As US regulators set about tightening the rules on commodity derivatives trading, banks fear the changes may do more harm than good. Geraldine Lambe reports.

In the US, the fall-out from financial crisis and pubic outrage over huge government bank bail-outs has collided headlong into another heated topic which already had the public steaming: the price of petrol at the pump. Just as bankers are the focus for public anger over the financial crisis and the use of opaque derivatives, so are 'greedy' speculators - and the commodity derivatives they trade - being blamed for artificially driving up the prices of fuel and food.

Anger was further fuelled in September when the US Office of the Comptroller's (OCC's) latest report revealed that since the onset of the financial crisis, banks have not reduced, but increased, their derivatives trading activities. The total notional value of derivatives held by commercial banks at the end of Q2 this year had risen to $203,460bn, from $165,645bn at the end of 2007. Moreover, according to the report, US banks earned nearly $5.2bn from trading derivatives in Q2, up 225% from the same period last year.

The OCC report gave weight to the regulatory push already under way. The Obama administration released its blueprint for overhaul of the overall derivatives markets in August, which focused on forcing 'standardised' over-the-counter (OTC) derivatives to be traded on exchanges and centrally cleared. This was followed by slightly diluted proposals from the House Committees on Financial Services and on Agriculture. Each proposal aims to eliminate the 'abusive' use of derivatives.

In the commodity derivatives markets there are two key proposals currently being debated in the US: the first would impose limits on derivatives positions, in order to route out 'excessive' speculation. Their particular target is index funds, where activity has increased dramatically over the past few years. The second regulation would force more of the commodity derivatives currently transacted in the OTC markets - such as commodity swaps - to be traded on exchanges, meaning that more transactions would be centrally cleared and subject to up-front margin requirements, with the aim of increasing transparency and reducing systemic risk.

Currently, banks, market participants and end-users of commodities are in limbo. Until the US House of Representatives and the Senate agree on the final shape of regulations (as The Banker went to press it was hoped that a decision would be reached by the House, at least, by December), crucial details remain elusive. Market participants in Europe, too, are awaiting the results of the EU's proposed regulatory clampdown.

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Edouard Neviaski, global head of commodities at Société Générale

Sensitive subject

This is an extremely sensitive subject for banks - and they are unusually quiet. Already unpopular in Washington, DC, and other political circles, banks are wary of openly criticising the proposed regulations for seeming too self-serving. "We just do not feel that our arguments will be given a fair hearing, given the current view of bankers in Washington or on Main Street. We are persona non-grata," says one senior banker.

Bankers are, however, talking to their clients about the potential impact on their business. And clients are clearly worried. At Credit Suisse, a recent call with Mary Whalen, the head of its public policy unit and the bank's representative in Washington discussions, attracted nearly 1000 clients.

In turn, industrial and other affected companies have been vociferous in their opposition to limits on the use of OTC derivatives to hedge risks. In August, Chesapeake Energy Corporation, the largest producer of natural gas in the US, told a Commodity Futures Trading Commission (CFTC) hearing, that using figures from July 2008, for example, it would have been "nearly impossible" to fund the enormous amount of cash required to post margin on the $6.3bn outstanding natural gas hedging transactions that had not yet matured. More importantly, when that negative position turned to a positive $1.3bn mark-to-market position in December 2008, requiring a cash margin would have defeated the purpose of Chesapeake using derivatives in the first place.

Costs to business

Other companies have laid out the potential costs to their business. In an interview with the Financial Times, European utility Eon revealed that it currently has €150bn of interest rate, foreign exchange, commodity and other derivatives on its books. If European Commission proposals were passed, this would mean having to raise about €7.5bn in new credit lines or extra cash reserves. Siemens said it would need more than €1bn in new credit lines or cash and Rolls-Royce estimates that its margin payments for last year would have been €2.7bn.

"It would be difficult to ask corporates to pay margin in order to protect future cash flow," says Edouard Neviaski, global head of commodities at Société Générale. Equally, the idea that bankers could finance margin calls would be challenging, he says. "For one thing, legally, it would be very complex, but it would still be an additional cost which would make hedging unaffordable or uneconomic for companies."

As a result of lobbying by end-users, the House Committees on Financial Services and Agriculture in the US suggested amendments that would exempt producers or end-users of commodities from central clearing. Bankers and many economists believe, however, that this would still reduce liquidity in the market and increase costs.

Many argue that speculators cannot be blamed for long-term price rises and that historical attempts by US regulators to limit speculation had only harmed the market's efficacy as a risk management mechanism. In his testimony to the US's House of Representatives Committee on Agriculture in July last year, Scott Irwin, a professor in the Department of Agricultural and Consumer Economics at the University of Illinois at Urbana-Champaign, argued that market fundamentals and monetary policy had been the main drivers for price rises and that there was no evidence anyway that increasing futures margins was effective at lowering overall price levels.

"The only consistently documented impact of the higher margin requirements was a decline in futures trading volume due to the increased cost of trading," said Mr Irwin. "So, while proposals currently being considered might in fact curtail speculation - through reduced volume of trade - it is very unlikely that the measures will cure the 'problem' of high prices. But, legislative and regulatory initiatives could severely compromise the ability of commodity futures markets to accommodate the needs of commercial firms to hedge price risks."

Percentage total notionals by type, Q2 2009

Percentage total notionals by type, Q2 2009

Drive to 'do' something

As current proposals stand, the effect on banks and other commodity market participants will be dramatic. Even with the proposed exemptions, if swaps or other derivatives transactions which do not have a non-financial (ie: end-user) counterparty are subjected to additional margin and capital requirements, this will add billions to the cost of trading. If the capital cost becomes too great for hedge funds and other speculators, many fear they will simply withdraw from the market and vital liquidity will be lost. The additional costs that this will add to hedging transactions and overall risk management by banks will be passed on to end-users.

Despite testimonies from the likes of Mr Irwin, the public pressure on regulators and policy-makers to be seen to 'do' something to rein in risky bank activities seems overwhelming. For one thing, politicians believe that the derivatives market, the OTC market in particular, is out of kilter with the real economy. Moreover, regulators argue that the concentration of derivatives positions at banks makes the banks' protestations that proposed regulations will damage client hedging activities sound hollow.

Some banks are accused of running large proprietary trading books that have no connection to client trading flows. Critics argue that the September OCC report - which looks at the entire derivatives universe - supports this. It revealed that in Q2, for every dollar of end-user exposure, derivatives dealers have $78 in nominal derivatives exposure, (up from a ratio of 1:24 in 2003) and that while end-users' exposure is at an all-time low, dealers exposure is at an all-time high.

In addition, just five US commercial banks represent 97% of the total US banking industry's notional amounts: JPMorgan ($79.94bn); Goldman Sachs ($40.478bn); Bank of America ($39.06bn); Citibank ($31.94bn); and Wells Fargo ($5.11bn).

Whichever side of the argument one stands, it is hard to know how much of these, or which of these, are client-related transactions, but regulators fear that such high levels in so few banks present some kind of concentration risk anyway - especially when the OCC figures show that the same five banks also account for 88% of the US industry's net current credit exposure.

Commodity bankers say that the commodity derivatives market represented just 0.6% of the total notional derivatives positions outstanding in Q2. They add that if research from economists such as Mr Irwin is to be believed, whether or not there is a lot of speculative activity, it has little effect on commodities pricing and that trying to reduce such businesses will do little to reduce prices overall.

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Amine Bel Hadj Soulami, head of commodity derivatives at BNP Paribas

Market mechanics

Regulators believe that the compromise already offered - to exempt transactions in which one counterparty is a producer or end-user of a commodity (although yet to be agreed) - is enough to address industry concerns about harming those companies for whom the market operates. But bankers maintain that politicians and regulators fail to understand the way the market works: defining on a case-by-case basis, for example, a prop trade and client trading, is very tricky.

A five-year West Texas Intermediate (WTI) swap, with an oil producer, for example, will be entered into a bank's own trading book, but it may take multiple subsequent trades to offset that risk and the moment when a client trade becomes a prop trade becomes blurred. "You cannot hedge exactly the same risk, so the subsequent trades are all directly related to the original client transaction," says Amine Bel Hadj Soulami, head of commodity derivatives at BNP Paribas, who adds that OTC swap transactions account for more than 80% of BNP Paribas' commodity derivatives business.

"Removing the non-[commodity] users will mean less liquidity and less competitive swap pricing," says Mr Bel Hadj Soulami. "And removing that liquidity may make the market more erratic in other ways. Liquid markets such as crude oil have suffered a lot of price volatility, but so have other, illiquid, markets like some agricultural products, where there are fewer speculators," he says.

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Joe Gold, co-head of commodities at Barclays Capital

Unintended consequences

The exchanges, which would seem likely to benefit from forcing OTC contracts on to exchanges and into central clearing, are surprisingly unenthusiastic about the proposed regulations. David Peniket, president and chief operating officer of derivatives exchange ICE Europe, says that while more than 96% of ICE's OTC contracts are centrally cleared (by ICE Clear Europe), the exchange does not support mandatory clearing of all OTC contacts.

"Mandatory central clearing could have significant unintended consequences," says Mr Peniket. "First, forcing transactions that are not readily clearable on to central counterparties could increase risk not just to clearing houses, but to the financial system as well. Second, requiring commercial market participants - including those who would rather, for a price, outsource risk management to OTC swaps dealers - to trade standardised contracts that do not precisely match risk management needs could increase risks and costs to companies and consumers."

Another unintended consequence of rushed regulation could be to push the business offshore. Joe Gold, co-head of commodities at Barclays Capital, says that many banks are worried that hard limits do not reflect the global nature or the portfolio effect of the commodities business and that this could force banks to rethink the way they hedge risk. "For example, we may have a client trade in Asia that we hedge in the US because the best way to hedge it is with a WTI contract. If there are hard limits in the US, the result may be that instead of hedging the Asian business in the US, we'll hedge it in Asia."

Mr Gold is not the only one to believe that the proposed regulations could backfire on the US. Speaking at a recent commodities conference in Singapore, Terry Duffy, executive chairman of the Chicago Mercantile Exchange, the world's largest derivatives exchange, said that the regulations could drive US business offshore to an unregulated OTC platform in Asia, or elsewhere. He argued that this would be counterintuitive to the regulators' aim to bring more transparency to the marketplace - adding that this would not be achieved by driving business out of a regulated market.

Singapore, for example, says Asia is driving commodity demand and that it wants to become the region's commodity trading hub. It plans to attract further business through newly planned oil futures contracts and more OTC swaps clearing mechanisms. In October, Reuters reported that Singapore says it sees little use in following the US in imposing stricter rules to curb speculation and volatility. When contacted by The Banker, the Monetary Authority of Singapore (MAS) responded with a written comment: "MAS continues to closely monitor international developments. We will consult market participants on any regulatory changes that we may be considering."

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Adam Knight, head of global commodities at Credit Suisse

Increased transparency

Mr Duffy's point about transparency is picked up by most commodities bankers. No bankers seem to object to processes or rules that would increase transparency or bring standardised OTC transactions on to an exchange. "We are committed to the idea of greater transparency because the market has suffered because of its opacity," says Société Générale's Mr Neviaski, adding, however, that any requirements for better reporting should be applied to all market participants, including major utilities, industrial companies and physical traders - not just banks.

Adam Knight, head of global commodities at Credit Suisse, believes that much of what regulators want to achieve can be done through tweaking existing processes such as the CFTC's special call. This has already begun; as of September, the CFTC began breaking out managed money and swaps in its weekly 'commitment of trader' (COT) reports, providing more granular information on market activity, including index investment and a better view of overall trading activity in the futures markets.

"We are willing to give detailed information about the bank's activities via mechanisms such as the special call, which give regulators a clear picture of what each firm is doing and an overall view of what is happening in the market," says Mr Knight. "This provides the framework through which [regulators] should be able to monitor if one firm is doing too much proprietary trading, or if any trading activity is excessive, but will not damage liquidity."

Targeting the big banks

Some suspect that proposed regulations also aim to break up the duopoly of Goldman Sachs and Morgan Stanley at the top of the commodities business (and the top five players in the overall derivatives markets) by imposing position limits. It is certainly true that the banks which are most hard hit would be those with the biggest businesses and big proprietary trading books.

The banks with the most to gain are those such as Société Générale and BNP Paribas, which are still in the early stages of building out their commodity platforms. BNP Paribas' Mr Bel Hadj Soulami says the largest portion of the bank's business is hedging and it is nowhere near any prospective limits, so it still has plenty of room to grow. Since its acquisition of Fortis and its commodities business, the bank says it plans to double commodities revenues over the next three years.

Goldman Sachs is not so sanguine. In its testimony to the CFTC, it said that the market could "splinter", not on the basis of knowledge or experience of managing commodity price risk, "but simply on the basis of [a bank] having room under the regulatory position limit".

Most market participants regard the evidence against commodity speculators as sketchy, at best. Moreover, they see only downside for the US economy (and Europe if the European Commission follows suit) and the market if rash regulation is pushed through. More than one banker has called current proposals the "Sarbanes-Oxley of the commodities market", referring to the 2002 regulations which they argue reduced the US's competitiveness versus foreign financial service providers by introducing an "overly complex and onerous" regulatory environment.

Bankers are against a 'one-size-fits-all' policy where every commodity is treated as if it is crude oil - ie: very liquid and easy to understand - saying the danger is that less liquid and more obscure markets could easily be abandoned. Moreover, most bankers say that they are happy to comply with any sensible requirements to improve transparency through better reporting and the expansion of the categories included in the COT reports.

Based on the debate so far, however, market participants are less than optimistic. One banker says: "On a scale of one to 10, where 10 is the most damaging outcome, I am expecting an eight or a nine."

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