Derivatives.
This is pure speculation w.r.t. ENE, but this is how it works.
XXX is an investment bank, and it has lots of clients - blue-chip and hedge funds.
XXX advising these clients, or on behalf of them, recommends that the do some rinky-dink energy derivative (more fees) for a variety of reasons:
i) Hedge clients' risk - rainfall/snow/gas prices etc.
ii) Take a bet (as its analysts are so good at calling the market)
In this instance a hedge fund may make a bet with XXX rather than ENE as XXX can manage the hedge funds credit exposure better than ENE, as this is done across the entire hedge fund's portfolio not deal-by-deal.
In essence the retail market (Bank XXX's clients) cannot deal with the wholesale market (ENE and DYN etc), because of credit, and also because they prefer tailor made products - hence the Over The Counter (OTC) derivatives markets.
Bank XXX stands in the middle and brokes the trade either explicitly,
Bank XXX buys and sells simple products (low fees),
or via derivatives (high fees) -
Bank XXX trades 'complex' derivative with client
Bank XXX hedges simple derivative with Trader - ENE.
So if the market counterparty - ENE, say goes under then Bank XXX is left with one part of the trade - the trade with the client.
It is Bank XXX's responsibility to manage this trade so now they have an unhedged trade. In general the whole market knows what is happening and tries to spoil Bank XXX hedging it thus costing money.
In general the investment bank would trade a long-dated product say 5-10 years with client, but would hedge shorter-dated in the wholesale market as this is more liquid for large size.
Speculation.
Say the State of California wanted a 10yr Natural Gas linked swap. They would trade with their blue-chip investment bank - not with Enron! Their friendly investment bank would then trade with the energy markets to get a hedge.
If their counterparty goes under then the investment bank may be screwed.
Say California bought 10yr Gas from XXX.
XXX buys a hedge from ENE.
Price of gas falls!
California loses money on swap/ XXX gains.
XXX loses money on hedge/ ENE gains.
If ENE goes under XXX has to pay the market value of its trade to ENE which is positive (as gas has fallen).
This is no problem as it has made money from California, and provided XXX can re-hedge without the price of Gas going up then XXX is safe. The trick is getting the re-hedge on when the market is going crazy - c.f. LTCM.
My guess is that bank XXX is a little hurt (no fat bonuses), but not destroyed. They are usually hedged on these trades.
hope that helps.
-macavity |
