Transcript Establishing the Right Approach to Energy Trading Compliance in Light of Changing Regulation Miki Kolobara, Esq. Presented at Energy Trading Operations and Technology Summit.

Establishing the Right Approach to
Energy Trading Compliance in Light
of Changing Regulation
Miki Kolobara, Esq.
Presented at Energy Trading Operations and Technology Summit 2011
November 16, 2011, Houston, TX
Every fundamental change in the market
place requires re-evaluation of hedging
strategies by market participants in order
to reassess:
• Appetite for risk
• Revenue and cash flow
• Hedging or funding costs
• Forecasted market prices
• Operational requirements
• Counterparty or credit risk
2011 © Miki Kolobara, Esq.
2
The Dodd-Frank Act (“DFA”) is supposed to
prevent another financial meltdown by regulating
OTC products even though:
• The very nature of OTC products is inconsistent with
the “one-size-fits” all approach;
• Energy products had nothing to do with the financial
crisis of 2008;
• The liquidity and operational reliability in the energy
markets will be negatively impacted; and
• The increased cost of hedging will be reflected in the
higher cost for the U.S. energy providers and
consumers.
2011 © Miki Kolobara, Esq.
3
Recently, the CFTC finalized the Position Limit
rule. The final rule defining a bona fide hedge
transaction requires that any hedging transaction
must fall in one of 8 enumerated hedging
strategies:
1.
2.
3.
4.
5.
6.
7.
8.
Sales of Referenced Contracts;
Purchase of Referenced Contracts;
Offsetting sales and purchases in Referenced Contracts;
Purchases or sales by an agent;
Anticipated merchandising hedges;
Anticipated royalty hedges;
Service hedges; and
Cross-commodity hedges
2011 © Miki Kolobara, Esq.
4
Before hedging, market participants need to
know their status in respect to every transaction—
swap dealer or end user—because of:
•
•
•
•
Mandatory clearing and margin cost;
Registration and approvals (internal and external);
Capital and margin requirements;
Product volume/type/liquidity at a particular delivery
point could determine the designation.
2011 © Miki Kolobara, Esq.
5
In order to comply with the Dodd-Frank Act,
swap dealers and end users must understand
and implement the relevant business conduct
standards rules:
• Yes, the Dodd-Frank Act imposes business conduct
standards rules on end users;
• Many energy companies do not have the resources or
need a significant risk management infrastructure;
• The Dodd-Frank Act forces most market participants to
elevate their risk management skill;
• It did not work for Lehman Brothers.
• Swap dealers could face a cost-prohibitive legal risk and
drive many away from the market and, thereby, exacerbate
the liquidity concerns even more.
2011 © Miki Kolobara, Esq.
6
The over-expansive definition of a swap will
negatively impact the liquidity and hedging
strategies:
• The proposed definition of “swap” includes some physical
options with embedded volume optionality;
• Thus, all fuel requirements, tolling agreements, well
production agreements, take-or-pay agreements, full
requirement agreements, and many other types of physical
energy transactions could be deemed swaps under the
Dodd-Frank Act;
• The overreaching definition of “swap” imposes additional
obstacles for investing and building energy infrastructure,
especially where the infrastructure is most needed (illiquid
markets).
2011 © Miki Kolobara, Esq.
7
Practical considerations for utilities, load serving
entities, and asset based energy companies:
• Whether to hedge baseload and pass the increased cost on the
customers or risk market volatility and rate instability;
• Whether to invest the capital required for a significant riskmanagement infrastructure (as required by the Dodd-Frank Act)
or to forego hedging altogether;
• How to shift from financial to physical hedging without violating
the anti-evasion provisions of the Dodd-Frank Act;
• The final rule on Position Limits does not allow for “proxy” or
“dynamic” hedging;
• How to ensure that an “over-hedge” or “under-hedge” doesn’t
become a speculative position (and lose its bona fide hedge
status);
• How to comply with the affiliate position aggregation.
2011 © Miki Kolobara, Esq.
8
“This rule will make hedging more difficult, more
costly, and less efficient, all of which, ironically,
can result in increased food and energy costs for
consumers.”
--CFTC Commissioner Jill Sommers, dissenting
from the 3:2 decision by the CFTC to adopt the
final Position Limits rule.
2011 © Miki Kolobara, Esq.
9
UP FRONT DEAL FLOW
ANALYSIS
2011 © Miki Kolobara, Esq.
10
Up-Front Deal Flow Analysis
A clearly communicated set of procedures
outlining the steps or sequence of events should
be followed for every transaction, in order to
ensure that all transactions are analyzed
BEFORE they are executed.
2011 © Miki Kolobara, Esq.
11
Up-Front Deal Flow Analysis
1. It should be a violation of policy manual(s) for
any employee to trade without ensuring that
the transactions can be appropriately
captured, valued and reported in order to
ensure the ability to properly identify,
quantify, and manage risk – end users will be
required to demonstrate this by Swap
Dealers or Major Swap Participants.
2011 © Miki Kolobara, Esq.
12
Up-Front Deal Flow Analysis
2. Each transaction must fall within a specific
trader’s or originator’s approved limits,
adhere to prescribed deal approval process,
transacted using approved instruments, and
fall within all applicable laws and regulations
governing commodities trading in order to
ensure that the traders do not inadvertently
violate bona fide hedging designation,
position limits, end user designation, or any
other Dodd-Frank Act rule.
2011 © Miki Kolobara, Esq.
13
Up-Front Deal Flow Analysis
3. Any new products or markets must be
analyzed and approved in advance by all
relevant departments including, but limited to,
tax, accounting, legal, risk management,
credit and compliance in order to ensure both
internal and external requirements including
relevant Dodd-Frank Act provisions.
2011 © Miki Kolobara, Esq.
14
FRONT OFFICE COMPLIANCE
2011 © Miki Kolobara, Esq.
15
Front Office Compliance
All traders must abide by and stay current
with all applicable rules of the market(s) in
which they trade, including applicable
exchange rules, tariffs, protocols and
manuals in order to ensure compliance with
position limits, bona fide hedge designation,
and end user designation (if applicable).
2011 © Miki Kolobara, Esq.
16
Front Office Compliance
1. All traders should execute an
affidavit stating that they have read,
understood, and will comply with all
the market rules and regulations for
all markets and products they trade.
2011 © Miki Kolobara, Esq.
17
Front Office Compliance
2. All traders should be able to
articulate the business purpose of
their bids/offers and to demonstrate
compliance with approved trading
strategy.
2011 © Miki Kolobara, Esq.
18
EFFECTIVE ADMINISTRATION OF
RISK MANAGEMENT
POLICIES/PROCEDURES:
2011 © Miki Kolobara, Esq.
19
Effective Administration of Risk Management
Policies/Procedures:
The internal risk policy (along with associated
procedures) should be effectively and
proactively administered as a “living document”
to in order to minimize legal and financial
exposure to the enterprise, and ensure that the
policy properly reflects and encompasses the
most current industry standard practices and
standards, and the underlying rules and
regulations governing commodity and
derivatives trading and related activities.
2011 © Miki Kolobara, Esq.
20
Effective Administration of Risk Management
Policies/Procedures:
1. A policy manual should outline the
approved trading strategies and a brief
explanation of those strategies.
2. A mandatory affidavit should be included
requiring all traders to sign it and
providing the penalty for non-compliance.
2011 © Miki Kolobara, Esq.
21
Effective Administration of Risk Management
Policies/Procedures:
3. A procedures manual should be
drafted (or a comparable section
included in the policy) outlining, among
other things, a sequence of events
required prior to executing trades,
including the necessary approvals
required in order to ensure the
documentation requirements of the
Dodd-Frank Act.
2011 © Miki Kolobara, Esq.
22
MASTER AGREEMENT
PROVISIONS IMPACTING RISK
MANAGEMENT
2011 © Miki Kolobara, Esq.
23
Master Agreements Provisions Impacting Risk Management
Triangular Setoff as a risk management tool.
On October 4, 2011, the United States
Bankruptcy Court for the Southern District of
New York issued a new opinion in the Lehman
Brothers bankruptcy case.
The Court refused to allow “triangular setoff”
despite the Bankruptcy Code’s safe harbor
provisions and the language in the ISDA
Master Agreement permitting such setoffs. In
re Lehman Brothers, Inc.
2011 © Miki Kolobara, Esq.
24
Master Agreements Provisions Impacting Risk Management
Under the Dodd-Frank Act, Swap Dealers
or Major Swap Participants may refuse a
transaction if they believe that the end user
does not adequately understand the risks
involved.
2011 © Miki Kolobara, Esq.
25
Disclaimer
This presentation and materials herein are for
informational and educational purposes only
and must not be used or construed as legal
advice for any particular transaction, trading
strategy, or product.
The views expressed herein are solely those
of Miki Kolobara and not those of any of his
employers, clients, trade or professional
associations.
2011 © Miki Kolobara, Esq.
26