CORPORATE AFTERSHOCK 2 PHẦN 1 ppt

ONLINE TRADING AND CLEARING AFTER ENRON 141 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 Transparency after 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 fine bid/offer spread. As such, EnronOnline became a focal point for market information, a point that cannot be overemphasized. NY 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 NYMEX po- sitions.” He continued to say, “I don’t hear people complaining about it being missing. It has, however, opened up opportunities for the NYMEX, which is pushing very hard to take advantage of the situation.” 11 CLEARING AND CREDIT RISK MANAGEMENT POST-ENRON With EnronOnline acting as counter party to every transaction until an offset or match occurred, the credit risk that counter parties assumed 142 ENERGY AND DERIVATIVES MARKETS AFTER ENRON 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 requirements, 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. NY 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 Clearing 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 litigation 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 143 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. CONCLUSIONS 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 beneficial, 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 144 ENERGY AND DERIVATIVES MARKETS AFTER ENRON 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 markets. 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. NOTES 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 file 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). 145 7 DO SWAPS NEED MORE REGULATION? D AVID M ENGLE T o 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. MARKET FAILURE? 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). 146 ENERGY AND DERIVATIVES MARKETS AFTER ENRON 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 addition, 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. ADEQUACY OF THE CURRENT ENVIRONMENT 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 finally were corrected in October and November 2001, after DO SWAPS NEED MORE REGULATION? 147 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 Officer Andrew Fastow’s interest in them. 1 A 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 significant initial premium in- come ($41 million) distributed by each of the Raptor entities to the LJM2 partnership (see Chapter 8). 148 ENERGY AND DERIVATIVES MARKETS AFTER ENRON CAN REGULATION IMPROVE THE CURRENT SITUATION? 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- fluence corporate governance because each 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 firms 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? 149 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 regulation would im- prove the effectiveness of, let alone supplement, market mechanisms. CONCLUSION Enron’s actions were the result of trying to reconcile two conflicting 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 flout—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. NOTES 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). [...]... were abandoned or prohibited altogether In fact, structured finance—that part of corporate finance making use of special purpose entities (SPEs )1 is a sound business management tool when appropriately deployed Further, the development and growth of this market has contributed substantially to both the American consumer and corporate prosperity characterizing the United States’ most recent economic expansion... Enron’s vehicles were contrived to hide or delay the impact of poor investment decisions ,2 hide debt, and manipulate revenue streams on certain derivatives transactions.3 Through the simultaneous failure of a number of usual safeguards surrounding use of these structures, Enron was able to create structured 15 3 15 4 STRUCTURED FINANCE AFTER ENRON f inancing partnerships that bear virtually no resemblance... products allow investors to own a 15 6 FIGURE 8 .1 Assets Securitization Process Asset Originator or Sponsor of SPV Payment for Assets with Funds Obtained from Investors SPV (Trust, Corp, Partnership, etc.) Purchase Price of Securities Interest and Principal Equity Contribution Residual Interests in Assets Debt Investors Equity Investors AN INTRODUCTION TO STRUCTURED FINANCE 15 7 particular piece of GMAC’s... dramatically and now includes credit card receivables, corporate trade receivables, aircraft leases, stranded utility costs, plant projects, patents, and more The underlying assets may be mortgages, auto loans, credit card receivables, or a myriad of others; the securitization process in general, regardless of underlying asset, is summarized in Figure 8 .1 Investment Demand Who buys these securities and... definition and the roles of each party in structured transactions become clearer in the later examples Structured finance as we know it today has its origins in two different phenomena dating back to the 19 70s: securitization and the use of special purpose subsidiaries After discussing these two seminal early vehicles, several more recent and popular structured f inancing innovations are also presented... SPE—that then issues the securities to investors Interest and/or principal paid on the new securities are financed by cash f lows accruing to the underlying asset pool AN INTRODUCTION TO STRUCTURED FINANCE 15 5 Asset Divestiture The origins of securitization can be traced to the American residential housing markets Government-sponsored enterprises (GSEs), such as the Government National Mortgage Association... cases, the securities issued against the underlying assets represented obligations of the SPE rather than of GNMA or FNMA itself We return to this very important separate entity concept later In March 19 87, Sperry Corporation undertook what is widely regarded as the first major securitization involving nonmortgage assets—an engineered security whose cash f lows were backed by the receivables on Sperry’s... has been rife with reference to the large number of partnerships in which Enron was apparently hiding assets and debt from the general investing public In consequence, many now believe that legitimate corporate finance should not involve special purpose entities or, alternatively, that current industry standards and practices surrounding use of such entities must be drastically altered Some have suggested... used in extrapolating Enron’s behavior to the need for greater regulation Bockus, Northcut, and Zmijewski return to the issues of accounting, disclosure, and regulation of structured finance in Chapter 10 TH E E VOLU T ION OF S T RUC TU R ED F I NA NC E Structured finance is a term widely used but rarely defined For the purposes of this chapter, we stick to the simple and broadly accepted definition... helps ensure that the investor takes on only risks it desires—in this case, those of a diversified population of car loans The SPE’s primary purpose in this case is to achieve what is often described as corporate separateness.” Simply incorporating a separate legal entity with legal title to the underlying assets in question does not alone constitute “separateness.” Legal, accounting, and regulatory standards . Source (October 18 , 20 02) . 6. Bryce (20 02) , p. 21 7. 7. Woods (20 02) , p. 12 5 . 8. “A Conversation with the LME’s Simon Heale.” Wall Street and Technology (April 5, 20 02) . 9. See note 8. 10 . See Computerworld. (December 10 , 20 01) . 11 . Power and Gas Marketing ( January/February 20 02) . 14 5 7 DO SWAPS NEED MORE REGULATION? D AVID M ENGLE T o be effective, government regulation must either (1) bring about a. void. NOTES 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 , 20 02) . 2. “Enron