Houston, 22 December 2010

The Dodd-Frank Wall Street Reform and Consumer Protection Act become law some 150 days ago, bringing with it the promise of comprehensive market reform via the regulation of swaps, the derivative financial products that have been cast by many as the root cause of the 2008 financial crisis.

Specifically, the Dodd-Frank bill was passed with the intent to:

• Regulate Swap Dealers by subjecting them to capital and margin requirements, effectively preventing any individual dealer from getting too big to have undue influence in the market;

• Increase transparency and improve pricing in the derivatives markets, by requiring near real-time reporting of market activities, allowing regulators to better "police" the markets.

• Lower risk to the American public by moving all, or as much as practical, of the standardized derivatives to centrally cleared markets, increasing transparency and decreasing the likelihood of systemic market defaults which could endanger the integrity of the financial markets.

While the full impact of the legislation for companies operating in the energy space is yet to be determined, it is clear that the effects will not feel the same for all market participants. Clearly, major banks and the largest energy companies, many of which play the role of "market makers," will be the most impacted, being hit not only with new aggressive reporting requirements, but also facing the yet to be determined position limits, and potentially, depending on their ultimate classification, the new capital and margining requirements.

In reality, most companies trading energy derivatives will not be subject to the position limits or capital requirements as their volume or style of trading will not elevate them into the threshold of Swap Dealer or Major Swap Participant; nonetheless, they will not be immune to all the effects of the legislation. In fact, the yet to be fleshed out reporting requirements will most certainly be the component of the new law that will have the greatest impact on the largest number of market participants, and will be the most costly to the industry as a whole.

Lots of Activity … But Progress?

Gary Gensler, the chairman of the Commodity Futures Trading Commission (the agency tasked with implementing and enforcing Dodd-Frank), appeared in front of congress last week and announced that the CFTC would not be able to meet a January 17 deadline for establishing position limits for energy (and precious metal) contracts. And he indicated that until the agency has appropriate reporting and market clearing mechanisms in place, the CFTC is going to have to proceed in incremental steps, phasing in limits over an extended period of time, something not envisioned in the original legislation.

The CFTC last week also released new estimates of the impacts of Dodd-Frank, noting that some 40 energy traders would be impacted by spot month limits currently being considered.

And in a significant change of regulatory reach, the CFTC is now proposing allowing banks to keep both hedging books and speculative books, where hedging book would not count against speculative positions. This is a major change in scope from what was originally envisioned when the legislation was drafted and is a revision which may ultimately allow many banks to continue much of their pre-regulation energy trading activities.

Real World Impacts

This process of developing a new regulatory framework covering a significant portion of the energy trading markets is obviously complex and its impacts cannot be underestimated, even as they are not yet fully understood.

What does seem certain though, that for virtually every market participant, the evolving regulatory regime is going to be much like the IRS in that even if you don't owe taxes, you still have to report how much you made and how you made it—essentially defending yourself from the presumption that you owe taxes. Dodd Frank will most likely be similar in its scope—even if your company doesn't fall into one of its top regulatory classifications—Swap Dealer, Major Swap Participant—there is little question that your company will be required, under threat of legal action, to continually report (in the vernacular of the CFTC) "as soon as technologically practical" swap trades as they are executed (through an exchange or "designated contract market," via a "swap execution facility," or directly to the agency or someone designated by the agency). Additionally, aggregate derivative positions will need to be reported to the CFTC, and on a frequency that has yet to be determined.

Though little in the way of specific reporting requirements is available yet, on Dec. 7, 2010 the CFTC did release some proposed rules for the real-time reporting of swaps and, based on this information, the industry has been working to identify some of the fundamental elements that need to be in place in order for any market player to reasonably expect that they can meet the new requirements once they fully implemented. In fact, I sat through a webinar recently that was hosted by Abacus Solutions, Inc., in which their CEO, Salim Jabbour, did a very good job of summarizing many of the CTRM system impacts.

Mr. Jabbour noted the following areas as potentially critical in meeting any new requirements:

• A robust reporting engine capable of creating real time, detailed reports of trades; and in which form may change based upon the entity type, the trade type, whether and how the deal was cleared and/or if it was executed on a market/exchange.

• A strategy to meet potentially conflicting requirements for timeliness and report formats as more regulatory authorities become involved in the markets, including the CFTC, FERC, state agencies, ISO/RTO's and others.

• Trading activity surveillance and real time position monitoring to ensure full compliance and avoidance of likely onerous penalties

• A strategy to address record maintenance and data retrieval requirements as they may be ultimately defined.

As Mr. Jabbour noted during the discussion, these are not inconsequential requirements. ETRM/CTRM systems are, on the whole, notoriously poor data stores for reporting purposes and most users are acutely aware of their current systems' shortcoming in this area. While a few of the most recently developed systems have architectures better suited for data retrieval and reporting, few companies will have the luxury of replacing systems in time to meet new Dodd-Frank requirements.

All energy traders should be now auditing their capabilities, at least in terms of the broad requirements outlined above and begin to design and implement the combination of business process changes and technical tools that will, no doubt, be required as the regulatory sausage making continues at the CFTC.

Ends --

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