Phil Thompson (pthompson@mobiusriskgroup.com)

Today we will address challenges faced in the optimal execution of a risk management strategy.

Challenge

One of the biggest challenges in effectively executing a risk management strategy is the balance between expediency and value protection. Moving large volumes in the market across the less liquid tenors without losing value can be difficult. Illiquidity is exacerbated by the increased hedging requirements of lenders that mandate up to 5 years of de-risking within a small window of time (this generally coincides with deal close). Noticeable liquidity gaps appear in the tenors beyond twelve months, when large volumes are involved, at illiquid basis locations, in odd tenors, and at times due to key market participants being absent.   These liquidity gaps often result in value being discarded.

Hedge strategy discretion is essential to protecting value as a company goes to the execution phase of the risk management process.   The more informed the market becomes about a company’s hedge strategy, the faster value is destroyed as smart money “pre-hedges” the position.

Balancing the Board of Directors’ mandates against market liquidity has been, and will continue to be, a challenge.   Expediency comes at a cost.   In our experience, this concept is often lost on a Board so the more they understand the aforementioned challenges, the better bottom-line result.   It is important to define the cost of a trade, whether the trade still makes sense, what information it releases to the market, and how the trade affects the balance of the portfolio.   There is no silver bullet solution for this challenge, but understanding the value levers involved and educating the Risk Team will allow informed decisions and an accretive result.

Lack of Liquidity – The Background

The 2008 financial crisis brought derivatives and speculation into the public consciousness. The word “derivatives” became akin to   “snake oil sales,”’ and their   supposed complexity provided an easy scapegoat that   willing market participants could hide behind. The Dodd-Frank Act focused on market opaqueness as a critical contributor to the financial crisis. Transparency and reducing the role of speculators became a top priority, with the ultimate goal to reduce systemic risk.

The voluntary/involuntary restrictions, in addition to exits by hedge funds and other speculators left the market with a liquidity gap not easily filled. The oil market crash of May 2020 perfectly illustrates this challenge. Refiners, end-users, remaining hedge funds, pension funds, and trading companies use nearby contracts to speculate and risk-manage their activities. Stepping out 3-5 years in any market without losing material value requires art and patience.

Over-the-counter (OTC) execution allows almost infinite flexibility and has many advantages when compared with the standardized ‘Exchange-Traded’ products. The cleared ‘Exchange-Traded’ markets remain essential, as they provide transparency into a pure market, price discovery when there is liquidity and reduced costs when compared to OTC derivatives.

Hurdles

The development of the Swap Data Repositories (SDR) was designed to create  transparency in commodity markets. Once a trade is executed Over The Counter (“OTC”), one party to the trade reports it to either CME, ICE or DTCC. These trades are posted within a certain time frame and provide the entire marketplace basic information about executed trades. The unintended consequence of having an SDR in an illiquid market is that now the market has insight into all trades conducted and pricing trends.   Using discretion when executing a strategy (volume/timing/tenor) should be viewed as part of the strategy itself.   

Solutions

Every risk strategy is unique.   Optimal process starts with knowing your position, understanding your risk, and knowing the best use of each dollar spent to reduce risk. Sometimes an aggressive strategy is prudent; however, being discreet, hedging the commodities and tenors of highest value in the portfolio, and doing so without damaging the forward curve will often increase asset value.   Take the time to properly measure risk and mitigation costs.   Educate your Board, your capital partners and stakeholders.   Banks should not be viewed as risk advisors.  Embrace the term ‘strategy’ and implement a plan which encompasses all value levers, including an understanding of how execution can materially alter portfolio value.