Once considered the most complex solution, we are now driven by the need to find an alternative to EOL as soon as possible. The current problems experienced with EOL have shown that Enron have to speed up their development and their implementation by increasing the number of employees dedicated to the project. The cost of this provision cannot be underestimated. The lack of confidence between traders and Enron have cost the company at least one billion dollars (the market has moved from 60 million dollars monthly average to less than 10 million dollars). What was the cause of the delay? The cause was the inability to guarantee an operating capacity at least equal to Enron's trading volume on behalf of the developers. In fact, our internal volumes on the EOL are only 50% of the volumes traded. To solve this problem, Enron developed a software platform allowing banks to make markets with Enron but with the condition that if Enron's volumes are under-utilized (as stated above), the banks' volumes will also be under-utilized. It is therefore natural that banks will not accept the responsibility of providing liquidity to the market if Enron is not the same confident. We now have the responsibility to find a way to operate the system even if Enron fails to implement the system. We believe that we need to construct a system which will: (a) allow Enron to provide liquidity to the market while (b) enable banks to operate Enron's system in case (c) make Enron's system more robust. These problems have been solved by the use of an automatic matching system in a distributed manner. The market maker's operation is not as the market maker, but as an intermediary/book-keeper. Similarly, Enron can be an intermediary/book-keeper, but without the obligation to provide liquidity to all market participants. This role can be automatically distributed to independent market-makers in case Enron fails to do so. However, in order for banks to remain active, Enron must give to banks the tools to operate Enron's system and in particular the tools to manage the counterparty credit risk. (c) Enron's future as a Market Operator When Enron can become the market-maker of choice for many counterparties by being able to operate the system of the counterparties, it will create new business opportunities in many other areas. What is this mean? For example, there are many sites that Enron can bid on behalf of its customers. At the moment, the company does not buy or sell gas because it cannot make markets on EnronOnline. The proposed model allows Enron to buy and sell. If the counterparties are willing to hedge their positions with Enron, the prices will reflect the true values. An example will clearly show the point. A customer wants to buy some 3 year natural gas from Enron's suppliers (or traders). The customers' price is the price set by the inter-regional bid-based markets and agreed with Enron's suppliers. Enron's margin will depend on the management of the counterparty credit risk. To become the market-maker of choice for its customers and counterparties, the company must allow its customers to manipulate prices if they are willing to do so. A way for the counterparty to manage the price risk is to use call options (option to buy or sell) to manage the position risk. This operation will allow the customer to lock the price risk at the price set by Enron and the option to purchase the gas at the current price. The operation is very similar to the energy basket construction if we consider the futures contract as the energy basket. This is the proposed business model in case Enron wants to play the role of the market-maker of choice. The main drivers for Enron's business are the following: (1) become the market-maker of choice for its customers (2) allow customers to manage their positions by acting through its market making entity, in the same way market makers manage the positions of their customers. The management of the positions will generate a control on the counterparty credit risk by allowing the customers to modify liquidity/ funding and cash flow positions, i.e., time and collateral requirements. As a consequence, the system can be implemented without a haircut for the banks. This is a proposal of the future of Enron's business. We are looking at various type of structures and legal agreements with Enron (including bankruptcy). We hope to be able to explore more this issue and propose further improvements in the trading system. The implementation of this structure will not eliminate all risks. The company's management must be aware of the risks that are inherent in the trading operations. (d) Collateral management solution. The main risk in the trading operations is related to the absence of collateral and to the haircut applied on the defaulting parties. A structure in which the defaulting party is going to be forced to sell part of its positions to the market-maker is eliminating the risk from the system. The collateral received from the market maker for the hedged position will allow the defaulting party to meet its obligations and keep on trading. The collateral can be either in the form of futures contracts (in case Enron acts as the market-maker of choice), or cash/insurance in the case in which Enron acts as an agent. The collateral management should be performed by a
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8 market-maker or by a regulated market-maker (or swap dealers in the US). The collateral management procedure is as follows: (1) Enron will set-off the mark-to-market of the portfolio sold to Enron against Enron's risk-free position. If the mark-to-market of the portfolio is higher than the offsetting Enron's risk free position, Enron will buy futures contracts with the counterparty and transfer the position to the third party (default management agent or a bank) for settlement. In the case Enron acts as a market maker of choice, the transactions must be cleared through an Enron subsidiary. (2) Enron will close out all positions managed by the third party. Enron will give the third party an option (call option) on Enron's portfolio (which is a combination of futures and/or insurance). The call option should be written for a period of one year and must be settled at the option's inception date. The option will have a strike equal to Enron's risk-free rate plus an additional 20% margin, and a time value of zero. The premiums on the option will be equal to the mark-to-market exceeding the mark-to-market of the portfolio. The call option value will therefore be equal to the market value of the portfolio (the total value minus the shortfall of Enron's risk-free position). Example 1: Enron is long 1000 MWh in a region with a settlement of day-ahead market. The mark-to-market position on day a is 400 MWh. Enron's risk-free position is short 500 MWh. Enron will close the position by buying 500 MWh and write an option for a net shortfall of 500 MWh. Example 2: Enron is long 1000 MWh in a region with a settlement of day-ahead market. The market maker position on day a is 750 MWh. Enron's risk-free position is short 200 MWh. Enron will close the position by buying 200 MWh and write an option for a net shortfall of 500 MWh. Example 3: Enron is short 1000 MWh in a region with a settlement of day-ahead market. The market maker position on day a is 750 MWh. Enron's risk-free position is short 200 MWh. Enron will close the position by selling 200 MWh and write an option for a net shortfall of 500 MWh. The portfolio is long 700 MWh and short 300 MWh. The risk-free position is used as the reference portfolio and the call option is written on Enron's position. The portfolio to be managed is Enron's risk-free position. The strike price of the option is the sum of the risk-free rate and the initial margin. The price of the option is calculated by the following formula: C * (P^ strike * sqrt(T) + 1) * exp(-r * T) / (P * sqrt(T) * sqrt(T)) Where: C is equal to 20%. P is equal to the risk-free rate, which is defined as the U.S. Treasury Bill, three-month interest rate. T is equal to