Monthly Archives: August 2012

Alice’s Adventures in Australia

Liam Denning at the Wall Street Journal has a nice piece today on why Chevron has chosen not to hedge its apparent exposure to fluctuations in the value of the Australian dollar.

The apparent exposure arises from its Gorgon liquefied-natural-gas project. Sales of natural gas are denominated in US dollars, but a large fraction of Chevron’s costs at Gorgon are denominated in Australian dollars. Let’s look at the project’s value measured in US dollars. How are they exposed to fluctuations in the exchange rate between the Australian dollar and the US dollar? A mechanical sensitivity analysis will show the US dollar costs fluctuating as the exchange rate fluctuates, while the US dollar revenues will be constant. That creates the apparent exposure.

Continue reading

Griffin’s Risk Management Superpower

 

The third installment of the feature film series Men in Black features the alien Griffin. Griffin possesses the critical ArcNet shield that can protect the earth against the impending Boglodite invasion. Griffin also possesses an amazing superpower: he can see the many possible futures in store for us. The movie’s writers, director and the actor playing Griffin, Michael Stuhlbarg, exploit this superpower to great comedic effect, first in a scene that takes place in 1969 at Andy Warhol’s Factory, and then later at Shea Stadium where Griffin visualize’s the Miracle Mets’ entirely improbable victory in the World Series later that year. Griffin’s superpower goes an important step further, and this is a key to how the comedy is written. Not only does he see the wide array of possible futures, but he understands, too, which futures are consistent with events as they play out, and which futures are suddenly ruled out by current events. He sees what mathematician’s call the filtration.

Continue reading

Moody’s correction

Moody’s issued a correction today.[1] It had previously tagged as ‘credit negative’ for energy companies, the decision by ICE to move many of its cleared energy OTC swap contracts over to its futures exchange platform. Now Moody’s recognizes that as ‘credit neutral.’ Platt’s coverage is here. Continue reading

Moody’s Slips on ICE

As reported by Platts, Moody’s recently issued an analysis of the decision by ICE, the Intercontinental Exchange, that starting January 2013 its cleared OTC energy swap products would switchover and be traded as futures products. Moody’s called that “credit negative for power producers.”[1]

There are many things wrong with the Moody’s analysis. Continue reading

Exelon’s On- and Off-Balance Sheet Collateral Costs

In covering the Intercontinental Exchange’s decision to move its energy swap trades onto its futures exchange, the Wall Street Journal’s Jacob Bunge and Katy Burne cited data on the power company Exelon in order to highlight how this move might impact end-user costs:

One company worried about costs, Exelon Corp., said in a regulatory filing on May 10 that “even if the new regulations do not apply directly to us, [its power plant subsidiary Exelon Generation] estimates that a substantial shift from over-the-counter sales to exchange cleared sales may require up to $1 billion of additional collateral.”

But the $1 billion figure is only half the story. The other half of the story is the contingent capital that Exelon saves. But since that contingent capital is off-balance sheet, it is commonly overlooked, leading both corporate executives and reporters to significantly exaggerate the cost of using cleared futures exchanges.[1]  In comparing the financing costs of non-margined OTC trades against the financing costs of exchange-traded derivatives, it’s important to look at both the on- and off-balance sheet capital demands.

Continue reading

Turn a Blind Eye to Credit Risk?

When a bank makes a loan to a business it assumes some risk that the loan will go bad. Regulators, when they do their job, demand that the bank estimate that risk and hold capital against it. That’s safe and sound banking.

What if a bank embeds the same loan inside a derivative it sells to the business? Should the regulators treat that credit risk the same and demand that the bank estimate that risk and hold capital against it? Six U.S. Senators say “no.” They want bank regulators to turn a blind eye to credit risk so long as that risk is packaged inside an OTC swap. So much for safe and sound banking.

Yesterday Senator Mike Johanns (R-Neb.), Mike Crapo (R-Idaho), Herb Kohl (D-Wis.), Jon Tester (D-Mont.), Pat Toomey (R-Pa.) and Kay Hagan (D-N.C.) filed a bill (S. 3480) designed to block bank regulators from recognizing the credit risk embedded in OTC derivatives sold to end-users. Naturally the Senators’ press releases wax lyrical about how their bill protects these end-users by lowering their costs of managing risk. This is a dangerous illusion.

All American businesses suffer when the U.S. financial system is made unsafe and unsound. Following on the Dodd-Frank Act, banking regulators last year proposed a sensible rule finally requiring banks to properly recognize the credit risk embedded in the derivatives they sell. That’s safe and sound banking, and if this country can find its way back to a safe and sound banking system all of America’s businesses will benefit.

The proposed bill seeks to reverse course, directing bank regulators to turn a blind eye once again to obvious risks. It’s a seductive proposition. With a stroke of a pen, the Senators believe they can save a few businesses the costs associated with this credit risk. But no act of law can actually erase the credit risk and the associated cost. The proposed bill only encourages more unsound trading and the accumulation of unaccounted for risk. For a short while, certain businesses will benefit by not having to pay full fare for the risks they add to the banking system. It’s always good while the party lasts. But, in the end, we all lose.

OTC RIP

On Monday, the Intercontinental Exchange, ICE, announced that as of January 2013 all of its cleared OTC energy swap products would switchover and be traded as futures products.

This is one of the outcomes of the Dodd-Frank Act’s reform of the OTC derivatives markets. A very large fraction of swap transactions are economically identical to futures transactions, and the only rationale for that portion of the OTC market had always been evasion of regulation. Now, with the OTC swaps market subject to a parallel set of regulations substantially comparable to the regulation of futures contracts, the rationale for trading many products as OTC swaps is gone.

The OTC swaps market will continue to provide customized products not suitable for trading and clearing on futures exchanges, and in its press release, ICE confirmed that that portion of its OTC swaps business would remain: “All uncleared swaps will continue to be listed on ICE’s OTC platform, which will register as a swap execution facility.”

During the debates over reform of the OTC swaps market, much was made of the OTC market’s ability to offer customized products. While this ability was advantageous, its relevance to the size of the OTC market was always exaggerated. ICE’s announcement for its energy products is likely to be just the first in a major switch back to futures trades for a sizable fraction of the OTC market. The exact extent and the timeline for this switch will depend on many factors, including the ongoing battles over how specific rules are implemented and the ongoing shakeout in the future business model for banking.

Follow

Get every new post delivered to your Inbox.

Join 30 other followers