Posted: 1/2002

Trading Desk

Carriers Seek Rewards of Risk Management

By Josh Long

The energy merchants that pioneered commodity bandwidth trading lost hundreds of millions of dollars in 2001. Now, other backbone providers are investigating their dogged pursuit of risk management and seeking to assuage potential liabilities on global networks that have proved as volatile as the stock markets.

Risk-management experts say carriers are beginning to dabble in structuring deals to protect themselves, if the price pendulum or supply-demand ratio on certain routes swings dramatically. That doesn’t mean necessarily that they are lining up to trade in futures, but they are employing various risk-management techniques.

Taking Inventory

Bandwidth traders say it would be asinine to suggest carriers could begin to assess their network risks when they don’t know what they have.

Carriers, zealous to build and sell optical networks during the Internet gold rush, didn’t pay much attention to managing their inventories, says Nick Cioll, former chief strategy officer at RateXchange Corp.

Carriers have put a certain value on their networks, but there is no way to make an accurate assessment, says Seth Libby, a senior wholesale analyst at The Yankee Group.

Ciara Ryan, a partner in the bandwidth team at global consulting firm Andersen, agrees. Ryan explains the lack of visibility is due in part to mergers and acquisitions creating carriers that are an amalgam of many parts. The information pertaining to these assets has been integrated poorly, making it difficult to employ risk-management tactics, she says.

Ryan says carriers must be able to extrapolate key bits of information from their databases to manage their network assets properly. This would include, how much they have sold on a particular route, from which point of presence (PoP) it was sold, what the service level agreement (SLA) entailed, whether an option was sold on the contract, whether a contract was a short-term lease or indefeasible rights of use (IRU) agreement and what the definite and projected sales include on particular routes.

“Very, very few of them would be able to give you this information,” Ryan adds.

One of the most aggressive U.S. carriers to employ risk-management techniques, Williams Communications LLC, is working to keep real-time tabs on its network inventory, say traders at the Tulsa, Okla.-based company, which spun off from its energy company in 2001.

But it is no easy feat keeping track of a 33,000-mile network.

Traders admit even they can’t analyze their entire portfolio in real-time and the prices with which network elements are associated. But they say they are working towards that end.

Asked how much it costs to build the tracking and provisioning systems capable of fully analyzing inventory, traders generally agree the investment is massive.

Managing Credit

Williams traders underscore that to manage risk, telecom providers don’t necessarily have to participate in commoditized bandwidth trading, a nascent sector that lost steam in 2001, as its mightiest proponent, Enron Corp., endured one crisis after another. Enron’s woes finally culminated in a merger agreement with rival Dynegy Inc. that was subsequently cancelled.

One form of risk management is implementing rigid credit policies. This could include setting a cap on the amount of business conducted with any single carrier.

Heading into the 2001 holiday season, backbone providers had to write off billions of dollars after carriers ran out of money.

The future of U.S. backbone providers that have invested billions of dollars remains uncertain. Cioll says that if he were a network operator, he would not sell more than 5 percent to 10 percent of the company’s bandwidth to a single customer — even to AT&T Corp. — because it is not wise to have too much exposure to any one company.

Apart from hard-line credit policies, a number of ways exist to manage network risks.

Many carriers and resellers gripe that their network suppliers fail to procure a circuit when they promise.

Williams has offered companies options that protect them in case their supplier cannot deliver on a commitment to procure a circuit by a specified date. Williams will step in and provision the circuit, if given a week’s notice, say traders.

Are you looking to cut your losses or increase your margins on service level agreements?

A carrier might evaluate its performance on particular routes and subsequently offer higher or lower SLAs based on the route performance, says Andersen’s Ryan.

Risk-management executives also say projecting short-term demand and supply on a particular routes may help a carrier squeeze the most out of its pipes.

Sprint Corp. perceives value in elements of risk management, such as knowing whether there is an excess or shortage of capacity on routes, says Jim Steffens, director of Sprint wholesale marketing.

Based on demand and excess capacity in the last half of 2002, the carrier, in theory, could seek a return on a short-term basis, Steffens explains.

Risk-management experts say such a move would be a prudent way to avoid letting capacity go to waste.

Exercising Options

Without the energy merchants operating broadband in the European market, carriers abroad have begun offering their customers options on contracts.

Last June Ebone, a subsidiary of Global TeleSystems Europe B.V., began offering a “Liquid Bandwidth” service that allowed customers to change geographic reach, bandwidth capacity and the type of service and upgrades to new services Ebone offers.

The European backbone company also offered price protection, with prices marked to market on a semi-annual basis.

Also last June, Storm
Telecommunication Ltd. launched Lighting, a service that reportedly gives users the flexibility to move around a 16-route pan-European network as their needs change. At the time a Storm executive said traditional bandwidth pricing is “dead.”

France Telecom, which is building a national backbone network in the United States and operates a desk to trade minutes, was expected to make a formal decision on a bandwidth trading and risk-management strategy before the end of 2001, wholesale executives said during an interview in November.

Most carriers don’t know where they have an excess or shortage of capacity, the France Telecom executives explained. Consequently they don’t know what their risks are.

Hedging Bets

Hedges are perhaps the best known — and least embraced — of the risk-management tools.

In generic terms, some hedging tools include options that allow a carrier to mitigate its risk-to-price exposures if the value of bandwidth rises or falls in the future.

A service provider might buy such an option from a carrier, energy merchant, or some day, a bank. For instance, a competitive carrier might purchase an option that would give it permission to buy capacity from another supplier the fourth year of a five-year contract, if the bandwidth prices declined by a certain percent.

In hindsight, it’s the kind of insurance carriers would have craved scoring a few years ago before the price of optical circuits hit rock-bottom, leaving national and global wholesale providers with excess capacity and mounting debt loads.

Service providers now are beginning to realize that selling network assets is no longer based on their costs, but what the market will bear, says Carlos Alarcon, vice president of consulting firm, LYNX Technologies Inc.

Traditional carriers, however, have yet to turn to bandwidth exchanges to trade and hedge against price. If a carrier does trade through a neutral exchange, it is to fill an existing demand, not to offer to resell the asset in hope of finding a desperate buyer that will pay more.

Bandwidth traders say carriers were not ready in 2001 to embrace the sophisticated risk-management schemes regularly
employed in liquid markets, such as oil and natural gas, because the telecom market has not reached a state of liquidity.

A barrel of oil may be a barrel of oil, but the value of bandwidth is not the same around a city block, let alone around the nation.

Despite the high number of carrier hotels, data centers and collocation facilities, telecom providers are spread out, and it is expensive to get from point A to B, particularly within Boston, New York City, San Francisco and other corporate epicenters.

Donald Noonan, vice president of networks at Band-X Inc., says a carrier can lease an OC-3 from New York to Los Angeles for $11,000 a month to $10,000 per month, but the cost to access the last mile network within the Big Apple can range from $2,000 to $10,000 per month.

Traders say carriers will make more efficient use of their networks once more interconnections are established, paving the way for a liquid market on at least certain routes.

During an interview last October, Williams’ trader Louis Hunsucker said he anticipated major U.S. routes would reach a state of liquidity within 18 months.

Dane Howell, director of trading and origination at Dynegy, was even more optimistic. He says that he expects bandwidth to become a commodity in six months to a year.

Band-X’s Noonan is less bullish, noting, “I believe you will be able to transact in the financial markets in 2003 and 2004 as a speculative tool.”

Still, some critics don’t think bandwidth will ever become a commodity because a T1 and optical circuit have more dynamic characteristics than a barrel of oil and bushel of wheat.

For the time being, however, the energy merchants are the only companies employing financial hedging tools for bandwidth to any great degree. Their losses during the last few quarters will do little to earn them followers into the trading arena.

Enron has written down the value of its $600 milion broadband investments and is expected to try to sell its assets.

Dynegy, which announced in October that it has completed its 16,000-mile optically switched mesh network, hasn’t fared much better.

The Houston-based energy merchant reported a $15 million third-quarter loss, which it attributed to startup costs associated with network development and decreased demand.

“Dynegy Global Communication’s overall strategy hasn’t changed,” said Dynegy spokeswoman Deanna Cox.

The bandwidth exchanges also are reeling in the wake of decreased demand and falling prices. But that is not to say trading has ground to a halt. In fact, it is growing.

In its bandwidth brokerage partnership with Amerex Bandwidth, RateXchange reported the total number of DS-0 miles traded grew 157 percent to roughly 1.5 billion miles during the third quarter, up from 583 million miles during the second quarter.

AT&T, WorldCom Inc. and Sprint all have dabbled in the trading for several months, says Peter Fusaro, president of Global Change Associates, risk-management consultants.

“They have all traded. They just don’t want to announce it,” says Fusaro. “Frankly this market is a couple years away.”

A spokesperson for AT&T, however, told PHONE+, “We don’t do bandwidth trading. We are generally careful to build our networks in keeping with our projections of what the market demands, and thus are neither running out of bandwidth nor finding we have a lot of extra bandwidth left over.”

Realizing Value

While carriers may not yet be so bullish on the value of trading, some of them are beginning to tout the potential benefits of risk management.

Cable & Wireless plc.’s vice president of trading and risk management Martin Gray recently gave a presentation at a European conference on risk management. Articulating its benefitsm he said carriers successfully can employ risk- management techniques before the trading market matures, despite the lack of standardized contracts and interconnections that have inhibited the trading market.

Risk-management experts underscore that carriers won’t make headway without gaining senior management approval. Williams’ traders say the notion of risk management cuts into every aspect of a carrier’s business, from provisioning to customer care to legal and finance issues.

Yankee Group analyst Libby says the pressure to follow in the footsteps of the energy merchants is not on. He and others say the bandwidth trading initiatives came on too fast and too aggressively.

One Sprint executive said bluntly that Enron tried to cram its initiatives down carriers’ throats.

Adds, Libby: “There is no pressure yet to force carriers to look at bandwidth as a commodity risk.”

But competitive carriers may have a good reason to take stock in risk management. They are running out of money and Wall Street is running out of patience. If U.S. backbone providers don’t figure out how to make better use of their networks soon, somebody else might.