The reporting required to comply with new regulations on trading are the most challenging operational requirement for utilities, says Simon Tywuschik of PA Consulting. Nearly all respondents to a PA Consulting survey expected falling OTC liquidity and rising capital requirements for energy commodity trading houses.
The EU energy trading landscape is not only challenged by falling wholesale prices and asset portfolios, but is also in the midst of a huge regulatory transformation.
Partly, this was initiated by regulatory initiatives such as the Markets in Financial Instruments Directive (MiFID I, 2007) and the first part of the Regulation on Energy Market Integrity and Transparency (REMIT, 20011). The pace of change is increasing: the introduction of European Market Infrastructure Regulation (EMIR, 2013), REMIT reporting (expected to go live in 2015) and MiFD II (expected to go live in 2017) is clearly a paradigm shift in an industry whose operations and business model have been largely unaffected by regulatory requirements in the past.
To understand its status and key lessons learnt for the future, PA conducted a survey to review the state of EMIR implementation amongst the major energy commodity traders.
The biggest implementation barrier has been the lack of regulatory clarity and guidance. In the EMIR case, 80% of participants believe that the European Securities and Markets Authority (EMSA) has not introduced clear, complete and reliable information on EMIR requirements. Although the measure has been in force for more than a year, the energy market still lacks the information and advice it needs. We have found companies still struggle to comply with operational EMIR requirements. In particular, many companies are struggling to achieve all the new reporting requirements, which had to be in place by the deadline in February this year.
As well as compliance, there are also market concerns. On the strategic side, more than nine in ten of respondents expect falling liquidity in the OTC market and rising capital requirements, which will result in increasing trading costs. Moreover, four out of five companies seem to be convinced that adjustments in their trading focus are unavoidable.
The survey revealed that although companies confirm their strong commitment to EMIR and compliance readiness, they still have concerns about how regulators will assess their EMIR implementation once they are audited.
This state of uncertainty is driven by the lack of a complete set of guidance in the regulation, and hence by different opinions on what constitutes a compliant practice.
On the positive side, however, two common implementation barriers in large transformation projects, slow decision making and low resource level, have received limited attention in our survey, demonstrating that organisations are taking the EMIR very seriously.
Three key lessons were learned from the EMIR Implementation:
Business involvement and strategic change Very few companies mentioned a direct and continuous front office involvement in the EMIR project team. This suggests that they may have underestimated the implications of EMIR on their trading strategies and organisational model.
EMIR is clearly more than just a compliance, IT and back office topic. It should have been clear for the industry that EMIR will affect the way the business is executed. EMIR implementation, now accompanied with the introduction of MiFID II, needs stronger focus on front office and risk management aspects and less focus on IT in the long term.
To maintain a competitive edge in the highly competitive environment, front office needs to understand and take into account the impacts from EMIR in its trading and origination activities. As there are often only subtle differences in what affects the EMIR threshold calculation, decision tools and clear information needs to be provided for each trading desk.
Although EMIR and the other measures are widely perceived as cost blocks for companies, they may also present opportunities, given that financial regulation has triggered a huge market transformation, with banks exiting and downsizing their commodity trading activities in the US and Europe.
Embedding financial regulation in the corporate DNA What we learnt from EMIR is that there is a strong correlation between the number of derivatives an energy trading company holds, and the size of project teams executing the implementation work.
Smaller companies with 50 or fewer derivatives have small teams monitoring EMIR.
Larger asset back trading units, with over 1,000 derivatives and double-digit notional value, need an ‘EMIR army’, often allocated into separate work-streams, to manage day-to-day work and analyse strategic impacts – the biggest projects run with 40 staff and more. Currently, many companies downsize their projects, with clearing being the only outstanding EMIR requirement, and hand most activities to line management. However, companies must ensure that knowhow has been absorbed. Since REMIT and MiFID are just around the corner, companies must maintain a high level of know-how to master the future challenges.
EMIR reporting clearly sheds light on the REMIT reporting, so to manage the workload and the technological and regulatory uncertainty, companies should think about a Plan B to fully maintain their ability to trade all their physical business.
Managing ongoing uncertainty and understanding the ‘known unknowns’ Uncertainty exists when situations are complex or unpredictable, when information is inconsistent or when people feel insecure in their own knowledge.
This fits the world of financial regulation – the scope of a financial derivative. As a consequence, companies may oversimplify or overreact to external developments and take suboptimal decisions, thereby risking sanctions, foregone opportunities or stranded investments.
Management tools such as scenario planning can ensure that regulatory impacts on future business models have a high acceptance across the organisation. However, to be able to anticipate regulatory change and to adequately respond, the ‘known unknowns’ must be identified and their impacts analysed.
For EMIR, our survey revealed that the biggest areas of uncertainty are threshold calculation and the margining and clearing requirement. The majority of companies seem not to have prepared or reviewed the requirements of non-financial plus status, clearly indicating a lack of scenario planning. This is a risk especially given the background of the changing definition of MiFID II, and dynamic market opportunities.