Position limits being considered by the US Commodity Futures Trading Commission to eliminate "excessive" market speculation could create problems for companies trading energy commodities, said John England, managing partner for energy in Deloitte & Touche LLP's markets consulting practice. Proposed regulatory changes would affect hedge funds, banks, insurance, and other firms, said England. "It is important for most energy market participants to consider the potential impacts of these proposed rule changes on their ability to manage risk," he said.
To centrally regulate the OTC market, all transactions would be through monitored clearing exchanges. "Although it is expected that the exchanges would adapt by offering a greater variety of OTC products, it is unlikely that the products would cover all possible trading locations, product specs, and time frames," England said. "This could cause a decrease in the variety of instruments available today for laying off basis risk and may decrease the trading activity in high-risk, high-margin markets." He added, "If nonphysical transacting entities are limited in the volume of derivatives they can trade, the demand for these instruments may become low enough that it would not make economic sense for the exchanges to offer a wide variety, thus further limiting the ways that companies can manage or mitigate their basis risk."
England noted, "Typically in commodity markets, a decrease in liquidity results in higher bid-offer spreads and potentially higher costs to hedge in the market. This could have a large impact on both market participants (potentially unable to hedge adequately) and exchanges, as roughly one quarter of their revenue is derived from energy trading." A decrease in the variety of products offered in the US market could trigger a shift to other global exchanges and increase exposure to foreign currency and foreign governments, he said.
"The proposed rules could lead to an increase in margin call activity for derivatives normally traded directly with counterparties or through a broker on credit terms. Forcing transactions to clear on a more transparent clearing exchange rather than through OTC means would result in more cash being required to support deals and less ability to rely on credit," England said.
Problems in laying off risk could make it more onerous to value positions and risk exposure at less-liquid points. "In short, it could become much more difficult to price a large number of physical markets," said England.
Increased red tape
Information requirements and disclosure expectations are likely to be more frequent and more detailed under the new regulations. "Since the content of the reporting would come directly from existing trading systems where their financial positions are maintained, companies will need to determine whether these systems are reliable and support regular reporting," England said. "In some instances, these activities could lead to the need for significant investments in infrastructure (processes and systems), increasing costs and potentially squeezing razor-thin profit margins."
He said, "Should the proposed rules come into force, there is a high probability that the reporting requirements and expectations regarding transparency would rise in lockstep. Institutions transacting energy contracts on US exchanges would have to report to the CFTC on volumes in addition to the standards they are currently meeting. Regulatory oversight could expand into areas beyond the regulation of markets by treading into the regulation of speculative behavior, price movement, and price volatility. With an increase in reporting, this would heighten the risk of misreporting and subject entities to potential fines."
Regulators in both the US and UK are working to share information so as to more effectively track global market manipulation. If the US passes legislation to centralize regulation, it may also pursue an international agreement for regulatory standards in the major global markets, increasing the impact and reach of regulatory changes.
However, England said the global nature of energy markets makes it difficult for the CFTC to manage position limits. To be effective, the majority of exchanges worldwide would have to employ similar restrictions. If regulators and the International Organization of Securities Commissions are unable to spearhead a global response, "commercial transactions will naturally migrate to less onerous markets, again drying liquidity and potentially increasing transactional risk," he said.
(Online Sept. 21, 2009; author's e-mail: [email protected])
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