Betting the Business

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.

First, it confuses ICE’s cleared OTC swap products with other types of swaps. Moody’s emphasizes that futures have

…standardized contract terms compared with more customized swap arrangements. But the standardized futures will create challenges for effectively hedging electricity because they expose power producers to basis risk.

Here Moody’s is confusing customized swaps with the specific ICE swap products being moved over to its futures platform are not customized. As noted in an earlier post, many, many swap products are not especially customized, and that’s true of these ICE products. Power producers who currently use these ICE swap products for hedging can continue to use them afterwards, with all of the same terms. They will just be called futures. There will be no additional basis risk.

Second, Moody’s looks at on-balance sheet liquidity requirements and ignores completely the off-balance sheet liquidity requirements. The report states that

An industry shift toward futures will increase collateral requirements because exchanges require daily margin settlement versus other collateral agreements negotiated in bilateral swaps. For example, EFH held $1 billion in cash from counterparties for over-the-counter and other non-exchange-cleared transactions on an approximately $2 billion, in-the-money position for OTC products at year-end 2011. EFH’s counterparties would have to post approximately another $1 billion if using futures contracts and collateralize their payables 100% to EFH’s account at the futures exchange.[2]

In a paper with my colleague, Antonio Mello, we have shown that a margined futures contract places no additional capital or liquidity requirement on an end-user than does a non-margined OTC swap contract. The swap contract entails an off-balance sheet contingent loan. Moody’s analysis in this report ignores this off-balance sheet contingent loan. Switching to a margined futures contract does impose collateral requirements, but it simultaneously releases the company from the off-balance sheet contingent capital claims.

The net effect is not net negative for a power producer. At least is shouldn’t be if credit rating agencies like Moody’s would pay equal regard to these contingent capital requirements.

The Moody’s report on EFH focuses on its on-balance sheet collateral. But a look at the company’s 10K reveals that its OTC swaps contain significant explicit contingent capital calls. The same is likely true for EFH’s counterparties. Moody’s cited Exelon as a company with a credit outlook negatively impacted by a move away from uncleared OTC swaps to cleared futures; in an earlier post I illustrated the positive half of the picture for Exelon.

It’s a shame that Moody’s pays so little regard to that half of the credit equation.