Clearing Physical Energy - RMG Financial - Clearing...NGX •Leading physical energy exchange and clearinghouse - Natural Gas, Power, and Crude Oil. •Est. 1994 - Headquartered in

© 2009 TSX Inc. All rights reserved. Do not copy, distribute, sell or modify this document without TSX Inc.’s prior written consent. This information is provided for information purposes only. Neither TMX Group Inc. nor any of its affiliated companies guarantees the completeness of the information contained in

this presentation and we are not responsible for any errors or omissions in or your use of, or reliance on, the information.

Clearing Physical Energy Implications for Credit Professionals

NAPCO – September, 2014


this presentation and we are not responsible for any errors or omissions in or your use of, or reliance on, the information. 2

Agenda

NGX – Background Information Physical Clearing – The Basics General Overview on Regulations Impacting Commodity Trading Implications for Credit Professionals



Introduction to NGX N

GX • Leading physical energy exchange and clearinghouse - Natural Gas,

Power, and Crude Oil. • Est. 1994 - Headquartered in Calgary, Alberta, office in Houston, Texas. • Physical Delivery - End-to-end delivery with physical backstopping. • Wholly owned subsidiary of TMX Group Limited • ICE Alliance – All major NGX markets on global leading ICE.

TMX

Grou

p Li

mite

d • Est. 1852 - Leading Canadian equity exchange • 2nd largest exchange worldwide by listed issuers • 7th largest exchange globally by issuer market

cap. • Preeminent marketplaces for listings, trading

cash equities, fixed income derivatives, and physical energy products

1993 •Westcoast

Energy

2001 •OMX (now

NasdaqOMX)

2004 •TMX Group Inc.

2012 •Maple Group

purchase majority of TMX

3



TMX Controlled by Canada’s Largest Financial Institutions

• “Maple” investors consist of 11 of Canada’s most well recognized players in the Canadian investment industry

• Affiliates of TD Securities, CIBC World Markets, National Bank Financial and Scotia Capital are lenders to TMX • Each of these bank-owned dealers or their affiliates

committed to own at least 6.25% of TMX Group Limited for the first year and at least 5.625% of TMX Group Limited for the 4 following years

• TMX has ready access to equity markets to raise capital if ever required

Entity DBRS Credit Rating Lender

AAA (Stable)2

AAA (Stable)

AAA (Stable)

AA (Stable)

AA (Stable)

AA (Stable)

AA (Stable)

AAL (Stable)

AAL (Stable)

N/A

N/A

1. The chart shows the relative ownership of TMX Group Limited shares held by each of

the above named investors or their affiliates, following completion of the subsequent arrangement on September 14, 2012 (taking into account the number of TMX Group Inc. shares held by each applicable investor and/or their respective affiliates as reported in the TMX Group Inc. Plan of Arrangement Circular dated August 13, 2012). This percentage has been updated for known transactions.

2. Notionally AAA as expressed through Cadillac Fairview Trust guarantee.

77% Collective Ownership at Q3/121 Strong and Stable Shareholders

4



Introduction to NGX

Estimated 80-90% market share of Cdn physical spot gas and financial power

NGX’s physical natural gas and power indices are the Canadian benchmarks

NGX markets also include Cdn crude oil and U.S. physical power (Nasdaq alliance)

U.S. Natural Gas - NGX is exclusive clearinghouse for ICE’s OTC natural gas markets. Market share

varies by hub - average of 10% cleared.

NGX’s trading primarily transacted on ICE trading platform with some OTC and auction volumes

Clear physical and financial energy products across north America

No clearinghouse defaults since inception in 1994

Managed major failures including Lehman and Enron without any losses

Over $3B in collateral holdings 70-75% L/Cs and remainder cash

Unique direct clearing model - no clearing members (non-mutualized)

NGX manages complete physical delivery process

5



NGX Product Locations

6



Agenda




General Role of Central Clearinghouses (CCP)

8

Independent, Highly Regulated, Risk Mitigation Providers

• CCP does not take positions - sole focus is risk management to ensure transactional certainty

• Fully collateralized, independent daily settle valuations, and sophisticated risk systems that ensure tail risk being managed.

• Enforce collateral requirements failing which positions are liquidated and collateral used to cover any losses.

Centralization of Transactions

• Through a uniform, centralized novation process, interdependencies amongst participants minimized

• Ability to maximize set-off positions • Reduces gross market positions down to the net end buyer and seller positions.

Waterfall Provisions

• Extensive provisions in place to mitigate losses • Series of backstops that are stress-tested for adequacy • Highly prescriptive regulations in place to ensure financial adequacy



Clearinghouse Requirements

9

Capital Requirements •All positions collateralized (including potential price movements) - no exceptions. •Collateral can only be reduced by flattening book (buys and sells) or, on NGX, selling physical.

Standardized •No contractual or transactional flexibility. •Uniform rules

Eliminate Counterparty Interaction •Fully anonymous - no ability to gain market knowledge through CP interaction •Rely on CCP price indices for market price intelligence

Level Playing Field • Inability for larger companies to leverage balance sheet for transactions

Centralization of Risk •Risk concentrated with clearinghouse, albeit fully netted and collateralized.



Basic Structure of NGX Clearing Operations

NGX Clearinghouse Role • Buyer to every seller and vice versa on a fully collateralized

basis • Fully anonymous trading • Complete physical delivery (firm delivery in key markets)

Private Clearing Operation • No mutualized or legal relationship amongst counterparties. • All collateral segregated and for owner usage only. • Do not require access through clearing member

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Direct vs Mutualized Clearing Model

Mutualized (FCM) Model Direct Model (NGX)

11



NGX Clearinghouse Backstop Model

12

PAYER PAYEE $

$ or Commodity

$

$ or Commodity

Guarantee to TD Bank by TMX Group Inc. (USD $100MM)

TD Letter of Credit (USD $100MM) issued to BNY Mellon

Settlement Banking Credit Facility - $300MM daylight + $20MM Operating Line + NGX Cash ($42MM)

Defaulting Party Collateral (100% Coverage Under NGX Exposure Model)

NGX Guarantee Fund (USD $100MM BNY Mellon Trust)

Insurance Policy (Drawdown on Fund over $15MM)

Size of a CCPs guarantee fund determined by stress test

results (cover 1 or cover 2)



Clearinghouse Drivers

13



Agenda




NGX Regulatory Status

15

In Canada • NGX is recognized as an “Exchange” and “Clearing Agency” by the

Alberta Securities Commission (ASC) and has applicable exemptive relief in other Canadian provinces

• ASC as the “Lead (Exchange) Regulator” for NGX in Canada

In U.S. and Europe • NGX recognized by the Commodity Futures Trading Commission

(CFTC) as a “Derivatives Clearing Organization” (“DCO”) in December 2008

• NGX has been an “Exempt Commercial Market” (“ECM”) since November 2002 under the U.S. Commodity Exchange Act.

• NGX’s ECM status replaced by Foreign Board of Trade (FBOT) status in May/13 (1st FBOT issued by CFTC post Dodd-Frank).

• NGX has applied for foreign recognition under Article 25 of EMIR



NGX Product Classifications

Product Market Clear or Uncleared Trading Classification Clearing Classification

Canadian Physical Natural Gas

ICE Web Screen Cleared Future Future

Bilateral or Broker OTC Cleared Physical Forward or Block Future1 Future2

ICE Web Bilateral Screen Uncleared Physical Forward5 N/A

U.S. Physical Natural Gas

ICE Web Screen Cleared Future3 Future



Canadian Financial Power ICE Web Screen Cleared Future Future

Bilateral or Broker OTC Cleared Swap or Block Future1 Future2

Canadian Physical Crude Oil

ICE Web Screen Cleared Future Future



Notes: 1) Product classification to be determined by transaction market source (bilateral participants or broker) 2)Traded and cleared as block future if transaction meets minimum block future size threshold. Otherwise may be cleared as futures by use of EFP or EFS. 3) Upon US natural gas orders being matched for clearing on ICE screens, transaction will be deemed as transacted and cleared as a future 4) Not NGX markets – classification determined by ICE. 5) NGX physical crude oil and natural gas, uncleared ,markets are forward markets

All screen traded and cleared deals are deemed Future transactions.

16



Further Regulation of Commodity Trading – Necessary?

• Global derivatives market – over $700 trillion in annual notional trading*. Sounds big...worldwide annual GDP is only $50 trillion.

• Gross market exposure on open positions ~ $20 Trillion. Net exposure amount - $3 to $4 Trillion. Not quite as big now...but still significant.

• Even prior to new regulations, majority of all derivative positions collateralized (cash 80 – 85%, Gov’t securities 10-15%, with rest in other forms)

• Total commodity (excluding gold) • Notional $2.7 trillion • Gross Exposure of about $400 - $500 billion • Net Exposure $60 - $75 billion

• Energy only a small fraction of total (3-4%). • Trading in energy markets were clearly not the cause of the 2008

market crisis.

* Bank of International Settlements

17



The Essence of Regulations

• Measure the Markets and Apply Data to Make Rules – Regulators need the data to measure the size of the markets

in aggregate and by entity. To do this, they need the data – from that data they can identify potential issues.

• Prevent Big Blowups (and big bailouts) – Limit the amount of un-collateralized positions – Impose position limits by product – Limit bank involvement in certain products – these are the

entities that underpin financial infrastructure.

• Protect Companies and Consumers from Bad Behaviour – Impose qualification standards on brokers and advisors – Compliance and market monitoring requirements – Monitor and measure to mitigate price manipulation

18



Dodd Frank Timeline

September 2009

•G–20 Leaders agreed to OTC derivatives reform - ‘‘all standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties.”

July 21, 2010 •President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Title VII

•Over-the-Counter Derivatives Legislation - Stringent oversight of the over-the-counter derivatives market, including mandatory clearing and real-time reporting of derivative trades.

Objective

•The primary goals of the legislation is to increase the transparency and efficiency of the OTC derivatives market and to reduce the potential for counterparty and systemic risk.

July 16/11 •General effective date was to be July 16, 2011, many key rules not effective until 2013.

19



Basic DF Requirements

• Registration and Regulation of Swap Dealers and Major Swap Participants

– Primarily applied to bank dealers. Only two commercial entities registered to date.

• Mandatory clearing and exchange-style trade execution – Largest Interest rate and CDS products mandated – no energy products

• Trade reporting and recordkeeping – Extensive IT efforts by SD to meet reporting requirements.

• Extraterritorial rules – Complex rules around “US persons”.

• Position limits and large trade reporting for physical commodity derivatives

• Business conduct and documentation standards for swap dealers and new duties for customers

• Risk management, compliance, and other internal duties for swap dealers

20



Regulatory Classification

• regularly enters into Swaps with counterparties as an ordinary course of business for its own account (holds itself out as a dealer in swaps).

• makes a market in swaps • does not include:

• a person that enters into Swaps for its own account, but not as a part of its regular business; or • engages in a “de minimus” quantity of Swaps in connection with transactions with or on behalf of

its customers (under $8 billion/annum)

• Maintains a “substantial position” in Swaps excluding positions held to hedge or mitigate commercial risk.

• Has outstanding swaps that create “substantial counterparty exposure that could have serious adverse effects on the financial stability of the United States banking system or financial markets”

• Is a “financial entity” that is “highly leveraged,” is not subject to capital requirements by a Federal banking entity

• Include Swap Dealers, MSPs, private funds, commodity pools, certain employee benefit plans and persons predominately engaged in the business of banking (> $10 billion in total assets)

• Not a Financial Entity • Swap limited to hedging activity…not a blanket exemption.

21

“Special Entity” level for public utilities only $25MM, but under review.



Basic Swap Requirements

If neither party exempt, both Financial entities must post/receive collateral (some exceptions). Requirements being phased in from 2015-2019

Financial entity must set credit exposure limits for exempt entity and collect margin for any excesses. Rules for end-users recently softened.

If End-User dealing with a Financial entity, then financial entity handles reporting requirements. If both entities are end-users, parties must choose one to report.

Exempt Entity

One party must report

Swap to Swap Repository

Requires Swap

Agreements

Financial Entity

Financial must post initial and

variation margin with 3rd party.

Need to enter into a Credit Support

Agreement

Exempt can elect to require clearing.

Financial must report the Swap

transaction.

Exempt Entity

Must designate a party to report

the swap

Hedges do not count towards position limits

Position Limits may

apply

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Basic Swap Requirements (cont’d)

Financial Entity

Financial Entity

Must be transacted

on approved facility.

Must be cleared

Clearinghouse will report trades to

CFTC

Exempt Entity

Qualified hedges exempt from

clearing.

Swaps still need to be reported

23



Forward Contract Exclusion

• Forward exclusion under the Commodity Exchange Act (CEA) basically states that private commercial merchandizing transactions that create enforceable obligations to deliver, but in which delivery is deferred due to commercial convenience or necessity, are outside of regulation.

• July 10, 2012 – Joint Final Rule issued by CFTC and SEC which defined “swaps” and interpreted the Forward Contract Exclusion.

• The Forward Contract Exclusion from the definition of swap requires that:

– the commodity be a nonfinancial commodity – the transaction be a sale for deferred shipment or delivery, and – the parties intend to physically settle the sale.

• Facts and circumstances test to determine the parties' intent regarding delivery.

24



Forward Exclusion – The Basics

•Related to a commercial activity - producer, processor, fabricator, refiner or merchandiser Commercial Entities

• intended to be physically settled create binding obligations to make or take deliveries Intent to Deliver

•non-financial commodity (exempt or agric. commodity). CFTC clarified that Brent interp. not just applicable to Brent oil. Physical Commodity

• Includes intangibles that can be delivered (ie environmental credits) Intangibles •Any offset requires a separate, subsequently negotiated agreement

(bookouts) Offsets •Exchanging products by location or grade with intention to

physically deliver. Exchanges •Netting agreements and termination rights do not disqualify

transaction Netting

25



Physical Book-out Requirements

26



Why are Physical Markets (“Forwards”) being impacted by Dodd Frank?

• Prior to Dodd Frank which imposed additional regulation, and further defined “Swaps”, companies under less pressure to ensure adherence to forward exclusion requirements.

• Introduction of Swaps has a) blurred the lines between regulated and unregulated products and b) added “consequences” for “forward” transactions that are deemed to be Swaps.

Dodd Frank’s regulation of Swaps has narrowed the gap between regulated and non-regulated markets

27



Position Limits

• CFTC adopted a position limits rule in 2011, which was later vacated by a federal district court

• CFTC issued re-proposed rule in November 2013 – Re-proposed rule would establish specific limits on speculative positions in 28

physical commodities – CFTC simultaneously proposed a rule requiring position aggregation by

affiliates – Re-proposed rule would apply to energy, agricultural, and metal commodities – Applies to futures, options on futures and economically equivalent swaps – Set thresholds for spot month, individual month, and all months combined – Exempt bona fide hedging – Require DCMs and SEFs to establish position limits or (in some instances)

position accountability rules

• Market participants are concerned that re-proposed rule will limit important risk-management efforts by narrowly drawing hedging exemption

28



Canadian Regulatory Approach

• In U.S., single federal regular each for securities (SEC) and derivatives/commodities (CFTC) • In Canada, provincial regulars which oversee both derivatives and securities.

General Canadian Regulatory Structure vs. U.S.

• Committee of provincial securities, CSA Derivatives Committee (“Committee”), developing the regulatory framework to meet Canada’s G-20 commitments

Canadian Securities Administrators Derivatives Committee

• Committee has published a series of derivatives consultation papers outlining policy recommendations for the regulation of the $12-trillion Canadian derivatives market

Consultation Papers

• CSA developing a National Instrument by adopting IOSCO’s PFMI requirements.

Clearinghouse requirements

• Aim to provide effective regulatory oversight of derivatives and derivatives market activities in balance with commercial considerations.

• The regulatory framework will be implemented through provincial rules

Objective

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Basic Registrant Categories

• Persons carrying on the business of trading • No proposed de minimis exemption

Derivatives Dealer

• Provide advice for trading derivatives including hedging strategies

• Does not include advice that is incidental to a derivatives trade.

Derivatives Adviser

• Entities that maintain a substantial position in derivatives

Large Derivative Participant

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Exemptions from Registration

• Acceptable regulator in Canada • Includes Canadian banks and others under equivalent supervisions

Existing Regulated Persons

• If subject to equivalent requirements

Foreign Derivatives Dealers and Advisers

• At all levels from Federal to municipal levels (including crown corps) when trading with qualified parties

Governments

• If advice only relates to trades where dealer does not have discretionary trading authority and doesn’t charge a fee for advice,

Various dealer exemptions

• Clearing agencies recognized or exempted under provincial regime.

Clearing Agencies

• If registration solely results from trading with or on behalf of affiliate

Transactions limited to Affiliated Entities

31



What Are Derivatives (Canadian version of Swaps)

•Definition of derivative is in existing and proposed provincial securities legislation • Includes swaps and forwards, but varies by province.

Derivatives

•An insurance or annuity contract •Physical commodities

Excluded Derivatives

•Contract or instrument for delivery of a physical commodity •Must provide for immediate or deferred delivery of a physical commodity •Physical goods - does not include financial commodities such as currencies, interest rates,

securities and indexes, •A firm obligation of a party to the contract or instrument and not merely an option to make

or take physical delivery. • If intention to physically deliver changes, the contract would become subject to all applicable

derivatives rules. • If physical delivery occurs for reasons outside of control (force majeure etc.) , then OK, but

not if cash settlement provision/option included in agreement.

Physical Commodity

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Canadian vs U.S. Rules

Generally Aligned • Key attributes are aligned with Dodd frank rules which stands to reason as both aiming for same G-20 objectives. • Registration based on activity type (dealer or advisor) or size (large derivative participant) very similar • Carve out for physical commodities are very similar • Requirements for reporting, use of repositories, mandatory clearing, risk management requirements etc.

Distinct “Futures” Category • “Futures” market (exchange traded and cleared derivatives) not as well defined and segregated from OTC derivatives in

Canada. • May mean that those entities that transact in Futures still may be subject to registration and Canadian regulations.

More Difficult to Avoid Registration in Canada (based on proposed rules) • In the U.S., commercial entities avoided Swap Dealer registration though: • Staying under the $8 billion de minimus threshold; • Keeping swap count low by using Futures instead; • Keeping swap count low through hedging exemption • These mechanisms may not be available in Canada

End User Rule – Blanket Rule in Canada (proposed), but not under Dodd Frank • Under Dodd frank, End Users were a) those that were not financial entities (including Swap Dealers and Major Swap

Participants) AND b) were undertaking a transaction that was a bona fide hedge. • In Canada – either you’re an End User or not...and if you are, there are no provisions for non-hedging activity.

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PFMI Overview

• In April 2012, the Committee on Payment and Settlement Systems (CPSS) and the International Organization of Securities Commissions (IOSCO) issued the Principles for financial market infrastructures (PFMIs).

• IOSCO policy maker only – up to local regulators to adopt or not. • Prior 2004 FMI standards disjointed and not widely adopted – all changed

following global crisis prompting regulators to adopt. • CPSS and IOSCO members (including Canada) committed themselves to

adopting the 24 principles (the Principles) and the five responsibilities (the Responsibilities) included in the PFMIs.

• “Full, timely and consistent implementation of the PFMIs will be fundamental to ensuring the safety and soundness of key financial market infrastructures and to support the resilience of the global financial system”

1.

• PFMIs play an important part in the G20’s mandate that all standardised OTC derivatives should be centrally cleared.

1) CPSS-IOSCO – Implementation monitoring of PFMIs – Level 1 assessment report – August 2013

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PFMI – Key Provisions

• Disclosure Requirements – Extensive quantitative disclosure requirements to clearing members and the public. – Initial proposals not well received by clearinghouses. Disclosures jeopardized client position

confidentiality, requires extensive IT investment for very detailed reporting and created commercial competition disclosure issues.

• Recovery and Wind Down Provisions – Very detailed plans need to be put in place as to how the CCP will manage a recovery or

wind-down in the event that the financial resources have been exhausted in a large loss scenario

– Essence is in determining how losses would be allocated (i.e. Contract tear-up, re-allocation of collateral, elimination of MtM gains etc.)

• Financial Resources and Liquidity Requirements – Extensive requirements for ensuring financial resources, and liquidity of such resources, are

more than adequate to meet thin tail risk.

• Stress and Back Testing Requirements – Sophisticated modelling requirements to ensure that initial margin rates remain adequate – Stress testing results form the basis for determining adequate financial resources.

35



PFMI Implementation by Regulators • Most global jurisdictions are in the process of implementing the PFMIs • Being implemented in variety of ways. Some jurisdictions applying in a

modified basis through existing regulations and others implementing specific regulation requiring adherence to PFMI principles.

• In the U.S., CFTC mandating PFMI requirements for systemically important DCOs and providing optional adherence for non-systemically important CCPs.

• Bank of Canada (BOC) implementing PFMI in systemically important CCPs. Some provincial regulators also recognized PFMI requirements in clearinghouse regulatory orders (including NGX’s orders)

• PFMI compliance is necessary for clearinghouses such as NGX to become Qualified Central Counterparties (QCCP). Under Basel III, bank capital charge for clearinghouse exposures are 2% vs 50-100% for non-QCCP counterparties.

• Bottom line, PFMI has become the global standard for Financial Market Infrastructures – form and timing of implementation will vary by jurisdiction ranging from immediate to 2015.

36



Other Regulations Impacting Bank Commodity Trading Business

• Basel III • Volcker Rule • Swaps Push-Out Rule • Proposed rules on Bank Commodities Activities

37

Total commodity trading revenue at banks has fallen to a third of their $14 billion peak in 2008.



Basel III • Purpose: “To improve the banking sector’s ability to absorb shocks arising from

financial and economic stress, whatever the source, thus reducing the risk of spillover from the financial sector to the real economy.”

• Higher minimum/quality capital requirements • Leverage ratio:

– requires a minimum amount of loss-absorbing capital relative to all of a bank’s assets and off-balance-sheet exposures regardless of risk weighting (Tier 1 capital/total on-balance sheet assets).

– US rules impose higher ratios for large banks.

• Capital conservation buffer: – Additional capital to be available for drawdown during periods of financial stress.

• Countercyclical capital buffer: – Additional capital for large banks would increase during economic expansions and

decrease during contractions.

• Liquidity coverage ratio: – requires unencumbered high-quality liquid assets to meet liquidity needs for a 30

calendar day liquidity stress scenario.

• Additional proposals for systemically important banks, including requirements for increased contingent capital and strengthened arrangements for cross-border supervision and resolution.

38



Volcker Rule

• Purpose: To prohibit U.S. banks from making speculative investments that do not benefit their customers.

• Prohibits “banking entities” from proprietary trading in “financial instruments” and owning “covered funds”

– Proprietary trading generally means trading as principal principally with a short term purpose or in a dealer capacity

– Banking entities include banks and their affiliates – Financial instruments include securities, derivatives, futures, and options on

any of these – Does not include physical spot commodities or forwards

• Permitted activities include: – Risk-mitigating hedging – Market making – Trading on behalf of customers – Trading solely outside of the U.S.

• Extensive compliance burdens for permitted activities • Banking entities must be in full compliance by July 2015

39



Swaps Push-Out Rule (Lincoln Amendment)

• Purpose: Require insured banks to spin off “risky” derivative trading operations to separately capitalized affiliates to minimize exposure of customer deposits and need for taxpayer bailouts.

• Prohibits “federal assistance” from being provided to a swap entity (e.g., swap dealer, major swap participant)

• Banks that receive federal assistance (e.g., insurance or access to the Federal Reserve’s discount window) must “push out” swaps activities into an affiliate

• Exemption for swaps used to hedge or mitigate risk and swaps involving rates or national bank-eligible assets (e.g., swaps referencing currencies, bullion, loans, bank-eligible debt)

• Uninsured U.S. branches and agencies of foreign banks will be treated as insured depository institutions for purposes of the rule

40



Proposed Rule on Bank Physical Commodity Activities

• Federal Reserve Board (FRB) recently issued a proposed rule on further prudential restrictions or limitations on bank activities related to physical commodities

• FRB noted recent environmental hazards and liabilities resulting from catastrophes and disasters involving physical commodities – Concern that liabilities resulting from these activities could

threaten bank stability and create systemic risks • Potential rules could:

– Reduce maximum amount of assets or revenue attributable to commodities activities

– Increase capital or insurance requirements – Prohibit holding unduly risky physical commodities – Restrict investments in companies engaged in commodities activities – Restrict 4(o) grandfathered activities (FRB authority to restrict is limited

by what statute permits)

41



Agenda




General Impact of Regulations on Commodity Trading Markets

• Higher Costs – Capital and Reporting requirements – The vast majority of financial commodity transactions have moved to exchange traded and cleared

(collateralized) markets. – Cost of derivative trading have increased due to higher capital, collateral, information system and

legal/regulatory requirements. The estimated increase in annual global costs for capital and collateral alone is between €15 billion and €32 billion1.

– The efficiencies gained from clearinghouse netting are expected to offset in part, the increased collateral requirements.

• Exit of Banks – While there are some banks that have chosen to remain active in the commodity sector, many have

exited or decreased their level of participation. – To an extent, they’re being replaced by private funds (hiring all the ex-bankers) and foreign nationals

(China, Russia, Middle East etc.)

• Futurization of OTC markets – Liquid OTC markets migrated to futures markets on regulated exchanges and clearinghouses – Resulted in far fewer entities exceeding swap threshold level ($8 billion) – Few liquid swap instruments in energy sector relative to futures markets.

• Reduction in Availability of Structured Commodity Transactions – The regulatory requirements have resulted in a reduction in the number of participants willing to enter

into off-exchange swap transactions – Capital requirements for swap transactions have increased their costs.

43

1 Macroeconomic Assessment Group on Derivatives , Bank For International Settlements, August 2013



Impact of Regulations on Physical Trading Markets and End Users

44

“Congress was crystal clear that commercial end-users, which make up the overwhelming majority of companies in America, did not cause the crisis” Commentary by CFTC Acting Chairman Mark Wetjen

• Minimal Direct Impact on Physical Energy Trading and Clearing – Forward exclusions generally meant little change to end users in physical market participants – No regulatory requirements for mandated exchange trading or clearing – There are book-out reporting requirements on physical transactions that do not go to delivery.

• Indirect Impact – Exit of Banks – Banks exiting the business. While a smaller participant in physical markets (about 10% in natural

gas phys.), they did fill an important role in liquidity for end users. – Generally being replaced by lower creditworthy, less regulated counterparties. – May result in further concentration risk



Impact of Regulations on Physical Trading Markets and End Users cont’d

45

• Banks provided a number of services to the physical commodity markets which may diminish (or become more expensive) with the exit of many participants.

– Market Making • Banks make markets in physical commodities providing liquidity for entities looking to

hedge positions. • Often instrumental in the development of tradable instruments, new tenors, options

etc. that meet the needs of physical participants.

– Risk Management Solutions • Through physical storage and related instruments, provide solutions that allow end users

to manage their price risk

– Credit providers • Banks typically provided trading lines and various credit facilities to minimize the

balance sheet impact of trading and hedging positions

• Potential for Increased basis risk in physical hedging programs – Positions that have optionality provisions outside of “physical” allowances will be subject to

swap requirements and may be more difficult to find counterparties. – The “costs” of taking positions in marginal products may exceed the benefits. – Banks provided physical positions in off-exchange locations and products



Impact on Physical Clearing of Commodities

• Global clearinghouse requirements do not distinguish between physical and financial clearinghouses – rules are the same

• Same uniformity applies to direct (end user) clearinghouses vs. mutualized (FCM) clearinghouses.

• Significant increase in costs: – IT and reporting infrastructure – Operational requirements for risk reporting (extensive backtesting, stress

testing and margin modelling requirements) – Financial resource requirements – Increased liquidity facilities (committed lines)

• Comprehensive bank counterparty reviews to ensure Qualified Central Counterparty (QCCP) compliance and application of favorable capital rates.

• Despite requirement for complete alignment with all regulatory requirements, physical clearinghouses not likely to benefit from mandated clearing requirements.

46



Impact on Credit Professionals

Physical Trading Requirements •Must ensure that transaction is a bona fide physical deal to avoid derivative /swap reporting

requirements •Proper documentation of “book-out” language, limits on optionality, and various steps to ensure that

“physical” deals are not essentially financial transactions.

Increased Importance of Credit/Risk Personnel •Regulations highlight the need for diligent credit and risk management of transactions. •KYC requirements largely addresses through annual credit review process.

Exchange and Clearinghouse Reviews •To the extent the volume of cleared business increases for your company, credit professionals will need

to a) understand risks inherent with Clearinghouses and Futures Commission Merchants, and potentially undertake reviews of these entities on an ongoing basis.

•Understand clearinghouse collateral requirements and steps to a) minimize collateral costs and b) ensure the security of your deposited funds.

General Understanding of Regulations •To date, regulators played a relatively minor role in the oversight of energy trading activities. •Derivative reform will most certainly have some impact on your business and will require that you have

at lease a basic knowledge of your requirements.

47



Impact on Credit Professionals

Potential Reduction in Bank Counterparties • Banks typically of high creditworthiness and have sufficient capital to meet regulatory

requirements. • Being replaced by foreign entities and private capital funds which often are of lower credit quality

Less Collateral Available • Even if new rules don’t require your company to post more collateral, likely to effect some of your

counterparties (larger dealers and financial entities). • This means there may be less collateral available for other, non-regulated activity (i.e. physical

trading)

Potentially More Physical Transactions • For those entities with relatively small derivative books, make be inclined to eliminate such

activity and use physical transactions for hedging instead.

Regulation Has Reduced the Overall Level of Unsecured Trading • Industry still subject to large trading losses, however, such losses should have limited secondary

market impact due to collateral rules, particularly for large dealers.

48



Summary

• For many of the commercial entities here today, particularly if you have minimal financial swap business, new trading regulations should not have a significant impact on your business.

• Many of the prudent risk management functions already exist within our industry...physical energy trading did not cause the crisis!

• For financial entities, and other registrants that have significant derivative/swap activity, the changes will be more pronounced, but manageable.

• For physical energy market participants, clearing will remain a matter of choice and access to liquidity rather than a regulatory requirement.

• Those that have a) large derivative books and b) primarily transacted in bilateral/brokered markets, may be required to clear more of their business

• Biggest impact will apply to the banks – so your interactions with banks need to be reviewed.

49



_____________________ NGX 10th Floor, 300-5th Avenue SW Calgary, Alberta Canada T2P 3C4 Phone: 403.974.1700 Fax: 403.974.1719 www.ngx.com

Steve Lappin - VP, Clearing Operations & Development 403.974.4308, [email protected]

For further questions on bank, derivative, swap, forward and other related legal matters, please feel free to contact: Paul M. Architzel | WilmerHale 1875 Pennsylvania Avenue NW Washington, DC 20006 USA +1 202 663 6240 (t) +1 202 663 6363 (f) [email protected]

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Clearing Physical Energy - RMG Financial - Clearing...NGX •Leading physical energy exchange and clearinghouse - Natural Gas, Power, and Crude Oil. •Est. 1994 - Headquartered in