Streetwise Professor

May 9, 2023

Oh No Not This BS Again: The EU Looks to Regulate Commodity Trading Firms Like Banks

Filed under: Clearing,Commodities,Derivatives,Economics,Energy,Politics,Regulation — cpirrong @ 1:09 pm

In response to the liquidity crunch in the commodity trading sector (especially in energy trading) last year, the European Union is looking to regulate commodity traders more like banks:

For decades, Europe’s commodity traders have avoided being regulated on par with other financial firms. A new proposal currently working its way through the European Union legislative system could change that.

To close “loopholes,” dontcha know:

The loophole allows industrial companies like utilities and food processors — but also commodity trading houses — to take derivative positions without the scrutiny facing investment firms. Designed to reduce the burden of managing price risk, it also means that traders aren’t subject to rules on setting aside capital or limiting positions the same way banks and hedge funds are. 

2022 certainly saw unprecedented liquidity pressures in the commodity trading sector, as firms that had sold derivatives (especially on gas and power) to hedge their exposures from supplying the European market saw huge margin calls that greatly strained credit lines and led a coalition of traders to request ECB support (which the ECB declined).

The crucial part of the previous paragraph is “to hedge.” The danger of restricting or increasing the cost of such activities through regulation of the type that is apparently under consideration is that it will constrain hedging activities, thereby (a) making these firms more vulnerable to solvency, as opposed to liquidity problems, and (b) raising the costs of commodity intermediation.

Note that the companies that received state support that are mentioned in the article are not commodity traders qua commodity traders, e.g., Vitol or Trafigura or Gunvor. They are energy suppliers who were structurally short gas and did not hedge, and hence were facing serious solvency issues when gas prices exploded in late-2021 (before the Russian invasion) and winter and spring 2022 (when the invasion occurred). That is, firms that didn’t hedge were the ones that faced insolvency and received state support. (Curiously, Uniper is missing from the list of companies in the Bloomberg article, although Fortum Oyj was collateral damage from Uniper’s collapse.)

The relevant issue in determining whether commodity trading firms should be regulated like banks or hedge funds is not whether the traders can go bust: they can. It is whether (a) they are financially fragile like banks, and (b) whether they are systemically important.

These are exactly the same issue I addressed in my Trafigura white papers in 2013 and especially 2014. To summarize, commodity trading firms engage in completely different transformations than banks and many hedge funds. Commodity traders transform commodities in space, time, and form: banks engage in liquidity and maturity transformations. The difference is crucial.

Liquidity and maturity transformations are inherently fragile–they are the reasons that bank runs occur, as the recent failures of SVB, First Republic, and Signature Bank remind us. That is, the balance sheets of banks are fragile because they finance long term, illiquid assets with liquid short term liabilities.

Commodity traders’ balance sheets are completely different. The “pure” asset light traders especially: they fund short term (“self-liquidating”) relatively liquid assets (commodity inventories) with short term relatively liquid liabilities. Further, hedging is a crucial ingredient in this structure: banks are willing to finance the inventories because the price risks can be hedged.

This is not to say that commodity traders cannot fail–they can. But they do not face the same kinds of fragility (vulnerability to runs) that entities that engage in maturity and liquidity transformations do. It is this fragility that provides the rationale for bank capital requirements and limitations on the scope of their activities. This rationale is lacking for commodity trading firms. They are intermediaries, but not all intermediaries are alike.

Further, as I also pointed out almost a decade ago, major financial firms dwarf even the largest commodity trading firms. Even a Trafigura, say, is not remotely as large or systemically important as, say, Credit Suisse. Yes, a bankruptcy of a big trader would inflict losses on its lenders, but these losses would tend to be spread widely throughout the global banking sector given that most loans and credit lines to commodity traders are widely syndicated. And the potential for these kinds of losses are exactly reason that banks hold capital and that it is prudent to impose capital requirements on banks.

As I noted in the 2014 study, virtually the entire merchant energy sector in the United States imploded in 2002-3. Lenders ate losses, but the broader economic effect was minimal, the assets of the failed firms continued to operate, and the lights stayed on.

In sum, analogizing commodity traders to banks is seriously intellectually flawed, and what’s good or justified for one is not necessarily for the other because of the huge differences between them.

Pace Bloomberg, the events of 2021-2022 did not “expose” some new, unknown risk. The liquidity risk inherent in hedging has long been known, and I analyzed it in the white papers. Indeed, it’s been a focus of my research for years, and is the underlying reason for my criticism of clearing and collateral mandates–including those embraced enthusiastically by the EU.

Thus, a more constructive approach for Europe would be not to apply mindlessly regulatory restrictions found in banking to commodity firms, but to investigate ways to facilitate liquidity supply to commodity traders under extreme situations. Direct access of commodity traders to central bank funding is inadvisable, but central bank facilitation of bank supply of margin funding to commodity traders during such extraordinary circumstances worthy of investigation.

Recall that the Federal Reserve’s response to a funding crisis originating in the Treasury futures markets was instrumental in containing the systemic risks arising from COVID in March 2020 (as described in my Journal of Applied Corporate Finance article, “Apocalypse Averted“). The Fed’s actions were extemporized (just as they were during the 1987 Crash). The EU and ECB would do well to use that experience, and that of 2021-2022, to devise contingency arrangements in advance of future shocks. That would be a more constructive approach to the risks inherent in commodity risk management than to impose regulations that could impede risk management.

It is important to note that making hedging costlier instead of making it cheaper increases the risk of extreme price disruptions. Constraining risk management means that commodity traders will supply less intermediation especially during high risk periods. This will swell margins and make commodity supply less elastic, both of which will tend to exaggerate price movements during periods of stress.

I always wonder about the political economy of such regulatory proposals. Yes, no doubt regulatory reflex is a driver: “We have to do something. Let’s take something off the shelf and make it fit!” But my experience in 2012-2014 also motivates a more cynical take.

The genesis of the Trafigura white papers was an abortive white paper I wrote for the Global Financial Markets Association, a banking industry group. The GFMA approached me to investigate the systemic riskiness of commodity trading firms, and I came up with the wrong answer, so they spiked the study. Somehow or another Trafigura got wind of this, and that was the genesis of the influential (if I do say so myself) papers I wrote for the firm.

The point being that in 2012 the banks were pushing to regulate commodity trading firms with capital requirements and the like in order to raise the costs of competitors, and were looking for intellectual cover for that endeavor–cover I did not provide after a deep dive into the commodity trading sector.

Hence, I wonder if this reprise of the ideas that were largely shelved in the mid-2010s is an example of “let no crisis go to waste,” i.e., whether there are interests in Europe pressing to regulate commodity firms for shall we say less than public spirited reasons.

The proposals are apparently very protean at this stage. But it will be interesting to see where they progress from here. And I’ll weigh in accordingly.

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  1. What’s to stop the commodity traders moving their businesses to Brexitland and avoiding this schemozzle? (Assuming that B’Land doesn’t do something equally daft.)

    Comment by dearieme — May 9, 2023 @ 3:59 pm

  2. A small bone to pick, I suppose, but Signature Bank did not fail; it was ready to open that Monday morning. The Biden administration murdered it that Sunday night as part of a coordinated attack on crypto. The crypto-friendly Signet payment platform (which, like crypto, ran 24/7/365) was a particular target.

    You could add Silvergate’s voluntary wind-down to the list, though.

    The recent bank failures are driven by interest rate hikes driving down the mark-to-market price of government debt. The *trigger* however, was crypto-friendly banks getting hit with runs as depositors reacted to the FTX debacle by limiting USD balances on exchanges, which were held as deposits in a small number of banks that ran the regulatory gauntlet needed to serve the industry. SVB and First Republic were caught holding the bag on crashing commercial real estate prices. I doubt any of that is much of a factor in commodities trading.

    Comment by M. Rad. — May 9, 2023 @ 5:44 pm

  3. General and @dearieme: how many commodity trading companies are in EU Land? Many are in Switzerland, not (yet) part of the EU. As Prof wrote, the troubled companies where not commodity traders, they are energy provider and they were not hedging, they were speculating in order to gain additional profits: and even during the public commotion the job ads still were asking for traders that would kot just hedge…

    …on top of this, the problematic situation was likely caused by the policy of the German finance ministry and it’s orders to Trading Hub Europe, not by ‘normal’ market activity. Link in next post, not sure whether links work here.

    Comment by Mikey — May 10, 2023 @ 5:32 am

  4. Trading Hub Europe moved prices on orders of the German ministry of finance, if just the chart try to go back to the article (in German).

    Comment by Mikey — May 10, 2023 @ 5:36 am

  5. Errata: German Ministry of Economics, not Finance…

    Comment by Mikey — May 10, 2023 @ 5:38 am

  6. I get it that banks need to be regulated. (Though the track record of regulators is pretty poor, the behaviour of banks is worse.) It’s because banks are holding Joe Public’s money.

    But where is the risk to the public in commodity trading? Why should the EU stick its oar into the activities of some gamblers and private shareholders? True, the likes of Trafigura (and for that matter, BP) make a lot of money from trading and retailers (e.g. gas suppliers) consistently lose. But that’s because the retailers are basically insuring by buying forward contracts. The rest is a zero sum game.

    So far as I can see this is a solution to something that isn’t a problem.

    Comment by philip — May 10, 2023 @ 1:31 pm

  7. the more they mess with free markets, the more they mess up free markets, and then they justify messing more with free markets. bureaucrats are a circular firing squad.

    Comment by Jeff Carter (@pointsnfigures1) — May 13, 2023 @ 9:15 am

  8. I kook forward to these Solons applying the same brilliance to commodities that they did with Basel II.

    Comment by Sotosy1 — May 13, 2023 @ 9:56 am

  9. @Jeff-It’s the regulatory dialectic. The previous regulatory screwups create a “justification” for more regulation.

    Comment by cpirrong — May 19, 2023 @ 7:20 pm

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