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.