Miki Kolobara, Esq. Presented at Energy Trading Operations and Technology Summit 2011 November 16, 2011, Houston, TX Establishing the Right Approach to

Miki Kolobara, Esq. Presented at Energy Trading Operations and Technology Summit 2011November 16, 2011, Houston, TX

Establishing the Right Approach to Energy Trading Compliance in Light of Changing Regulation

22011 © Miki Kolobara, Esq.

Every fundamental change in the market place requires re-evaluation of hedging strategies by market participants in order to reassess:• Appetite for risk• Revenue and cash flow• Hedging or funding costs• Forecasted market prices• Operational requirements• Counterparty or credit risk


The Dodd-Frank Act (“DFA”) is supposed to prevent another financial meltdown by regulating OTC products even though:

• The very nature of OTC products is inconsistent with the “one-size-fits” all approach;

• Energy products had nothing to do with the financial crisis of 2008;

• The liquidity and operational reliability in the energy markets will be negatively impacted; and

• The increased cost of hedging will be reflected in the higher cost for the U.S. energy providers and consumers.


Recently, the CFTC finalized the Position Limit rule. The final rule defining a bona fide hedge transaction requires that any hedging transaction must fall in one of 8 enumerated hedging strategies:1. Sales of Referenced Contracts;2. Purchase of Referenced Contracts;3. Offsetting sales and purchases in Referenced Contracts;4. Purchases or sales by an agent;5. Anticipated merchandising hedges;6. Anticipated royalty hedges;7. Service hedges; and8. Cross-commodity hedges


Before hedging, market participants need to know their status in respect to every transaction—swap dealer or end user—because of:

• Mandatory clearing and margin cost;• Registration and approvals (internal and

external);• Capital and margin requirements;• Product volume/type/liquidity at a particular

delivery point could determine the designation.


In order to comply with the Dodd-Frank Act, swap dealers and end users must understand and implement the relevant business conduct standards rules:• Yes, the Dodd-Frank Act imposes business conduct

standards rules on end users;

• Many energy companies do not have the resources or need a significant risk management infrastructure;

• The Dodd-Frank Act forces most market participants to elevate their risk management skill;

• It did not work for Lehman Brothers.

• Swap dealers could face a cost-prohibitive legal risk and drive many away from the market and, thereby, exacerbate the liquidity concerns even more.


The over-expansive definition of a swap will negatively impact the liquidity and hedging strategies:• The proposed definition of “swap” includes some

physical options with embedded volume optionality;• Thus, all fuel requirements, tolling agreements, well

production agreements, take-or-pay agreements, full requirement agreements, and many other types of physical energy transactions could be deemed swaps under the Dodd-Frank Act;

• The overreaching definition of “swap” imposes additional obstacles for investing and building energy infrastructure, especially where the infrastructure is most needed (illiquid markets).


Practical considerations for utilities, load serving entities, and asset based energy companies:• Whether to hedge baseload and pass the increased cost

on the customers or risk market volatility and rate instability;

• Whether to invest the capital required for a significant risk-management infrastructure (as required by the Dodd-Frank Act) or to forego hedging altogether;

• How to shift from financial to physical hedging without violating the anti-evasion provisions of the Dodd-Frank Act;

• The final rule on Position Limits does not allow for “proxy” or “dynamic” hedging;

• How to ensure that an “over-hedge” or “under-hedge” doesn’t become a speculative position (and lose its bona fide hedge status);

• How to comply with the affiliate position aggregation.


“This rule will make hedging more difficult, more costly, and less efficient, all of which, ironically, can result in increased food and energy costs for consumers.”

--CFTC Commissioner Jill Sommers, dissenting from the 3:2 decision by the CFTC to adopt the final Position Limits rule.


UP FRONT DEAL FLOW ANALYSIS


Up-Front Deal Flow Analysis

A clearly communicated set of procedures outlining the steps or sequence of events should be followed for every transaction, in order to ensure that all transactions are analyzed BEFORE they are executed.



1. It should be a violation of policy manual(s) for any employee to trade without ensuring that the transactions can be appropriately captured, valued and reported in order to ensure the ability to properly identify, quantify, and manage risk – end users will be required to demonstrate this by Swap Dealers or Major Swap Participants.



2. Each transaction must fall within a specific trader’s or originator’s approved limits, adhere to prescribed deal approval process, transacted using approved instruments, and fall within all applicable laws and regulations governing commodities trading in order to ensure that the traders do not inadvertently violate bona fide hedging designation, position limits, end user designation, or any other Dodd-Frank Act rule.



3. Any new products or markets must be analyzed and approved in advance by all relevant departments including, but limited to, tax, accounting, legal, risk management, credit and compliance in order to ensure both internal and external requirements including relevant Dodd-Frank Act provisions.


FRONT OFFICE COMPLIANCE


Front Office Compliance

All traders must abide by and stay current with all applicable rules of the market(s) in which they trade, including applicable exchange rules, tariffs, protocols and manuals in order to ensure compliance with position limits, bona fide hedge designation, and end user designation (if applicable).



1. All traders should execute an affidavit stating that they have read, understood, and will comply with all the market rules and regulations for all markets and products they trade.



2. All traders should be able to articulate the business purpose of their bids/offers and to demonstrate compliance with approved trading strategy.


EFFECTIVE ADMINISTRATION OF RISK MANAGEMENT POLICIES/PROCEDURES:


Effective Administration of Risk Management

Policies/Procedures:The internal risk policy (along with associated procedures) should be effectively and proactively administered as a “living document” to in order to minimize legal and financial exposure to the enterprise, and ensure that the policy properly reflects and encompasses the most current industry standard practices and standards, and the underlying rules and regulations governing commodity and derivatives trading and related activities.



Policies/Procedures:1. A policy manual should outline the approved trading strategies and a brief explanation of those strategies.

2. A mandatory affidavit should be included requiring all traders to sign it and providing the penalty for non-compliance.



Policies/Procedures:3. A procedures manual should be

drafted (or a comparable section included in the policy) outlining, among other things, a sequence of events required prior to executing trades, including the necessary approvals required in order to ensure the documentation requirements of the Dodd-Frank Act.


MASTER AGREEMENT PROVISIONS IMPACTING RISK MANAGEMENT


Master Agreements Provisions Impacting Risk Management

Triangular Setoff as a risk management tool.On October 4, 2011, the United States Bankruptcy Court for the Southern District of New York issued a new opinion in the Lehman Brothers bankruptcy case. The Court refused to allow “triangular setoff” despite the Bankruptcy Code’s safe harbor provisions and the language in the ISDA Master Agreement permitting such setoffs. In re Lehman Brothers, Inc.


Master Agreements Provisions Impacting Risk Management

Under the Dodd-Frank Act, Swap Dealers or Major Swap Participants may refuse a transaction if they believe that the end user does not adequately understand the risks involved.


Disclaimer

This presentation and materials herein are for informational and educational purposes only and must not be used or construed as legal advice for any particular transaction, trading strategy, or product.The views expressed herein are solely those of Miki Kolobara and not those of any of his employers, clients, trade or professional associations.

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Miki Kolobara, Esq. Presented at Energy Trading Operations and Technology Summit 2011 November 16, 2011, Houston, TX Establishing the Right Approach to