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Counterparty risk and collateral calculation at the APX-ENDEX energy exchanges

IJgosse, W. (2011) Counterparty risk and collateral calculation at the APX-ENDEX energy exchanges.

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Abstract:APX-ENDEX is an energy exchange that provides a platform to trade power and gas in the Netherlands, Belgium and the United Kingdom. The company acts as central counterparty for its spot markets, which exposes it to counterparty risks such as market and credit risk. This research evaluates the risks involved, the exposure APX-ENDEX has to these risks and the ways to cover for this exposure. The research consists of two parts. In the first part the counterparty risks involved were identified, the ways to cover for these risks were investigated and an assessment was done whether the current risk capital structure is adequate given the risks found. The counterparty risks faced by APX-ENDEX are linked to the contractual obligations it takes on to handle clearing and settlement of transactions. This entails delivery risk towards sellers and credit risk towards buyers, with the exposure depending on the commodity and the market. Several ways to cover for these risks where found. The ways to cover for counterparty risk under normal market conditions are to set participant requirements, enforce position and trade limits and to set a collateral requirement. The ways to cover for counterparty risks under extreme market conditions are to set up a default fund, take out insurance or lay down a claim on members to cover residual losses. The current risk capital structure employs the viable coverage ways from the ones named earlier, excluding insurance and a residual claim. A confrontation of the risk capital structure with the different counterparty risks that APX-ENDEX faces did not lead to suggestions for amendments. Therefore it can be concluded that the current structure is in line with what literature and the recommendations for central counterparties suggest and is well suited to cover the exposure to the counterparty risks faced by APX-ENDEX. After the conclusion of this first part of the research, the second part of the research focused on the main element of coverage; the amount of financial security requested from the members. Based on an analysis of the current methodology and the characteristics of the data available, and input gathered from a literature review, a benchmark of methods in use by other energy exchanges and interviews with stakeholders, several alternative calculation methods were formulated. The last step of the research dealt with setting up criteria, and comparing the performance of the alternative methods on these criteria. The criteria used are measures of prudentiality (how well does the method cover the exposure, and what is the magnitude of the shortfall that is to be expected) as well as measures of opportunity costs imposed by financial security demands. Furthermore the issue of combined collateral across different markets for the same member is addressed as well as the contribution to the default fund. The outcomes are outlined in the following two sections for the collateral requirement (for the auction) and margin level (for continuous trade). Auction collateral: Currently a member taking part in the auction in Belgium as well as in the Netherlands faces separate collateral charges, even though it could have positions in these markets that would offset each other. The consolidation of the clearing operations into one legal entity opened up the possibility to introduce a single combined collateral requirement for these two markets. The suggested approach comes up with a netted exposure figure for each day, taking into account the difference in delivery risk between these markets. This allows for a simplification in the formulas needed which also makes the approach easier to understand. When applying this netting approach while keeping the rest of the calculation methods the same, a drop in collateral level of 5% to 20% could be expected, depending on the member and its trading behaviour. The analysis of alternative methods identifies the 'ExponentiallyWeighted Moving Average' (EWMA) as a viable alternative method for the calculation of the collateral requirement. This method has some attractive characteristics, such as letting the collateral requirement decline gradually, with a certain persistence, after a peak has occurred and has a rationale in the choice of parameter setting. In the tests for performance EWMA outperformed the current 'Simple Moving Average' (SMA) method on the measures of prudentiality as well as the measure of opportunity costs; for moderate to high persistence choices of the EWMA parameter. Continuous margining: The performance tests done on the alternative margin setting methods for continuously traded instruments gave the impression that the more reactive methods outperformed the current fixed margin method. However, from the results of a stress-test it can be concluded that a fixed collateral level is more prudent and clearly provides a better cover than the reactive margining methods. The reason is that while the reactive methods let the margin decline when volatility allows for it, this in turn increases the magnitude of the shortfall when the next peak occurs. Given that the total shortfall scales with the position of a member, the resulting total uncovered exposure is higher than with a (non-declining) fixed margin. It is therefore recommendable to keep the fixed margin method and regularly review the adequacy of the chosen levels for the different instruments and adjust these where needed. Since the markets are relatively illiquid the choice of the somewhat 'high' amount of 50% of initial margin in the current system being available for mutualisation of losses can be considered prudent.
Item Type:Essay (Master)
APX-ENDEX, the Netherlands
Faculty:BMS: Behavioural, Management and Social Sciences
Subject:85 business administration, organizational science
Programme:Industrial Engineering and Management MSc (60029)
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