Removing barriers between offices: an energy commodity risk management necessity

Louis Caron, Global Energy Risk Specialist, RiskAdvisory (A Division of SAS)

Many front and middle-offices at energy trading organizations have in the past split apart due to conflicting agendas. The front-office viewed itself as the firm’s moneymaker, generating the revenue to pay everyone else’s salaries. The middle-office viewed itself as keeping the front-office in check, ensuring that today’s big profits don’t turn into tomorrow’s cataclysmic losses. These competing functions led to interdepartmental conflagrations and turf wars, wasting time and energy.

Organizations seeking the most efficient and effective trading and risk management operations should remove strict barriers between front and middle-offices and recognize the competitive advantates that can be gained from a strong middle-office working harmoniously with the trading group. Re-examining relationships is a good idea right now, as more information comes out about the investigations by US commodities regulators against energy market players feeding false supply and demand information to the market. The investigations, announced in early September, remind of the market manipulations engineered by Enron and other power marketers in the early part of this decade. The oil and gas industry does not need a similar debacle.

This article examines the traditional areas of conflicts between the front and middle-offices of trading organizations, and offers solutions for addressing the challenges.

Goals and cooperation

The relationships between front and middle-offices at energy commodity trading firms aren’t much different from those of investment banks or money managers. Risk is taken in the front-office. The middle-office measures and manages the risk. Their respective goals aren’t mutually exclusive, but neither are they exactly the same. Cooperation between the two operations is essential to creating a successful organization. The six areas of contention and need for solution are:

• Trading limits
• Reporting
• Staffing
• Compensation
• Recruitment
• Corporate roles and responsibilities

Trading limits

Trading limits are perhaps the primary issue of profound disagreement between the risk takers and risk managers. Almost invariably, front-office traders want limits far higher than those imposed by the middle-office risk managers. Imagine the “can’t do anything wrong” mentality some traders develop when oil goes up day after day. It’s hard to argue against them. And when particularly strong personalities are involved, the clashes conflagrate into angry phone calls and email battles, resulting in tremendous inefficiencies and wasted, misdirected energy.

Solution: To manage such situations, the Risk Management Committee – which should include a cross section of all the relevant trading and risk management players and meet at least once per month – should be prepared to step in firmly and resolve the dispute. Risk management committees should always be empowered to settle these kinds of disputes.

Reporting

Reporting is another common area of disagreement. When firms employ the classic model – in which the middle and front-offices are completely segregated – the middle-office marks positions to market independently, at levels that are often different from the front-office’s perception of where the market is. Almost invariably, the middle-office marks to market at more conservative levels than the front-office would. From the traders’ perspectives, senior management sees vastly different risk numbers from what traders perceive as reality, while the middle-office views itself as the safeguard for the company’s overall health. Conflict is inevitable.

Solution: Creating a more harmonious mark-to-market process will solve many misunderstandings between the two groups. The front- office often has superior information on which it is making its decisions, especially when establishing forward pricing curves in illiquid markets. Ideally, risk managers must work with front-office managers in developing forward curves, to get the best of both worlds.

Staffing

All too often relatively inexperienced risk managers – even with unquestioned mathematical acumen – impose strict limits on seasoned traders and create serious animosity and dysfunction.

Solution: Managers should look for middle-office personnel with front-office experience. Risk managers who have taken positions themselves and have dealt with trading limits and controls from the other side are better attuned to the effects of risk controls on traders’ psychologies than are, say, entry-level quantitative specialists fresh from business school.

Compensation

It’s no secret that front-office personnel are usually more highly compensated than those in the middle-office. With the higher salary comes a certain amount of swagger and, in some cases, a heightened or even exaggerated sense of importance. When someone in the front-office not only makes huge bonuses but also has a bigger base salary than a risk manager, there’s a tendency to downplay the importance of the risk manager.

Solution: While no one would argue for absolute parity, middle-office personnel should be compensated at levels comparable to those in the front-office. It’s easy to measure a trader’s performance, but risk managers – who help traders by making strategy recommendations, handling reporting functions and so on – sometimes, get short shrift. Leveling the playing field demonstrates to risk managers and traders alike the value the firm places on the risk management function. Consider making base salaries higher for middle-office personnel. At the same time ensure that bonuses remain greater for front-office personnel. If companies pay greater attention to roles and responsibilities of the two groups, as discussed below, there is more justification for taking this approach to salaries and bonuses.

Recruitment

The demand for qualified energy risk managers is off the charts and executive search firms freely admit that finding qualified candidates is one of their most difficult tasks. Nonetheless, companies must attract candidates with the right skills and educational background to staff the middle-office.

Solution: Appropriate remuneration signals must be sent to the marketplace of candidates. Higher prices are likely inevitable for this scarce resource.

Corporate roles and responsibilities

The stormy relationships between front and middle-office personnel are one-way streets. Each organization is equally responsible and should seek to understand their roles and responsibilities.

Solution: Middle-office managers must recognize their role as service providers for the front-office, providing accurate information on the potential impact of transactions on mark-to-market, value-at-risk and credit risk limits in a timely fashion.

The front-office should view the best middle-office managers as an additional resource with respect to the comprehension of risk and value in complex transactions. The two should work together to justify the expansion of permitted products and transactions.

All of these activities can lead to a more cooperative atmosphere and a better working relationship between these vital areas comprising an energy commodity trading and risk management operation.