——— FINANCIAL POLICY FORUM ———

DERIVATIVES STUDY CENTER

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                     rdodd@financialpolicy.org                                                                                                                            Washington, D.C    20036

 

 

SPECIAL POLICY BRIEF

 

 

 

"Repairing Trust and Confidence, and

Restoring Liquidity In Energy Markets"

 

Randall Dodd

Director

Derivatives Study Center

 

October 11, 2002

 

 

 

This Special Policy Brief addresses the question of how to raise trust and confidence to energy derivatives markets on the way to restoring liquidity to these markets.

 

To put it bluntly, the markets for electricity and gas derivatives are in shambles, and this has left energy producers, distributors and users in a jam.  There is a lack on confidence that plagues not only the spot market for electricity in California, but pervades electricity markets in many other parts of the nation as well.  The energy sector has lost a tremendous amount of value in terms of the stock market's valuation of its equity, and this has lead to greater problems in raising capital and financing transactions.  One especially critical problem is that many energy merchant firms have become – shall we say, disreputable – and many more are characterized by lower, very low, credit quality.  Nearly all are suffering from very low equity values.[1]

 

Most energy producers, major energy users and energy distributors are finding it far too difficult to engage in forward pricing contracts, or use options to protect against adverse price movements or to enter into fixed-for-float or basis swaps contracts. 

 

There is no one single reason why energy markets have failed to perform as promised by the proponents of deregulation.  The multiple factors determining the market failure might be described by Sigmund Freud as "over determined."  Better yet are the words used by the great wit and sage Yogi Berra to explain the Yankee's loss in  the 1960 World Series, "We made too many wrong mistakes."

 

There are many problems in the energy markets and there is no one silver bullet that will fix all of them.  Nor does the sanguine attitude of the opponents of prudential regulation – that nothing bad really happened and that as proof "the lights did not go out" – convince most energy market participants that laissez-faire is the best thing to do.  After all, it was the deregulated, laissez-faire markets that exploded and then subsequently imploded in the past years. 

 

One critical part of this set of problems that can be fixed is that involving the over-the-counter (OTC) market in energy derivatives.  This cannot be fixed by improvements in the spot or cash market alone.  Even though problems in a cash market can be transmitted to the related derivatives markets, it is also true that markets for derivatives trading have problems of their own.  Even though derivatives prices are derived from energy commodity prices, the derivatives markets are ultimately financial markets and have similar challenges to other financial markets.  Derivatives markets function best when they are transparent (and inefficiency results when they are not); they are best when trading is liquid; they need for adequate collateral in order to best manage individual and market-wide credit risk; and  they need an efficient and dependable clearing and settlement system.  And like all financial markets, the need the means to detect and deter fraud and manipulation. 

 

After all, Enron did not fail due to problems in the spot market – rather Enron appears to have thrived on them – but Enron’s failure did disclose some serious flaws in the structure and normal businesses practices in the OTC derivatives markets.  In general, the lack of liquidity and the abundance of distrust came about not from the failure of any daily energy exchange or spot market but instead the wash trades, other trading scams, failed counterparties and dismal credit ratings of many other counterparties in the energy derivatives markets.

 

Although correcting the cash market will not solve problems in the derivatives markets, fixing the derivatives markets will go a long way to reducing the market pressures that have given rise to the congestion and price spikes in the spot markets.  There are strong economic reasons for the energy market to focus its activities in derivatives markets instead of spot markets.  By comparison spot markets seem an odd and inappropriate way for these markets to price such an important resources, and spot markets are a precarious manner in which to arrange for the delivery and transfer of such resources.

 

Consider the electricity market.  A lot is made about the lack of storage for electricity.  Technically that’s true, but the real economic point is that the capacity to generate electricity can be stored, and this capacity can generate power almost instantaneously.  The capacity can be stored in the form of power plants.  In the short- to medium-term, the supply of the capacity is inelastic because of the time it takes to construct new capacity.  However, within the limit of existing capacity to generate power, the supply is elastic to some degree. 

 

What has not been adequately identified as the crucial economic characteristic of energy production capacity is the high fixed cost of electric power production.  The $1 billion plant incurs enormous capital costs whether it is producing at 25% capacity or at peak.  Once the high fixed costs have been committed to a power plant, then management has all the incentives they need to produce at peak at all times.  So the economic problem should be identified as how to construct long-term capacity when it entails putting massive amounts of capital at risk as a fixed investment.  The need to solve this problem should direct the market towards long-term price risk management and other "supply contracts" that guaranteed an operating profit for the firm.

 

The high fixed cost on the supply side is matched by inflexible use or inelastic consumption on the demand side.  The short-term inelastic demand for power is embodied in the energy efficiency of equipment installed in factories, offices and homes.  Another part is due to the difficulties in charging real time prices for electricity use.  The real flexibility in demand is naturally located in intermediate to long-term decisions, and the markets in which long-term decisions are made are the energy derivatives markets and not in the spot markets. 

 

Markets characterized by high fixed cost on the supply side and inflexibility on the demand side, are not well serviced by spot markets along.  This is all the more the case for markets for important resources such as energy.

 

One illustrative analogy comes from imagining a market for oxygen on Mars.  There is a high fixed cost of transporting the oxygen to the planet and an inflexible demand for its use once people are there.  Relying on a spot market for oxygen on Mars would not likely result in stable oxygen prices; no matter how many reserves and anti-congestion buffers you tried to build into the market, there would always be the threat of extreme market pressures as consumers tried to negotiate spot prices as they turned blue in the face.

 

A better market practice would be to negotiate long-term contracts between suppliers and users before they left Earth.  The same could be said for energy producers and users.  Power plants know there are going to need to sell their output and users know that will need energy tomorrow and the day after and the day after, and so negotiating prices on a day-to-day basis on a spot market is not nearly solving the task at hand. 

 

In this way it is more economical to settle supply and demand quantities and prices in forward-looking derivatives markets.  It enables investors in long-term energy assets to observe long-term prices and to establish long-term delivery or pricing contracts at those prices.  It similarly allows users and consumers to observe their future energy costs and take the best steps to conserve or invest in more energy efficient equipment and structures.  

 

Moving energy trading onto energy derivatives markets requires a more careful structure than simple cash-and-carry markets for most commodities.  These derivatives markets must be liquid and fair, and in order to assure them to be so, there are a few regulations that are in order.  These regulations are the product of the wisdom gleaned from the prudential regulation of U.S. banking markets, securities markets, insurance markets and exchange traded derivatives markets.  In this way these regulations are taxi-tested tough to get the job done of maintaining stable markets while keeping the economy running. 

 

As an indication of the success of the prudential measures, one need merely to appreciate how well those markets are behaving during the past two and one-half years of economic trouble.  The stocks (equity shares) have lost a great deal of their value and many listed firms have gone completely broke.  Nonetheless, the stock market remains highly liquid.  Volume on the NYSE is a high as it was at the peak of the market, and no security firm has gone broke.  Similarly, banks are not failing and there credit losses are no more than what would be expected during an economic downturn.  In fact the mortgage market continues to go gangbusters and is fueling the brightest segment of the economy. 

 

The success of the well-regulated, exchange-traded derivatives markets is similarly noteworthy.  They remain liquid, transparent and free of credit failure.  They are not only resilient in their own right, but they even functioned as a safe haven after the failure of Enron and the subsequent collapse of trading in the OTC energy derivatives markets.  When energy producers and users withdrew from trading with energy merchants, they engaged in a flight to quality and moved their gas and oil positions onto the NYMEX. 

 

These prudential regulatory measures needed for OTC energy derivatives markets are of three basic types.  The first type relates to reporting and registration requirements and is designed to improve the transparency – and thus the pricing efficiency – in the markets.  Reporting requirements also enable the government, and other market surveillance authorities such as exchanges, to better detect and deter fraud and manipulation.  Registration requirements are especially useful in preventing fraud. 

 

Registration and reporting requirements. 

All financial institutions should be registered.[2]  Registration is a means to insure that each financial institution meets key minimum standards; minimum standards should include that the requirement that firms have an operating plan and be well managed; meet minimum capital requirements;[3] employ competent sales agents and other sales staff; and that key personnel do not have criminal records for fraud or similar crimes or that they intend to use the financial institution for criminal activities. 

 

One standard is for competence.  Brokers and agents are usually required to pass an examination that tests their knowledge of their field of finance, e.g. Series 7 exams for stock brokers in the U.S.  Another standard is fiduciary integrity.  Registration also allows regulators to conduct background checks on individuals who have fiduciary responsibility over customers’ funds or who act as brokers, agents or salespeople to customers.  The background checks should test for past criminal conduct because individuals convicted of fraud should not be allowed to act as brokers or other responsible persons (front-line representatives of financial institutions).  An example in U.S. law is that an individual convicted of securities fraud cannot be a registered broker for securities or exchange traded derivatives (futures or options).  However, that same individual can act as a derivatives trader for unregistered OTC derivatives dealers such as the Enron Corporation.  Yet another standard requires that financial institutions be well managed, and that responsible persons or officers at financial institution are designated.  A fourth standard is that a financial firm meet minimum capital standards as a precondition for registration.  The minimum standards should not be so high as to prevent competition from new entrants into the industry, but rather to provide assurance that every financial institution

 

In the case of the U.S., all securities brokers and dealers, insurance agents, banks and other depository institutions, futures and options brokers, exchanges and most managed funds are registered.  Derivatives dealers in the OTC market and financial institutions such as GE Capital are not registered.[4]  Hedge funds are required to register but if they satisfy certain size and investor qualifications, they have no reporting or other regulatory requirements.  Long Term Capital Management was required to report annually to the CFTC on the capital adequacy of its futures trading because it was also organized as a Commodity Pool Operator.

 

These requirements are not a burden to conducting business in the financial sector.  Any successful firm will be well managed and keep records.  No firm or investor will advocate filing false reports to shareholders and the wider public, and the honest ones will benefit if the dishonest are identified and punished.  In order to minimize the reporting costs, the regulatory authority should have efficiently designed procedures for filing applications for registration and reports, and should police the registration approval process to prevent corruption or needless delays.  One example of how regulators can accomplish more efficient filings, is provided by the CFTC’s “fast track procedure” for approval of new futures and options contracts which successfully promise approval within ten business days if the filing meets certain conditions.

 

Together, these standards help prevent fraud on the market and provide assurance that the marketplace is not unduly disrupted by the failures of undercapitalized and poorly managed financial institutions.  Whereas firms should fail when they are badly managed or make disastrous decisions, the productivity of the entire marketplace and the value of the financial industry would not be enhanced by reckless, under-funded new endeavors followed by widespread chaotic failures.

 

Collateral and capital requirements.  

The second type of prudential regulatory measure involves capital requirements and collateral requirements.[5]  Capital requirements function to provide both a buffer against the vicissitudes of the market and a governor on the tendency of market competition to drive participants towards seeking high returns and thus higher risks.[6]  Collateral requirements have basically the same effect, although collateral requirements apply to transactions in particular and not institutions.[7]  Thus non-financial institutions that would  not otherwise be subject to capital requirements would be subject to collateral requirements on their derivatives transactions. 

 

Capital requirements should apply to all financial institutions.  This should include OTC derivatives dealers, such as the former Enron Corporation, that might not otherwise be registered as a financial institution.  Capital requirements should be updated that so they apply to balance sheet as well as off-balance sheet activities and positions.  The rate of the capital charge should reflect both credit risk and market risk (potential future exposure and value at risk (VAR)).

 

Capital serves two functions: first, it acts as a buffer so that when a firm suffers from an adverse event it is less likely to go bankrupt or fail to perform on debt or derivatives obligations to others; and second, it serves as a limitation or disincentive to a firm’s risk taking in so far that it is required to hold capital commensurate with risk.  Capital requirements are critical to prevent the problems at one firm from becoming problems at another firm.  This is especially important for dealers in financial markets because their failure can lead to market problems such as illiquidity (market freeze-up) or meltdown. 

 

Capital requirements also function as a governor on risk taking.  In the context of international capital flows, financial institutions in developing countries would find that the capital requirements would limit their ability to accumulate foreign currency denominated debt in excess of foreign currency denominated assets, and it would similarly limit their ability to finance long-term investments with short-term debt.  While it would not prevent these activities, it would require the financial institution to hold capital in proportion to the amount of these activities and thereby limit it for a given amount of capital.

 

Capital requirements should be based on the assessment of the value of assets, liabilities and positions using current market prices, or assessments based off of current market prices, and not simply the historic or booked value of the assets and positions. 

 

Capital requirements are potentially of several types.  Traditionally, the requirement has been calculated as a simple percentage of assets.  The amounts to a leverage ratio equal to the amount of assets divided by capital.  In the 1990s, the Bank for International Settlements, at the behest of central banks from several industrialized countries, formulated a global standard for capital requirements for banks and in doing so updated the approach by setting capital requirements as a percentage (8%) of risk-weighted assets.  The risk-weight standard required no capital charges on government bonds from OECD countries and only a 20% weight on loans from banks from OECD countries.  Corporate debt was assigned a 50% weight and most other debts were assigned a 100% weight.  This new approach was also important for applying the capital requirements to off-balance sheet transactions, such as derivatives and securities lending, as well as balance sheet assets.

 

The limitations to these both these approaches is that they focused on assessing capital as a percentage of credit risk, and that the assessment was a static measure of that risk.  Credit risk changes with the changes and magnitude of changes in market prices as counterparties experience losses and greater losses.  What is more, credit risk is not the only concern.  Many firms go bankrupt from trading losses due to market price risk, and the potential for these losses is completely ignored in both the leverage ratio approach and risk-weighted asset approach.  

 

Collateral requirements for financial transactions function much like capital requirements for financial institutions: both provide a buffer against financial failure, and both provide incentives to economize on risk-taking by raising the cost of holding open positions.[8]  It helps prevent liquidity or solvency problems at one firm from causing performance problems that impact other transactions and other firms.  In so doing it reduces the costs of the externalities of risk-taking by reducing the likelihood of default on transactions and thereby reduces the market’s vulnerability to a freeze-up or meltdown. 

 

Collateral and margin should be in the form of cash or government securities (or at a minimum liquid, investment grade notes and bonds).  The minimum requirements should be reevaluated regularly by the regulatory authority according to changes in the market place so that they are neither excessive nor insufficient.  Market participants must be required to frequently (usually daily) to adjust their levels of posted collateral to account for changes in the fair value of open positions.

 

The practice of rehypothicating collateral should be limited to ability of the clearing house or clearing and payments system to maintain liquidity and promptly transfer collateral between counterparties.

 

The current market practice for the use of collateral, in so far there is one, is inadequate.[9]  One particularly dangerous market practice is to require small initial collateral levels, but then requires a firm to become "super-margined" if its credit rating drops.  This initiates a large increase in the need for collateral just at the time the firm is experiencing problems with inadequate capital.  This amounts to a crisis accelerator.

 

Orderly market rules. 

The third type of regulatory measures is Orderly Market Rules designed to address the need to maintain an orderly marketplace.  The most important of these is a market making requirements for dealers that helps maintain market liquidity, and another important rule is for the prohibition of bucket shops that reduce trading volume, liquidity and price discovery at central markets.

 

A well functioning financial system requires a highly efficient and dependable system for the clearing and settlement of payments (in local and foreign currency), securities transactions and derivatives transactions.  The clearing of local currency payments is usually conducted through the central bank, often in conjunction with the major banks, which acts as a clearing house to net payments so that clearing banks need only transfer their net obligations to other banks through the central bank.  This process economizes on the amount of liquid assets, i.e. money, government securities or other highly liquid securities, that is tied up in the clearing process.[10] 

 

Clearing houses are an effective means of improving the efficiency and dependability of clearing and settlements for derivatives, securities and foreign exchange.  As such, they should be encouraged, and in some cases required, as part of the regulatory system.

 

Clearing houses greatly reduce the trading risk and credit risk inherent in trading and holding positions in securities, derivatives and foreign currency.  Clearing houses reduce trading risk by providing trade confirmation services, and they can act as an arbitrator to settle disputes regarding trades or the settlement of trades without the delay and costs of court proceedings.  In performing these critical services, clearing houses mitigate several problems.  One, they reduce the number disputed trades because the trade is confirmed daily, and any dispute can be mediated by the clearing house acting as a third party.  Two, they reduce the number of incomplete settlements, known as “fails,” because of the enhanced ability to economize on the payments and securities needed to make delivery.  Three, they improve market liquidity by creating a high standard for credit rating on exposure in the market. 

 

Clearing houses facilitate multilateral clearing that allows for the highest possible degree of netting of trades and outstanding positions.  Consider the example of party A trading with four counterparties B, C, D and E.  Party A buys 100 units from B, sells 180 to C, buys 200 from D and sells 110 to E.  After reporting the trades to the clearing house, party A must present the payment for the net purchase of 10 units and then receive delivery of the units.  The netting process reduces transactions costs because only the net payment in each currency and security need be transferred to the clearing house.  In addition, the clearing house can expand the number of hours during which payments and securities can be made beyond the hours offered by the central bank’s clearing and payment system.[11]

 

Not only does netting reduce each firm’s or individual’s outstanding credit exposure, but the clearing house further reduces credit exposure by converting positions into obligations against their own high credit rating.   In the U.S., clearing houses for securities and derivatives have the highest possible rating, then they also improve the quality of the remaining credit exposure for each investor.

 

While the role of clearing houses mitigates many public interests concerns about orderly functioning of the financial system, they create one very important public interest concern.  A clearing house concentrates a market’s credit risk into a single financial institution.  In doing so it internalizes the potential for systemic failure into the clearing house.  This concentration of credit exposure gives the public regulatory authority good reason to set high capital standards for the clearing house and to maintain oversight to ensure that it is well managed and is operating successfully.

 

In order to protect the integrity of market prices so that they encourage the widest possible market participation and do not signal distorting signals throughout the economy, fraud and manipulation should be strictly prohibited and punishable by civil and criminal penalties.

 

Require large trader position reports. Derivatives dealers and exchanges would have to report each entity that amasses a certain size of position in the market.  This information would be compiled across markets in order to detect and deter market manipulation.  This large trader reporting data has proven very useful by the Commodity Futures Trading Commission in the U.S. for the purpose of market surveillance.

 

Extend “know thy customer” rules to all financial institutions conducting lending, underwriting, repurchase agreement transactions, securities lending transactions, and all derivatives transactions with entities in developing countries.

 

This provision will discourage financial sharpsters from “blowing-up” their customers.  For example, the PERLs served no positive purpose for East Asian investors and were primarily a stealth vehicle for financial institutions in developed countries to acquire long-dated short positions in developing country currencies.[12]  This provision also exists in U.S. securities markets and a comparable measure exists for U.S. banking markets. It should be extended to derivatives markets where there is even greater concern with the implications of large differences between market participants in the degree of financial sophistication.

 

Dealers benefit from the privilege of their role in the market.  In addition to earning their bid/ask spread, dealers are also privy to the most current changes in the market.  Along with this privilege should come the responsibility to help maintain a liquid and orderly market.   U.S. stock exchanges, such as the NYSE and NASDQ, already require that “specialists” act as dealers or market makers throughout the trading day.  In the OTC cash market for U.S. Treasury securities, the primary dealers are also required to act as market makers throughout the trading day.  Those markets have proven to be some of the most efficient and most liquid in the world, and so this supporting market rule has proven its merit.

 

Securities and derivatives markets are not the only part of financial markets where liquidity is essential for an orderly market.  Banks and insurance companies must have a minimum share of their liabilities held in liquid assets.  Banks are invariably funded in large part from short-term deposits and other liabilities and therefore should be required to hold liquid assets, usually call reserves, in order to meet the needs of their deposits or other creditors.  Insurance companies, particularly property and casualty insurance companies whose liabilities are far less predictable than life insurance companies, should be required to hold a minimum share of their liabilities as liquid assets to ensure their ability to fulfill payments on damage claims.  Hurricanes and other large natural disasters can generate enormous damage claims on a property and casualty insurance, and it is imperative that they be able to promptly honor those indemnities.

 


[1] )  There is no official data on the volume in OTC energy derivatives, but widely held to be the case and it the presumption behind the current debate.  The collapse in stock prices of energy merchant firms has been widely reported.

[2] )  This section is written for “all” financial institutions, however it would be reasonable to exempt certain micro finance activities and firms providing micro finance services if loans are small and funding does not come from customer deposits.

[3] )  Note that this public requirement is not out of line with business practice.  Many stock exchanges, including the NYSE and NASDAQ in the U.S., have minimum capital standards as a perquisite for listing on those exchanges.

[4] )  However many OTC derivatives dealers are registered as some other institution such as a bank or securities broker-dealer.

[5] )  The term collateral is used for these purposes to mean the same thing as margin.  And like margin, collateral is presumed to be held in the form of cash or government securities.  When collateral is mentioned in the context of lending, then I will specify that real assets are serving as the collateral for the loan.

[6] )  John Eatwell has raised some serious concerns about the ability of capital held to meet capital requirements to successfully function as a buffer against such changes. See Eatwell, John. 2001. “The Challenges Facing International Financial Regulation.” presented to the Western Economic Association in July, 2001.

[7] )  Collateral should be in the form of cash (money deposits) or liquid government securities, and the government securities should be subject to a “haircut” that is proportional to their price convexity.

[8] )  Reminder: the term collateral is used to mean that same thing as margin because they have the same economic function: a performance bond to protect a derivatives counterparty from performance risk that the other counterparty will fail to perform on schedule (or at all). 

[9] )  For good background reading on collateral provision in OTC derivatives markets in the U.S., read Christian A. Johnson. 2002. Over-The-Counter Derivatives: Documentation.  Bowne Publishing, New York.

[10] )  As an alternative to netting, very highly efficient payments systems can use electronic payments systems to facilitate the use of real-time gross settlements that allows the near instantaneous transfer of gross amounts of funds between counterparties.

[11] )  See Dodd (1996) for a discussion of the economics of clearing.

[12] )  For descriptions of these structured securities and how they are transacted, see Frank Parnoy’s F.I.A.S.C.O. and Randall Dodd. 2002. “The Role of Derivatives in the East Asian Financial Crisis.” In Lance Taylor and John Eatwell (editors), International Capital Markets: Systems in Transition.  Oxford University Press.