ENGLAND-CFTC’S
IMPACT ON ENERGY
The Dodd-Frank Wall Street Reform and
Consumer Protection Act became law on July 21,
2010. As a response to the financial crisis, it seeks to
increase accountability and transparency in financial
markets. Much of this legislation is aimed at Wall
Street. New over-the-counter derivatives regulation by
the Commodity Futures Trading Commission (CFTC)
will affect energy companies.
Potential pro-active steps by energy companies
to assess the potential effects of new regulatory
options being considered by the CFTC would examine
staff training and hiring needs, policies and procedure
modifications to assure exempt status, cost/benefit
assessment of non-exempt activities and infrastructure
needs.
A broad energy industry coalition, including the
Natural Gas Supply Association, Edison Electric
Institute, Electric Power Supply Association, and
American Petroleum Institute were active in lobbying
Congress to include energy firms in the commercial
end-user exemption.
|
John England |
This exemption's intent is to allow energy firms to continue using OTC
markets to manage risk and market fluctuations
without being subject to the mandatory
clearing and margining requirements.
The degree to which energy transactions
are included in this end-user exemption
and the overall impact of this new legislation
likely will not be known until the
CFTC completes its drafting of regulations,
a process that could take 12 months or
more.
Of key importance to energy firms
will be how the CFTC defines end-user and
hedging activities. Congress has provided
guidance on how it hopes regulators will
interpret the Reform Act. A June 30th letter
by Sens. Christopher Dodd, D-Conn., and
Blanche Lincoln, D-Ark. aimed to clarify
the intentions of exempting gas and electric
utilities looking to hedge from the
clearing, margin, and capital requirements
of the bill. It stated that "the major swap
participant and swap dealer definitions are
not intended to include an electric or gas
utility that purchases commodities that are
used either as a source of fuel to produce
electricity or to supply gas to retail customers
and that uses swaps to hedge or
manage the commercial risk associated by
its business."
Significant ambiguity remains around
which energy firms will qualify as commercial
end users, as energy marketing and
trading organizations often participate in a
variety of asset-backed transacting activities
to optimize the value of their portfolios.
It appears likely that the CFTC will classify
as narrowly as possible hedging transacting
versus speculative transacting. Once
the regulations are established, energy
firms will need to determine which activities
they are confident will qualify as bona
fide hedges if they do not want to risk their
end-user status. At this key juncture in the
rulemaking process, industry participants
should seek opportunities to confirm the
CFTC's understanding of their business
activities so that regulations can be properly
crafted. The CFTC is likely to initiate at
least 50, and perhaps as many as 100 rulemakings.
Assuring that the concerns of
energy end users are accommodated will
be a challenge for the energy industry.
The full effects of the Reform Act will
not be known for at least a year.
Nevertheless, energy companies can begin
to prepare now for potential outcomes of
the upcoming regulations which may
include tighter cash flows, uncertain
dynamics in market liquidity, additional
transparency, expanded internal and external
compliance oversight and reporting
requirements and global transacting
impacts.
TIGHTER CASH FLOWS
The Reform Act calls for certain derivatives
to be cleared through regulated central
clearing organizations and mandatory
trading through either regulated exchanges
or swap execution facilities, which would
impose additional margin requirements as
compared to current practices of trading
directly with counterparties or through a
broker on credit terms. The cash flows
required to support these transactions
could reduce cash available for new investments
in infrastructure or other strategic
investments, or force energy firms to raise
additional capital through debt or equity
markets. The positive effect for transacting
companies is that the rule changes could
forcibly reduce counterparty credit risk.
Energy companies which transact
both to hedge their commodity risk positions
and to seek incremental gains by taking
proprietary positions should evaluate
this additional capital cost of transacting. In
addition, portfolio optimization transacting
strategies which may appear to have some
elements consistent with speculative activity
should strongly consider and determine
the risk of the CFTC viewing the activity as
speculation, thus placing the company's status
as an end user at risk.
In preparation for the final CFTC regulations,
energy companies may benefit
from reviewing and modifying as necessary
their transacting procedures to ensure they
may confidently claim to be bona fide
hedges. A clearly documented transacting
mandate could facilitate demonstrating
intent in a potential CFTC audit. For firms
where proprietary trading is a core business
strategy of its trading operations, companies
should review their capital allocation
strategy as well as their credit and margining
procedures to be in position to respond
promptly to new regulations.
MARKET LIQUIDITY
The intent of the Reform Act was not
to hinder the ability of end users to hedge
their commercial risk; however, there
remains significant uncertainty of how the
market will ultimately respond. If an energy
company qualifies for the commercial
end-user exemption, it will not be required
to trade through the regulated exchanges
or post additional margin on transactions.
Their primary counterparties on the other
hand, would likely qualify as swap dealers
or major swap participants, and thus be
subject to the additional costs of trading
that appears, at this time, to be the CFTC
chairman's intent. This could potentially
decrease the attractiveness for some financial
firms to participate in these markets,
thus reducing the availability or increasing
the cost of customized swaps to energy
companies.
Energy companies could thus be
forced to decide whether to pay a premium
to hedge with customized swaps which
better match their risk profile, or purchase
more standardized products that do not exactly match the commodity price risks
they are trying to hedge and accept additional
basis risk. This could also reduce
the hedge effectiveness of those derivatives
and introduce additional earnings
volatility into their financial statements.
The lessened liquidity could also contribute
to a widening of bid¬-ask spreads.
In some cases, there may be a regulatory
risk from state public utility commissions,
which may not accept the costs associated
with transaction on 'dark' markets.
ADDITIONAL TRANSPARENCY
By moving certain derivative transactions
to regulated exchanges or swap
execution facilities, market participants
will have increased transparency to transacted
prices. Energy companies previously
had limited visibility into what prices
like products were closing at, giving dealers
a significant competitive advantage
with regard to pricing. The increased visibility
through the use of regulated
exchanges, and the additional reporting to
the CFTC, could contribute to a narrowing
of bid-ask spreads for these products,
with other things being equal.
EXPANDED COMPLIANCE
As the CFTC develops its rulemakings,
a significant increase in reporting
requirements appears likely. Institutions
transacting energy contracts on U.S.
exchanges would have to report to the
CFTC on volumes in addition to standards
they are currently meeting. In addition to
standard reporting, energy companies
transacting derivatives would be subject to
CFTC audits and should be prepared to
demonstrate that their activities fall within
the parameters of the commercial end
user exemption, or that they have complied
with the additional requirements.
Regulatory oversight could expand
beyond the regulation of markets by
treading into the regulation of speculative
behavior, price movement and price
volatility. An increase in reporting would
heighten the risk of misreporting and subject
entities to potential fines.
Reporting may also introduce significant
new requirements relative to positions.
The CFTC may, for example,
require reporting to verify qualifying for
exemption. Reporting on and/or calculating
positions will likely result from CFTC
position limit rules.
Once the exact nature of the new
reporting requirements becomes known,
organizations will face assessing their current
trade capture practices and technology
infrastructure to ensure they maintain
the appropriate data; maintaining data for
reporting to the CFTC using the required
medium and within the required time
frames will also become important. Given
the CFTC chairman's interest in narrow
exemptions, it does not take much to
anticipate that those not reporting as
required would lose exemptions.
GLOBAL IMPACTS
The CFTC in the United States and
the United Kingdom's FSA have shared
information between their respective regulatory
bodies to more effectively track global
market manipulation. Now that the
United States has passed legislation to centralize
regulation, the CFTC must proactively
pursue international agreements for regulatory
standards in the major global markets,
otherwise risk the migration of commercial
transactions to less onerous markets,
further affecting liquidity and potentially
increasing transactional risk.
BOTTOM LINE
The effect on energy companies and
their transacting strategies, supporting
processes, and infrastructure could be significant.
The Reform Act expanded CFTC
regulatory authority and granted a commercial
end-user exemption. However, it is
not well defined where each energy company
will fall within that exemption or what
activities will be permissible to maintain it.
Although the answer may be one year
away, energy companies that want to stay
ahead of these transformational changes
can begin evaluating their businesses today. |