Professional Documents
Culture Documents
A Supplement to
OCTOBER 2009
ENERGY
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Men
ulling through 57 publicly reported instances of unauthorized trading and/or improper trade valuation between 1974 and 2009, recurring, actionable themes jump off the page. Your ETRM system may not be able to remedy a star trader culture, or independent prices sourced from a buddy or trades that havent been entered. But in many cases, all the information necessary to detect the problem has been properly captured in the system. The key is knowing what to look for.
The English language has no word meaning he or she and the phrase itself is clumsy and distracting to the reader. Many writers work around this by alternating the use of he or she when the person being discussed could be a man or a woman. But that compromise doesnt seem quite fair in this case. In reviewing published reports of 57 instances of rogue trading, I could find only one case where a female created the losses (Citibank 2003). There are two other cases in China where female supervisors were held accountable for their male underlings misdeeds (Hunan Zhuzhou Smelting Plant 1997, China State Reserves Bureau 2005). Well omit consideration of the male Morgan Grenfell fund manager who showed up in court dressed as a woman. Rogue trading, it seems, is very much a guy thing. So he is used throughout this article.
we were not looking for routine options expiring in-the-money. The report should include the counterparty, trade date, expiration date, delta, trade P&L and value. The risk managers local knowledge of what is normal is critical if were to spot trades that seem to break the pattern. Does anything on the report strike you? Is a lot of value concentrated in a few trades? Do you see any pattern in the counterparties? Focus on the bought options. Are those counterparties real? They werent at Barings in 1995 or at West LB in 2007. If a hole is to be discovered in your accounts tomorrow, it will look like a receivable today. Now, for each open high delta option, rerun the report as of the option trade date. Were looking for two things evidence of an off-market trade price which will show up as a large P&L number and/or a high delta. Options with a high delta when traded merit a closer look. With rare exception, at-the-money or out-of-the-money options are traded. When a broker goes out to market makers for a price, only the expiration date and strike - the price at which the underlying will be bought or sold if the option is exercised - is mentioned. Unless specified up front, strikes above the forward price are calls and strikes below are puts. The implied volatility price for a strike applies equally to the put and call. There may be a legitimate reason for trading a high delta option, such as closing out a specific position to reduce a credit exposure, but that reason should be clarified.
Related transactions
What about instances where the trade date P&L is large? Did prices move that day? If not, were there other related transactions, possibly with the same counterparty? Is there evidence that a gain on one trade was offset by a loss on another? Follow the money. If there is a disconnect between realized and unrealized P&L for the purposes of bonus or budget calculations, the possibility of gaming must be considered. Do these related transactions have the effect of moving P&L from one reporting period to another? Is P&L being moved into or out of the period used to determine bonuses? Both would be problematic, but into is more so. Robbing Peter to pay Paul is one thing. Robbing Peter to pay the traders is another. Out of may be sandbagging. Are bonuses capped in any way? Is P&L in the next reporting period worth more to the traders than P&L this period?
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Triple Point Technology possesses the widest reach and most comprehensive solution of any vendor in the market.
Patrick Reames, Vice President, Trading and Risk Management, UtiliPoint International
Commodity XL provides transparency into risk measures and analytics, allowing organizations to holistically manage and mitigate risk.
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ast years turmoil and changing market conditions reinforced the need for stringent risk management and highlighted business inefficiencies in the distribution network that crude oil producers and other physical market participants cannot afford to ignore. As the industry seeks to cut costs and operate more effectively, pipeline scheduling, crude oil logistics and improved wellhead management are now taking center stage, explains OpenLinks Dr. Wolfgang Ferse Of course, some companies with sophisticated trading operations that already deploy integrated commodity trading, risk, and logistics systems, that can straddle physical and financial markets, have managed to generate handsome trading profits in this challenging environment. Despite such instances of savvy risk management and profit generation, the oil industrys P&L rollercoaster ride during the last 18 months has highlighted that reluctance to aggressively hedge downside risk during the bull market was far from uncommon. In addition, beyond this culture of upside participation, there is a more subtle risk management issue that many oil and gas producers have realized now needs to be addressed- the large hidden risk exposures, business inefficiencies, and systems redundancies associated with production, pipeline scheduling and crude oil logistics. One example, from an efficiency perspective, is the demanding task of managing ownership shares and changes in producing properties, changing marketing arrangements, and calculating estimated and actual wellhead volumes to the custody transport point of sales as well equity and royalty splits, comments Dr. Wolfgang Ferse, OpenLinks Executive Vice President of Commodities and Energy Solutions. Weve noticed a significant increase in interest among producer clients in modeling their deal life cycles in their entiretythat is, including splits and also in improving wellhead accounting, with improved coupling to downstream marketing for energy trading, risk, and logistic systems, he added. OpenLinks ENDUR system has included integrated crosscommodity trading, risk management and logistics functionality for some time, explains Ferse. But, client awareness of the operational risk and inefficiency associated with the transfer of data between disparate trading and risk systems and off-system work arounds has grown, resulting in the current interest to provide a
single, fully integrated solution for straight through commodity life cycle management. To address this, OpenLink has invested significantly over the last years to extend the life cycle coverage of its integrated system suite to cover the producer side as well.
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The snowball
Really big losses dont usually start out that way. They start small and the trader tries to trade his way out. As positions expire, the losses will have to be rolled forward to avoid detection. As the losses mount, the positions being rolled forward grow ever larger. We saw this in the China Aviation Oil fiasco of 2004, for example. Run a report of your P&L on open trades grouped by counterparty. Look for unlucky counterparties; the counterparties to your profitable trades. Do one or two stand out? If so, pull up all trades with these counterparties over the past year. Is there any evidence of trades regularly being rolled over into bigger positions? Pull up all versions of these trades to see changes since inception. Has the quantity or delivery date ever been changed?
data using a statistical tool called the t distribution. Well, it turns out that your theory can be rejected with less than a 1 in 20,000 chance of being wrong. A review of the cases shows that the vast majority amount to coin flips gone wrong, as you assumed. So winning rogue trades are simply not being reported. Is the root of the problem rogue trading or rogue management? *After a liquid lunch, a Morgan Stanley oil trader went short 5,395 oil futures on May 9th of this year. They were closed out at a profit the next day.
Concentrated business
Run a report of your trading volumes by broker. Is your business highly concentrated? Are any of your independent prices sourced from brokers with whom you are doing a large amount of business? In particular, does your portfolio contain a large, non-standard OTC trade? Who is providing the market price used to value this position?
A daily blackout
Does your system have a defined cut-off point when no new trades are entered and reports are generated? This kind of daily snapshot instead of real-time monitoring is particularly susceptible to gaming. Run a report of all cancelled trades. Are there a lot of them? Is there any evidence that trades are being entered for the snapshot and then quickly cancelled before they can be confirmed? Fake trades have featured several incidents including Daiwa Bank in 1995.
Sandbagging
Sandbagging, as used here, is hiding P&L for recognition in a later reporting period. Look closely at your time series of daily P&L by trader. Does P&L arrive either very early or very late in the reporting period? Can money be hidden anywhere? Has there been any change in reserve assumptions? If not, compare volatilities before and after the P&L arrival.
Unlucky?
Are all rogue traders unlucky? An unscientific survey of 57 publicly reported cases of rogue trading between 1974 and 2009 only turned up one instance* where the trades were profitable. If you were to bravely assume that companies will report ALL cases of rogue trading and, less bravely, that rogue trades amount to 50/50 bets, you would have expected roughly 23 instances of winning rogue traders. Lets see how your theory stands up to the
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ith 25 years of steady growth and deep industry knowledge, Allegro Development is the global leader in energy trading and risk management (ETRM) solutions. Allegro helps companies manage all commodities on a single, integrated platform that provides unparalleled visibility into all financial and physical positions, complete logistics functionality and advanced tools that enable strategic decision-making across the enterprise.
To contact a regional office directly, please call: Europe +44 (0)20 7382 4310 North America +1 888 239 6850 Asia Pacific +65 6236 5737 Email info@allegrodev.com www.allegrodev.com
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n 2008, NYMEX became part of CME Group. Together, we offer the most extensive and liquid energy complex in the world, including Light Sweet Crude Oil (WTI), natural gas (Henry Hub), petroleum, and electricity products. Q. What are the biggest challenges facing energy trading companies today and how will CME Group help them address these issues? A. Uncertainty in the regulatory arena is our biggest challenge today, as far as what kind of regulatory changes will be made and when. These changes will definitely affect how we manage risk in the energy markets, and that applies not only to most U.S. companies but to anyone who has to manage risk. CME Group will be helpful in how the energy companies address these issues because of our close regulatory relationship with the CFTC. We have a good opportunity to manage that relationship and also make sure we have the right products and risk management procedures to help our customers. Q. What do you consider the most important advancement that CME Group has made in the past five years? A. Its not really just one advancement but several that have worked together to bring us to a position of industry leadership. With the innovative introduction of CME ClearPort seven years ago we began offering clearing to the OTC energy markets, and we also had the additional foresight to bring in electronic trading. Those were important venues to add, and then when we went to sideby-side trading with the CME Globex electronic trading platform three years ago, that really started the ball rolling toward the globalization of our products. We now offer more than 700 products on CME ClearPort, and have launched 222 products so far this year as we continue to address the hedging needs of our customers. Q. What services does CME Group offer that your competitors do not? A. We offer an unparalleled range of products across asset classes, outside of energy, that includes precious and industrial metals and agricultural commodities, Our customers also enjoy the benefits of cross margining when they trade different products and that makes a big difference in terms of the overall cost of trading. In addition, we are continually introducing new products and we make sure we offer the products our customers need to manage risk. We listen to our customers carefully and that is why we offer products and services that our competitors do not. The combination of all
our products, our global distribution and our industry-leading clearinghouse, make us the largest clearing source globally and give us the ability to manage risk on a daily basis that is second to none. Q. Who is trading energy (electricity, natural gas, crude oil, and refined fuels) these days utilities, oil companies, banks, brokers, or all of the above? A. All of the above. We see with the globalization of our products and our niche products, like our Singapore products and European products, that our reach is 24-7 around the world. We have more than 10,000 global users on CME ClearPort. We are reaching end users who never thought of clearing products in the U. S. and now those companies are our direct customers in a unique marketplace, and are allowing us to address their risk management concerns. Q. Have most energy trading firms made the transition from Excel spreadsheets to sophisticated ETRM systems? Should they? A. Yes, they have I myself tried using spreadsheets back in the mid 80s and it was painful. Absolutely they should switch over to ETRM systems. But most of the switching over actually happened with Enron in the late 90s. When it defaulted in 2001 it pushed the whole marketplace to trading risk management systems and straight through processing, which systems and exchanges should have. Q. What are your leading products? A. Many of our contracts are benchmarks that set the price for these resources worldwide, including Light Sweet Crude Oil (WTI), which is our highest volume product, followed by natural gas (Henry Hub). Our zonal 5MW electricity contracts are also performing well since they were introduced late in 2008. Q. How do people access these markets? A. There are three ways to access to our markets electronically, through CME Globex, via a broker on the trading floor, and through CME ClearPort, which provides a range of OTC clearing services for transactions conducted off-exchange.
For further information please call the CME Group energy and metals hotline at 212-299-2301, or visit www.cmegroup.com/energy
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The smile
The smile is a subset of improper valuation issues. Variants of this were seen Natwest in 1997, NAB in 2004 and BMO in 2007. The value of a standard option is function of the underlying price, the strike price, time to expiration, interest rates and volatility. Four out of five of these valuation factors are transparent. The volatility, the annualized standard deviation of the underlying price, is the only unknown. For this reason, options are actually quoted in terms of volatility, say 10%. The idea being that all the variables can be plugged into an agreed formula to yield the dollar price. The agreed formula assumes a normal distribution. But it turns out that markets behave somewhat differently than predicted by a normal price distribution. Markets tend to both sit still and undergo large moves more often than would be expected if the underlying process was normally distributed. Rather than adopt a more complex formula, the convention is to simply assign a different volatility to each strike. This is called the smile because the lowest vol is typically for at-the-money options, where the strike is near the forward price. Strikes that are away from the forward price are usually assigned higher volatilities. Note that this is not always they case, in which case the smile becomes the smirk.
Offer
Would you like a spreadsheet to help price out-of-the-money options? Price any strike for any date. Inputs are at-the-money volatilities, butterfly and risk reversal prices, interest rates, holidays, and weekend and holiday variance factors. The input information is used to build the volatility surface. To price an option, type in the expiration date, put or call, strike and underlying price. The output is the implied volatility and delta. Results are not reliable below five delta. The spreadsheet assumes vanilla options, no dividends and out-of-the-money volatilities >= at-the-money volatilities. If youd like to receive this free pricing tool, send an email to lhickey@riskltd.com. What can go wrong? Well, if all strikes for a given expiration date are valued against a single volatility, there is an opportunity for gaming. By selling strikes away from the forward price an artificial profit appears if the sales are being marked against the lower at-the-money volatility. However, selling options will produce a short vega - the change in an options price for a 1%
increase in volatility - position and increase VaR. So the trader may buy in the cheaper at-the-money strikes, to flatten the vega exposure while still showing the artificial profit. This is called selling the wings and can be accomplished using a vega neutral call spread, put spread or butterfly. Keep in mind, that at-themoney options have more vega than out-of-the money options. So the trader is selling more out-of-the-money options than he is buying at-the-money options. VaR is still going up. Under certain market conditions, the fear is one direction only. Take stocks, for example. If conditions improve, markets may be relatively orderly and quiet as prices climb the proverbial wall of worry. Think of May to August of this year. If conditions worsen, markets are likely to be panicked and see violent price swings. Think of January to April of this year. The fear is down. Higher prices point to lower volatility and lower prices point to higher volatility. So out of-the-money puts trade at a higher price than out-of-the-money calls. The smile is now a smirk. In this environment, the trader need not take a position in the at-the-money options at all. He can show an artificial profit by selling the put and buying the call. The trade is roughly vega neutral. To determine if your portfolio is short the wings, run a report that shows your vega position by month. Now raise all volatilities by 1% and rerun the report. For each month, if your vega position went up or became less negative, you are long the wings. If it went down or became more negative, you are short the wings. If you are using a flat volatility and you are short the wings, your P&L is overstated. If you are concerned that the position is systematically short wings on one side and long on the other, run the report showing your vega position by month with the underlying price down by 1% and then up by 1%. If youre long calls and short puts, the second vega will be higher. If this is an equity portfolio, your P&L may be overstated. Market prices for this trade, called a risk reversal among other names, are readily available from brokers. Rogue traders are proving to be a persistent lot. The most recent incident at PVM Oil Associates, the worlds largest OTC oil brokerage, was reported in July of this year. But there doesnt seem to be a lot of innovation among them. We see the same old games played time and time again. A savvy risk manager asking the right questions of his ETRM system has to be favored in heads up play. OGFJ
Implied volatility
Larry Hickey started the first foreign exchange options business in Ireland for AIB in 1996. Hickey left the bank in 1998 for the deregulating US energy markets. One of his former colleagues at Allfirst Bank, then part of AIB Group in Baltimore, was John Rusnak, who was sentenced to 7-1/2 years in prison on Jan. 17, 2003, for hiding US$691 million in losses at the bank after bad bets snowballed in one of the largest ever cases of bank fraud. Rusnak was released from prison on Jan. 5, 2009, after serving less than six years of his sentence. For the past decade, Hickey has focused on risk management in an effort to prevent such behavior as Rusnaks. He has worked for several vendors in the ETRM space and continues to collect stories of how rogue traders exploit the very gaps those systems seek to fill.
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here are many opportunities to realize returns through improved risk management along the petroleum supply chain. All energy market players need the right data at the right time for faster and more accurate decisions on fastpaced transactional opportunities. With the extreme price volatility and high trading volumes in the liquid hydrocarbons market, software tools must improve market participants trade floor knowledge of stock levels and feedstock/product qualities, even as they also address shorter-term trades and new deal structures. Optimizing stock levels for risk-free margins in storage plays, blending for better product value, and scheduling flexibility for commercial and arbitrage opportunities are key priorities. Better coordination of trading and logistics will help participants stay ahead of the market.
a vendor as well as P&L trends on particular blending transactions, yield matrices, or credit term flexibility to certain counterparties.
Contract Standardization
Increasing pricing complexity around crude and refined products transactions requires greater scrutiny of the terms of every deal. However, a large percentage of physical trades have similar terms across counterparties, many of which book-out or net-out and never go physical. If data transfer standards are adopted, these deals can lend themselves to automation. The challenge to sharing this data is in reaching agreement between counterparties on a wide swath of physical contract details. This is why the use of industry data integration standards is essential. As market contracts get standardized, either through clearing on the exchange platforms, direct exchange trading, or subscribing to industry organizations such as ISDA or LEAP , the multiple combinations that must be managed are reduced. Further, new CTFC regulatory policies that push for stricter position limits on energy futures contracts may well require going beyond the current documentation requirements calling for new levels of reporting flexibility and transparency.
Dynamic Limits
The recent financial market upheaval illustrates the challenges posed in this complex new environment. Energy derivatives trade around illiquid markets with high volatility and are also exposed to underlying impacts of currencies and interest rates. Traditional risk management practices have focused on placing limitations on maximum exposure to identify and track opportunities and threats. However, there are many cases where the business processes to manage these limits are not updated to the complexity of todays marketplace for example, when oil moves $5 or $10 per barrel in a single day. Similarly, setting static limits on outright or spread positions may restrict market participants ability to squeeze out margin when the opportunity presents itself. Market participants must be able to combine actionable intelligence with detailed P&L attribution and separation of model components. Specifically, they must have the ability to accurately attribute P&L changes resulting from a variety of factors including those arising from market curve shift, deviations in delivered product quality, outturn losses, timing, additional costs, new trades, hedging and pricing events, and so on. Given this, a dynamic set of limits which react to changes in market price levels, changes to volatilities and other factors such as currency rates, interest rates and credit ratings is essential. Combining deep P&L attribution with the ability to set dynamic limits allows companies to better understand where money is being made or lost. Taking this further, the ability to perform what if and hypothesis testing around deal terms, risk, scheduling, credit, etc. is of critical importance for understanding the impacts of different scenarios on position, P&L and true cost basis. Examples would be to estimate changes in quality on supplies from
Automated Data
There is already a key part of the market that has provided full electronic information exchange. The ICE, Nymex and many brokerage houses today already have established standards for providing the market platform and trade information to their customers for the most liquid instruments. Most of these data flows are already tested and secured, and can be configured to enable significant automation of executed trades. Other areas for automation are letter-ofcredit and treasury management, specialized scheduling and tank management, specialized risk systems for value at risk and cash flow at risk, and specialized tax management systems. Market participants need actionable intelligence should a trading spike breach basic trading limits. The solution is to combine detailed P&L attribution, splitting out the components of the model used to calculate the measure, with a dynamic set of limits that better coordinate all functions in the petroleum markets. The resulting flexibility will accommodate new deal structures and create attractive new commercial and arbitrage opportunities for the market participants who employ these practices. David Newton can be reached at info@amphorainc.com or +1 713 339 5600.
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WellPoint Energy Broker (ENB) is an integrated oil and gas marketing solution focused on mid-stream companies. ENB provides dynamic and innovative marketing, scheduling and nomination software designed to manage complex pricing scenarios, streamline supply/demand analysis, and expedite contract and nomination confirmations. It also provides detailed administrative, management and executive financial reports.
Manage the Business: Retain all historical data, denominated in any number of currencies, for comparative reporting Trace every transaction to its source document Evaluate variances between historical production and current month availability to assist in transactional decision making Understand your daily contractual, inventory, imbalance commitments Prepare accurate settlement documents and ensure timely journaling
www.wellpointsystems.com