daily business processes,” said Woody.
Energy companies “need technology in order to have control over the compliance requirements until they can be automated, and the automated system itself has to be a bulletproof solution that gives them confidence their compliance efforts are being managed”, Woody said. "Those are some of the key ways RiskAdvisory helps our clients with the Dodd-Frank compliance challenge,” he added.
One of the more challenging issues is the requirement to report key data items to designated SDRs.
“The critical element here is that there is a widely varying level of readiness among the various SDRs, making it a challenge to execute the reporting aspect of Dodd-Frank,” said Schwarz at SunGard.
The latest version of SunGard’s Aligne offers energy companies new support for Dodd-Frank, including the ability to monitor position limits in real time, interface with and report data to SDRs, and calculate regulatory capital requirements such as required initial margin, calculated variation margin, comparison to collateral and margin thresholds.
“Ultimately, it comes down to an immense amount of data capturing, accounting and reporting,” said Schwarz. “Using technology to optimize the trading lifecycle can help relieve the burden and risk of complying.”