Notes to the Consolidated Financial Statements
(Years ended December 31, 2007 and 2006 (In thousands of dollars, except per share amounts)
6. NGX clearing risk and backstop fund:
As an electronic exchange and clearing house for physical and financial natural gas and electricity contracts, NGX is the central counterparty for all transactions traded on the exchange between participants (“Contracting Party”). Physical contracts have fixed prices determined by the electronic matching of bids and offers from Contracting Parties at the time the trades are initiated. Financial contracts, generally swaps, require the payment of a differential between fixed prices, as agreed through the bid and offer process, and specified market indices at future dates. The terms of energy contracts outstanding at December 31, 2007 range from one day to five years.
NGX does not take physical delivery of energy products traded on the exchange. In the event of non–performance by a Contracting Party in a physical transaction, NGX has arranged for third party physical backstopping with the hub operator or other third parties, with all related costs payable by the non-performing Contracting Party.
As a clearing house, NGX is exposed to credit risk in the event that a Contracting Party fails to pay amounts owing to NGX (recorded on the balance sheet as energy contracts receivable). NGX is exposed to market price risk if a Contracting Party fails to take or deliver energy products which have been contracted at prices less favourable than current market prices. To mitigate these risks, NGX maintains comprehensive credit policies and practices. NGX requires each Contracting Party to provide sufficient collateral, in the form of cash or letters of credit, to exceed all outstanding credit exposure as determined by NGX in accordance with its margining methodology. This collateral may be accessed by NGX in the event of default by a Contracting Party. NGX measures total potential exposure for each Contracting Party on a real-time basis as the aggregate of:
| (i) | Outstanding energy contracts receivable; |
| (ii) | “Variation Margin”, comprised of the aggregate “mark-to-market” exposure for all forward purchase and sale contracts with an adverse value from the perspective of the customer; and |
| (iii) | “Initial Margin”, an amount that estimates the worst expected loss that a contract might incur under normal market conditions during a liquidation period. |
As a result of these calculations of Contracting Party exposure at December 31, 2007, NGX held cash collateral deposits of $273,612 (2006 – $296,957) and letters of credit of $2,230,928 (2006 – $2,087,175). Cash collateral deposits are segregated in individually designated bank accounts held by NGX at a major Canadian chartered bank. NGX also maintains a clearing backstop fund, which was increased on November 1, 2007 from secured $30,000 Canadian to unsecured U.S. $100,000. The Company is the guarantor of this fund.
In addition to continuous monitoring of margin requirements, NGX requires the use of a Contracting Party agreement, a standardized agreement that allows for netting of positive and negative exposures associated with a single Contracting Party. NGX also monitors the financial condition of Contracting Parties (and their support providers, if any). In the event of a default by a Contracting Party, including a failure to take delivery of product, a failure to deliver product, failure to pay, failure to deposit collateral, or insolvency, NGX has the right to liquidate that Contracting Party’s open positions, draw down their collateral and terminate them from transacting on the exchange.