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FINANCIAL
HAGGLING AT THE CLEARINGHOUSE
By Joan Esquivar and Ausma Tomsevics
With the deterioration of top energy traders' financial positions, the drop in their credit ratings, a reshuffling in their rankings, and the absolute disappearance of several energy trading platforms, electric companies and regulators are debating what structural reform energy trading needs and, indeed, what the trading world will look like. A company with a strong financial position and healthy rating may be able to develop unsecured, highly structured contracts on strength alone; or parties to bilateral contracts can share risk between them. In a market where many parties have financial positions all over the board, the clearinghouse concept—which can provide credit enhancements and minimize the impact of price volatility—is one more option to explore.
Several clearinghouses exist, among them, EnergyClear, Guaranty Clearing, Intercontinental Exchange, London Clearing House, Merchant's Exchange, and NYMEX—each with differences in structure, emphasis, and product line, and each jockeying for position in a currently low-ebb, illiquid market.
At a basic level, a clearinghouse is a group of energy market participants that come together and concentrate or transfer credit risk in order to protect themselves from the failure of the other participants in the market. Also, in this model the trade clears quickly: A clearinghouse helps a participant mitigate risk by keeping the contract period short.
The clearinghouse has equal risk if prices rise or prices fall—it does not bet on price fluctuations. Instead, the clearinghouse process insures there are
adequate resources on hand. Clearing-houses function as a buyer to every seller and a seller to every buyer—they are a central counterparty, and their primary focus is to avoid the default of a contract party. The mechanism provides insights into a party's financial status if its financial position begins to deteriorate; and the clearinghouse has the right to liquidate those positions. Regardless of its net worth, the clearinghouse needs liquid funds to accomplish its functions.
Generally, clearing—that is, coordinating payments among counterparties or providing final resolution of claims—will add liquidity to the market. But the mechanism cannot be used to trade in all segments of the marketplace, nor can it solve all the challenges there, because electricity contracts are often highly negotiated and difficult to standardize. There are hybrid solutions that do not fully involve clearinghouses; some companies have services that provide a number of the same steps as a clearinghouse, but fall just short of clearing. But even if the clearinghouse by itself is not sufficient to support a robust trading market, many companies find that it is an excellent risk management tool, if not a solution.
Standardization in the
Clearing Process
Standardization of contract terms is a fundamental requirement for clearinghouses. It keeps the process objective and, since liquidity is crucial for the clearinghouse, offers the ability to keep contracts fungible and simplify the liquidation of contract components.
But it takes a considerable amount of work to ensure that the terms (like product, maturity framework, termination process, and contingencies) are identical. Moreover, electricity trading has some intrinsic impediments to it. Structured deals have always been a concern of the standardized clearinghouse models. Electricity has its peculiar issues of storage, regional characteristics, and congestion pressures. There are requests for unique production or consumption requirements. Differences usually relate to payment, but other attributes such as power-quality differences and location are also common points of negotiated terms that are not standardized in energy contracts. A contract could stipulate interruptible services or a firm delivery. Price requirements may need to accommodate a fuel adjustment mechanism in the supply contract.
Still, any relatively standardized contract can have a segment that is highly negotiated. If the parties want to clear the contract in the clearinghouse, though, they need to convert the nonstandard terms to new ones. Industry participants continue to debate whether the bulk of the risks can be mitigated with standardization.
Since Enron's bankruptcy, the standardization of electricity contracts has increased, due simply to a reluctance to engage in a complicated, unique, "unexplainable" trade. Management and the board of directors would probably find it hard to accept the unique features of an unexplainable trade in the current environment. Furthermore, traders recognize that it is difficult to liquidate a nonstandard agreement and locate a party willing to take on the contract.
The need for electric trade standardization became obvious with the wholesale market disruptions in the Midwest that occurred four years ago. The city of Springfield defaulted, worrying the counterparties to its contracts, but when companies tried to unwind the transactions, they found that contract terms differed in critical ways—even though the contracts purported to sell the same product.
Energy contracts have always had a great number of structured deals, and it certainly is not clear that these should or will go away as the energy market evolves. Instead, the energy clearinghouse model needs to reflect customized production or consumption requirements. This is evident as the utility contracts out its load-serving requirements for retail customers. For this purpose, the utility requires a customized, variable quantity of electricity, difficult to standardize. Clearinghouses may not be able to guarantee these load requirement contracts, but some protection could be provided.
Collateral
All clearinghouse participants have collateral requirements, regardless of the player's capitalization level. Clearinghouses take collateral for each trade they guarantee—the collateral covers any change in the contract value for a one-day price movement. Collateral management policies can change depending on the market, with heightened requirements for illiquid positions or if the market's volatility increases. The collateral calculation is based on statistical analysis and varies among products and marketplaces.
Some clearinghouses use the concept of risk mutualization, which requires all members to contribute capital if another party fails to resolve a financial crisis. If
a member defaults, the clearinghouse needs supplemental funds—contingency resources—beyond collateral. These include such resources as security deposit pools and security funds, guaranteed funds, and clearing funds.
Enron's bankruptcy created a major shift in the emphasis of trading organizations. Before the collapse, most considered online trading systems as convenient and transparent. Price was the single most important factor, while counterparty credit risk was secondary. It was not uncommon to trade on a completely uncollateralized basis. These transactions depended on the inherent financial strength of the companies, at a time when the overall creditworthiness of the sector was satisfactory.
After Enron's bankruptcy, credit counterparty credit risks took center stage. This was accompanied by a drop in trading transactions and increasing concerns of liquidity pressures.
Collateral deposits cover market risk and represent a true balancing act between adequate market protection and efficient use of capital. If the margins are too high, there is little risk, and no parties will want to trade. Conversely, if the margins are set too low, capital will flow freely. Among different clearinghouses, there is a wide range of margin requirements after the initial good-faith deposit:
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Concentration margins are collected when a trader holds a large trading position;
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variable margins will cover price movements for a day or more (depending on the clearinghouse);
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net margins are allowed for markets that are highly correlated; and
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gross margining provides for excess margin collections as extra protection in volatile markets.
Most clearinghouses require the margin positions to be paid the day it is calculated before you can trade an additional position on the next day.
Some More Benefits
Other aspects of clearinghouses offer risk management advantages. Its mark-to-market process mitigates a position's risk and provides stability to the marketplace; and the parties' collateral positions ought to cover the maximum probable change in valuations between the mark-to-mark periods. The calculation is usually done daily with a high probability that the collateral position is sufficient to cover a price movement over a particular period.
Clearinghouses are typically intermediaries. In case of a default, the guarantee extends only to the clearinghouse members. The clearinghouse offers stability and predictability to the marketplace if a default were to occur.
The clearinghouse also acts as a central counterparty. When members exit clearing positions, it is not necessary to go back to the original party. Instead, the position can be unwound with any member of the clearinghouse.
Clearinghouses generally allow netting, which aggregates obligations of highly correlated products and nets them to a single position. This increases efficiency of capital resources, reduces liquidity pressures, and frees up a portion of the balance sheet.
Because a clearinghouse monitors the creditworthiness of its members, it takes away that burden from credit managers at individual companies. The process of evaluating credit issues is timely, even for those with strong ratings. Clearinghouse participation will benefit those with less credit quality, since they transfer some of their risk to others when they enter the clearing system. To that extent, those with better credit quality have to weigh the trade-off between collateral costs at the clearinghouse and more risk with unsecured or bilateral contracts.
Still, the clearinghouse levels the playing field. In the model, all traders (not just select ones) have an equal chance to execute a trade; companies with lower credit ratings have the same chance of clearing trades as the higher-rated ones. These opportunities create market integrity, a transparent system for market participants, strong record keeping, and a reduction in opportunities for market manipulation.
A Risk Management Tool
Like any contract system, the clearinghouse does not give absolute protection to counterparties—also, it needs regulation and control because one of its main roles is to concentrate credit risk. The strategic importance of a clearinghouse mechanism will continue to be debated by the energy sector. Market participants must determine whether a central counterparty could be beneficial to the complex nature of electricity trading—and whether a classic clearinghouse model could be applied to a portion of the marketplace, considering the unique features of electricity.
It is clear there is no single answer for all of the market participants. Several models of clearing or hybrid clearing could exist. However, if there are too many models, the liquidity could be spread too thin across the marketplace.
It remains to be seen if the clearinghouse model will become a viable solution to mitigate risks and alleviate some of the credit gridlock. The model would have to overcome some of the concerns of contract standardization and in some cases a solid delivery framework. The system for energy trading needs to be modular since a one-size standardized feature does not fit all transactions. As these concerns are resolved, solutions will be proposed to mitigate risks. If this risk management tool is accepted by the marketplace, it can assist in restoring investor confidence.
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