COMMODITY CAPITAL REQUIREMENTS
‘Mitigation of operational risk’ is discussed extensively
in the supporting documentation to the new regulations. For example in Europe, Electronic Confirmation Matching (ECM) has been made compulsory for all non-cleared OTC deals. Indeed not all traders currently confirm trades electronically. The three main pillars of the legislation’s require that all ‘standardised’ ...
1. OTC derivatives contracts should be traded on exchanges and cleared through a central counterparty by the end of 2012 at the latest;
2. OTC derivative contracts transactions and holdings should be reported to trade repositories; and,
3. Non-centrally cleared contracts should be subject to higher capital requirements.
For many, the most important element of complying
with the new legislation has become ways to find new sources of margin capital.
Measuring Margin Capital Requirements Clearing of standard OTC derivatives will require
margining (initial and variation); generally replicating the process used by exchanges to clear standard futures contracts, and includes netting of exposures. Companies will need to be able to fund the cash-flows associated with the margining process, and be able to validate the end-of-day margin statement issued by their clearer. This will be a crucial area of intelligence and analysis.
Value at Risk (VaR) is a near academic calculation compared to the vital importance to estimating credit requirements; the numbers may look quite similar
... Dodd-Frank is ahead of its EU counterpart – EU companies should already be checking their US regulatory liabilities
but the consequences of underestimating the amount of margin capital required could be serious. For true margin and collateral optimisation, firms should conduct day-ahead ‘what if’ analysis of the impact of unfavourable, extreme market moves in parallel with their VaR calculation. If value is lost to a company’s credit standing and reputation for not having the appropriate analysis, then such a situation should be in-excusable. Not being able to meet a margin call tells the market
and the counterparties that your firm is a credit risk and traders will stop trading with that firm. By enforcing margining regulators are providing transparency and mitigating credit risk. Wherever possible, OTC derivative trading will take
place in some kind of organised, regulated market, preferably on a robust electronic trading platform
66 March 2012
where prices and volumes are made public. But while the legislation explicitly states “Exchanges” for OTC derivatives contracts trading there are equally valid alternatives. In Europe examples include Organised Trading Facilities, roughly the equivalent of US Swap Execution Facilities. This will provide transparency but will also require margining – a key issue with these legislations. Indeed, clearinghouses themselves could become the new institutions which will be “too big to fail” as Michael Barnier, the French EU commissioner for internal markets and services recently commented. Higher Capital Requirements are yet to be defined in
Europe (ISDA’s document on collateral management best practice is the EU’s preferred benchmark), but there is enough evidence to suggest they will be substantial. What is clear is that the requirement is ‘dynamic’ – the collateral to be deposited is linked to the mark-to-market (MTM) of the underlying position, so the out-of-the- money counterparty will need to deposit further capital to meet the requirement.
Higher Capital Requirements: An Urgent Strategic Issue for Commodity Traders The European financial system has its own challenges
right now. Furthermore, the requirement for trillions of Euro’s of investment over the coming decade will mean finding working capital to support energy and commodity trading won’t be easy to obtain; it never has. This could put commercial banks at the coal face of
energy trading, a position where we can’t expect them to be very comfortable. Specialist investors may be required to supplement and support energy trading activities. And the numbers are large. A study was co-authored
by Sharon Brown-Hruska, a former commissioner and acting chairman of the CFTC concluded that for each of 26 non-financial firms studied, the agency’s proposed definition of a dealer would cost $388 million in margin, capital and other expenses.2 Large European utilities have said they may need
around €1 billion to support trading; while a large international oil firm recently said they could require nearer $2 billion. This transparency from the new regulations will also
inform not only the regulators, but also financiers who will be able, potentially for the first time to see the value that is being created (or destroyed) through a trading book. IAS 39 accounting standard which was brought in after the fall of Enron was supposed to show the exposures of commodity trading but it was complicated to understand and communicate. However, the drawing on large working capital or lines is something that bankers will understand immediately and will watch very closely. If financiers or commercial banks do not understand or
approve of a clients use of a facility, you can be sure that a call will be made to the Chief FinancialOfficer (CFO). If
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