Are Global Standards in Commodity Derivatives Fit for Purposes?
Excerpts from IOSCO Emerging Market Committee's Conference
I welcome the opportunity to introduce to you a topic that is novel for many emerging market securities regulators. The key question that has been posed to this panel is whether the global standards in commodity derivatives markets are fit for purpose. To address this question there are three sub-questions that I believe would be relevant in this regard.
The first one is why commodity markets are in focus for securities markets regulators in the first place? A second sub-question to this would be what trends are developing and impacting market infrastructure? And finally, what risks are being considered and addressed by market authorities of developed and emerging markets around the globe. I will share with you some of my observations around these three sub-questions.
As this topic may be new to many present here, let me start with pointing out the relevance of these markets in general. Farmers, miners, oil producers, commercial end-users and consumers across the globe depend on well-functioning derivatives markets. These markets are essential so that they can secure a future price of a commodity or transfer excess risk, and focus on their core business: efficiently producing commodities for the economy.
Futures allow farmers or oil producers to get price certainty on their crops. As they were planting their crops, or pumping their oil fields, farmers could lock in a price prior to harvest time or shipping. Further economic benefits were created by concluding these transactions in a central market, rather than just relying on competition among local merchants.
The last decade has shown considerable growth in exchange traded derivatives including commodity derivative markets and a heightened activity of financial services firms in these markets. Both through regulated markets and clearing houses, and in the over-the-counter space. This development is more prominent in well-developed markets than in emerging markets.
Commodity derivatives markets have become more accessible to more participants. Price information has become less asymmetric and is obtained faster. In general terms, commercial hedgers and institutional investors have become more sophisticated in the way that they approach the market and implement risk management practices.
Market conduct rules in many jurisdictions are now increasing including civil or criminal powers to deter market abuse in commodity derivatives markets.
In emerging markets there is a growing demand for more benchmarks with reduced basis risks and enhanced price discoveries for local produce, as well as commodities procured. This has been the catalyst to trading and clearing platform initiatives to be developed in both producing and consuming countries, for instance in African nations and China.
The growth of derivatives has not only manifested itself in more intensive use of derivatives as a risk management tool, but increasingly commodities have become the underlying instrument to innovations such as: (i) exchange traded funds, (ii) the investment of choice for specialised investment funds, or (iii) as a way to diversify for pension funds and hedge funds. Rough estimates indicate an increase in managed commodity activity to total assets under management in commodities reaching $412 billion in October 2012: an 8-fold increase from 2004.
There has also been a significant increase in electronic trading. Instead of face-to-face trading on an exchange floor, more than 85 percent of the futures volume in 2012 was traded electronically.
More recently, high-frequency trading has also become a more prominent feature of commodity markets, as it has in financial markets. These developments together helped turn commodity derivatives into increasingly liquid financial instruments with tenures of years and accessible to a wider range of investors.
This so-called ‘financialisation of commodity markets defines the answer to my first question and forms part of the motivation for the closer attention of members of the International Organisation of Securities Commissions and IOSCO as an organisation to these markets. To that effect IOSCO established a committee in 2012 exclusively tasked with coordinating standard setting work for commodity derivatives markets.
However, there does not seem to be conclusive evidence that this trend toward greater financialisation has been a significant factor of the overall level of commodity prices. Research, from both the academic and financial community, has difficulty identifying such a relationship. Various studies confirm that the fundamentals of supply and demand driving the physical markets appear to be largely intact in driving the price formation.
There may however been other causal effects on volatility of commodity markets and correlation between commodity prices and those of securities markets. This is demonstrated for instance by an increased correlation between a commodity index (CRB) and the S&P 500 and US treasury bonds.
Notwithstanding this, there have been periods recently where the price action is dominated by so-called “risk-on” and “risk off” flows that drive correlations high and overshadow the fundamentals.
Reversely, and on a slightly different note, the effect of longer term holding of commodity assets can lead to risks in the commodity spot markets as well. For example, the World Federation of Exchanges estimates the total global listed market cap for securities at USD 59 trillion and of US equity markets around USD 21.3 trillion. The current notional value of CME’s NYMEX is around USD 240 billion. This highlights the disproportionality that a minimal re-allocation of capital from listed securities into commodity derivatives markets would cause.
Commodity derivatives markets form a complex matrix of physical and financial, or ‘paper’, transactions. With the risk of generalising too much, on the one hand we have physical markets largely driven by, for instance, the need for flexibility, spot market transactions and commercial activity. In this market the role of transport and logistics, operating warehouses and storage facilities, the availability of supply including restriction of delivery destinations are but a few of the parameters.
On the other hand financial commodity markets may be largely driven by paper hedging, portfolio diversification, asset allocation and speculation.
These two markets are increasingly overlapping in price formation, participants, and conduct issues. Physical traders, refiners and end-users are equally likely to find themselves on the other side of a transaction with banks, hedge funds and pension funds. The regulation is adapting to this new order.
In the past the vast majority of securities regulators had at the core of their mandate the regulation and supervision of securities markets. Now those emerging market authorities responsible for supervising brokers, market operators and clearing houses find themselves confronted with markets and clearing houses developing commercial interests and capability in commodity derivatives. This requires appropriate standards and focus from financial regulatory authorities.
Let us now look in more detail at some of the key changes that have developed in these markets after the global crisis.
Lack of transparency about the hedge funds and financial services divisions belonging to physical commodity trading conglomerates could make it difficult for statutory market supervisors to determine for example if a position is for bona fide hedging or financial speculation, and to prevent manipulative behaviour from combined strategies in physical and financial derivatives markets.
The reduction of acceptance of credit risk has caused a substantial effect. European banks have been particularly handicapped whilst Asian and North
American banks have grown their client businesses in commodities. There has also been a resurgence of trading houses and merchants.
Increased capital costs are one of the implications of regulations that have contributed to the reduction in commodity Value at Risk (VaR) at banks. Most prominently demonstrated by a deleveraging effect.
The push for standardization of OTC swaps has been high on the G-20 agenda. This is further exacerbated by the higher collateral requirements recently accepted by IOSCO-CPSS for OTC transactions.
The reduction in proprietary trading activities, in parallel with the reduced appetite of banks to assume risk, has changed the nature of the price action. At times producer hedging flows may have a greater impact in the short term as no party may be able to take the other side.
In many cases, centralised clearing eliminates the need for individually negotiated bilateral credit agreements, giving many traders easy access to a larger number of potential counterparties. For example, virtually all hedge fund business in the crude oil space executed OTC has now moved to clear through NYMEX or ICE for credit intermediation purposes. Clearing means immediate price transparency. This can be an advantage to some participants, but is a risk management challenge for others. A short delay in reporting block trades for example may improve transparency, but impede the ability to seek a hedge.
Interconnectedess is defined by the increasing difficulty of distinguishing between bona fide hedging positions and speculative positions, given that bona fide hedging companies also trade for speculative purposes and financial companies also increasingly own parts of the physical commodity chain. In this regard we should consider electrical power plants and refineries. As stated earlier, this may form a growing risk to the stability of the financial system by the increasing interconnectedness between players, strategies and products on the commodity markets and those on financial markets.
So how is the ‘financialisation’ of commodity markets impacting markets and financial services regulation? And, what work is under way by regulators?
At the standard setting level and through the IOSCO Commodity for Futures Markets two significant pieces of work have been completed in 2012.
First, IOSCO’s members collectively drafted and issued the Principles for the Regulation and Supervision of Commodity Derivatives Markets in 2011. These principles set standards in contract design of commodity derivatives, and surveillance of markets, addressed risks for disorderly markets, defined principles for enforcement and information sharing between market authorities and for enhancing price discovery. This was followed by a survey on the compliance of these principles by all market authorities in the same year. We are now already witnessing that these Principles in frontier and emerging markets alike are applied as a reference and template in designing national regulation in emerging markets. As always, these documents are published and available on IOSCO’s website.
Secondly, over much of 2011 and 2012, work was completed on establishing Principles for Oil Price Reporting Agencies, PRA’s. This was completed under a G-20 mandate by “recognizing the role of Price Reporting Agencies for the proper functioning of oil markets, we ask IOSCO, in collaboration with the IEF, the IEA and OPEC, to prepare recommendations to improve their functioning and oversight to our Finance Ministers by mid-2012”. At a high level, the Principles require PRA’s to have various systems and controls safeguarding the integrity of the assessment process. They include:
• Formalised and transparent methodology
• Measures to protect integrity of assessments
• Integrity of the process
• Supervision, selection and training of assessors
• Audit trails
• Conflicts management
• Complaints process
• Cooperation with regulatory authorities
• External audit
So what purpose do they serve? In essence there are three objectives:
1. “ To minimize the vulnerability of the assessment process to factors that could undermine the reliability of a PRA assessment as an indicator of physical oil market values or increase the susceptibility of an oil derivatives contract to manipulation or price distortion”.
2. “ To facilitate a market authority’s determination as to whether a PRA-assessed price that is referenced by the terms of an oil derivatives contract accurately reflects the transactions in the physical oil market that it purports to measure, the data are sufficient to represent that physical oil market and such data are bona fide”.
3. “To facilitate a market authority’s ability to detect, deter and if necessary take enforcement action with respect to manipulation or other abusive conduct”.
Implementation will be done by (i) executing a review of PRA’s by an external auditor within 15 months of application (expected to be completed by the end of 2013); and (ii) through regulated markets. In this regard, IOSCO recommends that market authorities consider whether to prohibit trading in any commodity derivatives contact that references a PRA-assessed price unless that assessment follows the IOSCO Principles for Oil Price Reporting Agencies”.
* Eric Salomons has written this article on his personal title and the article not necessarily reflects the opinion of the DFSA
 G20 Leaders’ Statement, Cannes Summit, November 2011
About Eric Salomons
Eric Salomons is a Director, Markets with the Dubai Financial Services Authority DFSA) and has over the past 17 years been involved in derivatives arbitrage, risk management and regulation. Eric has further gained wide ranging and valuable experience of exchange operations and clearing houses as Project Manager for licensing and supervision of equity and (commodity) derivatives markets and clearing houses in Europe and the Dubai International Financial Centre (DIFC). Eric represents the DFSA on various local and international taskforces and committees, such as the UAE taskforce for developing market liquidity and the IOSCO Committee for Commodity Derivatives Markets. Prior to joining the DFSA, Eric was responsible for exchange supervision and regulation at the Dutch financial services regulator (AFM). He started his career as a derivatives market maker on the Euronext exchange floor and later Eurex for Amsterdam Option Traders N.V. (AOT). He is registered with the Dutch Securities Institute since 2000, is a Member of the Global Association of Risk Managers and a Certified Anti-Money Laundering specialist.