Patrick Reames
An UtiliPoint IssueAlert

About 10 years ago, vendors of middleware solutions, such as Tibco, gained much attention in the energy trading and risk management (ETRM) space with the promise of allowing companies to seamlessly tie together complex transaction management products from multiple vendors, enabling what could be called the “Best of Breed Phase” in ETRM solutions history. The promise was that through the use of “simple to build adapters” and the magic of the middleware bus, you could take a physical gas transaction system from one vendor, a physical power system from another, a financial transaction and risk management system from yet a third vendor, and a dozen or so on-line exchanges and price feeds and ultimately create the Real-Time Enterprise powered by straight thru processing and providing up-to-the-second, consolidated views of the entirety of your trading operations.

Unfortunately, the promise and expectation did not match up well with experience. Many of the larger commodity trading organizations invested tens of millions of dollars each into the strategy and few could demonstrate much success and certainly little tangible ROI for their efforts. Many mid-sized trading shops started down the road and were forced to turn back, having run out of funds and patience for what turned out to be, in many ways, giant data reconciliation projects.

What was left behind for many of these failed projects were disparate systems, nominally integrated via point-to-point links, providing after the fact and somewhat awkward reports that fell far short of the desired global portfolio management solution capable of providing real-time intelligence. Even these hard fought minor victories were short-lived, for when the various vendors pushed out the dreaded upgrades for the individual systems, the links in the tenuous integration chain broke, requiring additional effort and funds to keep the technology strings attached to the proper tie downs.

Given the large investment in the various commodity or functionally specific systems that comprised the initial best of breed vision, few could, or were willing to make a quick move to the emerging multi-commodity, physical and financial solutions that had begun to appear on the market from a few vendors. Still, even as recently as a couple of years ago, with their investments fully depreciated, many companies were still reluctant to take advantage of the broadening capabilities provided by systems from the cadre of vendors that have made the investment in creating truly multi-commodity, physical and financial solutions.

Compelling Movement toward the Single Vendor Solution
Despite the availability of systems providing the entirety of the functionality required by the multi-commodity shops, it has taken time for many energy trading shops to start to realize the true benefits of a single vendor solution. However, there is little doubt that the movement is clearly away from the days of the costly to maintain and difficult to manage Best of Breed strategy. Somewhat surprisingly, cost may not necessarily be the primary driver; rather it could be the nature of today’s evolving energy commodity markets that are catalyzing many companies to make the move toward the consolidated, single vendor solution.

I recently meet up with Mark Jackson, Solarc’s Director of Risk Management, who offered some interesting insights into the growing willingness of these companies to move toward the single-vendor solution and the advantages of doing so. Solarc is one of the solutions providers that have been evolving their products from being highly capable systems serving the specific needs of discrete industry segments or commodities, to now providing greater breadth of capabilities across a much wider spectrum of physical, financial, functional and industry requirements.

As Mr. Jackson succinctly put it, “More and more companies are really beginning to comprehend not only the cost savings but also the value of faster and more precise risk reporting, streamlined back-office operations and more timely and accurate financial data offered a comprehensive, single vendor solution.”

Market Risks make a Single Vendor Solution more Attractive
Mr. Jackson noted the advent of electronically traded and centrally cleared commodity contract products has created a demand for robust ETRM systems that can handle both physical and financial transactions. “Commercial and trading operations are finding new ways to use these standardized products to procure their raw materials. And, firms are using a combination of cleared products and over-the-counter trades to deliver the commodities they produce.”

“All these new products are quoted, traded and risk-managed like traditional financial derivatives, but they are being used to exchange physical possession of commodities. Managing them requires an ETRM system that not only can meld financial risk reporting and physical/operational reporting but that also can handle all of the logistical, operational and accounting tasks that result from using these instruments.”

While cleared products in the form of futures contracts with their attendant clearinghouse guarantees have existed for many years, the movement toward the wider acceptance of cleared physical products took off first with Enron-On-Line and, after that company’s implosion, the Intercontinental Exchange (ICE) and ClearPort. With the recent credit crisis, however, their use has grown exponentially.

The protection from the collapse of individual trading partners is really starting to reshape the nature of trading in this business. As Mr. Jackson notes, “The collapses of Long-Term Capital Management (LTCM) and the threat of systemic implosion made the headlines for weeks. Yet when Amaranth Energy failed in 2006, it was largely ignored in the mainstream media because its use of ClearPort and NYMEX-cleared trades had prevented any spectacular counterparty collapses. The commodity trading community was quick to recognize the benefits of centralized clearing.”

As Mr. Jackson observes, “In addition to reducing credit risk, electronic trading has increased market transparency, transaction speed and the volume of market data generated. As a result, ETRM systems must be able to interface with exchanges electronically and to handle the increased data loads resulting from multiple fills on different platforms. They must be able to reconcile with brokers, confirm trades and handle all of the traditional clearing functions at a much higher pace than in the past.”

“Cleared products are forcing a redefinition of a trade and are changing the way traders interact with their systems. In the past, traders operated in one or two trading venues with rigidly designed contracts. The characteristics of those contracts drove interface and functional designs of ETRM systems. In the future, traders will decide what to trade and how to clear. The ETRM system will have to be intelligent and abstract enough to choose the appropriate system for execution, handle all the external reporting and verification, and clear and maintain the resulting transactions.”

“Finally, these products are blurring the line between the traditional physical trading world and the financial world, forcing the view of ETRM systems' risk and reporting to be revised. In the past, physical traders concerned themselves with operational and logistical risks peculiar to their markets. Depending on the market, price risk was either ignored or passed on to financial traders.”
“Now, physical traders are being constrained by shrinking credit lines, and they are turning to cleared products as a way of procuring the physical products they need. More liquid markets mean that players who would not traditionally trade physical contracts will do so secure in the knowledge that they can liquidate their positions. The bifurcation of reporting between physical risk and financial risk is being replaced by reporting on price risk and on detailed operational risk.”

The Role of Risk Management
Being on the wrong side of a volatile market has proven to be fatal for a few companies, and near fatal for more. These high profile failures and near-misses have elevated the risk management function in virtually all firms that trade in the energy commodity markets. As Mr. Jackson notes, “Risk management has changed from a part-time accounting function to a full-time specialty with visibility at the highest levels of the firm. An influx of talented risk managers is creating demand for tools that are closer to traditional trading tools than accounting reports.”

“The halo surrounding Value-at-Risk (VaR) as a standalone measure of risk has lost much of its luster. The electric power market’s enormous price moves led to questions about the ability of the underlying pricing models to accurately depict real-world markets. The collapse of Enron pointed to other risks, such as credit risk, that hadn’t been closely monitored at many firms.”

Indeed, in CommodityPoint’s recent study and report, Changes in Commodity Markets, Impacts on Traders and Systems, we observed the growing sophistication of analytics, especially in those shops affiliated with banks, hedge funds and other financially oriented organizations. While VaR continues to be used by virtually every one of these trading concerns, portfolio stress testing and pre-trade, or what-if analysis are increasingly being brought to bear.
According to Mr. Jackson, “Today's risk managers typically use VaR as an early warning indicator of risk rather than a risk number that, by itself, constrains a firm's behavior. These managers back up VaR with detailed reporting on interest rate risk, currency risk, volatility and skew risk, as well as price risk.”

“Risk managers are attuned to the risks that surround them. Risk tools are now expected to be able to quantify and manage risks throughout the enterprise. Implicit options in transportation, storage or purchase agreements are just one example of real options that managers must report on and incorporate into their calculations.”

“The growth in general knowledge about and awareness of risk at the executive level means that risk managers now have a much more diverse audience. With this diversity come differing information needs and understandings of risk. ETRM systems must have highly flexible reporting tools, including data visualization capabilities that allow for quick, customizable information extraction.”

Conclusion
While the best-of-breed approach did provide companies operating in the commodity trading space the opportunity to pick and choose those systems they felt were a best fit for a single commodity or business function, ultimately the strategy has shown its weaknesses - cost, complexity and an inability to provide the actionable information necessary to keep up in a very volatile and evolving marketplace. Still, until recently, many companies have proven reluctant to put all their eggs in one vendor’s basket, feeling that the best of breed approach kept them from being exposed to a potential failure of single vendor system.

However, recent experience has shown that the greater risk in this market is not vendor failure, but failing to keep up with the market itself - relying on incomplete or out dated data in a market that can, and will, run over those companies that don’t stay abreast or ahead by employing the best fully integrated ETRM solutions available.

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