NOS and Risk Handling AFM in Kiev March

NOS and Risk Handling AFM in Kiev, March 21 st and 22 nd, 2002 Ronny Schumann VP Technology, NOS ASA ronny. schumann@nos. no 1

Content • NOS ASA - multi-product clearing house • Risk handling • Central Counter Party functions • Market challenges = technological challenges • Technology 2

NOS ASA • Established 1989. Shareholding company. • Clearing derivatives at Oslo Stock Exchange since 1990 • Designed the Nordic power market together with Nord Pool in 1994. Cleared Nordic power derivatives since 1995 • Launched a cross border link (LEC) for trading and clearing between Oslo, Stockholm and London in 1997 • Acquired 40 % of Clearing Bank Hannover (CBH) spring 2001. CBH launches clearing of German OTC power derivatives spring 2002 • Launched the ship freight exchange Imarex autumn 2001 3

Why Clearing? Buyer • • • Trading risk NOS enters as counter party NOS garantees the fulfilment of the trade NOS demands a margin requirement from the trading parties • • • Removal of trade risk opens for new trading opportunities Reduced capital requirement for the traders Allows anonymous trade 4 Seller

Functions of a Clearing House • Reduces or eliminates the trade risk • Calculates ‘mark-to-market’ (loss and gain) and handles the settlement process • Calculates risk • Controls the collaterals (cash, guarantees, shares, etc. ) • Does ‘netting’ across markets • Monitors price development and participants • Processes defaults 5

Clearing House - role in the Markets • A recognised clearinghouse’ role is to guarantee fulfilment of contractual obligations for both buyer and seller related to derivatives trading • A clearinghouse provide risk reducing clearing services to market participants • The clearing house must have unquestionable financial strength to ensure its capability as a back-stop for the entire market • The clearing house manages its counterpart risk by calculating margin requirements to be covered by collateral 6

Margin Requirements • Margins must be sufficiently high to cover NOS losses in case of default • The margin requirement is a function of two variables: À Volatility À Liquidity • NOS uses its own adaptations of SPAN to calculate the margin requirement SPAN® is a registered trademark of Chicago Mercantile Exchange used herein under License. Chicago Mercantile Exchange assumes no liability in connection with the use of SPAN by any person or entity. NORDIC SPAN is NOS ASA’ implementation of the SPAN framework for the power and Imarex market. 7

Principles for Managing Counter Party Risk Margining to cover exposures – converting credit risk to market risk • margining at 99, 8% confidence level • continuous analysis of risk essential: volatility, liquidity and distribution • cross product portfolio margining • margin calculation by use of modified versions of SPAN® – maintain a clear view of the exposures • clearing at the end client level: positions, collateral, settlement – develop “lines of defence” in addition to the margins i. e. ”Base collateral”, mutuality, insurance policies etc. 8

Current and future business operations OSLO STOCK EXCHANGE RISK & SETTLEMENT SERVICES OTC MARKET FINANCIAL DERIVATIVES SHIP FREIGHT DERIVATIVES IMAREX SECURITY LENDING FISH & OTHER NEW MARKETS POWER DERIVATIVES UKPX NORD POOL OTC TRADED CBH EXCHANGES 9 MARKET PLACES EXCHANGE TRADED

Scope of business operations • Full clearinghouse or service provider for niche growth markets New markets (e. g. fish, gas, CO 2) Equity derivatives Security Lending IMAREX Freight derivatives Risk Management & Settlement services NORD POOL CBH Other UKPX 10 • Full-scale clearinghouse operations • Clearing systems and service provider

Risk management Market risk Operational risk Legal risk Products Credit risk Markets 11

Clearing goals Tools Goals Eliminated credit risk MARKET ACCESS Margining on end client level LOW RISK State of the art IT solutions LOW COST Cross product/market margining 12 LOW LOCKED-UP CAPITAL

Economies of Scale in clearing • Economies of scale for end-users – Collateral requirements – Settlement – Contractual agreements • Economies of scale for the clearing house – – Netting Capital requirement Technology Risk management Substantial benefits in serving multiple markets 13

Netting Bilateral trade Multilateral Netting Bilateral Netting A A Clearing House B D without netting C E One-to-one relationship 14 A B C` D E Every participant has a relationship to every other participant B C D E The participants have complicated relationships

Growth in commodity markets Broadband futures Gas futures Pulp futures Weather Live cattle futures. Barge freight index options Natural gas options Illustrative Platinum options & futures Drivers of growth: Live hog futures options • Lower barriers to trade • Standardized products Mortgage futures • Increased competition • Risk management techniques Turkey futures Gold Products Butter, eggs, poultry Silver Futures for eggs, butter, cheese, potatoes, onions Aluminium Nickel Copper Platinum Live cattle futures Edible oils index Steel scrap futures Oil forwards and futures Late 1800 s - early 1900 s 1940 0 15 London 1960 Catastrophy futures Norway Finland Singapore Japan Brazil IMM CBOT, NYMEX, CME, LME, Biffex, Nordpool Lean hog futures & options Propane Feeder Heating oil cattle futures Paris China Sydney Exchanges Emissions futures Boneless beef futures & options Paper pulp swaps Certificate of deposit futures Pork belly futures options Palladium Live hog futures Pork bellies Tanker freight Ammonia futures Russia Germany 1994 1980 250 M Number of derivative contracts traded annually 750 M 1998 1. 2 B

NOS Vision Market convergence Commodity markets CCP Energy markets CCP Equity markets CCP NOS vision is to be a leading clearing house and provider of clearing services 16

NOS clearing services for new markets Power Exchange system Gas Register Fish Other Clearing INTEGRATED SERVICES Internet-based global trading Real-time clearing On-the-fly margining of trades on end-user level T+0 settlement in US$ Integrated trading, clearing and settlement Interest-bearing margin deposits in US$ 17 Settlement

Requirements n Multi-product and multi-market. Tomorrow’s clearing systems must be able to offer cross-market clearing and netting. Clear. IT has a generic core with adjacent modules handling market and product specific features. This opens for cross-market clearing, either directly in one clearing house or indirectly through linked clearing houses. n Easy interfacing with other clearing solutions. The advantages of cross-market clearing are fully leveraged only when the system can interface with other clearing systems. n Multi-currency. Markets and market players are active across currencies and this puts demands on clearing solutions to be equally versatile. 18

Requirements (cont’d) n Internet based. Internet opens for access to market places and clearing services for anyone equipped with a browser. Internet, and extranets, serves also as the backbone for the infrastructure linking the financial institutions together. n Real-time margining. In order to be competitive clearing solutions must handle over-night market risk in the only way possible - by removing it. This feature enables clearing houses to offer not only higher speed and instant settlement but also lower clearing fees. n Instant settlement. Clear. IT opens, through instant settlement in Settle. IT, for lower capital costs and improved transparency. 19

Requirements (cont’d) n Open-source software. Clear. IT’s architecture is explicitly tailored to avoid commitment to any one set of software solutions. Instead, Clear. IT takes advantage of the continuous development taking place in the world of open-source software. When using commercial products, Clear. IT is explicitly designed so as not to become dependent on any one platform. n Platform independent. Easy system migration and use of open source software solutions prolongs the life span of the clearing system while offering easier maintenance. n Scalability. New markets require solutions that can be easily expanded both in scope, depth and complexity. 20

Clear. IT - key features • Multi-product clearing • Flexible account and participant structure • Real-time information distribution • Modular • Real-time margining • Instant / T+0 / etc. settlement • Multi-currency • Lower production costs 21

Clear. IT - NOS’ new clearing system (2002) Currently: Heterogeneous technology. Proven ability to supply whole ’silo’ Exchange (Imarex) Clearing (Nord Pool) Settlement (Nord Pool) 22 Clear. IT: Multi-market clearing on same platform as leading trading systems Exchange II Exchange. I I Clearing II Clearing. I I Settlement II Settlement. I I

Clearingmodel IMAREX • End-user Clearing, no defined ”broker role” – No Credit Evaluation but formalities to be observed; • Company records, ownerships • Annual Accounts, Equity • Risk management skills – Extra defences • ”Base collateral” defined by individual assessment of solidity and trading activity • Acts as individual default buffer, no mutuality – Margining • Elimination of overnight risk through ”on the fly margining” • Flexibility in respect of intra-day margin calls 23

European developments Switzerland UK France Belgium Netherlands Germany OSE, Norex Norway virt-x LSE Euronext Deutsche Börse x-clear LCH Clearnet Eurex NOS SIS CREST Euroclear Clearstream VPS Key issues: 24 • Horizontal vs. Vertical integration • Governance - User vs. Exchange • Access - Openness vs. Exclusivity

Additional Information • Nos. no • NOS brochures – – company information Clear. IT FOCS Imarex • Clearing Bank Hannover’s OTC clearing solution (GB/D) • NOS SPAN Manual 25

Energy Market Clearing Kiev, March 21 st and 22 nd, 2002 Ronny Schumann VP Technology, NOS ASA ronny. schumann@nos. no 26

European Power Markets Physical power market TWh/yr 380 Norden 320 UK 550 475 Tyskland Rest-EU De-regulation of power markets: • UK (1990) • Norway (1991) • Nordic region (1996 -1999) • Germany, Netherlands (1998) • Spain (2001) Gas markets follow Frankrike 135 220 Iberia Italia 27 Rapid development of new markets with requirement for clearing solutions

Nordic Power Market - Cleared derivatives 1997 1998 1999 2000 2001 44 56 75 97 112 Exchange derivatives OTC derivatives cleared 53 147 89 373 216 684 359 1180 910 1748 Total derivatives cleared 200 462 900 1539 2658 Exchange spot All in TWh 28

Risks in Deregulated Electricity Market • Market risk (volatility is high) • Counterpart risk – new counterparts with different purposes of participation – unknown financial and risk status • New financial risk – combination of bilateral cleared contracts and not cleared contracts • Juridical risk – bankruptcy legislation – non-standard contracts • Operational risk – back office system 29

Margin regime electricity market EXCHANGE TRADED DERIVATIVES OTC TRADED DERIVATIVES CLEARING ACCOUNT MARKET INFORMATION PRICES, TURNOVER ETC NORDIC SPAN ® MULTI CURRENCY SETTLEMENT CASH ACCOUNT 30 MARGIN GUARANTEES

Margin calculations - NORDIC SPAN® • Margin calculations based on the SPAN® framework – net liquidation value based on market prices – change in portfolio value based on 16 market scenarios within a scanning range – scanning range calculation based on • historical prices and volatility • time to delivery – theoretical prices for all futures, forwards and options are calculated for all 16 market scenarios according to well known formulas – extensive use of correlation factors and time spreads Margin requirement is equal to the largest theoretical loss SPAN®is a registered trademark of Chicago Mercantile Exchange used herein under License. Chicago Mercantile Exchange assumes no liability in connection with the use of SPAN by any person or entity. NORDIC SPAN is NOS ASA’ implementation of the SPAN framework for the power market. 31

Requirements for the central counterpart - 1 • Legal framework with rules and regulations – several lines of defense for the central counterpart – efficient use of participant capital • Reliable and flexible computer systems – – time to market for new products are short information capture and distribution via open networks continuous operation margin system that reflects the wide time span of the portfolios 32

Requirements for the central counterpart - 2 • Adequate procedures – – risk management collateral management settlement default handling • Ability to enforce the rules and regulations – trusted third-party – credible and neutral • Financial backing – own capital, guarantees or mutual fund 33

Cross market margining • Clearing of exchange traded- and OTC traded market in the same underlying segment: – Gives a correct measure of investors market risk – Gives the clearing house an improved basis for risk management – Gives the most efficient use of collateral – Gives the most efficient use of liquidity for settlement – May reduce margin levels and clearing house exposure 34

Nord Pool products • Futures - seasons, blocks, weeks of full load, weeks of peak load and days • Forwards – years of 3 seasons, seasons of 3, 4 or 5 months • Swaps – contracts for difference between area price and System Price • European Options - forward year and forward season • Asian Options - block future delivery periods 35

Conclusions • There is a need for a tight connection between the derivatives and the spot market of electrical power – firm prices to settle against – delivery of the ‘real’ underlying • Exchange trading and OTC trading should exist as complementary markets with common clearing – netting between the two markets – equal opportunity for all participants • There is a need for common clearing for trading in different markets/regions – netting between geographical markets based on the correlation – reduced costs - both settlement and capital - for all participants 36

The Future of Energy Markets? Power: • Growth of volume and experience leader Nord Pool • Sharp growth of Powernext and EEX • Iberia/Italy/Austria gravitate towards F/D • Central/Eastern European deregulation Gas and other: • Growth of markets around well-placed hubs • Growth in energy-related markets (CO 2, weather, etc. ) • Consolidation of clearing in 2 -3 large CCPs 37

Additional Information • nos. no • nordpool. no • NOS brochures – – company information Clear. IT FOCS Imarex • Clearing Bank Hannover’s OTC clearing solution (GB/D) • NOS SPAN Manual 38