Derivatives Study Center








Special Policy Brief 1




The Bigger They Come, The Harder They Fail


Enron’s Lesson For Deregulation


Randall Dodd

Derivatives Study Center

February 7, 2002



Based on data from Enron’s last annual report, the Derivatives Study Center calculates that the amount of derivatives contracts on Enron’s books at the end of 2000 was $758 billion in notional value.  It is likely that this figure grew by another $100 billion before Enron’s trading ceased about 11 months later.


            This represents a significantly large amount of trading and dealing in derivatives, and the notional value of Enron’s derivatives book compares in size to all but the largest derivatives dealers in the banking and securities sectors. 


            The fact that Enron had amassed such an enormous quantity of derivatives on their books means that Enron had become a major financial institution and played a significant role in the overall U.S. economy.  In order to accumulate a portfolio of that magnitude, Enron had to trade with a large number of firms in many sectors of the economy.[1]  The size also suggests that Enron Online and Enron’s other derivatives market making likely resulted in at least some degree of price discovery. 




            The most important implication of Enron’s enormous derivatives dealing activities is that Enron acted as a major financial institution in the U.S. economy, but was not subject to the safety, soundness and transparency rules that apply to banks, securities brokers and dealers, futures brokers, insurance companies and pension funds.  Since Enron was not regulated as a financial institution, it faced no capital requirements; specifically, it was subject to neither a minimum capital requirement nor a requirement that its derivatives and other financial activities be separately capitalized.  Enron was not required to register as a financial institution, and its traders were not required to be licensed to trade OTC (over-the-counter) derivatives.  In other financial markets, securities and futures brokers are required to pass exams and register as brokers.  Enron was not subject to reporting requirements like regulated financial institutions, and this is a major reason why so little is known about its trading activities and the derivatives markets in which it was operating. 


            The OTC derivatives markets in which Enron acted as a dealer were entirely unregulated and lacked a public regulatory authority with the capacity to detect potentially debilitating loses among trading firms, detect and deter manipulation or fraud on the market, and to create more transparent markets by requiring the dissemination of key market information. 


            In short, these numbers show that Enron was an unregulated financial institution engaging in a tremendous volume of unregulated derivatives transactions. 




Notional Value of Derivatives


Natural Gas


Crude and other liquids




Metals, coal, pulp, paper




Interest rate


Foreign currency







                         Enron.  Financial Report, 2000.  DSC calculations.

- no estimates made for these contracts due to lack of price information



Comparison of size.


            One of the problems with expressing the size of a derivatives dealer’s trading book is that the numbers are so large that it is easy to lose sense of their enormity.  Once figures reach the billions of dollars, then the hundreds of billions of dollars and then the trillions of dollars, they enter a realm so far beyond the value of people’s incomes, homes and even the rare lottery jackpots that it becomes hard to communicate their importance.  In order to provide some perspective, consider the following comparisons to the size of the total U.S. economy as well as the derivative books of other major financial institutions.


            The size of the total U.S. economy, as measured by the gross domestic product (all the final goods and services produced within the U.S.) reached $10 trillion or $10,000 billion, for the first time at the end of 2000.  By this yardstick, the notional value of Enron’s derivatives book was 7.8% the size of the total U.S economy.


            Another point of comparison is the size of major U.S. corporations.  The Microsoft Corporation is presently valued at $337.5 billion – about half the size of Enron’s derivatives book.  General Electrics is valued at $365.8 billion – again about half the size of Enron’s book. 


            Perhaps the most direct comparison should be with other derivatives dealers.  There are a couple of good sources of data to help in this.  The Treasury Department’s Office of Comptroller of the Currency (OCC) requires major U.S. banks to report some aggregate figures on the size of their derivatives holdings.  The OCC’s quarterly derivatives report for the period ending in December 2000, shows that Enron’s derivatives book would have ranked as the seventh largest amongst the largest U.S. banks and holding companies.  While definitely smaller that Chase, Morgan Guarantee (J.P. Morgan), Bank of America and Citicorp, Enron was larger than Wells Fargo, the Bank of New York and Fleet National.


            Enron can also be compared with major Wall Street securities firms.  In this case the data come from figures provided by Paul Spraug’s Swaps Monitor (www.swapsmonitor.com).  While top securities broker-dealers like Goldman Sachs, Merrill Lynch and Morgan Stanley are in a league of their own, with derivatives books ranging in size from $4 trillion to $6 trillion, Enron ranks alongside Bear Sterns, Berkshire Hathaway and AIG.  Based on commodity derivatives alone, Enron’s volume of transactions exceeded that of all of the major securities firms that reported their commodity contracts separately.


            Enron is certainly comparable to other commodity derivatives dealers.  These financial institutions are referred to as commodity dealers because they are not – that is, not at all – registered or regulated as either a bank, securities broker or dealer, futures broker or any other financial institution.  These commodity dealers are unregulated financial institutions operating in an unregulated OTC derivatives markets.


As a commodity derivatives dealers with an enormous derivatives book, Enron was not along.  Data for this comparison also comes from Swaps Monitor.  Their estimates for major OTC commodity derivatives dealers show that El Paso Energy had $576 billion in OTC derivatives on their books while Duke Energy had $390 billion and Williams Companies had $273 billion.   It showed that Enron had $201 billion in outstanding OTC derivatives in gas, electricity and oil.  According to these figures Enron was the fourth largest amongst commodity derivatives dealers.  However using the $758 billion estimate from the Derivatives Study Center, Enron was the largest of these OTC dealers.


The differences between the estimates from Swaps Monitor and the Derivatives Study Center are based on three factors: 1) Swaps Monitor excludes all but gas, electricity and oil and other liquids; 2) Swaps Monitor does not treat the commitments for future sales as forwards (without that adjustment the DSC figure is $568 billion); and Swaps Monitor converts the Btue units directly to dollars using the gas price for Btues.[2]  Their method is valid and simpler to calculate, but the DSC method does not rest on the assumption that the Btu content in the various energy sources is arbitraged out across commodity prices.  The DSC approach allows, for example, the price of Btues from electricity to exceed the price of Btues from crude oil or gas.  That is why DSC figures for gas differ very little from Swaps Monitors figures on the notional value of gas based derivatives, and the difference is due largely to estimates of the value of electricity and oil based contracts.




            The DSC estimated the size of Enron’s derivative book using the following methodology.  The basic facts were taken from Enron’s last annual report filed for the year ending December 31, 2000.  In the footnotes to that report, Enron stated the notional principle of its derivatives trading.  Most of the numbers were expressed in terms of TBtues, or trillion BTU equivalents.  DSC used standard measures for converting BTUs into physical commodity units such as cubic feet for gas, barrels of crude oil, and megawatt hours for electricity.  Once the numbers were converted in these units, then a price per unit at that time (end of 2000) was applied to calculate the dollar amount of notional principal.  The prices per unit were obtained from a Swaps Monitor report on commodity derivatives dealers published in 2001.


            Before proceeding further, a few issues regarding the methodology and numbers used in the estimates should be addressed.  First, the basis for the estimates are numbers reported by Enron, and the veracity of anything reported by Enron is now under suspicion.  However, there are no other alternative numbers because of the non-transparent nature of these markets and the lack of reporting requirements by OTC derivatives dealers.  Second, the figures reported by Enron for crude and other liquids were treated entirely as though they represented pure crude oil.  This yields a conservative estimate of the notional principal because the price of crude oil is lower than that for its distillates. 


Derivatives and Enron’s Failure.


            Derivatives played two roles in Enron’s failure: first as fraud and then as tragedy. 


            The catalyst for Enron’s collapse starts from the heavy losses they suffered on real, physical investment in such assets as an electrical power plant in India, a water treatment plant in England, a steel mill in Arkansas and fiberoptic broadband capacity across the U.S.  They also lost money, often associated with these assets, by investing in ventures designed to create new centralized markets that would dovetail with their wholesale and derivatives trading activities.  For example they tried to create such markets in steel, coal, wood pulp and broadband capacity.  When these investments turned bad, Enron turned to creative accounting.  They hid debt and moved loses off the books of the parent Enron Corporation and into a web of partnerships.  Then they used these partnerships to fabricate income that was reported by the parent Enron. 


Enron used derivatives extensively in the creation of these partnerships and then again in the effort to hide debt and loses while fabricating income.[3]  Derivatives were used to capitalize the partnerships and to guarantee them a positive rate of profit.  Derivatives were also used to generate income from the partnerships for the parent Enron Corporation.


            Eventually, Enron’s loses became so large that they had to be reported publicly as a $1.2 billion charge against equity.  This shocking news attracted greater scrutiny to Enron and its practices.  Two top executives left, the SEC announced that it was looking into Enron’s reporting practices, Enron restated income for four prior years to show a $600 million reduction in previously reported earnings and then the news got really bad.  Other energy companies and derivatives traders began to lose confidence in Enron as a derivatives counterparty.  Enron’s trading partners announced that they would either no longer trade with Enron or they would enter into only short-term transactions while they kept a close watch on the situation. 


The next blow fell when Enron’s credit rating was downgraded.  This required Enron to post “super margin” as a performance bond on their derivatives positions with derivatives counterparties.  The implication was Enron had to come up with a substantial amount of fresh capital at a time that it was already in trouble for having inadequate capital.


            The loss of both trust and investment grade credit rating caused Enron’s trading volume to evaporate.  Without trading volume, Enron could not earn their bid-ask spread as dealer for Enron Online and other derivatives markets, and without the bid-ask times volume there were longer the enormous trading profits earned in the previous years.  In the end, the bad investment decisions and fraudulent practices destroyed their previously profitable derivatives dealing activities. 



Legislative Remedies for Derivatives Markets.


            The following set of prudential financial market regulations would make OTC derivatives markets more safe, sound and transparent.  They are similar to regulations that apply to other sectors of the financial system, such as banking, securities and futures trading, and they should be applied to all OTC derivatives dealers and derivatives transactions in order to improve safety and soundness and to maintain regulatory parity.


            First, establish capital requirements and margin (collateral) requirements.  Capital requirements are critical to prevent the problems at one firm from becoming problems at another firm; and they prevent short-term problems at a dealer from causing the market to freeze-up or meltdown.  Margin (collateral) requirements do the same for each transaction.  The current market practice, in so far there is one, is dangerous.  It requires a firm to become "super-margined" if its credit rating drops, and thus initiates a large increase in the need for margin (collateral) just at the time the firm is experiencing problems with inadequate capital.  This amounts to a crisis accelerator.  

            Second, establish registration and reporting requirements. All brokers, dealers and other non-end-users of OTC derivatives should be licensed and registered.  This is the approach used for securities markets, banking, insurance and exchange-traded derivatives, and it should apply to OTC derivatives markets as well.  Reporting requirements will make the markets transparent for the first time, and will give regulators the capability to observe markets to detect problems before they become a crisis. 


            Third, establish obligations for OTC derivatives dealers to act as market makers.  They capture the advantages of their position in the market, and like dealers in U.S. government securities (the most efficient and highly regarded OTC market in the world) they should be obliged to act as market makers throughout the trading day.  This will ensure market liquidity was they must maintain bid-ask prices continuously through trading hours.










[1] )  Data indicates that dealers in commodity linked derivatives trade proportionally more with end-users and other non-dealers than dealers in financial derivatives.

[2] )  Based on telephone interview with Swaps Monitor staff.

[3] )  See the letter written by Enron employee Sharron Watkins explaining some of these transactions.