Evolution of risk management within energy trading firms

After the financial crisis, regulators across the globe built a spate of new rules that reshaped markets. In Europe, the second Markets in Financial Instruments Directive (MiFID II) came into force at the beginning of 2018. Throughout the process of the directive’s formation, risk managers at energy trading firms panicked in anticipation of the possible impact on everyday trading. Reporting and compliance costs for European banks are estimated to be around 2.6 percent of annual revenues or approximately $4.4 billion a year according to an article in Reuters. In Australia, Singapore and Malaysia, regulators have followed suit in developing complex regulatory environments with the aim of increasing transparency.

As regulatory risks have expanded, geopolitical risks have become much more difficult for analysts to scrutinize. Major market events are having less direct impact on benchmarks and underlying derivatives pricing structures. This, coupled with decreases in volatility across commodities markets, has made it more difficult for energy trading desks to seek out arbitrage.

It is not all been bad news, though. New forms of energy and associated financial products have come on stream in recent years, with global exchanges aiming to carve out new opportunities for energy traders to diversity their portfolios, and manage risks diversified across a different pool of energy.

A new way of approaching risk management for energy traders has been developed over the past few years. While much has been made of banks leaving energy trading markets, that void has been filled by trading houses and other market makers seeking  technological solutions for the new risk paradigms.

Tapping into ETRMs

Energy trading and risk management (ETRM) systems, which have developed in tandem with the markets they serve, are capable of data gathering and data management, and creating the complex risk models that most modern energy risk managers have come to rely upon.

However, given the risks faced by energy trading desks, ETRM systems must provide a range of functionalities. Analytical components are required to cope with regulatory-driven liquidity requirements. Multi-asset risk analytics and valuations must work constantly to provide assessments of a desk or a firm’s exposures at any given time. Multi-model functionalities allow for meaningful planning and position appraisal. Additionally, the ETRM should be able to integrate  with  other software systems, both third-party and bespoke.

Some of the most advanced ETRM systems sit on the cloud, allowing deployment of the systems on a large scale and across geographical boundaries. This is a valuable asset for firms operating in multinational energy markets. Further, a cloud-based ETRM allows a firm to modify software requirements as markets and risks evolve.

An ETRM contains historical data to allow for better risk modeling, sustains high-volume batch processing to help firms meet regulatory requirements and calculates  sophisticated intraday positions  in order to better assess exposures against different risks. The right software solution can provide such enhanced risk analytics tools, offering integrated and automated risk calculation and reporting capabilities.

Previously, risk managers relied on analysts projections, assessing market fundamentals and a limited set of models. Now, the energy trading world has become much more complex, with risk managers needing to quickly reassess the identification of and prioritization of risks. As the markets evolve, ETRM solutions can help firms stay ahead.