regulations of commodity derivatives

Since the US financial reform package, formally the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), which became law on 21 July 2010, the CFTC has put forward 18 final rules. The CFTC have already proposed rules on regulation of dealers. There are various rules on clearing and trading mandates. The purpose of the rules on clearing and trading is to reduce risk by moving “standardised“ derivatives onto clearing houses and to execute standardised swaps with more pre-trade transparency. The provision on trading oversight and market transparency includes regulation of swaps trading platforms (swap execution facilities (SEFs) and designated contract markets (DCMs)) and various post-trade transparencies. The provision on transparency to regulators includes reporting data on swap trades to regulated swap data repositories (SDRs), which are required to register with the CFTC, or reporting data directly to the Commission if there are no SDRs accepting the data. The final key element of the Act is the position limit on certain commodities.

The European Commission also issued several communications regarding commodity markets and raw materials. The first vehicle related to energy markets is the regulation of wholesale energy market integrity and transparency, so called REMIT, published in July 2011. The REMIT aims to prevent market abuse and manipulation in wholesale energy markets and to increase transparency for trading on those markets (See more on REMIT). The European Commission issued three proposals on financial markets that have an impact on commodity derivatives. The first deals with the regulation of OTC Derivatives (European Market Infrastructure Regulation (EMIR)). On 15 September 2010, the European Commission published its final proposal, which sets out to increase stability within OTC derivative markets by introducing a reporting and clearing obligation for eligible OTC derivatives as well as common rules for central counterparties (CCPs) and for trade repositories. The second proposal, published on 20 October 2011, aims to update and strengthen the existing framework to ensure market integrity and investor protection provided by the Market Abuse Directive (MAD). The third proposal deals with the transparency and oversight of the financial markets in the European Union (Markets in Financial Instruments Directive (MiFID), with final proposals also published on 20 October 2011. Specifically, proposals call for standardisation of all OTC derivative contracts traded on organised venues, narrowing of exemptions for commodity firms in line with G-20 commitments, creation of a new trading venue category (“organised trading facility – OTF”), more transparency of trading, including pre- and post-trade transparency, a position reporting obligation by type of participants, and position limits or some other type of position management.

The main goal of these reform packages is to increase transparency and efficiency of the OTC derivatives markets and to reduce potential counterparty and systemic risks. However, as pointed out by the Financial Stability Board (FSB), clear signs have emerged that substantial cross-border differences in the pace of implementation, as well as differences in some rule-making areas, might lead to regulatory arbitrage, in which market participants will seek out lighter-touch jurisdictions, thereby shifting risk rather than mitigating it.

In order to increase market transparency in OTC markets, new proposed rules call for:

• Standardising as many swaps as possible;
• Trading standardised swaps on designated contract organisations or swap execution facilities, where multiple traders can place bids and offers, thereby providing pre-trade transparency to market participants;
• Real-time reporting for cleared and uncleared swaps to centralised swap data repositories, thereby providing post-trade transparency; and
• The clearinghouse in the case of cleared swaps; swap dealers in the case of uncleared swaps will be required to disclose the pricing of swaps to the public, or to their counterparties, respectively.

While the US and EU’s proposed rules on transparency are similar, there are certain differences that might lead to regulatory arbitrage. For example, as opposed to the strict CFTC proposal that swap execution facilities be either order-book or request-for-quote (RFQ) facilities, the EU has proposed a looser definition of these platforms, which it calls ‘organised trading facilities’, which do not require order-book or RFQ facilities. This might create regulatory arbitrage opportunities, prompting banks to shift activity from the US to Europe to take advantage of a laxer regime.

Market participants have already raised concerns over some of the issues in the rules related to transparency. Their main concerns include the following:

• The opaqueness of the OTC markets is a myth: End-users in these markets are institutions and they have access to dealers’ screens. OTC markets are also not less transparent than futures markets; hiding volumes in OTC markets is very difficult since traders know their counterparties.
• Swaps are not identical to futures: They argue that the OTC market is different from the futures markets and therefore should not be regulated in an identical fashion.
• Standardisation and exchange trading: Swaps can trade infrequently, often in significant sizes, between dealers and end-users or speculators. If trading activity in the futures markets is any evidence, a relatively small number of highly liquid instruments have been effectively traded on the exchange. In contrast, the failure rate of exchange trading models in less liquid instruments has been very high.
• Real time reporting increases transaction costs, which will lead to lower liquidity, thereby increasing the cost of hedging.

The second purpose of the financial reforms is to lower inherent risk in the OTC market. In order to lower the risks, new rules call for:

• Comprehensive regulation of swap dealers and major swap participants to minimise systemic risk, via registration, capital and margin requirements and standards of conduct;
• Clearing requirements for standardised swaps through an intermediary company with sufficient capital, such as clearing houses or central counterparties (CCPs), to eliminate counterparty risk. Mandatory clearing requirements will not apply to existing swaps, however they still need to be reported to swap data repositories or directly to regulators;
• Exempting end-users using swaps to hedge or mitigate commercial risk from mandatory clearing; and
• Imposing aggregate position limits and large trader reporting requirements for swaps.

Critics argue that some of the proposed regulations might have unintended consequences in the market place. These include:

• Low liquidity: Liquidity in OTC markets is generally provided by the dealers, who use their own capital to make the markets. Market participants contend that the Volcker rule, which restricts banking entities’ proprietary trading, or investing in or sponsoring hedge funds or private equity firms, has the potential to change the structure of the market by lowering liquidity. Notwithstanding the potential for diminished risk to lead to lower interest rates, if liquidity were to decline due to margin requirements, clearing costs or any other clause in the regulation, the process of price discovery and the risk transfer function of these markets would be significantly compromised.
• Shifting risk from market participants to clearing houses: Some argue that mandatory clearing concentrates risk among a few large entities.
• Increased end-user costs: There are end-user complaints about costs possibly increasing were the counterparty to transfer some of the clearing costs to end-users; in addition, the broad definition of swap dealers would classify some end-users as financial entities, which would then be subject to mandatory capital and margin requirements.
• Hard position limits will severely constrain trading activity which would lead to increased, rather than reduced, volatility. Liquidity in futures markets, and especially in swaps markets, will, it is argued, be unnecessarily impaired. Producers and end users would have a smaller pool of counterparty firms to hedge their price risk with, which in turn increases the bid/ask spread, thereby creating more volatility. The proposed rule can also potentially constrain the size of trading entities. This would lead to market dependence on small speculators as institutional investors hit their respective position limits and are forced out of the market, thereby lowering liquidity and increasing trading costs. Higher trading costs would, in turn, force some entities to establish smaller positions. (See my blog on position limit)

Regulatory efforts to increase transparency and reduce systemic risks in global OTC markets have intensified in the last year. Some observers have argued that the CFTC has rushed to meet arbitrary deadlines without properly analysing the costs and benefits of new rules for swaps markets. However, despite the rapid pace of rule-making, the US missed the July 2011 deadline for the implementation of the rules under the Dodd-Frank Act. Slow progress on agreed reforms to meet the end of 2012 deadline set by the G-20 in Pittsburgh in 2009 is seen as another problem, notably the apparent lack of international consensus between regulators on how to achieve the key elements of the reform agenda. Regulatory arbitrage opportunities might undermine the impact of new regulations even in countries where more stringent rules are to be implemented. Therefore, more international coordination is needed for more consistent and effective oversight in OTC markets.(See my blog on cross-country differences in OTC market regulations)