The recent turbulence in the European power & gas market has clearly demonstrated that the risk governance frameworks, processes and systems of many trading organisations are not designed to cope with such stress.
The level of volatility seen within the last couple of months is unprecedented, causing significant issues for power trading businesses. This has had major impacts on the ability of energy companies to manage risk and has underlined 3 core challenges that risk functions now need to address:
- As market prices and volatility soar, the risk capital and trading limit capacity become more scarce. This makes dynamic allocation across portfolios and desks vital. Surging mark to market value of contracts leads to a massive increase in credit exposure values. Counterparty limits become intensively utilized and this in turn leads to trading becoming more short-term and liquidity on gas and power forward markets shrinking. As a result, hedging becomes difficult or very expensive.
- A significant increase in margin requirements is another driver for a substantial rise in the cost of trading. Firms may face an urgent need to raise capital or increase credit lines if existing liquidity reserves are not covering the risk of shock margin calls. In December 2021 many market participants were caught off guard by a spread (or arbitrage trade) gone wrong. This situation was challenging for trading firms with margin calls having reached a scale not seen before. The rising cost of funding caused by firms own deterioration of rating and/ or inability to access market liquidity due to credit constraints in general reinforces portfolio stress. Firms are not able to hedge and manage risk efficiently, while facing increasing transaction costs.
- In extreme conditions, risk models do not effectively account for correlations and offsetting portfolio exposures. This causes inadequacies in risk measurement. If under stressed market conditions prices and volatility are significantly higher than those in your historical data set, risk models can underestimate exposure as well as potential P&L swings. It can result in over- or under-statement of risk leading to limit breaches, inadequately hedged positions, larger P&L deviations, and higher risk capital utilisation.
How should organisations respond to these challenges?
It’s clear that business as usual will not suffice in dealing with the current challenges that trading organisations are confronted with. Consider these six steps to better equip your organisation in the face of increasing price volatility:
1. Establish stress test frameworks across risk types
It’s important to consider the interplay between market, credit and liquidity risk, e.g. by concurrently simulating correlated marked and credit moves and deriving the correlations from historical market rates and credit spreads in order to understand the combined risk of the portfolio. Aggregated stress test reporting across risk type will support adequate senior decision making.
2. Develop a contingency funding plan to address your liquidity needs under stress
It is essential to ensure definition and management of trapped liquidity across jurisdictions and understand the interplay of capital, liquidity, and leverage from a resourcing and balance sheet management perspective. The liquidity should be maintained as a contingency buffer to meet net stressed cash flow needs overnight as well as intraday.
3. Calibrate your risk models to account for intraday price volatility
Risk models should be tested to better understand boundaries and inflections in portfolio exposures and identify “hidden” correlations. Extreme intraday price volatility made clear the need for intraday risk measurement and limit tracking which incorporates real time price data into curve feeds and in model analysis and calibration.
4. Reassess your crisis management governance framework to ensure involvement of relevant stakeholder groups from across the organisation
The coupling of market, credit and liquidity risks may have a compounding effect and risk reducing actions when initiated in isolation (e.g. credit) may place strain on other areas (e.g. liquidity). This makes a coordinated assessment across business areas and evaluation of the combined risk of the portfolio crucial. Robust alignment and a clear decision framework involving several stakeholders such as corporate treasury, risk, finance, asset-liability committee, risk and capital committee, and the investment committee ensures quick and coordinated response to issues and challenges.
5. Increase transparency on the cost of trading
Liquidity and credit risk-based incentives should be incorporated by establishing the settlement of costs, benefits and risks in the internal pricing and performance measurement. This would allow for attribution of liquidity and credit risk exposures to individual business areas and their activities. Such internal pricing facilitates more accurate profitability measurement and risk capital allocation and it will necessitate the setup of an appropriate governance and reporting framework.
6. Assess your trading strategies to optimise your cost of initial and variation margin
Companies should create capabilities for smarter decision-making about what trades to enter into based on cost savings in margin utilisation. For example, conducting pre-trade analysis to understand if a specific trade is helpful or harmful to margin requirements and the funding impact of margin. It is important to establish an enterprise-wide view of margin costs and involve multiple business lines so the organisation can evaluate alternative trading scenarios that are driven by lowering capital costs. Funding for initial margin collateral balances needs to be planned into hedging strategy, as well as the amount of cash/short-notice funding facilities to keep in reserve for margin calls.
In the face of extreme price volatility, inaction is not an option. At Baringa, we’re working with CROs to help them respond to this unprecedented challenge. To discuss how we can support your business, contact Andrey Shutov or Henning Bottger.
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