Pre-Trade Risk Management
Energy traders are increasingly requiring pre-trade risk management solutions as they strive to comply with new regulations, maximize trading risk capital, and reduce the discrepancies between the pre- and post-trading environment.
By Guy Isherwood
WHILE THE POST-TRADE risk environment has increasingly been the focus of markets – and have been adequately catered for in many parts of the financial complex – commodity market traders (among others) are now under increasing pressure to manage their pre-trade risk environment more effectively. Dodd-Frank regulation in the United States
and its counterparts in Europe – the European Market Infrastructure Directive (EMIR), Markets in Financial Instruments Directive (MiFID), the Capital Requirements Directive (CRD IV), and Regulation in Energy Market Integrity (REMIT), constitute the real game-changers in energy trading and deal making. They are making a major and ongoing impact on the way in which companies conduct energy trades, manage exposures, comply with legislation, and maximise precious risk capital.
Regulatory Conditions Regulatory policy is being continually rolled-out
in order to secure the financial system following the latest financial crisis. It is the specific goal of legislation to reduce systemic risk in derivative markets. As part of this process, regulators are looking to enforce pre and post trade risk control policies across both the financial and energy markets. In the energy sector this process actually
Commodity market traders are now under
increasing pressure to manage their pre-trade risk environment more effectively
began more than a decade ago following the demise of Enron. Nevertheless, in the US and Europe especially, new trading and reporting requirements are being forced on the industry. It’s a ‘fluid’ process which continues to be adaptive in its construction and deployment. Last year, for example, the CFTC Technology
Advisory Committee recommended that trading firms be required to demonstrate to their trading counterparties and exchanges the existence of reasonable measures in their processes and systems before being approved to trade. In Europe, ESMA is the European body charged
38 December 2012
with safeguarding the stability of the EU’s financial system by ensuring the integrity, transparency, efficiency and orderly functioning of securities markets, as well as enhancing investor protection. The MiFID II proposals include text that implies ESMA will develop commodity derivative position limit standards similar to those of the CFTC. As such, the ESMA Guidelines on pre-trade risk management for automated trading engines are currently being incorporated into national regulations. The ESMA Guidelines cover electronic trading
systems (including trading algorithms) and the provision of direct or sponsored access by an investment firm as part of the service of execution of orders on behalf of clients. In this way ESMA, under the auspices of MiFID II regulations, will require those that provide execution facilities to traders to make sure that they have robust pre- trade risk management structures in place. The major change for energy trading firms is in
increased capital requirements. This has hit utility companies big and small who need to find ways to trade that include pre-trade risk controls. This has led some firms to lower both their
trading activity (or stop it all together in some cases), potentially jeopardising their ability to react to market events because of capital restrictions, and thus restricting activity (liquidity) and efficient market price formation. Whilst a solution to this trading dilemma could be to use a Prime Broker or a bank to access the market on its behalf, energy traders that (for example) use the Prime Broker route to market or trade under another name will be required to provide pre-trade risk management to their credit providers. They are, therefore, increasingly being required to look at their pre-trade risk controls and manage their credit exposures in order to meet these expected regulatory and financial risk management obligations. To be clear, the goal is for trading firms to
demonstrate to the exchange, broker and/or bank that pre-trade risk assessments and systems capabilities are in place, as well as describing their implementation and the internal procedures for maintaining them.
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