February 2006 Market Clearing in the Energy Industry 3-8 © Copyright 2006, CCRO. All rights reserved. is realized when counterparties would not trade with each other or would trade with one another in a way that incurred higher credit costs. Clearing also reduces the all-in cost of risk management in a number of ways: • The trade guarantee, a feature of market clearing, mitigates the credit risk associated with failed trades. • Market positions are netted, greatly reducing credit cost-of-carry. • The credit exposure, with respect to entities clearing transactions, is distributed to parties (i.e., banks, credit insurers, Futures Commission Merchants (FCMs) and other providers of credit) who hold the credit risk for a return, or transfer it through syndication or credit derivatives. This is a benefit to the extent that the cost of this credit is lower than it would be if obtained via other alternatives such as lending banks, commercial paper, or other credit sources. • Clearing facilitates the calculation of cash flow at risk (CfaR) as a measure of contingent liquidity, a key measure of a company’s capital (or liquidity) adequacy. In summary, the most commonly cited benefit of clearing relates to capital efficiency. The concentration of transactions with a single central counterparty can facilitate the netting of long and short positions in correlated products and across correlated time periods within the same product. This multilateral netting of positions leads to the calculation of a single initial margin for a market participant, which may be significantly less than the amount of collateral required for the same positions if the transactions were spread among bilateral counterparties. FIGURE 2-1:TO REDUCTIONS TO CREDIT COSTS How significant is the benefit of clearing? It is difficult to quantify precisely. But for situations in which all the benefits described above can be realized, it is estimated1 that clearing can reduce the credit cost of carrying positions (e.g., the credit cost-of-carry) from approximately 110 basis points (bps) to 36 bps per annum on notional credit exposure, an enormous cost reduction when considering the billions of dollars of notional credit exposure outstanding in the energy sector today. 1The analysis was performed by PA Consulting Group, Inc. based on generalized assumptions and its experience. It is intended to be indicative rather than definitive. Details of the analysis are contained in Appendix A. REDUCTIONS CREDIT COSTS (basis points) 36.7 110 42 17 10 5 Credit cost of carry - uncleared Multilateral netting by novation Multilateral close-out netting Collateral netting Payment netting Credit cost of carry - cleared