Managing Risks Effectively with Energy Trading Risk Management Systems

How Straight-Through Processing Reduces Costs?

Energy Trading Risk Management in today’s volatile markets is challenging and demands a robust, seamless, end-to-end integration of various processes for commodity trading activities from the inception point of the trade to post-settlement.

Any particular point in the life cycle of these trading activities can impact an institutions’ overall balance sheet, credit and trading limits, and the existing regulatory framework.

As part of the overall enterprise resource planning strategy, ETRM uses technology and software to integrate trading processes between the front, middle and back offices, often in real-time. An effective ETRM strategy includes managing commodity trading positions and exposures in real time with market-to-market analysis, P&L reporting, and regulatory monitoring.

Why an ETRM System Is Vital?Operational Risks

Financial institutions and investment banks engage in commodity trading using various systems including manual, automated, and often hybrid trading systems for trade execution and settlement, regulatory and accounting monitoring.

The operational risks associated with trading encompass a broad set of risks that are the result of systematic failures, back office and settlement errors, and manual trade-entry errors leading to an increasing number of failed trades. Business process errors and logistical errors also fall under the overall operational risk for an institution. These risks are often segmented within the institution, but on the whole, represent the most encompassing and largest risks an organization faces today. Having a robust ETRM strategy that involves an STP system mitigates these risks, reduces costs, and increases efficiencies.

Real-Time Access To The Markets

Straight Through Processing (STP), is the means by which financial companies utilize technological innovations to streamline the trading process. STP eliminates reentry of data and the manual process often involved with front and back-office operations.

For example, STP eliminates manual entry of trade details by enabling the uploading of trade blotters directly to the system parsing the data and assigning it to relevant fields. This process reduces the human error associated with inputting erroneous trade data.

Given the market volatility in the energy and commodity markets, it’s critical to gain access to real-time positions and data. ETRM systems provide near real-time access for MTM values concurrent with ICE and other exchanges. Automating the functions through electronic processing prevents costly errors due to human mistakes and delays in manual processes. Whether a financial institution, hedge fund or commodity trading firm, STP is necessary for managing real-time market risk and ultimately reducing operational costs.

Internal And Settlement Risk:

Front-to-back-office communications are often segregated and inefficient due to system limitations, different systems and servers from diverse geographical locations. The result often is manual entry or review of trades from the front office to the back office for confirmation. The multiple touches of trades increases the likelihood of errors and can impact a bank’s position, P&L, and ultimately the client.

One benefit of STP is the reduction in settlement and internal processing risk. Following a trade entry, back office personnel often manually confirm and process the trade for settlement to the proper counterparty or internal account. With manual entered and processed trades, checks and balances are needed to review trades for errors.

For example, for each trade that settles manually, at least two different people must process and release the trade to ensure proper settlement instructions. If there’s an error, the trade is sent back to the trading desk, and the process begins all over again, resulting in delays of settlement.

With an STP system, settlement can be processed automatically and efficiently with no manual entries ensuring the trade settles correctly and promptly. In addition to reducing costly errors, an STP is a cost-effective way to reduce processing times for the institution since the preformatted instructions are settled electronically with no human interaction.

Counter-party Risk Agreements And Credit Limits

Often trades are done with counterparties whereby an internal credit facility is established to ensure the counterparty is creditworthy enough to settle a trade and enter into long-dated hedging contracts. Credit documentation, trade limits, position-size limits, and settlement risk limits are all part of the facility. With a manual process, traders must check with a credit officer on the trading desk to determine if limits are sufficient before entering into a trade with a counterparty. In cases where errors occurred or credit checks were not performed, limit violations can result after the trade is booked.

ETRM using STP monitors limits in real-time for any breaches of trading and counterparty limits. ETRM can also seamlessly monitor for violations of credit risk documentation, and standardized legal agreements such as ISDA agreements (International Swaps and Derivatives Association) on file with the credit risk officer.

Regulatory Compliance

A trading system with Straight Through Processing (STP) provides risk officers a clear view of trade impact on the financial accounting standards (FASB rules), profit & loss calculations, and risk management calculations such Value at Risk (VAR). Institutions can use STP to aid in interpreting and monitoring the complexities of FASB rules to prevent violations and quickly spot violations once they occur.

Without a robust ETRM system, noncompliance is a significant risk because often the trading reporting and the regulatory information are typically housed on multiple systems within the institution. With an enterprise-wide ETRM system, a credit officer can see the regulatory violations on multiple commodities and counterparties simultaneously and in real time.

Often regulatory violations are due to a lack of transparency in the process and an inability to develop adequate financial controls as a result. With an ETRM system, the risks can be identified, tested and prevented, saving the institution fines from noncompliance violations and reputation risk associated with those violations.

Mark-To-Market Reporting Risk

With the price volatility surrounding commodities, price risk or market risk needs to be constantly monitored on trading desks for limit violations in trading and position size. The monitoring includes new trades, but also existing positions in oil, gas, and electricity. Trading positions need to brought to fair value frequently using mark-to-market. Mark-to-market measures the variation of the current spot price or forward price with the original price of the contract. Limits as to the size of this variation or market risk component of trading must be established and constantly monitored.

A trade may not be in violation at the time of entry as in the case of a long-dated hedge, for example. However, the market could move adversely against the bank and a costly unwind might occur. Price risk could result from a number of factors including, oil and gas inventory reports, OPEC production changes, geopolitical risks, and macro fundamental changes.

For example, if a trade is deemed a limit violation, the unwind cost, or mark-to-market value must be calculated accurately and quickly since commodity prices can move against a position within minutes. If the offending position is held overnight, the cost could be staggering. Given the high volatility of commodity markets, legacy systems and manual processes can often lead to costly errors and delays.

With an ETRM strategy including STP, mark-to-market can be calculated and monitored in real-time. Saving precious time helps avoid a costly trade unwinds due to trade-entry errors or  limit violations and can save an institution both financial and regulatory ramifications.

Credit risks:

Counter-party credit risk as a result of deteriorating financials can involve settlement risk and credit default. In an environment with multiple systems and manual monitoring, delays often result in identifying credit risks, and if the trades involved are not unwound or dealt with in time, the costs can be staggering.

By having an ETRM system, a transparent view of the credit changes as they impact positions, P&L, and ultimately the balance sheet of an institution can be achieved allowing risk officers to react more quickly and avoid costly losses.

Going Forward:

In our experience, financial institutions that have implemented an effective ETRM strategy see efficiency improvements, fewer violations and as a result, lower costs due to the reduction in violations. By utilizing straight through processing, monitoring position sizes, p&l calculations, trading limit violations, and regulatory violations, can be done in real-time.

The benefit of STP is an integrated, holistic view of the trade life cycle through the front, middle, and back office operations while simultaneously reducing costs, errors, and maximizing efficiencies. With advances in technology, machine learning, RPA, and AI enabled systems can achieve greater efficiencies furthering business improvements at a fraction of the time and cost.