The financial crisis of 2008 has resulted in regulators on both sides of the Atlantic introducing stringent new regulations to manage and report over-the-counter (OTC) derivatives transactions. These wide-ranging regulations affect both the financial and commodity markets and introduce stringent new controls, plus onerous transaction reporting and capital requirements which will impact all market participants.
In the US the regulations include Title VII of the Dodd-Frank Act as regulated by the US Commodity Futures Trading Commission (CTFC). The corresponding EU legislative packages are regulated by the European Agency for the Co-operation of Energy Regulators (ACER) and the European Securities and Markets Authority (ESMA).
The main problem with the regulations is the need to provide margin capital to cover credit risk. A recent study, co-authored by Sharon Brown-Hruska1, the former acting chairman and commissioner of the Commodity Futures Trading Commission (CFTC), concluded that each dealer would cost US$388m in margin, capital and other expenses. The real impact on margin capital requirements could be very big, yet hard to see.
The G20 Agreement
The financial crisis of 2008 has been largely blamed on the opaque world of OTC derivatives2 in which US$708 trillion are tied up in trading positions virtually invisible to regulators. This opacity makes it difficult for regulators to estimate systemic risk, and thus make contingency plans for failure.
In September 2009, the G20 made a statement on their intentions for the introduction of stronger regulation of OTC derivatives markets: “All standardised OTC derivatives contracts should be traded on exchanges…and cleared through a central counterparty by the end of 2012 at the latest; OTC derivative contracts should be reported to trade repositories; and non-centrally cleared contracts should be subject to higher capital requirements.”
How Europe Responded
The EU’s objective remains to have all the key post-crisis legislation in force by the end of 2013. After that, it has reserved the right to review the effectiveness of the new regulations, and make amendments where it deems them necessary.
Unfortunately, Europe doesn’t have the direct equivalent of Dodd-Frank in a single piece of named legislation. Instead the EU is implementing numerous, interlinked pieces of regulation such as Markets in Financial Instruments Directive II (MiFID), Market Abuse Directive (MAD), European Market Infrastructure Regulation (EMIR), Regulation on Energy Market Integrity and Transparency (REMIT), and the Capital Requirements Directive IV (CRD IV), all overseen by pan-EU oversight organisations like ESMA and ACER, plus up to 27 national regulatory authorities (NRAs). These regulations will be described in the following section.
The key implementation milestones for the new EU legislative packages continue through 2012 to 2014, but 2013 is really when the new laws start to bite. This does not give too much time to revise and implement trading system interfaces, develop new trading strategies and control policies. Key parts of the legislation have been created as EU ‘regulations’ rather than as EU ‘directives’, which mean they enter all member states national law immediately.
The Labyrinth of Regulations
The Dodd-Frank regulations and their EU counterparts can best be described as ‘labyrinthine’, but there are strategic consequences:
- MiFID (I and II) covers investor protection, and affects companies who provide services to large consumers like hedging programmes and (wholesale) trade execution.
- EMIR covers the mitigation of operational risk, and includes the ‘trade repositories’.
- CRD covers capital adequacy rules and the mitigation of credit risk.
- REMIT and MAD cover market integrity and transparency, forbidding activities such as ‘insider dealing’ and market abuse or manipulation (as applied to commodities).
- These sets of legislation are inter-linked and can result in liabilities under one or more of the others (leading to cases of ‘double-regulation’).
The most important element of complying with the new legislations is to find new sources of margin capital.
Measuring Margin Requirements
Clearing of ‘standard’ OTC derivatives will require margining (initial and variation), replicating the process used by exchanges to clear standard futures contracts. Companies will need to be able to fund the cash-flows associated with the margining process.
This will be a crucial area of analysis. Value-at-risk (VaR) is a near academic calculation compared to the vital importance of estimating credit requirements; the numbers may look quite similar but the consequences of underestimating the amount of margin capital required could be serious. For true margin and collateral optimisation, firms should conduct day-ahead ‘what if’ analysis of the impact of unfavourable, extreme market moves in parallel with their VaR calculation. It would be inexcusable if value is lost to a company’s credit standing and reputation for not having the appropriate analysis.
Not being able to meet a margin call tells the market and the counterparties that your firm is a credit risk and traders will stop trading with each other. This is what happened during the financial crisis, and regulators are responding by providing transparency and mitigating credit risk.
Higher Capital Requirements for Commodity Trading
Finding working capital to support energy and commodity trading won’t be easy to obtain. Large European utilities have said they may need around €1bn, while a large international oil firm said they could require approximately US$2bn.
This could put commercial banks at the coal face of commodity trading, a position where they may not be comfortable. This transparency will also inform not only the regulators, but also investors who will be able to see the value that is being created, or destroyed, through a trading book. The IAS 39 accounting standard which was brought in after the fall of Enron was supposed to show the exposures of commodity trading but it was complicated to understand. However, drawing on facilities is something that bankers will understand immediately and will watch very closely. If commercial banks do not understand a client’s use of a facility, a call will be made to the chief financial officer (CFO), who will have to rely on the crucial margin calculations to formulate an answer.
The EU financial regulations will have far reaching consequences for a company’s balance sheet and trading strategies. Possible implications could be:
- Trading strategies will evolve to allow shorter durations and reduced market liquidity.
- Credit risk will increase.
- Margin capital will take financial resources from the rest of the business. As a result, future growth and investment could stall.
- Investors and financiers will see the value being created or destroyed by energy and commodity trading.
The Ability to See Potential
With such changes, one solution is to use supply chain finance (SCF) to mitigate credit risk. It is a collaborative mechanism whereby two counterparties agree to use the technique to generate margin capital supplied by approved third party investors. By doing this you can dissipate credit risk into the wider financial markets. For example, if two counterparts are trading, one party will be in the money (ITM)/profit and the other one will be out of the money (OTM). The counterparty with the OTM position is a credit risk to the other trading party, and is asked to post collateral. Traditionally, this is in the form of posting cash or a letter of credit (L/C), which are expensive and use up vital bank lines.
Once the credit risk is evaluated the ITM trader would then ask (through back office processes) for the OTM trader to issue a ‘payment instruction’ through a settlement platform in their favour. Once the payment instruction request is issued and approved, it becomes available for third party investors to fund and the discounted cash is passed over within two business days. This whole process can be automated.
It could be a cheaper and more flexible alternative and can provide a source of added liquidity. SCF is now an approved instrument by the Bank of England (BoE) and has been widely used for many years. Specialist bank and non-bank investors use the product to take corporate credit payment risk.
Even if a firm is cash-rich and happy to post cash against their trading positions, they could use the mechanism to earn a superior return by using the technique to invest in the marketable securities issued by the platforms. What could be a safer investment for the treasury team than a firms own credit risk?
Future commodity trading market dynamics could change dramatically. The market will become very volatile with possible cross-commodity short positions arising. There is no trader, or any trading firm in existence, with the experience required to trade these markets safely. We have to find new ways to trade, and gaining access to margin capital could be vital for a commodity trading firm.
1As reported by Bloomberg, 20 January 2012.
2Source: The Basel-based Bank for International Settlements.
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