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Financial services

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Managing shifting regulation

Allegro Development’s James Brown explains the benefits of adopting an automated solution to meet constantly evolving regulation today.

EU legislation to enhance accountability in the wholesale energy trading markets has arrived. But even as rollouts unfold for the European Market Infrastructure Regulation (EMIR) and REMIT regulatory regimes, little clarity has been established. Deadlines shift, details change and the traders affected wonder what to do next to prepare for the impending requirements, restrictions, regulations and penalties for non-compliance.

The option is clear – automation is the best business decision

James Brown, Allegro
 
In response to the global financial crisis, the G20 agreed a series of reforms in 2009 to improve transparency in over-the-counter derivative markets, mainly through the reporting of trade activities to trade repositories. Since then, a lack of agreement on data formats, complicated by privacy laws and further confused by the growing number of active repositories participating in the reporting scheme, has made the rollout of new rules a stop-start affair. Regulators have pressed on regardless, holding companies accountable for changes the regulators themselves don’t fully understand.

The shifting landscape continues to perplex rule-makers and traders alike. Ambiguity in timing and details of regulations is causing wholesale energy traders much anxiety over their next steps toward compliance. Most companies have hesitated to act for fear of investing in solutions that turn out to be expensive dead-ends. The alternative of abandoning hedging strategies and capitulating to higher prices has almost seemed the lesser of the two evils.

In a recent survey conducted by Chatham Financial, 74 per cent of European and US treasury and risk management officials said they were not prepared for EMIR compliance. No wonder then that 13 per cent of the Chatham Financial respondents said they expected to hedge less or stop hedging altogether; or that 47 per cent said that they simply plan to pay higher prices; or that 40 per cent said that they would seek alternative ways of managing risk.

All energy market participants now need to register with national regulators. In the particular case of non-financial counterparties, only companies that exceed a ‘clearing threshold’ will be required to have their contracts centrally cleared. This means that non-financial counterparties dealing in derivative contracts must have an active monitoring capability in place to preserve their clearing exemptions.

That will require proper means of reporting, clearing and demonstrating risk mitigation in order to comply with new rules and continue operating under a hedging strategy. Furthermore, if a company’s operations cross-regulatory borders, specialised processes will need to be in place, as in most cases, harmony among the various regulatory bodies is unlikely.

The solution
Despite the lack of clarity around when and how many of the EMIR and REMIT rules will be implemented, there are alternatives in terms of what companies can do now to prepare. Managing the process manually is not one of them. There are electronic reporting and data storage requirements involved in each of the regulations that will quickly overwhelm manual processes, economically and technically.

Outsourcing may be a solution, but it comes with its own cost and risk. There is the added overhead of an ongoing contract to manage, and how active you are in the energy trading arena will determine your breakpoints financially. It’s worth bearing in mind that a third party provider would most likely not be held responsible for paying fines should any errors or missed deadlines occur. And, even if you could negotiate a contract that held them financially liable, what would an infraction mean to your brand? The collateral cost of cleaning up reputational issue can have far reaching consequences.

That leaves accepting higher prices by abandoning a hedging strategy altogether – not a good thing for your bottom line – or automating the process. The option is clear – automation is the best business decision.

Automating regulatory processes requires a basic energy trading and risk management (ETRM) system. A regulatory solution for commodity trading and corporate financial compliance is generally not a stand-alone application. Contract data, hedge accounting, revenue allocation in line with regulatory reporting requirements and other special functions do not happen in a vacuum.

A good ETRM should be able to:
• Efficiently execute trades
• Ensure trade compliance
• Enhance market intelligence
• Improve decision-making
• Uncover opportunities
• Identify best options.

If you have to bolt together various separate systems to have these capabilities, you need to stop and reassess. A robust ETRM capability can be achieved without massive customisation, which in turn minimises disruption to your business whilst it’s being deployed. I would also advise sourcing one with a component-based architecture so you can scale the solution to fit your needs, now and as your company’s business evolves.

There are software vendors with long tenures in the energy trading business, tracking the regulations as they evolve. In light of the evolving standards proposed by EMIR and REMIT, you will want to choose a solution that allows you to quickly and efficiently upgrade and manage your regulatory compliance process. Another qualifier to consider is the ability to install software on a captive system and maintain it internally, or purchase a software-as-a-service contract and maintain it virtually in the cloud. Implementing this option could affect your overall total cost of ownership as you integrate the system into other areas of your business.

Core to any solution would also be direct connectivity to trade repositories, including all required regulatory identifiers and formats. To that end, you don’t want to have to compile your data in one resource and then have to send it through a separate channel just to file; the connection should be built-in. The system should be able to simplify your threshold monitoring and facilitate risk mitigation obligations, including periodic portfolio reconciliations under the new rules.

All this leads to making an appointment for a program test-drive. Consider the user interface. Is it intuitive? Will it be easy to learn? How will your core data run on the system? Will your vendor be able to assist in the migration? Do they offer training?

Despite delays, deadlines are looming
As the regulation clock continues to tick, market participants face an uphill battle to understand and meet the obligation that new rules will impose. When the current ambiguities are cleared up and firm deadlines reset, everyone will be expected to switch on quickly. Failure to comply will be met with stiff penalties.

Energy traders planning to maintain a hedging strategy to mitigate risk will need to address the compliance conundrum. An automated solution offers the best alternative to meeting the requirements, given the evolving standards and timelines that define today's regulatory environment.

James Brown is senior energy consultant, EMEA for Allegro Development

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