The number of energy companies who have the financial and credit stability to carry out trading transactions on their own has plunged sharply since the collapse of Enron Corp. more than a year ago, causing more and more companies to look toward third-party clearing organizations to bear some of the risk and help restore confidence in the markets, said a Morgan Stanley executive Wednesday.

“I would suspect that the recent history of the energy market…has diminished the number of companies that are quite that self-confident” to go it alone, said John Davidson, managing director of Morgan Stanley, during a joint conference by the Federal Energy Regulatory Commission and the Commodity Futures Trading Commission (CFTC) to explore the need for clearing of over-the-counter (OTC) transactions in energy markets.

“I [believe] there are a larger number of people that are willing to do that [participate in clearing] than there were, say, three years ago,” he noted. Clearing currently is required by regulated exchanges, such as the New York Mercantile Exchange, but it is optional in the OTC markets.

In clearing, “the original contractual obligations that had been entered into and agreed by the two counterparties…are extinguished and are replaced with obligations by and to the central counterparty,” or clearinghouse, Davidson said.

While it sounds good, the clearing process — which lowers counterparty risk, thus allowing credit-poor companies to trade again — may not be right for all companies. A company may believe its ability to make counterparty credit decisions is “materially better” than those of a clearinghouse or other market participants, and that it doesn’t need the protections offered by a clearing organization, according to Davidson.

A company also may not want to risk its capital by joining a clearing organization, which requires members to assume the risks in the event of a default by another member. Likewise, companies may be dissuaded by the fact that their “opportunity for profit is diminished” in the clearing process, he said. On the plus side, however, clearing “minimizes the adverse impact” associated with price volatility.

“It seems to me that clearing processes [have] sort of a classical moral hazard question…especially in the energy field where entities of lesser credit may want to rush in,” said CFTC Commissioner Walter Lukken. “For somebody of lesser credit it’s a good deal to come into that system because they’re passing off that risk to other folks. But somebody with a higher rating, they may actually lose in that transaction. They may be taking on more risk…than they’re getting in return,” he noted.

“I think that the existing clearing structures do not impose unnecessary moral hazard to the extent that participation in the clearing process is voluntary,” responded Davidson. “But fundamentally it’s up to the design of the clearing organization to make sure that moral hazard is minimized.”

Clearing organizations should extend their guaranty protections only to their members, he said. “If I can gain those benefits, but I don’t have to observe the discipline that the clearing member has to observe, and I don’t have my capital on the line, that clearly would be a case of moral hazard,” Davidson told federal regulators.

Clearinghouses are governed by rules similar to the regulated exchanges. They have standards for company admission and continued participation in the group; a collateral requirement for participants — it may be equal to the maximum movement in product price on a single day; clearinghouses are required to have contingent financial resources in the event members’ collateral deposits are not sufficient to cover a member’s default; a clearinghouse guaranty protection generally extends to clearing members only, but there are some exceptions; clearing members frequently agree to what is called “risk mutualization,” a joint sharing of risk if a member defaults; and they agree on a single source for prices.

Avoiding default is the “No. 1 mission” of any clearinghouse and its members, although all are prepared to deal with this possibility, Davidson said. If a clearing party defaults, a clearinghouse must step in and meet the member’s financial obligation. If it doesn’t, “it might as well cease to exist as a clearing organization,” he noted.

A clearing organization has the right to liquidate a defaulting customer’s positions, Davidson said, and it has to carry this out “fairly quickly” — in one day.

He advised that before joining a clearinghouse energy companies should become familiar with the financial and credit conditions of a clearing organization and its existing members, whose names generally are available on the Internet. A clearing organization is only as good as its knowledge of the books and records of its members, according to Davidson.

He noted that other things to look for are:

Testimony later in the day revealed a lack of enthusiasm among energy companies for participating in clearinghouses. “I don’t think we have made it clear to organizations as a whole what specific benefit they’re going to get relative to the cost,” said Charles McElhenie, representing the Guaranteed Clearing Corp. “To get the energy industry to accept a clearing proposition it has to have value, and we’re all trying to figure out what that value is.”

Dennis Earle, president of EnergyClear Corp. described a meeting Monday in Houston among the CEOs of 35 energy companies. When asked for a show of hands as to how many thought clearing would help their company “five raised their hands and three of those represented clearinghouses.”

“They have their own market and it operates very well. The lights stay on,” Earle said, in opposing attempts by financial clearinghouses to force different standards on the industry. Neal Wolkoff, COO of the New York Mercantile Exchange, also opposed any attempt to require markets to go to clearing. “Mandatory clearing could raise costs and add unwanted risks into the system.” He suggested it was more important to push development of the underlying cash and derivatives market, and that part of the reluctance of companies to sign on with clearing organizations was due to the fact that there are three clearing companies currently competing for business. That splits liquidity and companies may be “sitting on the fence, waiting to see which is used.”

The IntercontinentalExchange has expended tremendous time and effort, but has had a problem getting companies to focus on the clearing solution, said ICE’s David Goone. So many branches of a company must be involved and it’s difficult to get people in the companies to push the clearing solution with other departments in their own company.

Edward Comer, vice president of the Edison Electric Institute (EEI), suggested the lack of response was in part because companies “clearly are reassessing their business models right now.” Also, they are waiting to see how FERC’s Standard Market Design (SMD) initiative progresses and the shape and nature of the markets that develop.

Comer detailed work by EEI and other organizations to provide standardized contract forms and the continuing work toward master netting agreements across commodities and across margins. He suggested the most important thing FERC can do is to finish the SMD process, centralizing real-time dispatch on a regional basis and solving the financial congestion issues. Also, he recommended support of bankruptcy law amendments in Congress that would eliminate loopholes which make protection of netting agreements “ambiguous at best.”

Others attendees at the conference pointed out it will be difficult to conform different commodities and unique contracts with special provisions representing practical requirements of business into master agreements. It also was suggested that many companies currently have positioned themselves to limit trading — keeping transactions below negotiated levels so they don’t have to post collateral. If they go to multi-lateral agreements they will have to post collateral starting at zero and they’re not willing to pay the high margins required by the clearing companies. “High price volatility translates to high margin requirements,” one attendee said, adding that there is the additional risk of concentrating risks in a few companies.

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