CORPORATE AFTERSHOCK 2 PHẦN 1 ppt

ONLINE TRADING AND CLEARING AFTER ENRON 1 4 1 this point, an Enron insider indicated that of natural gas volume on EnronOnline estimated at 85 percent of total EnronOnline volume, up to

ONLINE TRADING AND CLEARING AFTER ENRON 1 4 1 this point, an Enron insider indicated that of natural gas volume on EnronOnline (estimated at 85 percent of total EnronOnline volume), up

to 80 percent of the volume was once generated by only 10 of the largest market participants Given the bilateral nature of B2B participants and the high credit quality required for OTC trading, the growth of these “ex-changes” post-Enron thus may be limited Nevertheless, the B2B model of exchanges will survive well into the future

Market Transparenc y af te r Enron

EnronOnline and the army of marketers that operated the phones at-tracted over the years a significant number of energy companies that had never participated in energy and/or power trading, especially associated derivatives contracts EnronOnline also prided itself on displaying nu-merous prices both constantly and at a f ine bid/offer spread As such, EnronOnline became a focal point for market information, a point that cannot be overemphasized

N Y MEX prices and data have been available freely for many years, but the same cannot be said for the other two major energy B2B entities discussed in the prior section As such, transparency of market informa-tion in energy markets is bound to fall following EnronOnline’s demise And with the decline of transparent price information, liquidity and ac-tual trading volumes may also suffer

Numerous market rumors abound as to “market plays” that emerged during the final days of EnronOnline There may be some validity to ac-tivities such as attempts of larger and more stable energy companies— and particularly investment banks with energy trading desks—to squeeze Enron and other smaller entities from certain products, especially as smaller traders attempted to exit from their Enron positions at any cost Although these will most likely remain the secrets of traders’ bar discus-sions, this activity is not unusual in less illiquid and/or distressed mar-kets As one trader commented, “For me, [Enron’s failure is] virtually a nonevent, except for discussion of credit issues and Enron’s N Y MEX po-sitions.” He continued to say, “I don’t hear people complaining about it being missing It has, however, opened up opportunities for the N Y MEX, which is pushing very hard to take advantage of the situation.”11

C L E A R I NG A ND CR EDI T R ISK M A NAGEM EN T

P OS T-ENRON

With EnronOnline acting as counter party to every transaction until an offset or match occurred, the credit risk that counter parties assumed

when transacting on EnronOnline was Enron credit risk EnronOnline thus operated as a CCP of sorts, but without the usual time-tested conser-vative safeguards traditionally associated with a CCP (e.g., capital re-quirements, a default fund, margin rere-quirements, periodic mark-to-market

resettlement) A normal B2B exchange, by contrast, is essentially just a

trading platform that preserves bilateral credit agreements between trad-ing participants, just as in OTC derivatives markets However, as Woods (2002) explains, this “constrains the number of market participants that will be eligible counter-parties to any given transaction and thereby re-stricts the growth of the market” (Woods, 2002, p 132)

In that connection, the failure of EnronOnline has focused attention

of market participants on the potential benefits of centralized clearing and settlements for OTC derivatives products Exchanges have for many years coveted the prospect of expanding the role of their clearinghouses and clearing products other than the traditional futures and options Now with energy markets in disarray, several have been offering to clear energy OTC products N Y MEX has led the way successfully for several months ICE has followed by announcing in July that it intends to offer new clear-ing services for OTC power products with the Board of Trade Clearclear-ing Corporation in Chicago

However, the post-Enron environment is in many ways a double-edged sword While the regulated exchanges have expanded into new areas of clearing, many moves to change clearing practices have also stagnated

In particular, the combined impact of September 11 and the fall of Enron have forced insurance companies and investment banks to abandon moves for the creation of insurance-type bonds to be incorporated into the guaranty funds of the exchanges’ clearinghouses Without adequate supplementary capital, OTC clearing by existing exchanges becomes less attractive, especially for the current users and owners of those exchanges Another worrisome consequence of Enron’s collapse is the cancella-tion and litigacancella-tion that surround forward and/or derivatives contracts Many ex-counter parties of Enron are now seeking to renege on the per-formance of such provisions in their contracts One interesting lawsuit in-volves Merrill Lynch’s filing suits against Allegheny Energy, Inc., alleging the nonpayment for the sale of its energy trading business For its part, Al-legheny has cited alleged improprieties that occurred between Merrill and Enron, not to mention “other matters” relating to Merrill’s past en-ergy trading (whatever that may mean)

To date, it appears that corporations are merely trying to unwind their Enron exposure, and they are doing so via the U.S courts Kramer, Pantano, and Erickson have highlighted this problem and called for FERC

to “reestablish the sanctity of bilateral contracts by rejecting the attempts

ONLINE TRADING AND CLEARING AFTER ENRON 1 4 3

of parties to rescind contracts due to unfavorable financial results.” The greatest danger is that a precedent is being set for parties to renege on fu-ture payment and delivery obligations on their derivatives transactions, which could ultimately decimate the marketplace

CONC LUSIONS

It appears that market forces have triumphed, and the fall of Enron is but

a memory Trading is often considered a zero-sum game, and, in this case, there are obvious winners and losers from Enron And, as in all market disasters, the legal fraternity will triumph because litigation will surely continue over outstanding Enron exposures We hope the outcome of such litigation does not adversely impact the nature of derivatives and forward contracts, which could have disastrous results for the global fi-nancial markets and economies

Many markets do indeed benefit after absorbing a market shock This

is certainly the case with Enron As to online trading, the net impact seems to have been benef icial, as the remaining markets have now be-come more efficient Although some market participants have dropped out, the superior business models of the remaining trading exchanges can more easily accommodate energy trading over the long run than the Enron-credit-centric EnronOnline model In this sense, the long-term vi-ability of the energy markets may be well served by the migration of vol-ume away from EnronOnline toward more established and time-tested trading systems

The same can be said for clearing and settlement EnronOnline rep-resented an odd middle ground that did not represent the benefits of a full-blown central counter party settlement agent but, at the same time, did not constitute the pure bilateral credit risk model common to OTC

derivatives At least in the latter case, market participants know to manage

their credit risks By creating a false sense of security, EnronOnline may have actually been worse than either extreme Not surprisingly, both bi-lateral credit risk management and centralized clearing and settlements

of exchange-traded derivatives have gained ground following the death of EnronOnline Again, energy markets will be more solid as these entities carry energy trading, which is expected to benefit them in the long run Another familiar byproduct is always innovation, and, certainly, this will

be the case with clearing

There are also numerous regional considerations in energy markets The home of Enron—the United States—has suffered unprecedented market shocks since the September 11, 2001, attacks and none more so than the various accounting disclosure crises There is no doubt that this

has affected domestic and international energy markets More impor-tantly, as the expected crisis in confidence in the United States builds ap-parent momentum (see Bassett and Storrie, Chapter 2), the importance

of U.S markets for venues of trading, risk-shifting, and liquidity forma-tion will become even more essential

In international markets, the withdrawal of Enron has reduced com-petition and so is a boon for domestic markets This has particularly been the case in the European Union, where new energy markets have been ap-pearing since Enron’s demise The pattern is also similar to the ones ob-served in the United States, where markets such as Eurex (the German/ Swiss derivatives exchange), Euronext-LIFFE, and UKPX (the U.K Power Exchange) have been steadily winning business and introducing new prod-ucts The same applies for more peripheral markets such as Australia, Canada, and Asia

The return to normality (if there ever was such a time) in energy

mar-kets will ultimately be beneficial for all marmar-kets Enron was certainly an aberration, and many lessons will have been learned in online trading and clearing The facility to transact energy trades has not been damaged, and, although there may be some market distortions due to a small loss in price transparency, market efficiency has moved quickly to fill any void

NOTE S

1 For those seeking the lighter side of an Enron-related market analogy, I

rec-ommend Joe Bob Brigg’s “How Enron Works: The Mule Market,” National

Review ( January 22, 2002).

2 “Enron Networks,” Draft Presentation and Internal Discussion Document, November 2001 (on f ile with the author).

3 A cautionary note is that superior platform technology does not always gen-erate liquidity alone, as displayed on numerous global electronic exchanges that operate on substandard systems (e.g., The Korean Stock Exchange).

4 “Enron Networks,” op cit.

5 Energy Info Source (October 18, 2002).

6 Bryce (2002), p 217.

7 Woods (2002), p 125.

8 “A Conversation with the LME’s Simon Heale.” Wall Street and Technology

(April 5, 2002).

9 See note 8.

10 See Computerworld (December 10, 2001).

11 Power and Gas Marketing ( January/February 2002).

1 4 5

7

DO SWA PS NEED MOR E R EGUL AT ION?

To be effective, government regulation must either (1) bring about

a better result than the unregulated market or (2) improve the ef-ficacy of the self -regulating mechanisms of swaps activity, namely, corporate governance, market discipline, and legal certainty To demon-strate the need for further regulation of swaps activity, it is necessary to establish three things:

1 A market failure must exist that regulation might eliminate with-out introducing offsetting distortions

2 It must be shown that current laws and regulations are not suffi-cient to control the problem

3 There must be a realistic expectation that regulation would lead to

a superior outcome

M A R K ET FA I LU R E?

Examination of the failures and market crises of the past few years suggests that market mechanisms continue to function well The self -equilibrating mechanism of the market has consistently absorbed shocks and then allowed business to return rapidly to normal levels Enron is only the most recent—and possibly the most convincing—example of

Portions of this chapter are reprinted with permission from International Swaps

and Derivatives Assocation, Inc., Enron: Corporate Failure, Market Success, 17th

An-nual General Meeting, Berlin (April 17, 2002).

how market mechanisms work to diffuse shocks Further, each failure or market disruption has provided lessons useful in improving the self -regulatory mechanism Procter & Gamble’s problems, for example, led to increased management attention to understanding the risks a firm takes; the Barings failure led to increased attention to controls; and the market disruptions of 1998 helped focus attention on liquidity risk and counter party credit risk Yet, throughout these difficulties, swaps have continued

to grow in volume and are used by an increasing range of institutions Further, the market appears to have handled the Enron failure in an exemplary manner For example, approximately 800 credit default swaps involving more than $8 billion in notional amounts were outstanding on Enron, all of which appear to have been settled without disputes, litiga-tion, or mechanical settlement problems In addilitiga-tion, closeouts occurred

in an orderly manner: Obligations associated with the closeouts were ap-parently paid, where required, to Enron by the counter party, while counter parties that are owed money by Enron will have their claims con-sidered by the bankruptcy trustee Finally, the disappearance of Enron as

a trader appears to have had little market impact as volume moved to other trading firms It is difficult to see failure in the way the market functioned

A DEQUAC Y OF TH E CU R R EN T EN V I RONM EN T

Even if you could demonstrate that market failure occurred, you must also show that current laws, regulations, and standards are not sufficient to cope with the problems encountered in the Enron failure In fact, the Enron bankruptcy is replete with examples of failures to meet existing standards In the Chewco transaction, for example, Enron’s plan de-pended crucially on fulfilling two requirements for not consolidating the Chewco Special Purpose Entity (SPE) in Enron’s books (See Chapters 8 and 10 for a discussion of Chewco.) First, it would be necessary for non-consolidation that the ownership of a subsidiary consist of at least 3 per-cent outside equity; the requirement was not met Although Chewco attempted to treat a bank loan of the required amount as equity, the bank’s insistence on collateralization of the loan caused the outside in-vestment to fall well short of the required 3 percent outside equity at risk Second, it would be necessary to show that Enron did not control Chewco Because Chewco’s manager was also an employee of Enron, however, it is unlikely that this was the case Despite failing to meet the requirements, Enron excluded Chewco from its consolidated financial statements, which led to errors in its reported income and debt These were among the er-rors that f inally were corrected in October and November 2001, after

DO SWAPS NEED MORE REGULATION? 1 4 7 which the market lost confidence in Enron Had Enron followed the rules that were in place, losses in the investments would have been recognized

as they occurred and the restatement might not have been necessary and certainly would have been significantly smaller But it is also true that, had Enron recognized the losses, the market would have seen through Enron’s appearance of creditworthiness and consequently curbed, if not eliminated, its role as a dealer in derivatives

Another example of a violation of standards already in place appears

in the Raptor transactions (see Chapter 8) First, recognizing the value

of the appreciation of a company’s own stock, even if done by means of forward contracts, is inconsistent with accounting principles Second, as the value of the investments hedged by the Raptors and the value of Enron shares fell, the Raptors’ credit capacity deteriorated Instead of recognizing the deterioration by setting up reserves, Enron undertook a series of questionable restructurings that delayed loss recognition but were ultimately unsuccessful Given that the amounts involved were ma-terial, it is unlikely that these restructurings were consistent with current standards

Third, as with Chewco, the Raptors did not meet the nonconsolida-tion requirements But, unlike Chewco, the Raptors did not meet the re-quirements because the SPE that capitalized the Raptors was able to recoup its initial investment by means of a put option Enron purchased on its own stock but settled early In each case, the premium was distributed

to the SPE Because the premium was sufficient to return not only the en-tity’s invested principal but also a substantial (30 percent) return on the investment, the original investors had little, if any, risk left in the sub-sidiaries This lack of capital at risk should have disqualified the Raptors from nonconsolidation

Finally, Enron was obligated to disclose details of the SPE transac-tions, along with Chief Financial Off icer Andrew Fastow’s interest in them.1A great deal of information was disclosed in Enron’s annual re-port, yet assertions were made without support and certain key items were missing or misleading Enron, for example, asserted that the transactions such as those described in Chapter 8 were undertaken on terms that were

“no less favorable than the terms of similar arrangements with unrelated third parties.” But, as mentioned previously, an economically rational un-related party would not have agreed to such transactions, so it was mis-leading to characterize such transactions as having been at arm’s length

In addition, Enron did not disclose the signif icant initial premium in-come ($41 million) distributed by each of the Raptor entities to the LJM2 partnership (see Chapter 8)

C A N R EGU L AT ION I M PROV E TH E

CU R R EN T SI TUAT ION?

Finally, it must be shown that additional regulation would work better than the swaps framework of strong corporate governance, market disci-pline, and legal certainty Strong, effective corporate governance, for ex-ample, is essential to the functioning of swaps activity As the Group of

Thirty pointed out in its 1993 report Derivatives: Practices and Principles,2 senior management attention and involvement is the starting point for risk management Yet, regulators face a difficult task in attempting to

in-f luence corporate governance because each in-firm’s internal controls must

be consistent with its corporate organization, culture, and management style Regulators might be in a position to evaluate governance through

a supervisory approach, but more prescriptive regulatory approaches that involve detailed one-size-fits -all requirements incur the risk of reducing the effectiveness of corporate governance by ignoring the unique gover-nance characteristics of a firm

Second, government attempts to enforce market discipline, while well intentioned, should be approached with caution A major concern among policymakers and industry participants is that regulation can create a moral hazard in a market even in the absence of an explicit government safety net Individuals and f irms might assume, for example, that gov-ernment regulation creates a safer environment than is in fact the case.3 The result is that they take more risk individually, leading to a higher level of risk in the system

The same caution applies to attempts to augment market discipline by means of increased disclosure of relevant information to the market Policymakers have taken steps in the past few years to shore up market discipline through increased information disclosure An example is the Pillar Three of the New Basel Accord, which outlines disclosure standards

and, significantly, carries the title Market Discipline But there appears at

times to be a tendency among policymakers to elevate transparency through disclosure to the status of an end in itself rather than a means to

an end Any policies geared toward increased disclosure and transparency should, therefore, keep three things in mind:

1 It is essential to be clear on the objectives of new disclosures and whether the required information will actually help accomplish the objectives

2 Policies should take account of the explicit costs of new disclosure

in the form of administrative costs

DO SWAPS NEED MORE REGULATION? 1 4 9

3 Transparency policies should take account of the implicit costs of new disclosure in the form of information overload when new dis-closures are added to ones already in place

Early in 2002, there were repeated predictions in the media of new swaps regulation The matter has not been laid to rest, but it is now ap-parent that, even in the wake of Enron, the case for new regulation re-mains weak The proponents of new regulation still have not demonstrated

a market failure; indeed, the main argument seems to be that regulation

is needed because some parts of the industry appear not to be regulated the same as others Further, there is no convincing evidence that sufficient regulatory authority is not already in place Finally, the proponents of reg-ulation have failed to demonstrate that additional regreg-ulation would im-prove the effectiveness of, let alone supplement, market mechanisms

CONC LUSION

Enron’s actions were the result of trying to reconcile two conf licting strate-gies: One was to invest in energy, telecommunications, and other technol-ogy businesses, which required substantial debt; the other was to grow into

a major dealer in swaps, which required substantial creditworthiness Enron executives knew that their firm’s credit quality was essential to a counter party’s willingness to do business with Enron The market would not have

it any other way But rather than adapt the strategies to reality as the result

of experience, the executives apparently sought to make it possible to pur-sue the strategies until they could no longer be reconciled That they chose

to exploit—or f lout—accounting rules as well as the principles of corporate governance to maintain the appearance of creditworthiness is not an in-dictment of market discipline, but confirmation of it It would be tragic if policy actions designed to correct a perceived market failure were to have the unintended consequence of undermining a self -regulatory structure that has proven to work and work well

NOTE S

1 Regulation S -K, Item 404 (U.S Federal Securities Laws).

2 Global Derivatives Study Group Derivatives: Practices and Principles

(Wash-ington, DC: The Group of Thirty, 1993).

3 For problems that persisted in a regulated environment, see, for example,

“Daiwa Bank’s rogue employee allegedly made 30,000 illicit trades Why

didn’t anybody notice?” Time (October 9, 1995).