This is the fifth and final article in a series that takes a critical look at the application of financial regulation to the commodity market. We foresee a problem down the road when the regulators begin to assimilate the hecatombs of new data that will be reported to them by Dodd Frank Swap Data Repositories (‘SDRs’) and EMIR Trade Repositories (‘TRs’).
The first article in this series provided an overview of the policy objectives of the G20 group of Finance Ministers and their aim to restore global growth, strengthen the international financial system and reform international financial institutions following the 2007/2009 banking crisis and subsequent recession.
The second article considered the Dodd Frank Act, which is the US approach to meeting America’s G20 obligations.
The third article looked at the equivalent European response to the G20’s demand for tighter financial regulation, the European Market Infrastructure Regulation (‘EMIR’).
The fourth article examined two other pieces of European legislation of relevance to commodity markets: the Market in Financial instruments Directive (‘MiFID’) and the Regulation on Energy Market Integrity and Transparency (‘REMIT’).
This article focuses on the consequences of new US and European regulation for hedging price risk in the commodity market. Companies that avail themselves of end user or hedging get out clauses to avoid the more draconian clearing and risk mitigation aspects of the new regulations are likely to be put to proof that their hedge transactions are not in fact speculative and therefore are not subject to more intensive regulation or lower dealing limits than apply to hedge transactions.
Dodd Frank: Volcker
Dodd Frank does not target hedging instruments specifically. But it is in the realm of commodity hedging that it is felt most acutely through the Volcker Rule, which was adopted in December 2013. This is because Volcker caused some of the most creative and competitive commodity market makers, the US banks, to exit the business. US banks were adept at trading in physical commodity markets to construct their own risk management scaffolding around the less than perfect regulated commodity hedging tools, which were all that was available to the majority of end users and hedgers.
Volcker was based on the premise that banks were speculating with clients’ money. To prevent this, the Volcker Rule prohibits banks and financial institutions from proprietary (‘prop’) trading, or sponsoring or investing in hedge funds or private equity funds by more than 3% of the fund.
The SEC defines proprietary trading as engaging as a principal for the trading account of the bank or non-bank financial company supervised by the Board in any transaction involving any security, any derivative, any contract of sale of a commodity, or any other security or financial instrument that the SEC or the CFTC may determine. In other words prop trading means trading on the bank’s own account rather than on behalf of clients.
In the case of commodity markets the adoption of the Volcker Rule was when the baby was thrown out with the bath-water.
In the commodity markets dealers experience substantial basis risk between the myriad of physical contracts and the limited number of financial instruments that can be used to hedge them. To handle this the US banks that provided hedging services to Major Swap Participants (‘MSPs’) and to commercial end-users, often entered into offsetting physical contracts that were not immediately obviously a component of an unbundled hedging package. This occurred because, for example, the product quality, locational or timing characteristics of the hedges differed from those of the commodity being hedged.
Most US banks chose to exit the imperfect commodity hedging market once Volcker was adopted rather than run the risk of being judged to be conducting illegal prop trading. These risks therefore have either reverted to the principals or been laid off with less diversified third parties in a market less liquid because of the withdrawal of the US banks from market making activities.
This means wider bid-offer spreads and higher costs for the end-user. This is the exact opposite of the stated aims of Dodd Frank to lower transaction costs, improve confidence in the market, encourage participation by a large number of market participants and increase liquidity in the swap based securities market………..