The Systemic Risk, or Not, of Commodity Trading Firms
My latest white paper, “Not too big to fail: Systemic Risk, Regulation, and the Economics of Commodity Trading Firms” was released today. A video of me discussing it can be found here (as can my earlier white papers on commodity traders and LNG trading).
The conclusion in a nutshell: commodity trading firms do not pose systemic risks, and therefore it is inappropriate to subject them to bank-like prudential regulations, including capital requirements. Commodity trading firms are not systemically risky because (a) they aren’t really that big, (b) they are not that highly leveraged, (c) their leverage is not fragile, (d) the financial distress of a big trader is unlikely to result in contagious runs on others, or fire sale problems, and (e) their financial performance is not highly pro cyclical. Another way to see it is that banks are fragile because they engage in maturity and liquidity transformations, whereas commodity trading firms don’t: they engage in different transformations altogether.
Commodity traders are in line to be subject to Capital Requirement Directive IV starting in 2017. If the rules turn out to be binding, they will cause firms to de-lever by shrinking, or issue more equity (which may force them to forego private ownership, which aligns the interests of owners and managers). These will be costs, not offset by any systemic benefit. All pain, no gain.
It is my understanding that banks obviously think differently, and are calling for “consistent” regulations across banks, commodity traders, and other intermediaries. Since these firms differ on many dimensions, imposing the same regulations on all makes little sense. Put differently, apropos Emerson, a foolish consistency is the hobgoblin of little minds. Or bankers who want to handicap competitors.
The white paper has received some good coverage, including the Financial Times, Reuters, and Bloomberg. I will be writing more about it when I return to the states later in the week.
Minor problem “Too big…”, not “to big…”.
Comment by Margaret Aten — March 23, 2015 @ 4:32 pm
The concern may be different here: the failure of a trader may not impact the financial system as a whole, but maybe there are concerns about food or energy security. If they engage in bank-like activities in a safer/less-leveraged manner, maybe you have weaker capital requirements; but just because they are safer does not mean there should be no capital/regulatory requirements at all.
The argument made by regional banks in the US is similar to that of trading houses:
http://www.americanbanker.com/news/law-regulation/regional-banks-form-trade-group-in-fight-over-sifi-threshold-1073381-1.html
Comment by Greenhorn — March 23, 2015 @ 5:43 pm
@Margaret-Fixed. Thanks.
Not to be too cynical, my guess is that banks want everyone remotely in current or potential competition with them to be as hobbled by idiots as they are.
Comment by SOTOS — April 2, 2015 @ 2:44 pm
Amen. All the CFTC is doing is hurting liquidity.
Comment by @pointsnfigures — April 8, 2015 @ 8:40 am
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