Trading Tomorrow - Navigating Trends in Capital Markets

Navigating the Turbulent Energy Market with Karl Sees

• Numerix • Season 1 • Episode 6

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In this insightful podcast episode, we delve deep into the shifting landscape of the energy and commodities markets, discussing the ever-increasing volatility and its repercussions, particularly the growing need for robust counterparty risk measures. Host, Jim Jockle of Numerix, is joined by Karl Sees, CubeLogic's Global Head of Product Strategy and Pre-Sales as they also explore current risk trends and the surging interest in market-based analytics such as stress testing and cash flow evaluations in response to these challenges. 

Jim:

Welcome to Trading Tomorrow, navigating trends in capital markets. I'm your host, jim Jockel. In my decade plus of working with Numeric's global leader in capital markets risk management technology, I have launched our thought leadership division, a place where insights, innovation and expertise converge, just like this podcast. Through my journey in the financial realm, I've had the privilege of witnessing firsthand how the capital markets landscape has transformed the complex dance of market trends and innovative technology has redefined how the finance industry operates. With game changing innovations just around the corner, we now stand at a crossroads, one where it is more crucial than ever to understand the interplay between these realms. That's what we do here. We talk about current and future processes and technologies you need to be aware of moving forward.

Jim:

During this podcast episode, we'll discuss increased volatility and how it translates into increased need for counterparty risk measures, plus current and future risk trends. I would also carve out some time to cover up the upsurge in both interest rates and demand for market based analytics, like stress testing and cash flow evaluations, in response to this trend. And joining me for this discussion is Carl Cs. With over 25 years of experience in risk management and deployment of innovative risk technology, carl has invaluable insight. He's previously held leadership positions at major investment banks in Brokridge's, including Barclays Capital and RBS. Carl specializes in credit market and operational risk management. Currently, carl is the global head of product strategy and pre-sales for CubeLogic, a software company specializing in risk management and business intelligence solutions. Through leveraging advanced analytics, artificial intelligence and data visualization, cubelogic empowers businesses across industries to make informed decisions and mitigate operational risks. Carl, thanks so much for joining us today.

Karl:

Thank you very much, Jamie, and thank you for the invitation to participate in the podcast series. It's it's really, it's a really pleasure, as always, to be discussing these fascinating topics.

Jim:

I completely agree and I can't wait to get to some more of your insights. And why don't we just turn it now to the energy markets? You know, over the past 18 months there's been quite a ride in terms of volatility and what we've been seeing and how that has affected trading in the capital markets. You know, perhaps you can give us some of your insight as to how the market is managing this volatility.

Karl:

Yeah, Well, as we know, the energy and commodity markets have always been highly volatile, but the, the Russian invasion of Ukraine and all those knock on impacts in terms of gas supply, gas prices and all the other knock on effects has resulted in massive market distinctions and incredible volatility. So on top of that, you've got heightened default risk, high risk, high time performance risk, and when I mean when I talk about performance risk in the energy markets, that's the risk that somebody doesn't deliver the barrel of oil or or or can't deliver to you because of some, some event, that that, that that prevents that. So all of that's gone through the roof. Then you layer on top of that a nice healthy dose of of of liquidity risk. So the the the last 18 months has been a wild ride for for both managers and risk managers and traders, and this has led to an unprecedented level of of interest from firms, as they realized that this has been an area of underinvestment in in the past.

Karl:

So we're seeing I think this is this is a general comment across the whole market. We're seeing interest coming from big global players to smaller players across across a wide variety of of of different areas within counter party risk. So you've got the basic counter party management things like reference data, limits, exposure, that kind of thing. Then you've got the analytics of PFE, cva. I have to say a massive interest in stress testing across the piece. And that stress testing interest has also bled across to an adjacent area, which which is collateral management. You know the the energy companies tend to manage collateral within, within the credit functions and they've been really spooked by the liquidity risks caused by the huge swings in in margins. So they've invested heavily in predictive and analytics so they can anticipate margin calls and things like that.

Jim:

The energy markets has had one of the most notable crashes around counterparty credit risk and you know, obviously I think the market just viewed it as an energy company and didn't view it as a trading company. And you know, subsequent downgrades cost so many challenges in terms of the underlying CSAs. But as we think about and, ron, we're almost thinking about 20 years ago, why is counterparty credit risk only getting on the radar now?

Karl:

I Think, if you think back to Enron days, there was a surge in interest, there was a lot of investment, but in the intervening years, you know it's, it's, this is a feature in an investment banking as much as it is in the energy markets. But you know it's, it's when the it's when those market dislocations hit that people realize that that they need to continue to invest much more in in their risk management systems and approaches. So I think that I'm not saying you know the market became complacent, but I think that there were just practices within the market. There were features within the market that just got exposed as a result of these dislocations and and lessons are being learned.

Jim:

So, carl, where are we today in terms of adoption of technologies to manage effectively counterparty credit risk? Is this only the largest companies that are finally seeing the light, if you will, and in making these types of investments, or is it becoming much more pervasive across the landscape of the industry?

Karl:

It's, it's right across the piece, jim. 2023. There's been a record year in terms of investment. I think that's going to continue because these are multi-year projects. So on the one one one side You've got the big global players who have invested over the years, have got Very sophisticated systems, but because of the you know the M&A in the industry, they're very siloed, some of the technologies a bit antiquated. So those, those firms are looking to replace the old technology and implement truly enterprise solutions that enable them to see their risks right across the piece and also to be much prior, much more proactive in terms of their risk management, which which we can touch on a bit later. On the other side, we've also got smaller companies Still substantial companies, but smaller ones that are coming to market because they've realized their business models are a threat by relying on spreadsheets. So quite often what you see is spreadsheets are sitting at the back end of ETRMs and other trading systems and some firms, particularly in the wake of some losses, have realized that this is just not a threat to them.

Karl:

So, seeing that right across the piece, it is different types of underinvestment. The root cause of this is underinvestment over a number of years. In 2022 was really a wake-up call from many companies and at the end of the year and into 2023, it's almost like an arms race. In some respects they're really investing heavily. As I say right across the piece, I think that that's going to. You know, the consequences of that will be that you know the winners of the future will be those firms that automate Streamline so they can cope with the volumes and they can analyze their risks efficiently, but also those that implement good analytics in order to analyze their risks, maximize their risk-adjusted returns. And again, there's other consequences, because they need different skill sets and they need a different business model for managing credit risk. There's a lot of firms that still today are very risk adverse, that rather avoid the risk than take the risk in the full knowledge of what they're doing. So it's a fascinating time for the market in that respect.

Jim:

Carl, you bring up an interesting question around personnel and I want to get into that a minute. But thinking about the advent of risk-adjusted pricing in the broader derivatives market, obviously there were downstream impacts to client. We saw higher prices getting passed along based off of credit quality. Have we seen this impact yet of risk-adjusted pricing throughout the commodities world?

Karl:

It's something that's coming. It's not there yet. So in fact I had lunch yesterday with the head of credit for one of the largest energy commodity traders in the world actually, and they've got some very exciting plans for better measurement and monitoring of capital allocation, the risk capital allocation, pricing, that but yet even at that point there's still some hesitation about how that might get passed downstream and how that might get allocated out to trades and the businesses and things like that. So I think it's coming. I think that it's a natural evolution in the market and we're seeing movement of personnel from investment banks over to commodity players. In some respects it's a slightly different market. It's a very physical market. There are some that are just trading it purely for trading, but there are others there that are trading it because they're trading around their assets. It's actual physical supply and physical demand, and so it's a slightly different ball game there.

Jim:

Just out of interest. We saw it as related to the adoption of counterparty credit risk-adjusted pricing in some regions In Asia in particular, not wanting to introduce types of measures because they wanted it to be more competitive Obviously a short-term view on the market. However, do you see that potentially falling over to some smaller players in terms of remaining competitive against the larger players?

Karl:

Yeah, I think that that's the same concern. I see parallels between my experience in investment banking, where I was there at the beginning of CVA, cva trading and all of those debates. It's mirrored now in the energy market. So it's very, very similar, but with the physical market differences and considerations, because firms can become very quickly uncompetitive in that space.

Jim:

So it has been well documented that the troubles that Credit Suisse had, specifically in the derivatives market and the way they were looking at risk-adjusted pricing and counterparty credit risk however, they were still doing monthly runs, it wasn't flowing down into their trading grids and things of that nature. Now, obviously, energy markets are vastly indifferent because of the physical delivery. But is there a potential for an archgeos kind of situation in the energy markets if they're not being crude in terms of the introductions of these new technologies?

Karl:

I certainly think so, because I think that the general state of the market is the advanced analytics are not being applied systematically on a daily basis across whole portfolios, that kind of thing.

Karl:

So there's still a long way to go with respect to systematic PFE, cva and other analytics. One of that is due to the structural differences in the market. There's a lot of use of credit mitigation, so a lot of the trading activities don't generate the types of unsecured credit risk that you would see in the OTC investment banking market. So that is different. So therefore a lot more attention is placed on ELSI's guarantees, credit insurance, allocating that, and so you see a lot of effort to cover the risks rather than price it, trade it, etc. But I think that there's growing realization that that leaves money on the table, that there's room for a much more nuanced commercial approach to managing counterparty credit risk, and then there are ways to take advantage of those that are perhaps a little bit less advanced. So it's again it's like a replay of the 90s in some respects, but just with different nuances and considerations.

Jim:

So we touched a little bit on personnel and you know you mentioned that individuals are moving over from invest in banks into these large energy companies and I guess they're bolstering up their trading operations as risk operations. So what are some of the fundamental differences in the analytics themselves? I mean, I'm just thinking in terms of the rates market or the FX market. They have arguably predictable behaviors, but we've seen oil go negative. The electric markets and transmissions are completely different in terms of seasonality and weather and things of that nature. So how are the markets themselves different that could affect the personnel that are coming over to manage these types of risks?

Karl:

If you think about the energy commodity markets, you've got, you've got all products or cargo based products versus pipeline products, and those are very different. So if you've got something where you've got a trade where you're continuously delivering through a pipeline, or you've got a trade that's based upon electrons that are continuously flowing down down down wires very, very different to trading interest rates or FX and very different to trading a ship or a cargo or something that's being delivered by freight. So those differences affect the analytics and really are very, very new issues to cope with. If you've gone from fixed income trading background to a commodity trading background, then there's also the physical life cycle. So if you're delivering a physical commodity, you've got a market part of your exposure profile. You then start to deliver and then it goes into a crawl and then there's an invoicing cycle and then you've got 30 days to pay.

Karl:

So you can have a portfolio of transactions, any one of which are in in very different points in their life cycle, and those, those sort of three categories of life cycle, get broken down into Into into much, into sort of subcategories.

Karl:

You've got cargos that get held or released and you know pending LC allocations, all sorts of things. So coping with that granularity is enormous and and you have some firms that a Single trade will be represented by four layers of, effectively, cash flows, going from a trade to a leg, to shipment, to an individual parcel, on, on, on, on on a particular ship. So Not only does that, and and at each of those levels you can make choices about collateral allocation and netting and things like that. So the complexity, the life cycle aspects and, in some case, the sheer volume of of data Is a real challenge. And then you layer on top of that things like seasonality and and the the multi-factor nature of of of any analytics that need to estimate Cda, xba, v, that kind of thing. You know it's, it's of an order of magnitude much greater in some respects than then the fixed income or FX markets, as an example.

Jim:

You know it's interesting, we're talking about volatility, but you're making me think through this question slightly different and perhaps, how do you defy volatility in the commodity markets? I'm thinking volatility is supply chain disruption and what we've seen in ports in California and ships sitting out for weeks on end and Hurricanes and natural disasters and things of that nature. So when I talk volatility, obviously I'm talking market fluctuation and things of that nature. But, number one, should an energy company be thinking about volatility differently?

Karl:

Yeah, no, those types of factors sort of sit outside of Either your assessment of the counterparty risk. Because you could have two US companies that are trading you know I've got a trade between them on a particular commodity, so they're happy with the counterparty risk. The volatility may be high, but it may be. You know you're modeling that, so that's fine. But then you've got a product that's being delivered at some place in the world where you geopolitical risk, the risk of expropriation or or some other Physical manifestation, which which means that you cannot deliver or receive delivery of that commodity. So that then leads so so there's much more Focus on performance risk. You know you've got a ship sitting off offshore somewhere, as you mentioned, and it sinks or or or it gets captured by pirates, or you know there's. There are so many other Considerations. It just it's a fascinating market actually and that is a big. It makes managing counterparty risk much more challenging in those circumstances.

Jim:

Well, I definitely said the rates market would be a lot more interesting if it had pirates. So, thinking about traditional volatility, how is this affecting the way companies are trading right now?

Karl:

Yeah, there's been some big changes. So one one example is in Europe, where you had some countries that relied heavily on individual long-term supply contracts from, from Russian suppliers in the gas market so I think you can guess where I'm heading now. But it practically overnight these things disappeared and now you have a situation where that supplier is being managed through short-term markets with huge volumes of trading across a large number of counterparties. So not only have you got the volatility of a short-term markets, you've got massive volumes of trading, trading volumes just gone through the roof, and you've also got trading with many, many more counterparties, a significant number of counterparties. So what that's done is it's not only put firms under strain in terms of trying to stay on top of their risk positions, it's put them under strain in terms of their operational departments trying to stay on top of the, the volumes of trades, the volumes of settlements you know, as I said earlier, these, these, these physical settlements in the market, not trivial and and and then, from a counterparty risk perspective, the volumes of onboarding and your reviews, setting of limits, monitoring of limits, that kind of thing. It's, it's, it's, it's. It's been a Stressful time in terms of that transition.

Karl:

Then the other big shift has been a shift away from exchange trading towards more OTC trading, which you will find counterintuitive given everything that we've we've just talked about now.

Karl:

What's driving that is Is that it is really a liquidity threat. So what you saw is that the exchanges Naturally jacked up their initial margins and then the variation margins were just massively swinging all over the place and and and I think that's that's calm down now, but it's still a volatile place that threatened the light, that threatened the life of a few very significant companies, particularly in Europe. I'm sure it was the same in the US with what. What happened there is that firms, in their attempt to get on top of the stress that that was putting on on on their liquidity pools, that they they migrated a lot of their trading to the OTC markets where they can trade unsecured and and they've got more control over the the terms of trading if they are trading under collateral terms. So that actually introduced More counterparty risk into the market just at the point when when that was the last thing that anybody needed, and that was because the the most proximate risk for firms was was the risk of running out of cash.

Jim:

Carl, we've made it to the final question of the podcast and we call this the trend drop. It's like a desert island question. So if you could only track one trend in the energy market right now, what would that be?

Karl:

Oh, that's a really really good question. What is really fascinating is this is the thing, the things that we've been discussing here, which is the accelerated adoption of, of advanced analytics, which then really is driving an improvement in things like data management, it systems, etc. Because the more, the more powerful analytics, the more that you need the right data in the right format In the right place all at the same time, so that that that is driving Investment across the across the spectrum. I think, then, ultimately, what what we're seeing is the is the advent of much more commercial based trading in in the energy markets, in the sense that you know the cost of cash, the cost of capital, the cost of credit, all of those things We'll we'll need to be priced in, and we'll start to see some new winners and losers, losers in that space because of that trend very much, as we saw in the 80, in the 90s sorry, the 90s and the only two thousands when when CVA, xva trading took hold and and and that's all big shifts in in competitive positions.

Jim:

Carl, I want to thank you so much for joining us today Fascinating topic and I look forward to speaking to you soon as this evolution continues.

Karl:

Likewise, james, always pleasure to work with you, always pleasure to talk to you.

Jim:

Thanks, carl.

Karl:

All right, thanks, bye now.

Jim:

Coming up next week. The author of be is for Bitcoin joins us to discuss a technology that's being referred to as the future of capital markets. It's a must listen, but first, if you enjoyed the podcast, make sure you hit the subscribe button, leave a comment, a like and check out our other episodes. Thanks for joining.