Energy trading markets have been
undergoing radical transformation lately. These transformations are set to
accelerate in 2013 because of much anticipated implementation of new rules that
will govern global swaps markets.
These include measures
such as position
limits, mandatory clearing
and margin requirements,
capital requirements, pre-
and post- trade transparency
through position reporting
requirements to trade
repositories, as well
as trading standardised swaps
on designated contract
organisations or swap execution facilities where multiple traders can
place bids and offers, and real time
reporting of cleared
and uncleared swaps
to the centralised
swap data repositories.
These changing dynamics
present new challenges
not only for
financial speculators, who
buy or sell
any asset in
the anticipation of a price
change, but also for traditional energy companies that use previously
unregulated financial derivative
instruments to hedge or mitigate commercial risk.
The new rules are intended to
bring transparency to the swaps markets and lower their risks. A closer look at
the new rules suggests that lingering difficulties remain and that the process
of regulatory swaps market reform may still be undergoing teething pains. Regulatory uncertainties and inconsistencies within
and across jurisdictions might in fact lead to less transparent and more risky
global financial markets. Market
participants are already searching for ways to escape from costly and complex
regulations of the swaps market. Aside from cross-border disputes, in the
presence of regulatory arbitrage, there are concerns that market participants
may increasingly seek out jurisdictions with less strict regulations, thereby shifting
the risk rather than mitigating it, and eventually increasing the opaqueness of
swaps markets rather than bringing more transparency to them.
A closer look at the new rules
also suggests some interesting implications. In seeking to prohibit excessive
speculation and its possible effect on price volatility in futures markets,
regulators introduced hard position limits on speculative activity. The main
objective of the proponents of those hard position limits was to reduce
market-share concentration in commodity markets, supposedly by ensuring that
markets are made up of a broad group of participants with a diversity of views,
thereby preventing distortion in market prices.
The limit on the concentration of market share is also deemed necessary
to reduce systemic risk. However,
hard position limits
have the potential
of severely constraining
trading activity, which
would lead to
increased, rather than reduced, volatility. Liquidity in futures
markets, and especially in swaps markets, may be impaired. Producers and end
users would have a smaller pool of counterparties to hedge their price risk
with, which in turn increases the bid/ask spread, thereby creating more
volatility. The position limit rule can also potentially constrain the size of
trading entities. This will effectively lead to market dependence on small
speculators, as institutional
investors would be
forced out of
the market once
they reach their
respective position limit. This would lower liquidity and increase
trading costs. Higher costs could, in turn, force some entities to establish
smaller positions than their hedging needs.
A recent ruling by the District
Court in the US against the so-called position limit rule will potentially force
regulators to revisit some of their final rules. The court found that the US
Commodity Futures Trading
Commission (CFTC) overreached
by imposing position
limits without showing
they were ‘necessary
to diminish, eliminate or
prevent’ excessive speculation. However, the CFTC announced that they will move
forward with an appeal of the federal district court’s decision vacating the
position limits rule. Nevertheless, the court still did not rule on whether the
agency must conduct a full cost-benefit analysis, which we expect market
participants might use to further challenge the final rule. In contrast to the position limit rule, the
mandatory margin requirements rule may well lead to an increase in the concentration of market share of large
speculators while raising price volatility and having no effect on price levels. A study released by the
International Swaps and Derivatives Association (ISDA) suggests that the
initial margin requirement will be between $1.7 trillion and $10.2 trillion
depending on the specific models used. The analysis further finds that the
required margin requirement is at least three times higher during stressed
market periods, leading to increased systemic risk due to greatly increased
demand for new funds at the worst possible time for market participants. The
increases in margin cost will likely affect the end-users’ ability to hedge
price risks, especially during stressed market conditions when they need it
most.
Clearing requirements for
standardised swaps through an intermediary company with sufficient capital, such
as clearing houses or central counterparties (CCPs), a measure introduced to
eliminate counterparty risk, have also become a target of criticism. Proponents of the requirement argue that central
clearing has worked in the futures markets for over a century. Critics counter
that the present regulatory reform and regulations may not remove the systemic
risk from OTC derivatives but rather shift it from counterparties to central
clearing parties. A recent IMF paper concluded that the current proposed
central clearing system, far from reducing systemic risk, actually increases
it.
Higher capital
requirements for swap
dealers and major
swap participants might
as well increase
the concentration ratio leaving
only large speculators (investment banks) as viable liquidity providers in
the commodity derivatives markets, which
regulators try to limit in order to reduce systemic risk. Furthermore, the
proposed Volcker rule prohibits proprietary trading while allowing transactions
related to underwriting, market-making, risks mitigating hedging, trading in
certain US government obligations, and trading on behalf of customers. As a
response, most banking entities already closed their proprietary trading desks.
Some argue that they are merely moving these activities to their market-making
activities or that proprietary desks have morphed into independent hedge funds.
A recent interview with one market participant suggests that registration
requirements for hedge funds as commodity pools would likely force some of them
to liquidate their positions.
As mentioned in the November 2012
OMR, in order to reduce their clients’ exposure to compliance costs associated
with the new
rules imposed on
swap transactions and
to avoid dealing
with the increased
complexity facing swaps market participants (compared to futures market participants
for example), the Intercontinental
Exchange (ICE) has already converted all existing over-the-counter (OTC)
cleared energy swaps and option
products, including crude and refined oil, natural gas, electric power, and
natural gas liquids, into
economically-equivalent futures and option products on 15 October 2012, which
corresponded to the compliance date for
several new swaps rules. ICE further argued that already tested futures
market regulations give
market participants more
certainty than the
untested regulation in
swaps markets. Furthermore, futures markets also offer
clients the ability to margin their trades in one account rather than two
separate accounts, one for futures and the other for swaps. Similarly, CME have
listed all actively traded contracts on CME Clearport for execution on the CME
Globex central limit order book as cross trades on the trading floor and as block
trades. CME argued that since 15 October, customers have consistently traded
approximately 80% as futures, compared to approximately 15% beforehand. If
these futures-like products are successful, then the success of the swap
execution facilities, where only standardised swaps will be traded, will be
limited.
It is still too early to estimate
the full impact of the new regulations on liquidity in the derivatives market and
the cost associated with these rules. The implementation of some of the rules
just started, and some of the rules, including rules on swap execution
facilities, capital and margin rules, and the Volcker rule, still need to be
finalised. However, we have already seen some real consequences for the swaps
market, including the futurisation of swaps markets.
[†] This article first appeared in the International Energy Agency’s Oil Market Report dated 18 January 2013.
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