Commodities

Keynote Address by Commissioner Scott D. O’Malia, 2014 Bank of Canada International Economic Analysis Workshop on Financialization of Commodity Markets

2014-03-22T07:12:00.000-04:00

Impact of the Dodd-Frank Act on Commodity Futures and Swaps Markets

March 21, 2014

I want to thank Bahattin for inviting me to speak at this workshop. The topic of today’s workshop is “Financialization of Commodity Markets.” As we all know, commodity prices have experienced an unprecedented rise from the early 2000s. During this time, investors poured large amounts of investment capital into the commodity markets. As such, there has been much written about whether the increased presence of financial investors in the commodity markets led to higher commodity prices and volatility, the so-called “financialization of commodities” debate. Many of today’s distinguished panelists have and will offer their insights on speculative activity in the commodity markets and its relationship to the financialization of these markets.

I would like to use this speech to frame the discussion of the impact of the Dodd-Frank Act and Commission regulations on commercial end-users who have historically used the commodity futures and swaps markets for risk mitigation and hedging. In this regard, I will first discuss the importance of hedging in the commodity markets, especially given volatile commodity prices. Next, I will discuss the impact that Dodd-Frank and Commission reforms have had on hedging in the commodity markets, including the “futurization” of swaps. I will then discuss the potential impact on hedging of upcoming Commission rulemakings. Finally, I will touch on the importance of the Commission’s utilization of data in its oversight of the commodity markets.

Importance of Hedging in the Commodity Markets

It is important to remember that the futures markets originated as a way for buyers and sellers to hedge price risk in the grain markets.¹ Today, notwithstanding investor participants in the commodity markets, participants from producers to manufacturers to commercial end-users continue to rely on the futures and swaps markets in order to hedge their commodity price risk, which is essential in order to operate, invest, and grow their businesses.

As we all know, commodity prices are not static. A good example of this price risk is natural gas. Even with the boom in natural gas production,² this long and harsh winter reminds us that increased demand and supply disruptions can result in regional price spikes despite what seems to be an endless supply of natural gas. For example, the extreme cold temperatures this winter greatly increased demand and impacted production, storage, and transportation supplies for natural gas, causing cash prices in the Northeastern U.S. to hit record levels in late January.³ Chart 1 shows that ICE day-ahead cash prices for Northeast natural gas spiked to over $120 per million British thermal units at the end of January before falling back to more reasonable levels. The March – April natural gas spread has been similarly volatile this winter as shown in Chart 2. This spread widened to $1.208 on February 20 before narrowing. Given the increased demand and supply issues for natural gas, storage levels of natural gas are the lowest in 11 years as shown in Chart 3. As of March 7, working gas in storage was 49 percent below last year’s level and 46 percent below the five-year average.

Weather also brought the worst drought in decades to Brazil this winter, causing coffee crop losses of up to 30 percent.⁴ May coffee futures peaked at $2.0975 a pound on March 12, the highest level since February 2012.⁵Weather is not the only factor that can cause volatility in commodity prices. The PED⁶ virus, which has killed an estimated 5 million pigs in the U.S,⁷ has sent lean hog futures prices to record highs.⁸ Even the Crimean conflict contributed to increased wheat and corn prices this month.⁹

Given the volatility in commodity prices, hedging is an important function in the commodity markets so that participants can efficiently operate their businesses. Chart 4 provides an example of a potential consequence when a business does not hedge its exposure.¹⁰ Unfortunately, in this example, Clean Currents closed its business because this past winter’s “extreme weather … sent the wholesale electricity market into unchartered territories” and Clean Currents did not hedge this exposure.¹¹ In this regard, the Commission must be mindful of the impact of its rules on the cost of hedging for end-users so that they are able to engage in legitimate hedging activities. I will next discuss the impact of the Commission’s swaps rules on hedging in the commodity markets.

Dodd-Frank Impact on the Commodity Markets

As you know, over the past several years the Commission has been busy implementing the Dodd-Frank Act. The Commission has completed 68 final rulemakings and 8 exemptive orders and the Commission staff has issued approximately 172 no-action relief letters and 34 guidance and advisories. The Commission now has 98 provisionally registered swap dealers, 19 temporarily registered swap execution facilities, and 4 provisionally registered swap data repositories. In a rush to complete the rulemaking process, the Commission preferred speed over precision. As a result, the Commission’s swaps rules have introduced unnecessary complexity, vagueness, and costs into the markets, including the commodity markets. These consequences have, in certain instances, led some hedgers to seek out alternatives, such as swap futures. This trend is commonly referred to as the “futurization of swaps.”

On October 12, 2012, the joint CFTC-SEC rule defining the term “swap” became effective,¹² which triggered compliance requirements for a number of Commission swaps regulations. To avoid compliance with burdensome and costly swaps regulations, customers of both CME and ICE demanded that the commodity markets move to listed futures instead of swaps. In response, on October 15, 2012, ICE converted its cleared energy swaps into futures and CME began listing energy futures contracts.

Following this shift, CME Group and Eris Exchange launched interest rate swap futures in December 2012.¹³Singapore Exchange began offering commodity futures for trading in April 2013.¹⁴ ICE launched credit index futures in June 2013.¹⁵ Earlier this year, Greenwich Associates noted that “a clear trend exists towards growing demand for FX futures in lieu of traditionally bilateral FX derivatives.”¹⁶ Market participants have cited the complexity and cost of complying with the new swaps rules as major drivers to the futures markets.¹⁷Unlike the swaps markets, the futures markets have clear rules and provide market participants with regulatory certainty.

The Commission’s unjustifiably complicated swap dealer definition¹⁸ and unjustifiably expensive compliance requirements for market participants that meet this definition is one example of a Commission rule that has pushed market participants to the futures markets. In addition to brokers, many other market participants, including energy, agricultural, and commodity firms have to worry about being subject to this definition. Rather than providing a bright line test for determining whether a market participant is a swap dealer, the rule broadly applies the swap dealer definition to all market participants and then provides some limited conditional relief, but only if participants navigate through the complex set of hedging factors on a trade-by-trade basis and fall below the $8 billion de minimis level.

In a few years, the $8 billion de minimis level will fall to $3 billion if the Commission does not vote to change the threshold. Earlier this month, I asked the Commission staff how many additional entities would have to register as a swap dealer if the de minimis level moved to $3 billion today. The Commission staff could not answer this question. If the Commission cannot determine if an entity falls within the swap dealer definition, how can it expect end-users to navigate this complex rule?

Think about this in another way. If the Commission cannot identify swap dealers, how can it enforce this rule? The Commission’s data rules do not require a market participant to flag a trade as a dealing trade or a hedging trade. So, how will the Commission conduct compliance and oversight of this rule regardless of the de minimislevel? I suspect that the Commission will add all trades executed by a market participant and see how close the total is to the de minimis level, and then ask questions to determine whether the economic purpose of each trade was dealing or hedging. This solution will be a nightmare for both the Commission and the end-users.

To provide end-users greater certainty, I propose a modest fix that would allow end-users to exclude all cleared trades from the calculation towards the de minimis threshold. This fix would encourage end-users to clear their trades and would reduce regulatory compliance costs for those end-users who choose to do so.

Moreover, as I noted before, once an entity is subject to the swap dealer definition, the cost of complying with the swap dealer regulations is high. Swap dealers must comply with an array of complex and costly rules in areas such as minimum capital requirements, business conduct, and trade reporting – giving participants a strong incentive to stay away from being labeled as a swap dealer. Participants in the futures markets do not have to comply with such onerous rules.

The downside of futurization for participants in the commodity markets is reduced hedging flexibility because futures contracts, unlike swaps, cannot be individually tailored to meet specific risk needs. Given the volatility of prices in the commodity markets, and the different needs, risks, time horizons, and incentives for end-users in these markets, customized hedging is especially important.¹⁹ Because of the Commission’s rules, these participants will have to accept imperfect hedges, endure the higher cost of swaps, or forego hedging all together. All of these alternatives are unacceptable.

For example, smaller natural gas producers rely on customized hedging solutions to mitigate their exposure to volatile natural gas prices, which enables them to invest in their drilling programs.²⁰ There are more than 120 natural gas delivery locations in the U.S., which can vary significantly from the Henry Hub benchmark price traded on exchanges.²¹ In addition, producers may need the flexibility to enter into long-dated hedges; however, approximately 80% of Henry Hub futures volume is traded within a two-year maturation date.²² The lack of delivery locations and liquidity in long-dated hedges in the futures markets requires customized hedging solutions in many cases.²³ If end-users are forced to use swap futures because the cost of using swaps is too high, these participants will have a less perfect hedge, which could result in additional risk or reduced capital investment.²⁴

Upcoming Changes to the Commodity Markets

There are several upcoming Commission rulemakings that will impact hedging in the commodity markets. First, the Commission is considering a proposed futures block rule that will limit the availability of block trades, especially for energy futures. Exchanges have facilitated the transition from swaps to futures in the commodity markets by establishing extremely low threshold sizes for block trades in futures contracts. These thresholds are unlikely to stay at these levels with a Commission futures block rule. It remains to be seen how Commission rules would affect futurization in the commodity and other markets and the cost of hedging to end-users.

Second, the OTC margin and capital rules for uncleared swaps will increase the cost of hedging. It is important to note that the effort to establish a margin regime for uncleared swaps is a global effort. In September 2013, the Basel Committee on Banking Supervision and the International Organization of Securities Commissions released their final policy framework on margin requirements for uncleared derivatives.²⁵ These rules will spare end-users from mandatory initial and variation margin exchange. However, banks will be hit with new capital charges to offset the risk posed by OTC trades. Banks will pass these costs on to end-users. The Commission will need to finalize these rules, which will increase the cost of hedging for end-users in the commodity markets.

Third, the Commission staff is working on mandatory clearing determinations for additional interest rate swap contracts and non-deliverable forward (“NDF”) contracts. As I previously mentioned, it appears that there is already growing demand for FX futures in lieu of traditionally bilateral FX derivatives. Only time will tell if mandatory clearing and trading accelerate the move of NDFs to futures. While mandatory clearing for commodity swaps is likely a year or more away, commodity market participants should keep a close eye on clearing and trading in the interest rate, credit default, and NDF markets to determine how commodity markets may react in the future with the advent of mandatory clearing and trading. Commodity market participants should also watch for any impacts on the cost of hedging.

Finally, the position limits re-proposal has the potential to negatively impact end-users legitimate hedging activities. Setting position limits is not an easy task, especially with unusable data as I will discuss next. The Commission is supposed to stop excessive speculation and manipulation, but must also protect the essential price discovery process and hedging function in the markets. Unfortunately, the Commission’s position limits re-proposal may curtail end-users hedging activities as it scales back the bona fide hedging exemption. The current bona fide hedging exemption has been in effect since the 1970s and, from my understanding, has worked well in the markets. In developing a final position limits rule, the Commission must ensure that it does not impact longstanding and legitimate hedging activities.

Commission’s View into the Commodity Markets

I would like to next discuss the importance of the Commission’s utilization of data in its oversight of the commodity markets. Two fundamental goals of the Dodd-Frank Act were to increase the transparency and integrity of the swaps markets. To achieve these goals, Dodd-Frank required market participants to report information about each swap transaction to a swap data repository.²⁶ The Commission promulgated swap data reporting rules and swap dealers began reporting their trades in December 2012.²⁷

As important as data is, the Commission does not have a clear picture into the commodity swaps markets or financial markets, for that matter. Let me be clear. The data is extraordinarily difficult to use and the Commission is not utilizing this data effectively, or as it was intended. Without usable data, the Commission cannot conduct surveillance, set appropriate position limits, or analyze systemic risk in these markets. The swaps data is not merged with futures data and cannot be analyzed together. Despite the fact that market participants trade across markets and across jurisdictions with little effort; the Commission continues to struggle to develop its own oversight capacity, unless the Commission makes this a top priority.

However, I am pleased that the Commission is taking steps to improve the quality and consistency of its data. The Commission’s Technology Advisory Committee, which I chair, started to perform work on data harmonization back in 2011. Based on this effort, the Commission is currently working with the swap data repositories to harmonize the data within the credit asset class and will then move on to the interest rate asset class. Commodities, unfortunately, are well down the road.

In addition, based on my suggestion, the Commission formed a cross-divisional data team in January of this year to identify and fix our data problems. The Commission, based on the data team’s work, this past Wednesday put out for comment approximately 70 questions addressing several swap data reporting issues. Based on the comments and its own self-evaluation of the current reporting regime, the cross-divisional data team will make recommendations to improve swap data reporting to the Commission this summer.

I cannot emphasize enough how important it is for the Commission to improve its data quality and utilization so that the Commission has an accurate and complete picture of the swaps markets. Without this view, the Commission cannot surveil the markets for manipulation and other abusive trading practices. In addition, the Commission will not be able to set credible position limits or determine whether end-users are hedging or speculating. The Commission’s ability to perform vital risk analysis will also be compromised.

Conclusion

It is probably appropriate that I conclude my remarks by emphasizing that it is crucially important for the Commission to improve and effectively utilize its data so that the Commission develops a complete picture of both the swaps and the futures markets. In many respects, many of the questions regarding the impact of financialization on the commodity markets would be answerable if the Commission had a complete picture of market participants and their trading strategies.

In addition, the Commission must be mindful of the impact that its regulations have on the cost of hedging in the markets. This is especially true in the commodity markets where a wide range of participants hedge because of the volatility in commodity prices and specialized business needs. If the cost of hedging becomes too expensive, these participants may choose not to hedge or enter into less perfect hedges, which impairs efficient business operations.

Therefore, looking forward, the Commission must strive to issue clear, consistent, and cost effective rules that are informed by data and that do not interfere with hedging in the markets. Finally, the Commission must re-visit rules that have proved unworkable or overly burdensome. I am encouraged that the Commission has taken the first step by re-visiting its data rules. I encourage the Commission to not stop there and continue to re-visit rules that have impacted legitimate hedging activities.

Thank you very much for your time.

Note: Presentation is available under Related Links.

¹See Timeline of CME Achievements, available at http://www.cmegroup.com/company/history/timeline-of-achievements.html.

²Annual Energy Outlook 2013, U.S. Energy Information Administration, April 2013, page 79, available at,http://www.eia.gov/forecasts/aeo/pdf/0383(2013).pdf. The EIA report shows an increase in natural gas production since the mid-2000s and predicts a further 44 percent increase in production from 2011 to 2040, with shale gas providing the largest source of growth.

³Freezes hit U.S. natural gas output, California supply, Reuters, February 3, 2014, available at,http://www.reuters.com/article/2014/02/06/energy-natgas-weather-idUSL2N0LB1I420140206. Supply constraints also contributed to price spikes. Northeastern Winter Natural Gas and Electricity Issues, U.S. Energy Information Administration, January 7, 2014, available at,http://www.eia.gov/special/alert/east_coast/pdf/energy_market_alert_Jan_7_2014.pdf.

⁴Rains to end Brazil coffee drought, but damage done, Reuters, February, 13, 2014, available athttp://www.reuters.com/article/2014/02/13/brazil-coffee-rains-idUSL2N0LI1DY20140213.

⁵Coffee, sugar fall on producer selling, cocoa eyes expiry, Reuters, March 14, 2014, available athttp://www.cnbc.com/id/101494777.

⁶Porcine epidemic diarrhea virus.

⁷Pork Industry Launches Three-Prong Strategy to Stem PEDV Spread, National Pork Board, March 11, 2014, available at,http://www.pork.org/News/4575/PorkIndustryLaunchesThreeProngStrategytoStemPEDVSpread.aspx.

⁸Is virus-inflated U.S. hog market bubble about to burst?, Reuters, March 14, 2014, available at,http://www.reuters.com/article/2014/03/14/us-usa-pork-hogs-analysis-idUSBREA2D1YW20140314.

⁹Wheat jumps 2 pct on U.S. weather, Ukraine concerns, Reuters, March, 14, 2014, available at,http://www.reuters.com/article/2014/03/14/markets-grains-idUSL3N0MB3CX20140314.

¹⁰See Clean Current’s website, available at, http://www.cleancurrents.com/; Clean Currents turns off its lights after January’s polar vortex spiked energy prices, The Washington Post, February 3, 2014, available at,http://www.washingtonpost.com/business/capitalbusiness/clean-currents-turns-off-its-lights-after-januarys-polar-vortex-spiked-energy-prices/2014/02/03/8f9cde1e-8cf6-11e3-98ab-fe5228217bd1_story.html.

¹¹Id.

¹²Further Definition of “Swap,” “Security-Based Swap,” and “Security-Based Swap Agreement”; Mixed Swaps; Security-Based Swap Agreement Recordkeeping, 77 FR 48208 (Aug. 13, 2012).

¹³Deliverable Interest Rate Swap Futures, CME Group, available at, http://www.cmegroup.com/trading/interest-rates/files/dsf-overview.pdf. Eris Exchange to Launch New, Margin-Efficient Interest Rate Swap Futures, Eris Exchange, December 5, 2012, available at,http://www.erisfutures.com/EE/Eris_Exchange_to_Launch_New_Margin_Efficient_Interest_Rate_Swap_Futures.pdf.

¹⁴SGX to Introduce Iron Ore Futures as Investors Bet on China, Bloomberg, April 5, 2013, available at,http://www.bloomberg.com/news/2013-04-05/sgx-to-introduce-iron-ore-futures-as-investors-wager-on-china.html.

¹⁵Credit Index Futures on ICE, available at, https://www.theice.com/credit.jhtml.

¹⁶Futurization of FX Derivatives, Greenwich Associates, January 14, 2014, available at,https://www.greenwich.com/greenwich-research/research-documents/greenwich-reports/2014/jan/is-spl-futfx-2013-gr. Why Regulatory Changes Will Drive FX Trading Volume to Futures, kevinonthestreet, January 14, 2014, available at, http://kevinonthestreet.com/why-regulatory-changes-will-drive-fx-trading-volumes-to-futures/.

¹⁷Id. Futurization: Dodd-Frank Drives Swaps-to-Futures Migration, futuresINDUSTRY, January 2013, available at, http://www.futuresindustry.org/futures-industry.asp?iss=209&a=1531. Swaps Futurization Means Added Choice, Market Media, March 12, 2014, available at, http://marketsmedia.com/swaps-futurization-means-added-choice/.

¹⁸Further Definition of “Swap Dealer,” “Security-Based Swap Dealer,” “Major Swap Participant,” “Major Security-Based Swap Participant,” and “Eligible Contract Participant,” 77 FR 30595 (May 23, 2012).

¹⁹The Role of Banks in Physical Commodities, HIS Global Inc., 2013, at pages 4-5.

²⁰Id. at 24-25.

²¹Id. at 24.

²²Id. at 25.

²³Id.

²⁴Id.

²⁵Basel Committee on Banking Supervision and Board of the International Organization of Securities Commissions, Margin requirements for non-centrally cleared derivatives, September 2013, available at,http://www.bis.org/publ/bcbs261.pdf.

²⁶Sections 727 and 728 of the Dodd-Frank Act. Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. 111-203, 124 Stat. 1376 (2010).

²⁷17 C.F.R. parts 43, 45, and 46.

Last Updated: March 21, 2014

The Changing Structure of Energy Trading Markets[†]

2013-01-30T00:09:00.000-05:00

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.

[†] This article first appeared in the International Energy Agency’s Oil Market Report dated 18 January 2013.

Extending Principles for Price Reporting Agencies to All Assessments[†]

2012-12-26T10:30:00.000-05:00

Allegations of price manipulation in UK wholesale natural gas prices by some major power companies and financial institutions could not have come at a worse time for price reporting agencies (PRAs). Less than a month after IOSCO’s publication of principles for oil price reporting agencies, a price reporter at energy‐ industry data provider ICIS went public with the charge that natural gas prices are regularly manipulated by physical and financial traders, and that prices assessed by price reporting agencies do not accurately reflect the underlying physical market. Furthermore, he argued that poorly trained price assessors often developed close relationships with traders, which led them to routinely engage in Libor‐style price fixing exercises. Immediately following these allegations, UK Financial Services Authority (FSA) and energy regulator Ofgem launched investigations into the claims.

Market participants have long claimed that selective reporting by traders and inconsistent methodologies used by price reporting agencies can distort reported prices. These concerns were the basis of a report published by IOSCO in early October, to which the IEA, OPEC and the IEF, responding to a request from the G20, provided input.* The report suggested that “ the ability to selectively report data on a voluntary basis creates an opportunity for manipulating the commodity market data that are submitted to PRAs” and “the need for assessors to use judgement under some methodologies creates an opportunity for the submitter of data to deliberately bias a PRA’s assessment in order to benefit the submitter’s derivatives positions.”

In order to enhance the reliability of oil price assessments that are referenced in derivatives contracts subject to regulation by its members, IOSCO set forth a set of principles for the PRAs to follow. IOSCO proposed, in collaboration with the IEA, IEF and OPEC, to review the implementation of the PRA principles after 18 months. If implementation is ineffective, there may be further recommendations.

The IOSCO PRA principles are intended to establish a framework of best business practices for PRAs and include:

requirements for transparent methodologies adopted by PRAs as well as consultation with industry stakeholders for any proposed material changes in methodologies;
giving priority to concluded transactions in making assessments;
employing sufficient measures to ensure the integrity of submitted information;
encouraging submitters to submit all of their market data;
publishing criteria according to which transaction data may be excluded from a price assessment;
specifying criteria that define who may submit market data to PRAs;
implementing internal controls to identify communications between submitters and price assessors, and to ensure the integrity and reliability of assessments;
retention of all information and judgments made in reaching a price assessment for at least five years;
functional and operational separation of a PRA’s assessment business from any other business that may present a conflict of interest;
adoption of formal complaint-handling policies;
and finally, annual independent external auditing of a PRA’s adherence to its stated methodology criteria and with the requirements of the principles.

PRAs initially argued that they are basically news agencies and they are simply using their freedom of expression rights, therefore they cannot be subject to such rules. IOSCO overcame this objection by restricting these principles to be applied only in price assessments that are referenced in oil derivatives contracts. Practically, they recommended that “market authorities consider whether to prohibit trading in any oil derivatives contract that references a PRA‐assessed price unless that assessment follows the PRA principles.” It is a rather indirect way to force PRAs to adopt such rules. Instead of losing their customer basis, PRAs are expected to adopt these proposed principles.

While a step forward, these principles still do not fully address the problem of selective price reporting. Since traders are not required to submit trade data to PRAs, there is a risk that voluntary reporting could result in selective reporting and seriously compromise the integrity of price assessment. Therefore, it is important, in our view, to allow PRAs to use more information than concluded transactions in making their price assessments. Exclusive reliance on concluded transactions might lead to inaccurate price assessment if submitted prices are false or manipulated. Thanks to the use of other market information, PRAs can check the accuracy of submissions or assess whether submitted prices truly reflect the market place. Demanding traders who chose to voluntarily submit data to provide all of their market data in order to prevent selective reporting is not the answer. Given the voluntary nature of trade reporting, asking traders to submit all of their trade data amounts to an “all or nothing” policy which runs the risk of effectively discouraging price reporting and drastically limiting the pool of information available to PRAs, thereby adversely affecting the reliability of their reports. As long as the submission of data is voluntary, there is a strong risk that such “all or nothing” policy could end up fatally disrupting the flow of information from submitters to PRAs.

Another weakness in these principles has to do with complaint‐handling. While they do call for a formal complaint‐handling policy, the principles stop short from requiring the disclosure of complaints to market participants. The principles require PRAs to advise plaintiffs and any other relevant parties of the outcome of the investigation in the event of a formal complaint. Disputes regarding a daily pricing determination will be communicated to the market only when a complaint results in a change in price. However, if the aim of these principles is to increase transparency in price assessment, it may be argued that they should have called for an immediate announcement of all accepted formal complaints to market participants, similar to error trade announcements in exchanges. Furthermore, the principles called for recourse to an independent third party review of complaints if the plaintiff is dissatisfied with the way a complaint has been handled by the relevant PRA. However, the principles require that the independent third party be appointed by the PRA itself. Giving the right to appoint the third party to the PRA to review its own decision clearly creates a conflict of interest and undermines the independence of the external review. To ensure an independent review process, the appointment of the third‐party reviewer should be jointly handled by the PRA and industry stakeholders.

It is important to note that PRAs deliver more than just news. Their assessed prices are used not only in settlement of oil derivatives contracts but also in other derivatives contracts, including but not limited to natural gas and refined products. These assessed prices are also referenced in many long‐term physical market contracts. The recent allegations of price‐fixing in UK wholesale gas prices show the importance of reliable price assessments. Therefore, the principles developed for oil price assessments that are referenced in derivatives contracts should be universally adopted by PRAs for any price assessment activities.

*The report, “Principles for Oil Price Reporting Agencies”, was published on the IOSCO website on 5 October 2012 and can be accessed at http://www.iosco.org/library/pubdocs/pdf/IOSCOPD391.pdf

[†] This article first appeared in the International Energy Agency’s Oil Market Report dated 12 December 2012.

A New Era in Swaps Markets?*

2012-11-22T00:43:00.000-05:00

US CFTC Chairman Gary Gensler declared last month that a new era for the swaps marketplace would start on 12 October 2012, the effective date of the new US swap definition rule. This marked the beginning of the process of swap dealer registration and swap data reporting. Mandatory clearing by swap dealers and major swap participants is expected to follow in February. The new rules are intended to bring transparency to the swaps markets and lower their risks. While the 12 October date may indeed be remembered as a milestone, a close 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.

Those difficulties should not come as a surprise. There is an inherent tension between, on the one hand, the political clarity of the perceived need for, and urgency of, financial‐market transparency and regulatory reform and, on the other hand, the very complexity of those market’s financial instruments, and hence the great difficulty of regulatory adjustments. When G20 leaders set the broad reform agenda to be implemented by the end of 2012 to reduce systemic risk and increase transparency in the OTC derivatives markets, they might not have fully appreciated the complex nature of the instruments they were dealing with. They might also have held exaggerated hopes that new rules could easily achieve consistency across nations and win consensual international support. Instead, regulators in different countries followed their own paths in designing the rules that were supposed to govern global swaps markets, without engaging into much‐needed cooperation among themselves.

As indicated in the latest FSB progress report on OTC market reforms, it now appears that regulatory differences among regions, including in the cross‐border application of rules, will likely delay the full and timely implementation of the G20 requirements for OTC markets regulations. The FSB urged regulators for more international coordination to provide clarity on how the rules will apply to transactions and entities for more consistent and effective oversight in OTC markets.

Although the US CFTC is still working on the final guidance on the cross‐border application of Dodd‐Frank swaps market reform, interpretive guidance issued in June was heavily criticised by European and Asian regulators as well as other market participants when they met in Washington, DC on 7 November 2012. They have raised their concerns about the unintended consequences of cross‐border application of swaps rules, including potential market disruption or fragmentation resulting in increased systemic risks and reduced market liquidity.

Some observers argue that the CFTC has rushed to meet arbitrary deadlines without providing proper analysis of the costs and benefits of the new rules for swaps markets. The CFTC’s last minute issuance of a series of no‐action and interpretive letters and other guidance just before the 12 October deadline was interpreted as proof that the Commission had failed to develop clear and cost‐effective rules, as noted by one of its Commissioners.

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.

Moving to less heavily regulated jurisdictions would be a form a physical or geographical migration of the swaps market. Another form of market migration entails converting swap positions into equivalent futures positions, resulting in what could be called the ‘futurisation’ of swaps. Neither the physical migration nor the futurisation of the swaps market would likely have been the market response intended by regulators.

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. Similarly, Chicago Mercantile Exchange (CME) also announced the launch of a deliverable interest rate swap futures contract on 3 December 2012, which will convert or be delivered into an OTC swap that is cleared by the CME upon expiry.

Exchanges are introducing these swap‐like futures contracts to avoid complexity, cost and the lack of regulatory certainty. Of course, the success of these new products is still to be tested. Sufficient market liquidity and trader confidence are essential to the survival of these new products. If successful, a new era may indeed begin for swaps markets, though not quite in the sense intended by regulators.

*This article first appeared in the International Energy Agency’s Oil Market Report dated 13 November 2012.

Forecasting Price on Opaque Oil Markets*

2012-09-25T11:58:00.000-04:00

The summer of 2008 saw a spike in crude oil prices to $147/bbl, followed by a steep correction in late 2008/early-2009. A subsequent rebound over the last three years has brought the question of whether it is possible to accurately forecast prices over the medium and longer term.

Making reliable forecasts of oil prices has been of interest to a wide range of economic agents, including policymakers, oil producers and consumers as well as other market participants. However, in a rapidly changing oil market, any forecast of oil prices, especially at longer horizons, is highly uncertain, a fact illustrated by the wide confidence bands around price predictions. Research shows that forecasts based on futures prices, surveys of analyst forecasts, forecasts based on a variety of simple time series regressions and other common forecasting techniques are generally inferior to the random-walk forecast, which implies that the best forecast of crude oil spot prices is simply the current price of oil. Some models improve short-term forecasts up to a year; however, at longer horizons a random walk forecast outperforms all models with the exception of forecasts based on expected inflation due to the large inflation component in the nominal price of oil at longer horizons (See, e.g., Kilian and Baumeister (2012) and Kilian, Alquist and Vigfusson (2012)).

Apart from these simple forecasting techniques, recent research based on more sophisticated VAR-based models showed substantial improvement in short term price forecasting up to a year, and even longer horizon improvement in directional accuracy. These models, using percent change in global oil production, oil price, real global activity and global inventories as their main variables, can be used to not only measure the impact of demand and supply shocks on the price of oil but also to generate projections conditional on different economic scenarios. Although promising, these models also suffer from two distinct limitations. Firstly, they only allow for temporary shocks to global oil supply, such as a disruption in Iranian production, as opposed to a persistent decline in oil supply growth driven by resource constraints, such as finite oil reserves. Secondly, and more importantly, key macroeconomic as well as oil market-specific variables that are the subject of forecasts are not available to the forecaster in real time. Most data are available with a time delay. Furthermore, preliminary data tend to be revised over time. As a result, forecast accuracy is done using ex-post revised data. Therefore, it is not possible to measure the accuracy of forecasts, as opposed to forecasts based on more easily observed futures prices or expected inflation.

Future of Oil Price Forecasting

Recent advances in VAR-based modelling and forecasting are very promising. However, the success of these models relies on timely and accurate data on oil market as well as on other macroeconomic indicators. There is an urgent and growing need for more and better data on oil reserves, production, consumption, refining, exports, imports, inventories from both OECD and, particularly, from non-OECD countries, including data on floating storage and storage costs to fully understand oil price dynamics.

Furthermore, models should be augmented to capture the feedback effects of futures prices on producers’ and consumers’ activities. Recent research using state-of-the-art econometrics finds no systematic, deleterious causality running from so-called ‘speculative’ activity to prices. However, this research fails to measure the impact of activities of financial players on the formation of expectations by physical market players. At the same time, data limitations are not limited to physical oil markets. Energy derivatives markets are also partially opaque. Therefore, transparency in both the physical and financial markets is essential to better understand possible linkages between the two markets, as well as price dynamics in oil markets more generally.

* IEA OMR, September 2012

Speculation Demystified: Virtuous Volatility

2012-09-20T13:51:00.001-04:00

In recent years, the oil market has been characterised by rising, and at times, rapidly fluctuating price levels. From April 2012 to June 2012 alone, Brent crude oil prices gyrated between USD 125 and USD 89 per barrel. Higher volatility adversely affects oil exporting countries’ fiscal revenues and investment, reducing confidence in the economy, while it worsens inflation and growth prospects for oil importers.

In 2011, the Group of 20 (G20) nations called for policy options to combat increased volatility in commodity markets in general, and in oil markets in particular. In response, a G20 experts group emphasised the importance of improving data transparency in both financial and physical markets as well as phasing out inefficient fossil fuel subsidies. The experts group also urged the use of country-specific

monetary and fiscal responses to support inclusive growth in order to mitigate the impacts of excessive price volatility.

However, it is important to note that volatility itself is not the main problem. Instead, the main challenge would be elevated price levels combined with higher volatility. ...

My article appeared in print on September 20, 2012, on pages 34 and 35 of the IEA Energy Journal-Issue 3, Autumn 2012. You can read this article here (SSRN)

Treatise on the Definition of Swap*

2012-08-22T19:11:00.000-04:00

Almost two years after the Dodd-Frank Act was enacted into law, on 10 July 2012 the US CFTC voted 4-1 to approve a 600-page final rule, jointly developed with the US Securities and Exchange Commission (SEC), to further define the statutory term “swap”. Not only does the definition provide greater clarity on which financial products can be expected to fall within regulatory oversight, and thus become subject to reporting, clearing, capital and margin requirements, but passage of the rule also sets the compliance dates for a string of other Commission rules governing the $650 trillion over-the-counter global swaps markets. Those include rules on swap dealers (SD) and major swap participants (MSP) registration, SD and MSP swap data reporting and recordkeeping, registration of swap data depositories, large trader reporting for registered SDs and MSPs, real time reporting of swap transactions and pricing data, internal and external business conduct standards and position limits.

The Commission had been criticised for finalising other rules without first defining the term ‘swap’. Critics argued that defining a swap should have been the first rulemaking by the regulators rather than one of the last. Others countered however that it was arbitrary deadlines imposed on the regulators by the Dodd-Frank Act that led the US CFTC to delay the product definition rule. Furthermore, the Commission, along with the SEC, might have postponed the swap definition rule to ensure that market participants were ready for the new regulatory requirements that the final rule would trigger.

What is a “Swap”?

The final rule, consistent with the Dodd-Frank Act statute, defines a broad range of derivatives as swaps: interest rate swaps, currency swaps, commodity swaps, including energy, metals, and agricultural swaps, commodity options, currency options, cross-currency swaps, forward rate agreements, options to enter into swap (swaptions) and broad-based index swaps, such as index credit default swaps. The final rule also treats foreign exchange swaps and forwards as swaps except those exempted by the Department of Treasury.

What is not a “Swap”?

The final rule clarifies that insurance products, loan participations, certain consumer and commercial transactions, such as consumer mortgage rate locks, consumer and commercial loans, and service contracts will not be considered swaps. In line with the Dodd-Frank Act, the final rule excludes non-financial forward contracts that are intended to be physically settled from the statutory swap definition. Clearly, the scope of this exclusion or exemptions will have the greatest impact on energy market participants.

Exclusions for Energy Companies

The US CFTC also issued a guidance clarifying the extent of forward contract exclusion and its relevance to the new swap definition. The Dodd-Frank Act specifically excludes “any sale of a nonfinancial commodity or security for deferred shipment or delivery, so long as the transaction is intended to be physically settled” from its statutory swap definition. If the transaction is to be physically settled, even if settled at different agreed prices, then it will not be considered a swap. Book-out transactions in nonfinancial commodities would not be considered as swap as long as the underlying contracts meet the requirement specified in the Brent interpretation, which requires that the contracts (a) create a binding obligation to make or take delivery without providing any right to offset, cancel, or settle on a payment-of-differences basis and (b) are between market participants that regularly make or take delivery of the referenced commodity in their ordinary course of business. If the parties settle their delivery obligations through a subsequent, separately-negotiated agreement, these contracts still qualify for the forward exclusion from the swap definition.

Furthermore, the interpretation keeps forward contracts with price optionality, where parties can adjust forward contract prices during the course of the agreement, as forward rather than swap contracts. The final rule also excludes forward contracts with volumetric optionality, where parties have the option to adjust the volume specified in the underlying contract, from being classified as swaps provided that the underlying contracts satisfy the seven-part test. The CFTC has, however, requested public comment on the interpretation of forward contracts with volumetric optionality.

The final rule also excludes environmental commodities, such as carbon offset credits, emission allowance and renewable energy credits from the statutory definition of swap. The Commission guidance also excludes certain types of arrangements, such as fuel delivery agreements and physical exchange transactions, from being classified as swaps.

IEA Oil Market Report, August 2012

Volatility vs. Price*

2012-07-25T12:45:00.000-04:00

In recent years, the oil market has been characterised by rising, and at times, rapidly fluctuating price levels. In the last three months alone, Brent crude oil prices have fluctuated in a wide range from $125/bbl to $89/bbl. Higher volatility will certainly impact both consumers and producers. Oil exporting countries can be negatively affected by the impacts of high volatility in oil prices on fiscal revenues, investment and confidence in the economy. Higher volatility can have negative impacts on inflation and growth prospects in oil importing countries as well. As a response to observed higher prevailing volatility, for example, G20 leaders called for policy options to combat excessive price volatility in commodity markets in general, and in oil markets in particular. In order to reduce volatility in oil markets, the G20 experts group emphasised the importance of improving data transparency in both financial and physical markets as well as phasing out of inefficient fossil fuel subsidies. They also urged the use of country-specific monetary and fiscal responses to support inclusive growth in order to mitigate the impacts of excessive price volatility.

However, it is important to note that volatility itself is not the main problem. The main challenge is the elevated price levels combined with higher volatility. Oil prices, like those of many other commodities, are inherently volatile and volatility itself varies over time. Due to inelastic supply and demand curves, at least in the short run, any shock to demand and supply will lead to large changes in oil prices. For example, annualised average volatility in January 2009 peaked at 92%, followed by a rapid decline to relatively low levels. On the other hand, volatility reached its historical peak level (116% annually) in January 1991. Up until mid-March 2012, average annualised volatility in 2012 was relatively stable at around 23%. It is important to note that prices in this period increased from $110/bbl to $128/bbl. Volatility in Brent prices increased especially in June 2012, reaching more than 34% at a time when the price level declined by more than $15/bbl.

This pattern, volatility increasing as oil prices decline and volatility declining as oil prices increase, is consistent with the empirical evidence in the stock market. The increase in volatility when oil prices falls can be explained by the fact that falling oil prices often accompany deteriorating global activity and resulting uncertainties for global oil demand, such as the collapse in demand observed immediately after the demise of Lehman Brothers in September 2008.

Although policy makers and market participants generally point to peak oil prices in 2008, the average Brent oil price in 2008 was $96.94/bbl, only peaking at $144/bbl on 3 July 2008. Moreover, oil prices were above the $100 threshold level on only 128 days during 2008. Average Brent oil prices registered $61/bbl in post-September 2008 when the worst financial crisis since the Great Depression hit the global economy. In contrast, between mid-February 2011 and June 2012, oil prices have averaged above $100/bbl. The average Brent oil price registered $111.26/bbl and $113.17/bbl in 2011 and 2012, respectively. Given the fragile state of the global economic recovery, the impact of high oil prices on global growth, especially in oil importing countries, is potentially more severe now than in 2008. High oil prices already threaten to aggravate global economic slowdown by widening global imbalances, reducing household and business income, and boosting inflation.

This is not to say that volatility should have a second order of importance when considering market dynamics and oil prices. Prices and volatility cannot be separated from each other. However, persistently higher oil prices have been increasing the share of GDP spent on oil imports. This is especially the case in oil-importing developing countries because their economies are often more dependent on imported oil and more energy-intensive and because their energy use in a given sector is sometimes less efficient than the global average. Therefore, policies to deal with high oil prices should arguably be given priority over policies dealing with volatility. There are already many tools to combat oil price volatility, including not least at a micro level the use of commodity derivatives markets to hedge against price risk. Addressing elevated price levels may be a harder nut to crack however, unless price distortions in consumer markets on the one hand, and uncertainties in the upstream investment environment on the other are addressed, allowing markets to more readily self-adjust to international pricing signals.

IEA Oil Market Report, July 2012

Bank Losses Sharpen Focus on Proprietary Trading*

2012-06-26T12:09:00.000-04:00

On 10 May 2012, JP Morgan, the largest US bank by assets, announced that poorly designed and executed hedging strategies had caused more than $2 billion in derivatives trading losses from transactions in London. Even more worrying is the fact that some regulators, including the US Commodity Futures Trading Commission (CFTC) and the US Securities Exchange Commission (SEC), have argued that since they do not yet monitor JP Morgan as a swap dealer, they became aware of the trading losses after JP Morgan’s announcement despite earlier media reports at the beginning of April that raised red flags over the London Whale’s $100 billion notional exposure in one credit index. Even the regulators, the US Office of the Comptroller of the Currency (OCC) and Federal Reserve Bank, failed to detect the risk posed by the massive hedging strategy, despite having more than 100 of their own staff embedded at JP Morgan, up until April, around the same time that Bloomberg and Wall Street news reports suggested that the UK-based trader at the bank was playing a dominant role in certain markets and distorting prices.

Regulators might argue that it is not their responsibility to flag risks posed by some hedging strategy but it is important to note that JP Morgan is identified by the OCC as one of the top five systemically important financial institutions, which collectively accounted for more than 50 percent of the $700 trillion OTC derivatives in total notional value at the end of 2011. JP Morgan exposure alone exceeds $70 trillion, which implies a leverage of one to 31 times, given JP Morgan total assets $2.26 trillion, according to the OCC report.

Given the prominence of the company in derivatives trading (estimated to account for over 10% in notional value of OTC derivatives trading in late-2011), this raises important questions about regulatory oversight, the pace and extent of financial reform and ultimately (even though energy markets were not directly involved) the functioning of energy derivatives markets.

The Trades in Question

According to news reports, JP Morgan trades can be classified as directional bets, although some might argue that it is a complex hedging strategy to cover overall portfolio risk. In the simplest terms, the company initially purchased credit default swaps (CDS) on high yield bonds to hedge their loan book. Money could have been made if the economy deteriorated. In the event, as the US economy showed some improvement, this strategy did not perform well in terms of making money although it is the appropriate strategy in terms of risk management. In the second stage, JP Morgan sold substantial amounts of under-priced swaps on a basket of investment-grade corporate bonds, a traded index of credit default swaps, on the expectation that the economy would further improve.

It is especially this portion of the trades that are being questioned, and whether this constituted a hedge or a proprietary trade. Some have argued that this was a hedge against future obligations for which the firm is naturally short. Others argued that this is actually proprietary trading, which would have been prohibited under the Volcker rule. The company’s large position eventually created a material gap between the index price and the sum of the prices on the underlying CDS in such a way that buying protection on the index was cheaper than buying protection via individual company CDS. Instead of unwinding their position in the index, JP Morgan further took the opposite position to hedge their exposures in the index by buying CDS on the investment-grade bonds of individual companies, which led to further losses for the company.

We expect that debates surrounding these trades will have important implications for at least three contentious issues; namely the Volcker rule, the Lincoln swaps push-out rule, and the cross-border application of the Dodd‑Frank Act.

Implications for the Volcker Rule

As explained in the February OMR, the proposed Volcker rule prohibits proprietary trading while allowing transactions related to underwriting, market-making, risk mitigating hedging, trading in certain US government obligations, and trading on behalf of customers. For example, the proposed rule allows for banking entities’ risk-mitigating activities for their portfolio. The statute defines proprietary trading as engaging in the purchase or sale of certain financial assets as a principal for the trading account of a covered banking entity. The rule further provides guidance on what banking entities must do to prove that they are not undertaking proprietary trading but engaging in permitted activities, such as hedging, market-making or trading on behalf of customers. Finally, the proposed rule provides detailed limitations on the permitted activities. For instance, if their permitted activity would endanger the safety or soundness of the banking entity or the financial stability of the United States, then it is considered proprietary trading and it is prohibited.

The determination of what constitutes proprietary trading and what constitutes legitimate trading activity, such as hedging or market-making, remains under debate, although the final rule will now likely narrow hedging exemptions. Some suggest that portfolio hedging should not be considered as a legitimate hedging activity, and therefore should not be permitted. Also, regulators might interpret market-making activity more narrowly than the proposed rules. While recent events might boost popular support for more restrictive rules, they do not remove the need for thorough cost-benefit analysis on measures which might reduce liquidity in the market, adversely affecting price discovery and the transfer of risk functions of derivatives markets.

Implications for the Lincoln Swaps Push-Out Rule

The Lincoln rule specifically requires federally insured banking entities to move their risky trades, such as swap trading in uncleared credit-default swaps and energy and metal swaps, among others, from a banking unit into separately capitalised affiliates, while allowing exemptions for certain traditional bank derivatives activities, such as hedging and trades in interest-rate swaps. The rule is expected to be in effect starting on 16 July 2013. Banks lobbied against this rule and the US House Committee on Financial Services amended the Lincoln rule on 11 May to allow a wider range of swaps to stay in-house. However, due to the recent JP Morgan losses, the US House Committee on Agriculture granted an extension for further consideration, ending not later than 16 July 2012. It will be interesting to see whether and how recent events trigger a major regulatory rethink in the US Congress.

Implications for Cross-Border Application of the Dodd-Frank Act

The extent to which the Dodd-Frank Act will govern cross-border activities is an important issue in light of the global nature of the swap market. The Dodd-Frank Act gives broad authority to the CFTC over the global swaps markets by Section 722. Section 722 provides that the CFTC’s jurisdiction shall not apply to activities outside of the US unless they have a direct and significant connection with activities in, or effect on, commerce of the US.

The CFTC is yet to vote on interpretive guidance extending the Dodd-Frank Act to some overseas swap trading, but the Commission is likely to release its guidance in late June 2012. The US banking sector has argued that broader oversight of cross-border derivatives activities will diminish their competitiveness in global swaps markets with their foreign-based competitors. Others suggest that JP Morgan’s losses are a reminder of how trades overseas by subsidiaries and branches of US firms can quickly affect domestic banking units.

Although we still need to see the actual guidelines, CFTC Chairman Gensler provided some of the key elements in the interpretive guidelines on 22 May 2012, which include:

requirement for entities to register under the CFTC’s swap dealer registration rules if a foreign entity transacts in more than a de minimis level of U.S. facing swap dealing activity.
addressing what it means to be a U.S. facing transaction, which will include transactions not only with persons or entities operating in the United States, but also with their overseas branches.
a tiered approach for requirements for overseas swap dealers that could include entity level requirements, such as capital, risk management and record-keeping as well as transaction-level requirements, such as clearing, margin, real-time public reporting, trade execution and sales practices.
use of entity-level requirements to all registered swap dealers, but in certain circumstances, overseas swap dealers could comply with these requirements through substituted compliance.
use of transaction-level requirements for all U.S. facing transactions, but for certain transactions between an overseas swap dealer (including a foreign swap dealer that is an affiliate of a U.S. person) and counterparties not guaranteed by or operating as conduits for U.S. entities, Dodd-Frank may not apply.

Implications for Energy Derivatives Markets

Although JP Morgan losses were not related to energy derivatives trading, the implications of any resultant new interpretation of the Volcker, Lincoln and cross-border application of the Dodd-Frank Acts will certainly affect energy markets, where banking institutions have been the biggest liquidity providers through their hedging, market-making and speculative activities. Commercial traders have raised their concerns on the impact of the Volcker rule and other rules on market liquidity and their unintended consequences of higher trading costs. They were already lobbying for more exemptions from commercial banks’ trading bans ahead of the events surrounding JP Morgan, but might struggle now to win their case, not least if a narrower interpretation of hedging and market-making activities gains momentum. Cross-border application of the Dodd-Frank Act might complicate the international harmonisation of regulation if the CFTC’s guidance goes beyond its own jurisdiction. Genuinely increasing transparency and reducing systemic risks in the global swaps market will need such harmonised rules, and moreover rules that have been subject to proper cost-benefit analysis.

IEA Oil Market Report, June 2012

Margin Requirements in Futures Markets*

2012-05-23T12:04:00.000-04:00

Despite scant evidence of a negative impact of speculation in the oil market, in seeking to prohibit excessive speculation and its possible effect on price volatility in futures markets, the US CFTC approved final rules on federal speculative positions limits on commodity futures, options and swaps positions of speculators for 28 commodities in October 2011. As we reported in previous OMRs, position limit rules are being challenged by the International Swaps and Derivatives Association (ISDA) and the Securities Industry and Financial Markets Association (SIFMA) in court. They are challenging the final rule based on whether the Commission overreached its mandate by pre‐emptively setting a position limit on derivatives contracts, amid almost non‐existent cost‐benefit analysis in the final rulemaking, as well as insufficient review of some of the comment letters, which they argue that the Commission was bound to take into account. The court still has to deliver its decision on the speculative position limit rule.

The main hypothesis of proponents of hard position limits is to reduce market share concentration in commodity markets. They argue that doing so ensure that markets are made up of a broad group of market 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.

In a latest attempt to reduce price volatility and prevent excessive speculation in oil markets, President Obama asked the US Congress to provide the CFTC with additional authority to raise margin requirements in oil futures markets. However, raising margin requirements in oil futures markets may well lead to an increase in price volatility and concentration of market share of large speculators while having no effect on price levels.

One of the key safeguards in the risk management systems of futures clearing organisations is the requirement that market participants post collateral, known as margin, to guarantee their performance on contract obligations. In contrast to the operation of credit margins in the stock market, a futures margin is not a partial payment for the position being undertaken. Instead, the futures margin is a performance bond that serves as collateral or as a “good faith” deposit given by the trader to the broker. Minimum levels for initial and maintenance margins are set by the exchange. However, futures commission merchants (FCM) have the right to demand higher margins from their customers. The US regulator (CFTC) also has the power to increase margins in emergencies but they have rarely used this option, given the fact that exchanges frequently change margin requirements as a response to a change in volatility and they notify market participants at least one-day in advance.

In a traditional futures market, contracts are margined under a risk-based margining system, which is called SPAN. Portfolio margining systems evaluate positions as a group and determine margin requirements based on the estimates of changes in the value of the portfolio that would occur under assumed changes in market conditions. Margin requirements are set to cover the largest portfolio loss generated by a simulation exercise that includes a range of potential market conditions.

Marked to market ensures that futures contracts always have zero value; hence the clearing house does not face any risk. Marked to market takes place through margin payments. At the inception of the contract, each party pays an initial margin (typically less than 10% of the value of the contract) to a margin account held by its broker. Initial margin may be paid in interest-bearing securities (T-bills) so there is no interest cost. If the futures price rises (falls), the longs have made a paper profit (loss) and the shorts a paper loss (profit). The broker pays losses from and receives any profits into the parties’ margin accounts on the morning following trading. Loss-making parties are required to restore their margin accounts to the required level during the course of the same day by payment of variation margins in cash; margin in excess of the required level may be withdrawn by profit-making parties.

For example, the initial margin for one WTI futures contract is currently $6 885 and the maintenance margin requirement is $5 100 per contract for speculators, 6.5% and 4.8% of the value of the contract as of 1 May, respectively. Initial and maintenance margins for hedgers and clearing members, even for their speculative trading, is the same amount as the maintenance margin levels for speculative traders. However, clearing members’ initial margin for their speculative positions will be increased to that of speculators’ initial margin in early August. Whenever the margin account exceeds or falls below the maintenance margin, the customer receives a margin call from its broker (or broker receives a margin call from the exchange). If the margin account exceeds the maintenance margin, the investor is entitled to withdraw any balance in the margin account in excess of the initial margin and whenever it is below the maintenance level, the customer has to make a deposit to bring the margin account to its initial margin level. The extra funds deposited are known as a variation margin. Basically, if there is a price decline the investor who has a long position has to deposit extra funds, so called variation margin, to bring the margin account to the initial level. On the other hand, the seller of the contract account will be credited. That is to say, if a trader is on the right side of the market, there is nothing to worry about margin calls. However, if a trader is on the wrong side of the market, he/she gets a warning in terms of a margin call to reconsider his/her position.

The Effects of Margin on Market Activity, Composition of Traders, Volatility and Prices

Exchanges argue that changes in margin levels are related to volatility in the markets; if the market becomes more (less) volatile, they increase (reduce) the margin level. The purpose of a change in margins is not to control the composition of traders, volatility or prices but serve primarily as insurance to futures exchanges from default by traders – for example, by setting margin to cover 99% of possible price moves for a position in a trading day.

Some argue that setting higher margins should drive away less risk averse and less informed traders; and without them, markets will be more stable. Others argue that an increase in margin will result in thin markets due to an increase in the cost of using these markets, thereby increasing the volatility. Empirical research generally suggests that the effect of margin on market activity tends to be small as long as margin changes move in line with price volatility. Furthermore, extant research suggests that it is not obvious which types of traders leave the market when margin increases. These studies also find no clear impact of margins on the volatility or price behaviour in the futures markets. It is not surprising to see no relationship between margin levels and the price level, since the latter depends on physical supply and demand.

However, it is important to note that these results are obtained when analysing the impact of relatively small margin changes by exchanges. If we consider raising margin requirements to a very high level through regulations to combat speculation, then we might find that certain trader groups, especially the hedgers and cash-constrained small speculators, will be driven out of the market, increasing concentration share where few traders, especially large traders, participate in the price discovery, leading to more volatile, rather than more stable, oil markets.

IEA Oil Market Report, May 2012

Speculation and Oil Prices

2012-04-25T19:59:00.000-04:00

On 17 April 2012, Obama Administration proposed new initiatives to strengthen oversight of energy markets.

The President's plan call on Congress to:

Increase funding to increase the number of surveillance and enforcement staff charged with oversight of the oil futures market;
Allow the Commodity Futures Trading Commission (CFTC) to upgrade the technology used to monitor the energy markets;
Increase the civil and criminal penalties for those convicted of manipulating the oil futures market;
Provide the CFTC with additional the authority to raise margin requirements in oil futures markets to limit disruptions in the oil market; and
Expand access to CFTC data so that analysts can better understand trading trends in the oil markets.

Here are some initial reactions from economists on the impact of speculation as well as on the possible impact of Obama’s proposal on oil prices:

John Cochrane: http://johnhcochrane.blogspot.com/2012/04/speculation-and-gas-prices.html
Jim Hamilton: http://www.econbrowser.com/archives/2012/04/a_ban_on_oil_sp.html
Scott Irwin: http://www.farmdocdaily.illinois.edu/2012/04/speculation_and_gasoline_price.html
Lutz Kilian: http://www.cnn.com/2012/04/19/opinion/kilian-oil-speculation/index.html
and
http://www.voxeu.org/index.php?q=node/7892

Do Exchange Rates Matter?*

2012-04-25T14:06:00.000-04:00

Oil prices have experienced large fluctuations in recent years. The spike in crude oil prices in mid-2008 to more than $140/bbl, followed by a steep correction in late 2008/early 2009 and subsequent sharp rebound over the last two years have jolted the world economy and pinched consumers at the fuel pump. US dollar weakness in recent years is frequently cited as one reason for high oil prices. It is very common to see the financial press suggesting that a weak dollar has pushed oil prices higher. However, this explanation is challenged by the empirical observations that (a) a change in oil price tends to lead to a change in the exchange rate as predicted by economic theory and (b) the oil price has risen regardless of what currency unit one uses to measure the price of oil.

Empirically, there is clearly an inverse correlation between oil prices and exchange rates – that is, other things being equal, oil prices rise if the dollar falls. An assessment of the one-year rolling average correlation between the daily change in the oil price and the daily change in the nominal effective exchange rate shows that this relationship has been relatively strong in recent years, although the negative correlation has been declining in recent months. As we suggested in our Medium-Term Oil and Gas Markets 2011 report, however, the direction of causality tends to run from oil prices to exchange rate, especially when we use lower frequency observations. This is consistent with the traditional terms of trade argument on the relationship between exchange rates and oil prices. Terms of trade effects suggest that when the price of an import rises, if the demand for that import is very inelastic, (i.e. quantities demanded hardly fall at all when prices rise, as is the case for oil) the trade balance deteriorates, which would decrease the value of the local currency.

The price of oil in different currencies provides further support to the notion that weakness in the US Dollar cannot be the main reason behind the high oil prices. The relationship between the change in oil price and change in the exchange rate is considered to be country-specific. For oil-exporting countries, when oil prices go up, ceteris paribus, we expect the country’s exchange rate to appreciate. On the other hand, for oil importing countries, the reverse should hold.

For example, as expected, our analysis shows that the correlation between annual change in the oil price and annual change in the Canadian exchange rate is very strong. The price of Brent crude oil measured in US Dollars increased by more than 11% in the first quarter of 2012, from $111/bbl to $123/bbl. During the same period, the Canadian Dollar appreciated by 1% relative to the US Dollar. In the meantime, the price of oil measured in Canadian Dollars, as expected, increased only by 10%. Since the rate of currency appreciation is much smaller than the rate of oil price increase, we observed an increase in the oil price in Canadian Dollars as well.

The price of oil measured in different national currencies has followed very similar directional movement with oil prices measured in US Dollars, although some of these currencies appreciated against the US Dollar. The main reason for this, as suggested by Martin Feldstein, is that “the currency in which oil is priced would have no significant or sustained effect on the price of oil when translated into dollars, euros, yen, or any other currency.” The equilibrium price in the oil market is determined by global supply and demand; it is irrelevant which currency oil is priced in. The decline of the US Dollar has little to offer as an explanation to the increase in oil prices. On the other hand, the high and rising price of oil does, contribute to the decline of the dollar through the terms of trade effect.

High Frequency Traders: Flash Crashers or Liquidity Providers?*

2012-03-27T09:39:00.001-04:00

On 6 May 2010, major American stock indices and stock index futures nosedived by more than five percent before sharply recovering in less than 30 minutes. Since that infamous flash crash, high frequency traders (HFTs) have drawn the attention of regulators, exchanges and market participants, despite the fact that the crash was not triggered directly by HFTs, according to an official joint report released by the US CFTC and SEC. Nonetheless, fragmentation of trading venues and the establishment of the US Regulation National Market System and the European Union’s Markets in Financial Instruments Directive (MiFID) in 2007 requiring brokerages to find the best execution for customers, have led to the explosive growth of HFTs.

Some studies suggest that a few high-frequency trading (HFT) firms now account for more than 70 and 60 percent of overall trading volume on US equities and futures markets, respectively. HFTs’ share in European markets’ trading volume is estimated to be smaller than that of in US trading; however, they have continued to ramp up their activities on exchanges on both sides of the Atlantic.

High Frequency Trading in Energy Markets

According to CME’s algorithmic trading study (HFT is a subset of algorithmic trading) published on 15 July 2010, 35% of crude oil future trading and 71% of message traffic in the first quarter of 2010 came from algorithmic traders. Compared to other asset classes, algorithmic traders’ share in the volume of trade is still low, but in terms of message traffic, crude oil comes second after EuroFX futures. The CME report further suggests that increased algorithmic trading activity correlated with narrower bid/ask spreads, increased market depth and reduced volatility. That is to say, the presence of algorithmic traders substantially improved the quality of market.

Although HFTs presence in futures markets has been on the rise, they are present in limited commodity markets, such as crude oil due to its higher liquidity. Some market participants argued that as more swaps activity shifts to electronic platforms, we should expect to see HFTs dominate in these markets. However, HFTs’ survival depends on the short time delays in trade execution. Therefore, HFTs’ arrival relies on the initial liquidity in the market place. That is to say, the survival or even arrival of HFTs onto swap execution facilities (SEFs) solely depends on the success of SEFs and liquidity in these platforms. As noted in the January OMR, the OTC market is different from the futures markets. Instruments (swaps) in the OTC markets can trade infrequently, often in significant sizes. Therefore, we would not expect to see an influx of order flows from HFTs to SEFs.

High Frequency Traders and Their Impacts

Regulators on both side of the Atlantic, while urging new curbs on high frequency trading, are still debating its definition. The Securities and Exchange Commission refers to them as “professional traders acting in a proprietary capacity that engage in strategies that generate a large number of trades on a daily basis. These traders could be organized in a variety of ways, including as a proprietary trading firm. Other characteristics often attributed to proprietary firms engaged in HFT are: (1) the use of extraordinarily high-speed and sophisticated computer programs for generating, routing, and executing orders; (2) use of co-location services and individual data feeds offered by exchanges and others to minimize network and other types of latencies; (3) very short time-frames for establishing and liquidating positions; (4) the submission of numerous orders that are cancelled shortly after submission; and (5) ending the trading day in as close to a flat position as possible (that is, not carrying significant, unhedged positions over-night).” However, the term is still relatively new and there is no consensus yet on the definition of HFT. For example, the US CFTC announced in late January 2012 that it is forming a subcommittee that would be tasked with defining and identifying HFTs trading pattern and its possible impact on futures, swaps and options markets.

HFTs use several different strategies to enter the market. Some HFTs can be considered market makers, where they place buy and sell orders continuously throughout the trading day in order to earn bid and ask spreads. Some other HFTs can act as arbitrageurs to make profit from price discrepancies in certain assets trading simultaneously on separate markets. Most studies found that HFTs add substantially to the price discovery process, as well as eliminating any price differential across trading venues. Furthermore, it is argued that the arrival of HFTs and increased low-latency activity, defined as “strategies that respond to market events in the millisecond environment”, substantially improved the quality of markets by adding liquidity, lowering the trading costs (narrowing bid and ask spread), reducing short-term volatility and increasing the limit order book depth during normal and heightened uncertain times.

However, some studies suggested that without mandatory obligations to provide liquidity, HFTs may have exacerbated volatility by withdrawing liquidity from the market, especially during severe market episodes such as those experienced during the flash crash. Others also question the liquidity provided by HFTs. Since more than 95% of orders placed by the HFTs are cancelled immediately, some market participants are sceptical that high frequency trading provides liquidity to the markets. Some argue that HFTs provide liquidity when it is not needed. Others further argued that HFTs exhibit trading patterns inconsistent with the traditional definition of market making, in the sense that they aggressively trade in the direction of a price change that does not result in inventory accumulation.

As high frequency trading is becoming increasingly popular, concerns over trading practices and their impact on the quality and volatility of markets have been raised by some regulators and exchanges. For example, US CFTC Commissioner Chilton urges creating a registration category for high-frequency trading firms and imposing new restrictions on their trading practices if necessary. In the meantime, some exchanges in the US and Europe already took some steps by introducing penalties on high-frequency traders who place and cancel large number of bids and offers within milliseconds. Some regulators refer to such practices as parasitic trading. Others however, see HFT simply as a logical and inevitable upshot of both increases in risk‑hedging appetite and advances in information technology.

*IEA Oil Market Report-March 2012

Who is Going to Regulate the Regulators?*

2012-02-29T07:51:00.001-05:00

Considering the CFTC's policy on position limits, there are actually two questions that need to be answered.

The first is whether it is true that speculative positions affect prices. There are good economic reasons to reject this notion. A futures position is a commitment to deliver a commodity by the short side and a commitment to take delivery of that commodity by the long side. Those commitments are distinct from demand or supply of the product. This is because the long side can immediately sell the commodity received to someone who wants to consume it. Likewise the short side can buy the commodity immediately before delivering it per their contract. For the long side, these constitute transfers of the commodity as opposed to demands for the purpose of consuming it. Likewise, generally the short side satisfies its delivery requirement via a transfer rather than through engaging in its actual production. Examinations of the effect that undertaking positions has on prices have consistently found no relationship between position changes and subsequent price changes. This is precisely the result that the above economic reasoning predicts. That is, unless long positions actually shift commodity demanded or short positions actually shift commodity supplied, then trading in futures should have no effect on pricing fundamentals.

But suppose one concludes that empirical tests are flawed either because the necessary data are unavailable or because the test procedure lacks power. Then it is reasonable to conclude that the above economic rationale is unproven. But that conclusion does not support a policy of setting position limits. This is because lack of evidence for the conclusion that positions affect prices implies the lack of a metric for setting appropriate limits. This is an important point. Absent an ability to say by how much prices are affected by speculative pressure, one also lacks the ability to state the size of the limit necessary to remedy the problem. This is true even if one is absolutely certain that speculative positions affect prices. Lacking a measure of the effect, one can only guess as to the correct size of the limit.

This need to guess implies that setting limits comes with substantial risks. Setting the limit too high, one risks not addressing the problems created by speculators. Setting them too low, one risks diminishing the ability of hedgers to transfer unwanted risks and, therefore, bearing risks that exceed their tolerance levels. Hence, getting the policy wrong has consequences for the economy, consequences that are impossible to anticipate and likely difficult even ex post to measure owing to the disparate nature of its impact on market participants.

The CFTC lacks evidence that speculative positions affect prices. Throughout its history, the Commission has never produced an analysis that supports this conclusion. Therefore it cannot stipulate the size of the limit needed to remedy the problems it presumes excessive speculation is causing. It can only guess. Despite the fact that its position limit rule is entirely guess work, the Commission has failed to even consider the impact that imposing position limits may have on the needs of hedgers. Given the prominence lately accorded to consideration of costs and benefits, it is most remarkable that the cost that position limits may impose on market participants to obtain hedge position remains entirely unconsidered.

*I just received this text on position limits from an "anonymous economist". I am in full agreement with the text. Therefore, with the author's permission, I decided to post it here.

Volcker Rule: Grounds for Divorce?*

2012-02-24T04:37:00.000-05:00

In a narrow 3-2 vote on 11 January 2012, CFTC Commissioners proposed their own version of the Volcker Rule, which prohibits proprietary trading activities of banks and limits their investments in private-equity and hedge funds in line with the restrictions already proposed by the Federal Deposit Insurance Corp., the Federal Reserve, the SEC and the Comptroller of the Currency in October, 2011. The intent of the Volcker Rule is to reduce risk in the US banking system by limiting the excessive risk-taking activities of banking entities, defined as any insured depository institutions and their subsidiaries.

The Dodd-Frank Act mandates the rule to be implemented by 21 July 2012. Banking entities must comply with the new requirement by 21 July 2014 for their pre-existing investments. However, the Federal Reserve Board can extend the deadline for compliance for up to three years.

Volcker Rule

The rule has basically two parts. The first part is related to restrictions on activities of banking institutions, except for non-US banking entities’ transactions outside of the United States with non-US residents. The rule prohibits proprietary trading, while allowing transactions related to underwriting, market-making, risk mitigating hedging, trading in certain US government obligations, and trading on behalf of customers. The statute defines proprietary trading as engaging in the purchase or sale of certain financial assets as a principal for the trading account of a covered banking entity.

Financial assets include securities, derivatives, commodity futures and options on these instruments, but do not include positions in loans, spot foreign exchange or spot commodities. The rule also explains what constitutes an entity’s trading account. The definition of trading account specifically includes positions taken principally for the purpose of short-term (less than 60 days) resale. The proposed rule calls for the establishment of internal compliance programmes and reporting requirements on banking entities. The rule further provides guidance on what banking entities must do to prove that they are not proprietary trading but engaging in permitted activities, such as market-making or trading on behalf of customers. Finally, the proposed rule provides detailed limitations on the permitted activities. For instance, if their permitted activity would endanger the safety or soundness of the banking entity or the financial stability of the United States, then it is considered proprietary trading and it is prohibited.

The second part of the proposed rule is related to banking entities’ relationship with private equity funds and hedge funds. In order to prevent a bank from indirectly engaging in proprietary trading through direct investment and also to prevent a bank from possibly bailing out such funds, the rule limits banking entities’ investment in such funds.

Concerns over the Volcker Rule

Market participants, including regulators themselves, argued that the proposed regulation is overly complex. Even Volcker himself said during a speech in November that the proposed rule was much more complicated than initially intended. Regulators have already admitted the difficulty in implementing the rule. The determination of what constitutes proprietary trading and what constitutes legitimate trading activity will be challenging. Although most banking entities already closed their proprietary trading desks, some argue that they are merely moving these activities to their market-making activities. Some market participants urge regulators to put more clarity on the scope of proprietary trading and on the exceptions for permissible activities. However, regulators argued that compliance with the rules will not be based on trade-by-trade enforcement but rather at policies and procedural levels. On the other hand, if the rule mistakenly identifies banks’ market-making trades as proprietary trades, this will have an impact on liquidity and thereby on the overall economy.

Foreign governments also raised concerns over the prohibition of US banks trading in foreign governments bonds. Since the US banks are one of the biggest bond buyers, prohibitions imply more costly borrowing for foreign governments. The proposed rule, rather than reducing risk, most likely will drive that risk into other places. The Japanese, Canadian and British governments have said the proposal aggravates the risk for their markets. Some further argue that if the Volcker rule does result in increased borrowing costs for European governments, which are already faced with higher borrowing costs, then the economic fallout may not be contained to the Continent.

Impact on Energy Markets

In its current proposed form, the Volcker Rule does not prohibit banking institutions from holding positions in spot commodities, in which case several reports suggest that some banks may become very active physical market players. However, the rule prohibits proprietary trading by banking entities and their subsidiaries in energy derivatives markets. Banking institutions have been active players, especially since the mid-2000s in energy derivatives markets, including in over-the counter (OTC) markets. In fact, most swap dealers in energy derivatives markets are either banking institutions or their affiliates; the latest Commitments of Traders position data suggests that 27.18% and 35.46% of the open interest on the long side and short side, respectively, of the WTI futures contracts are held by swap dealers. However, there is no estimate of how much of the swap dealers’ position could be considered as proprietary trading. It will depend on how narrowly regulators interpret the scope of the definition of market-making versus proprietary trading. The interpretation is much more important in the case of their trading activity in swaps markets, where they are generally counter-parties to commodity index traders, hedgers and speculators. If their trades with other parties are considered as proprietary trading, then the ban would cover almost every trade by swap dealers in the futures and swaps markets. However, we expect most trades to be considered as market-making or trading on behalf of customers, and therefore we anticipate limited impact on liquidity in energy markets.

*IEA Oil Market Report-February 2012

Blame Game Continues: Speculators v Regulators

2012-02-17T01:08:00.000-05:00

On January 13, 2012, I presented at the International Workshop on "Financial Speculation in the Oil Market and the Determinants of the Oil Price", organised by the Fondazione Eni Enrico Mattei in Milano, Italy. My presentation was entitled "Blame Game Continues: Speculators v Regulators."

My presentation was based on the following articles that I co-authored:

Swap Execution Facilities*

2012-01-31T04:31:00.000-05:00

Regulatory bodies on both sides of the Atlantic will be busy in 2012 finalising rules on one of the most important requirements for bringing pre- and post-trade transparency to the over-the-counter derivatives markets by ensuring prices are posted to a wide variety of market participants, not just among dealers. Initially set by the G-20 leaders at their Pittsburgh Summit in September 2009 and later adopted in reform packages in the US and Europe, transparency would be achieved through the requirements that “all standardised OTC derivatives contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest.”

For this purpose, the Dodd-Frank Act in the US introduced a new trading venue called a swap execution facility (SEF), where only standardised swaps will be traded. The Dodd-Frank Act defines a SEF as "a facility, trading system or platform in which multiple participants have the ability to execute or trade swaps by accepting bids and offers made by other participants that are open to multiple participants in the facility or system, through any means of interstate commerce." SEFs are similar to multilateral trading facilities (MTFs) in European markets. In addition to MTFs, the European Commission also introduced a new trading venue category (“organised trading facility – OTF”) to cover hybrid platforms run by firms which currently do not fall under the current MiFID categories for organised trading.

Although the general details of these facilities and how they are going to function have already been proposed, final rules will emerge later in 2012. However, there are certain differences between regulators in the interpretation of swap execution facilities. For example, as opposed to the strict CFTC proposal that swap execution facilities be either order-book or request-for-quotes (RFQs) from a minimum of five possible seller facilities, the SEC has proposed a looser definition of these platforms, which do not require order-books and would allow buyers to request a quote from a single seller.

Furthermore, the SEC proposal allows for voice broking, rather than stipulating electronic trading as the CFTC has. However, the US House Committee on Financial Services approved legislation (H.R. 2586) in late November 2011 which would prevent the CFTC from imposing a requirement that swap-buyers seek quotes from at least five participants before executing a trade. On 23 December 2011, the US House Committee Agriculture granted an extension for further consideration by 1 February 2012. We expect the CFTC final rule to be similar to one that SEC has already proposed, including keeping voice broking.

On 5 December 2011, the CFTC proposed further rules establishing a process for designated contract markets (DCMs) and SEFs to make swaps "available to trade" without defining swap. The proposal calls for DCMs and SEFs to submit to the CFTC a determination that a swap is available to trade. To make a swap available for trading under the proposed rules, DCMs and SEFs must consider:

· The readiness and availability of buyers and sellers of the swap.

· The frequency and size of transactions in the swap on that DCM or SEF, or of bilateral transactions in the swap.

· The trading volume for the swap on that DCM or SEF, or of bilateral transactions in the swap.

· The bid/ask spread for the swap.

· The usual number of resting firm or indicative bids and offers that the DCM or SEF receives in the particular swap being considered.

· Whether the DCM's or SEF's trading facility or platform will support trading in the swap.

· Any other relevant factors.

A determination of which swaps would be made available to trade might be a challenging task both for regulators and trading facilities. As mentioned in previous OMRs, the OTC market is different from the futures markets. Instruments (swaps) in the OTC markets can trade infrequently, often in significant sizes,between dealers and end-users or speculators. If activity in the futures markets is any evidence, a relatively small number of highly liquid instruments has been effectively traded on the exchange. The failure rate especially in less liquid instruments has been very high. However, a lighter SEC proposal might be the proper way to bring transparency, while ensuring continued liquidity in the swap markets.

Some market participants raised concern over excessive fragmentation of markets with the introduction of different trading venues. For example, the purpose of introduction of OTFs, which can be considered a subcategory of MTFs, in the European Union is not well understood, except as creating further market fragmentation. Opacity in terms of unknown counterparties attracted by a shift towards electronic trading, as well as excessive fragmentation of markets, is actually a source of less, and not more, transparency in the market.

Market participants also argue that OTC markets are for professionals; not for retail investors. The role of brokers is primary in providing transparency. A move to a platform-based trading systems with a view to pre-trade transparency, actually removes transparency for the professionals that are involved.

A final criticism of moving swaps onto platforms is related to the claim that electronic trading is associated with higher volumes and volatility of trading. Critics argue that markets could be subject to the kind of volatility evident in the futures markets immediately after the introduction of electronic trading to the NYMEX and ICE exchanges. It is true that the volume of trading increased after moving from open outcry to electronic trading. However, there is no empirical evidence supporting the claim of increased volatility due to electronic trading.

*IEA Oil Market Report-January 2012

Seeking Common Ground on Oil Market Drivers*

2011-12-27T01:50:00.000-05:00

As part of their remit covering joint activities set out in the Cancun Ministerial declaration of March 2010, the IEA, IEF and OPEC jointly hosted their second annual workshop on linkages between physical and financial oil markets in Vienna on 29 November 2011. Over 100 participants attended from across the spectrum of research institutions, major oil producers and consumers, the financial sector, regulators and policy makers. Participants reviewed recent studies on commodity price formation, the role of price reporting agencies, developments in regulatory reform in the energy derivatives markets, and emerging issues and key challenges. A full joint report on the workshop will be provided to IEF Ministers ahead of their next meeting in Kuwait in March 2012. The following represents the IEA’s version of key take-aways from the Vienna event.

The debate on linkages between financial and physical oil markets has evolved over time. Opinion remains polarised between those seeing the majority of recent price move being due to oil market fundamentals and those who see speculative activity and the financialisation of commodities as amplifying price shifts in the short run. However, participants have different views on the concept of financialisation and what is meant by ‘short run’, making it difficult to agree on the true impact of speculative activity, on oil prices.

Some participants dated financialisation back to the rapid growth of commodity index investment around 2004, while others argued that the emergence of hedge funds, index funds, electronic trading and exchange traded funds (ETFs) and exchange traded notes (ETNs) were part of the process and therefore started around 2002. Furthermore, there was no consensus on what constitutes the ‘short-run’. Most market participants consider short-term to mean an intra-daily, or at most weekly, time horizon. However, some argued that prices might overshoot equilibrium levels for prolonged periods of time and that the extent of overshoot can be extreme.

The Impact of Speculation on Prices

While entrenched views on the role of speculation and fundamentals were evident, a majority of experts tended to view speculators as playing a more limited role than fundamentals, at least over longer periods of time. Market participants emphasised the important role of commodity derivatives markets in providing price discovery and transfer of risks, while acknowledging the strong linkages between financial and physical markets. They argued that physical and derivatives markets work in an integrated fashion. If futures prices did not reflect the underlying cash market, these should converge during the delivery period unless the delivery mechanism is itself broken. It was stressed that futures prices are not a particularly good predictor of long-run commodity demand and supply and therefore should not be used for price forecasting purposes, but instead for the transfer of risk. Physical market players extensively use derivatives markets to hedge price risks that arise in the period between production and delivery to consumers. As prices can be highly volatile, it is important that derivatives markets are highly liquid so that hedging can be matched to physical pricing. Therefore, the presence of speculators is necessary for derivatives markets to function properly. The natural question is, of course, whether speculators can affect commodity prices.

Before attempting to answer this question, market participants recognised that the distinction between hedging and speculation in futures markets is less than clear-cut. Traditionally, traders with physical commodity exposure have been called hedgers, while those without a physical position to offset have been called speculators. In practice, however, commercial traders may ’’take a view” on the price of a commodity or may not hedge in the futures market, despite having an exposure to the commodity, positions that could be considered speculative. Therefore, it is difficult to separate hedging from speculation. Keeping this fact in mind, alongside the limitations of the data employed by academic research, the weight of evidence shows no short run relationship between changes in commodity prices and changes in speculative positions. However, a few studies found a significant impact from investment flows by non-user participants on prices and volatility of commodities.

Participants agreed that the physical oil market is highly competitive, with physical prices determined by supply and demand. No oil firm can pass on any losses or gains from hedging or speculation on the financial markets in the form of higher or lower physical prices. To affect physical prices, futures prices must impact upon physical supply and demand. But how can futures prices impact physical supply and demand? The majority of experts agreed that the most important mechanism is through cash and carry arbitrage. If speculators correctly foresee an upcoming shortage (a future increase in demand or reduction in supply), they will bid up futures prices. With futures prices higher than spot prices, this sets off cash and carry arbitrage. Oil is pulled off the market and put in storage at times of relative abundance, and is brought back to the market in a later period of relative scarcity. In these circumstances, price swings that would have occurred from a shift in supply and demand are moderated. That is to say, the market works and the price swing is less than it would have been otherwise. However, if speculators were wrong about their prediction of coming shortage, oil may be pulled off the market in time of relative scarcity and brought back in a time of relative plenty. In this situation, cash and carry arbitrage exacerbates the price swing. In either case the impact is on the short-term price pattern and not on the long-run level of prices. Speculators can increase the price swings only if their predictions are incorrect. However, speculators have a strong incentive to correctly forecast market shifts. In this case, cash and carry arbitrage moderates price fluctuations. There might be other channels for financial players to affect physical supply and demand. If physical market players get irrational signals from futures prices, then their actions based on irrational signals will feedback into irrational expectations.

Volatility in Oil Prices

Participants agreed that intra-daily volatility in oil prices increased over the last year. However, there was a clear disagreement on the causes and remedies for such intra-daily volatility. As expected, those who saw speculative activity and the financialisation of commodities as amplifying price moves in the short run argued that speculative trading as well as high frequency traders play a major role in intra-day volatility. They argued that limiting high frequency traders and speculative activity are necessary to abate volatility in oil prices. However, others argue that volatility is related to uncertainty over the health of the global economy, as oil prices naturally track any macroeconomic news, particularly news coming from euro-zone countries. The geopolitical risk premium also added to volatility in oil prices. In addition, the lack of supply chain flexibility amplifies the natural volatility in prices. They further argued that data gaps, especially on physical demand, supply, inventories and transportation, contribute to price volatility. Participants emphasised the importance of improving data transparency in both financial and physical markets to reduce price volatility. Markets participants generally noted that eliminating the geopolitical risk premium by promoting favourable conditions for investments is necessary to reduce volatility in oil prices.

Other Emerging Issues in the Oil Market

The need for dialogue between industry and price reporting agencies was emphasised by some market participants. Some argued there is a need for an oversight and appeal agency when there is disagreement between industry and price reporting agencies. However, others argued that the role of price reporting agencies is well defined, and that the current structure works, leaving no need for government regulation.

Market participants also voiced their concerns about the unexpected consequences of the credit crunch, affecting the European banking system, in the form of lack of finance for spot crude and product cargoes which can be traded only with a letter of credit opened by a bank. The European banking system which is used to finance trade no longer has access to liquidity. The absence of liquidity in the Euro-zone system suggests that oil traders cannot easily access credit, thereby limiting oil trading activity.

Participants stressed that the correlation between individual commodities and other asset classes, including equities and exchange rates, has been gradually increasing over the last few years. Some suggested that hedge funds played an important role in causing this cross market linkages. However, others argued that the increase in correlation is concentrated among indexed commodities, which suggests that this has more to do with the attractiveness of commodity index investments.

Market participants argued that the emergence of ETFs or ETNs-type investment vehicles is less likely in oil markets as opposed to metals markets. The key difference is that it is extremely easy to store metals, with the exception of aluminum, with a minimal cost of storage. However, crude oil is an entirely different commodity and the costs involved in storage are enormous because oil takes up much more physical space. Overall, there is limited storage capacity available compared to the level of daily supply.

Market participants also emphasised that as soon as assets (stocks, bonds, houses or commodities) become sophisticated enough to be transacted in the market, economy-wide speculative beliefs will emerge, which can be transmitted into asset prices. This is the cost of progress. Since the oil market is part of large financial assets markets, there is no easy way to extract the oil market from the larger financial community. Therefore, it cannot be considered in isolation and well-designed rules are needed to bring efficiency and transparency to the commodity derivatives markets.

Market Regulation

Since the US financial reform package, formally the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), 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. 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.

While market participants emphasised the need for more international coordination to ensure consistent and effective oversight in OTC markets, they also argued that some of the proposed regulations might have unintended consequences in the market place. These include:

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, would be unnecessarily impaired.
Commodity trading belongs to two worlds: physical and financial, and to avoid unintended consequences, there is a need for more specific regulation on commodities than is encompassed by broad financial regulation.
OTC markets are for professionals; not for retail investors. The role of brokers is primary in providing transparency. Transparency will disappear if trading is forced to move into platform- based trading systems with a view of pre-trade transparency. Moving swaps onto platforms may create increased volatility due to higher volume as experienced in regulated markets when electronic trading was introduced.
Regulatory arbitrage opportunities might undermine the impact of new regulations in countries where more stringent rules are to be implemented.

*IEA Oil Market Report-December 2011

Regulation beyond Mandate?*

2011-11-24T12:01:00.000-05:00

In a contentious 3-2 vote on 18 October, the US CFTC Commissioners approved final rules on federal speculative positions limits on commodity futures, options and swaps positions of speculators for 28 commodities. These include NYMEX natural gas, crude oil, gasoline and heating oil, along with a number of metals and grains contracts.

In seeking to prohibit excessive speculation and its possible effect on price volatility in futures markets, the Commission adopted a two-stage approach for hard position limits as preventive medicine for excessive speculation. The main features of the final rulemaking include:

· Spot month limits, effective sixty days after the term “swap” is defined by the Commission, which is expected in December 2011. In the first stage, the Commission will take over the existing spot-month limits set by exchanges. In the second stage, the Commission will make its own determination on the spot-month limit based on the 25% of estimated deliverable supply. The spot-month limit will be adjusted biennially for agricultural contracts and annually for energy and metal contracts. That is to say, the earliest adjustment to energy contracts spot month limits based on estimated deliverable supply can be made in the first quarter of 2013.

· Non-spot-month and all-months-combined position limits for legacy agricultural contracts will go into effect sixty days after the Commission defines the term “swap”. For non-legacy agricultural, energy and metal contracts, the position limits will be effective after the Commission receives one year of open interest on swaps data. Thereafter, non-spot month and all months combined position limits will be adjusted every two years based on the previous two years’ open interest. The rules call for limits on non-spot month and all-months-combined positions up to 10% of the sum of futures, cleared and uncleared swaps open interest for the first 25 000 contracts owned by a trader and 2.5% thereafter.

· The cash-settled natural gas contract will be subject to spot month and non-spot month position limits set at five-times the limit that applies to the physical delivery natural gas contract.

· Bona fide hedging positions will not count towards the limits. Exemptions for bona fide hedging transactions have been broadened to include certain anticipated merchandising transactions, royalties, and service contracts in the final rulemaking. Hedge exemptions need to be approved by the Commission, rather than the exchanges. Also, if a swap dealer’s counter-party is a hedger, or a swap dealer completes a trade on behalf of a bona fide hedger, then the swap dealer might use bona fide exemption for this specific trade and it will not be counted towards position limits.

· The final rule requires quarterly position visibility reporting requirements for traders exceeding a non-spot month position visibility level in energy and metal contracts.

Proponents argue that hard position limits on speculative activity ensure the effective functioning of the market by minimising price disruption that could be caused by excessive speculation. They further argue that a hard position limit is necessary to reduce concentration of market share in commodity markets. This will ensure that markets would be made up of a broad group of market 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 cut systemic risk. Finally, they argue that rule-based hard position limits are preferable to position accountability levels, in that they provide much more certainty as well as preventing arbitrary intervention in the market.

In his support for the final rule, Chairman Gary Gensler argued that position limits have served to curb or prevent excessive speculation and its impact on prices. However, as pointed out by Commissioner Scott O’Malia in his statement of dissent, nine-legacy agricultural contracts, which are subject to spot month and non-spot month position limits, were not spared record-setting price increases. Chairman Gensler further argued that the Commission received more than 15 000 comments on the position limit rule, most of which were in favour of hard position limits. Nevertheless, most of these comments came from a letter writing campaign organized by silver advocacy group without any substance. Commissioner O’Malia suggested that there were only 100 substantive comments letters, some of which were not even taken into account during the final rulemaking. Commissioner O’Malia and Ms Jill Sommers further iterated market participants concerns over the inadequacy of cost benefit analysis, restrictive interpretation of bona fide hedging, lack of clarity on how the Commission reached its proposed position limit formula, possibility of reduced trading activity which would lead to increased, rather than reduced, volatility; and possibility of international or physical/cash settled regulatory arbitrage.

Commissioner Michael Dunn’s vote eventually determined the outcome of the rule-making. In his opening statement, Commissioner Dunn presented his views on speculation and its effect on commodity prices. He clearly stated that “No one has proven that the looming spectre of excessive speculation in the futures markets we regulate even exists, let alone played any role whatsoever in the financial crisis of 2008. After we implement position limits, in all likelihood, the prices of heating oil and gasoline will not drop precipitously as some have strongly suggested. Airline tickets will not be cheaper and the food you buy at the grocery store will be the same price. Investments in precious metals will continue to rise and fall unpredictably. Things will remain relatively the same, except for those who use the markets we regulate to provide the very resources we all need. For these farmers, producers and manufactures, position limits, and the rules that go along with them, may actually make it more difficult to hedge the risks they take on in order to provide the public with milk, bread and gas. The role of the futures market is price discovery, not price setting. If we limit participation in these markets through position limits, producers may receive inaccurate market signals when making production decisions. If this occurs, the prices we all pay for our groceries and to heat our homes may become more volatile. Position limits may actually lead to higher prices for the commodities we consume on a daily basis.” And finally he said “My fear is that position limits are, at best, a cure for a disease that does not exist or a placebo for one that does. At worst, position limits may harm the very markets they are intended to protect.”

After stating all his concerns, Commissioner Dunn voted in party line to support final rule-making simply because it is required by the law, as he said. However, this view is challenged by market participants as well as two dissenting Commissioners, Ms Sommers and Mr O’Malia. They argue that the Commission overreached its mandate by arguing that the Act clearly states that the Commission should adopt position limits if the Commission finds that position limits are “necessary to diminish, eliminate or prevent” the burden on interstate commerce caused by excessive speculation. They further argued that the Commission still did not have qualitative or quantitative criteria of what is meant by excessive speculation.

The debate over the position limit rule may continue further. Market participants might challenge the final rule based on whether the Commission overreached its mandate by pre-emptively setting a position limit on commodity derivatives contracts, on the almost non-existing cost-benefit analysis in the final rulemaking as well as insufficient consideration of some of the comments letters which the Commission was obliged to take into account. Some argue that substantive comments letters as well as Commissioners Sommers, O’Malia and Dunn’s statements could be used by opponents to challenge the final rule on position limits.

*IEA Oil Market Report-November 2011

Commodities: No Longer an Asset Class in their Own Right?*

2011-10-26T05:57:00.003-04:00

Investors, seeking to diversify their portfolio and hedge against rising inflation, have increased their exposure to commodities by directly purchasing commodities, by taking outright positions in commodity futures, or by acquiring stakes in exchange-traded commodity funds (ETFs) and in commodity index funds. This pattern has accelerated in recent years. According to index investment data collected by Barclays Capital for US and non-US assets under management, commodity index investment has increased from $55 billion in late 2004 to $431 billion in July 2011.

The initial surge in investment in commodities is due to the observed negative correlation between commodity returns and the other asset returns as well as positive correlation between inflation and commodity returns.

Although the positive correlation between inflation and commodity returns (0.55 for the last twenty years and 0.73 for the last three years in monthly inflation and commodity returns proxied by returns on S&P Goldman Sachs commodity total return index) is still present, the recent positive correlation between commodities and the other asset classes raise the question of whether commodities can still be considered as an asset class in their own right, and particularly a route to portfolio diversification.

A commonly used approach is to consider an investment as a separate asset class when:

Its expected returns are higher than risk-free returns;
Its returns perform differently from other asset classes in any given market environment; and
Its returns may not be replicated with a linear combination of other asset classes.

Up until Lehman Brothers’ demise in September 2008, commodities met all three criteria. However, since then, commodities have not displayed the last two characteristics of an asset class. Of course, there are episodes in history when commodities moved in sync with other assets, especially equities. Nevertheless, compared to other episodes in the last two decades, the last three years have seen different dynamics in their degree and duration.

Between September 1991 and September 2008, weekly returns on commodities proxied by Goldman Sachs commodity index were very close to equity returns and exceeded bond returns and risk-free Treasury-bill returns. They displayed negative correlation with stocks (-0.008) and bonds (-0.008) (as shown in the upper triangle of the correlation table). However, since September 2008, commodity returns registered negative returns as well as statistically significant positive correlation with equities (0.689) and bonds (0.022) (as shown in the lower triangle of correlation table) returns.

Furthermore, if we regress the weekly GSCI return on weekly stock returns for the two sub-periods considered above, then these regression analyses suggest that the variation in commodity returns is independent of either stock or bond returns between September 1991 and September 2008 – but not afterwards. Specifically, the regression results after Lehman’s demise suggest that more than 47% of the variation in commodity returns can be explained by variation in stock returns. The statistically significant coefficient on stock returns suggests that a 1% increase in stocks returns leads to 0.85% increase in commodity returns. Additionally, when we regress weekly GSCI energy returns on stock returns, we find a statistically higher coefficient on stock returns, revealing that a 1% increase in stocks returns leads to a 1% increase in energy-commodity returns. These findings suggest that post-Lehman commodity returns might be replicated by returns on stocks. In this sense, one may conclude that commodities in the last three years do not appear to fulfil the three criteria to be considered as a separate asset class in their own right.

As we argued earlier, the recent episode of high correlation between different assets may not be unique, and it is unclear whether the change observed between asset classes’ movement, or more specifically commodity prices, are permanent. Several recent academic studies suggest that the financialisation of commodity markets has increased the co-movements between equities and commodities. If these studies’ findings are any guide, we may well expect that co-movements between commodities and equities are here to stay as long as investors’ appetite for commodities stay strong.

*IEA Oil Market Report-October 2011

Bahattin Buyuksahin's Research in the Media

2011-10-02T07:24:00.005-04:00

Bahattin Buyuksahin’s research on the role of speculators in crude oil prices, with Jeff Harris of the Syracuse University, was the focus of an article on SeekingAlpha.com. The article discusses Buyuksahin and Harris’ research, summarizing their conclusion: “They do not dispute a correlation between speculative activity and oil price – the participants in the oil futures market increased dramatically during the oil price spikes of 2007-8 - but they do not assume causation..” ViewFull Article (1/5/12)

Bahattin Buyuksahin’s research on the ‘fair price’ pronouncements and the market price of crude oil, with Michel Robe of the American University, Celso Brunetti of the Johns Hopkins University and Kirsten Soneson of the CFTC, was the focus of an article on energy.aol.com. The article discusses Buyuksahin and others' research, summarizing their conclusion: “Fair price pronouncements by OPEC officials are ineffective at influencing crude oil market movements.” View Full Article (10/11/11)

Bahattin Buyuksahin’s research on energy markets’ financialisation and equity-commodity co-movements, with Michel Robe of the American University, was mentioned in an article on FT.com. The article discusses Buyuksahin and Robe’s research, summarizing their conclusion: "Commodity futures became “financialised,” the correlation between returns in commodities and equities increased amid greater participation by speculators generally and hedge funds especially.” View Full Article (8/30/11)

Bahattin Buyuksahin’s research on financialisation of commodity markets and equity-commodity linkages, with Michel Robe of the American University, was mentioned in an article on Reuters.com. The newswire article discusses the impact of speculators on energy prices and suggests that: "Singleton builds on the work of Ke Tang (Renmin University), Wei Xiong (Princeton), Bahattin Buyuksahin (IEA), Michel Robe (American University) and Yiqun Mou (Columbia Business School) who have investigated links between investment and prices and challenged or modified the previous consensus.” View Full Article (6/20/11)

Bahattin Buyuksahin’s research on energy markets’ financialisation and equity-commodity co-movements, with Michel Robe of the American University, was the focus of an article on AllAboutAlpha.com, a strategic information service for the asset management and hedge fund industries. The article discusses Buyuksahin and Robe’s research, summarizing their conclusion: “Cross-correlation patterns appear to show that hedge funds involved in both equity and commodity futures markets play a big, bad role in causing energy market distortions, which in turn affects both the price of oil and the prices drivers pay at the pumps.” View Full Article (6/5/11)

Bahattin Buyuksahin’s presentation on the role of financial players on financialisation of commodities was mentioned in an article on usinenouvelle.com. The article discusses Buyuksahin's research, summarizing his conclusion: “Oil price volatility has increased sharply after 2006, but other commodities that are not traded in exchanges experienced similar fluctuations and price surges in the second part of 2000s. This might suggests that it is the mismatch between supply and demand has pushed up more than the arrival of financial investors.” View Full Article (5/11/11)

Bahattin Buyuksahin’s research on the role of speculators in crude oil prices, with Jeff Harris of the Syracuse University, was the focus of an article on Forbes.com. The article discusses Buyuksahin and Harris’ research, summarizing their conclusion: “Their findings undermine the claim that speculators' behavior increases gasoline prices.” View Full Article (4/19/11)

Bahattin Buyuksahin’s research on the role of speculators in commodity prices, with Celso Brunetti of the Johns Hopkins University, was the focus of an article on QuantMinds.com, a strategic information service dedicated to financial risk management, trend forecasting and data mining. The article discusses Buyuksahin and Brunetti’s research, summarizing their conclusion: “Their findings provide evidence that speculative trading in futures markets is NOT destabilizing. To the contrary, speculative trading activity reduces volatility levels.” View Full Article (7/8/10)

Bahattin Buyuksahin’s research on equity-commodity co-movements, with Michel Robe of the American University and Michael Haigh of Societe Generale, was the focus of an article on HardAssetsInvestor.com, research-oriented Web site devoted to sharing ideas about hard assets investing. The article discusses Buyuksahin and others' research, summarizing their conclusion: “They provide ample evidence that shows the relationship between returns on commodities and equities has not changed significantly over the past 15 years.” View Full Article (5/6/08).

My Discussions on "Investor Flows and the 2008 Boom/Bust in Oil Prices" by Ken Singleton

2011-10-02T06:33:00.000-04:00

On August 24, 2011, I discussed Prof. Ken Singleton's new research paper, entitled "Investor Flows and the 2008 Boom/Bust in Oil Prices" at the U.S. Energy Information Administration's "Financial and Physical Oil Market Linkages Workshop" in Washington, DC. You can find my discussions here.

Commodity Index Traders -- The New Whipping Boys?*

2011-09-27T08:15:00.000-04:00

An August CFTC conference in Washington DC was organised to highlight and discuss recent academic research on key issues affecting commodity markets. The conference came at a time of intense debate surrounding recent CFTC rulemaking. Several conference panelists argued that speculators in general, and commodity index traders (CITs) in particular, have affected the functioning of commodity markets and caused oil price swings that cannot be explained by energy market fundamentals – especially during the 2008 financial crisis. However, in the presentations of that set of papers, we failed to see any detailed accounting for those very fundamentals. In contrast, the few papers at the conference that focused on fundamentals found no clear-cut evidence of speculators driving prices away from their fundamental values.

Perhaps one of the most discussed papers in the follow-up press coverage was delivered by Stanford University’s Kenneth Singleton. It is worth noting here that Professor Singleton’s paper, which has been seized upon by supporters of limits on speculative commodity positions, started as a survey that he conducted for the Air Transport Association of America (ATA). For this reason and because the paper has received wide publicity, it is worth discussing some of the paper’s limitations and methodological shortcomings – which its author himself has acknowledged.

Professor Singleton’s paper comprises two parts – a formal model of how speculation could, in theory, temporarily drive commodity prices away from their fundamental value, and an empirical analysis. The theory part assumes that investors are a heterogeneous bunch. Those market participants, including speculators, try to anticipate their competitors’ move given imperfect information on economic fundamentals and on speculative activity. Their decisions are therefore sometimes affected by other participants’ behaviour (herding); that is to say, investors sometimes mimic their competitors’ moves. Investors might also have different opinions about the future course of economic fundamentals. Although these investors might be using common knowledge, their interpretation of common information might be different, which leads to higher trading volumes and co-movements among different asset classes. This has the effect of moving prices away from their fundamental values, inducing higher volatility and generating booms and busts in prices.

Methodology Questions Abound

Professor Singleton next seeks to provide empirical evidence for his analysis. For his empirical work, he uses CIT positions imputed on the basis of investment advisor Michael Master’s methodology. This extrapolation method has significant problems. First, the imputation is based on CFTC Supplemental Commitments of Traders (SCOT) report, which does not contain any data for crude oil. To estimate crude oil CIT positions, one must therefore use data from 12 agricultural markets for which the CFTC gathers CIT position information, and then make a number of unlikely assumptions about the relationship between CIT positions in agricultural and energy markets. Second, the SCOT dataset itself is problematic when measuring CITs activity – even for the 12 agricultural commodities. This is because the SCOT, which initially identified 32 (now 43) CITs, classifies all the positions of a trader engaged in commodity index trading as commodity index investment – regardless of the trader’s actual trading strategy. Therefore, as has been pointed out by the CFTC itself, “the published aggregate futures position in the COT-Supplemental may overstate or understate the actual amount of index trading (overstate it to the extent the positions reflect other trading strategies, and understate it to the extent that index positions are internally netted against non-index positions before the net position is brought to the futures markets).”

As was pointed out in another paper presented at the CFTC conference by the University of Illinois’ Scott Irwin, the imputation methodology employed by Professor Singleton can lead not merely to some measurement errors but to huge measurement errors:

§ The netting effect might not be important for agricultural commodities where the swap dealers’ futures positions are generally limited to long futures hedges offsetting their short OTC exposure to those pension funds or other index-based traders. However, the netting effect might be very important where many swap dealers (as is the case in energy products), in addition to their commodity index-related OTC activity, enter into other OTC derivative transactions in individual commodities, both with commercial firms hedging price risk and with speculators taking on price risk.

§ Professor Irwin and his co-author Dwight Sanders show that the level of errors is quite large. Comparing the imputed position with Index Investment Data (IID) provides a glimpse of the extent of measurement errors (52% mean absolute errors). The measurement error at some point leads to a categorisation of some 70-75% of long positions as “index investments”, implying that not only all swap dealers’ long positions but also managed money traders’ positions are categorised as commodity index trading. This is not possible: the CFTC’s own “ Special Call” data indicates that at most 15-20% of index investment is carried out by money managers.

While some of the other papers presented at the CFTC conference proposed less imprecise alternatives to estimate CIT activity in commodity futures markets, they all relied on time series that the CFTC does not make public. If anything, the data difficulties faced by Professor Singleton and others in proxying for CIT activity points to the need for the CFTC to release more disaggregated position information. For example, there is evidence that the long positions of commodity swap dealers in near-maturity contracts provide a reasonable proxy for commodity index investment. Clearly, publicly available position data disaggregated by maturity would help underpin more detailed analysis in this sphere.

Finally, the interpretation of Professor Singleton’s estimation results also presents some difficulties.

First, to estimate realised excess returns in crude oil prices using weekly data from 12 September 2006 to 12 January 2010, the paper uses the change in the long positions of commodity index funds and money managers as well as some financial variables (such as the change in repo positions on Treasury bonds and lagged returns on emerging market equity positions as explanatory variables). As another paper presented at the conference by the University of California’s Professor James Hamilton showed, energy market fundamentals are crucial to understanding crude oil prices. Professor Singleton’s estimation procedure, however, does not directly account for oil market fundamentals such as demand growth in emerging market economies (especially in China), inventories outside of the OECD, or rising costs of production. Furthermore, as we have argued in previous issues of the OMR, both excess returns and commodity index flows might be responding to some common shocks (such as expectation of higher growth in China and other emerging countries). The point estimates in the regressions might thus be biased due to this endogeneity problem.

Significance: Economic versus Statistical

Second, the paper should provide descriptive statistics on the variables so that one can assess the impact of a change in index investment on realised returns. Professor Singleton’s paper argues that it presents evidence of “an economically and statistically significant effect of investor flows on futures prices, after controlling for returns in US and emerging-economy stock markets, the futures/spot basis, and lagged returns on oil futures.” The index investment coefficient is statistically significant, although it is difficult to assess the economic significance of commodity index investment on realised return, given the information provided on the paper.

Finally, as suggested by the University of Houston’s Craig Pirrong in his blog, suppose that Professor Singleton’s findings do indicate that excess returns on crude oil futures are predictable, conditional on measures of speculative activity. Nonetheless, such a predictability of returns would not imply that speculation has distorted prices. Rather, predictability is the result of market frictions that might create hedging demand, leading to an increase in the risk premium. Professor Pirrong suggests that, in such circumstances, speculative positions can predict changes in futures prices. To prevent the predictability of returns, it might be advisable to reduce constraints on the flow of speculative investment to commodity markets, rather than limiting them.

*IEA Oil Market Report-September 2011

Do Institutional Traders Predict Bull and Bear Markets?

2011-09-19T08:20:00.001-04:00

I will be presenting our new research paper (joint work with Celso Brunetti and Jeffrey Harris), entitled "Do Institutional Traders Predict Bull and Bear Markets?", at the American University, Washington DC, on October 13, at the International Monetary Fund in Washington DC, on October 14, 2011 and at the European Central Bank in Frankfurt, Germany on November 10, 2011.

Abstract:
We analyze the role of hedge fund, swap dealer and arbitrageur activity in a Markov regime-switching model between high volatility bear markets and low volatility bull markets for crude oil, corn and Mini-S&P500 index futures. We find that these institutional positions reflect fundamental economic factors within each market. More importantly, institutional positions also contribute incrementally to the probability of regime changes displaying the synchronization patterns modeled in Abreu and Brunnermeier (2002; 2003). Conditioning on hedge fund activity and arbitrageur activity significantly improves our probability estimates, demonstrating that institutional positions can be useful in determining whether price trends resembling bubble patterns will continue or reverse.

OTC Market Regulations: Where Do We Stand?*

2011-08-24T21:07:00.000-04:00

Market participants still await final rules which will govern global OTC derivatives markets. Meanwhile, according to the latest Bank of International Settlements (BIS) survey, total notional value of all OTC derivatives reached $601 trillion at the end of December 2010, of which $2.92 trillion (0.5%) was commodity–related derivatives. However, at their peak at end‐June 2008, the total notional value of commodity derivatives had reached a far higher $13 trillion, or 2.5% of the total market. Although the size of commodity‐related over the counter derivatives contracts is relatively small compared to the overall OTC derivatives market, new regulations will have important implications for commodity markets in general, and energy markets in particular.

When G20 leaders set the broad reform agenda to be implemented by the end of 2012 to reduce systemic risk and increase transparency in the OTC derivatives markets, they might not have anticipated the complex nature of the instruments they are dealing with. Although these regulatory efforts have intensified in the last year, as pointed out by the Financial Stability Board (FSB), clear signs have emerged that substantial differences exist across multiple countries in the pace of implementation as well as in some rule‐making areas that could lead to regulatory arbitrage. In this case, market participants will seek out jurisdictions with less strict regulations, thereby shifting the risk rather than mitigating it. Greater international coordination is needed to ensure more consistent and effective oversight in OTC markets.

Previous issues of the Oil Market Report (OMR) and the Medium‐Term Oil & Gas Markets (MTOGM) reports extensively analysed US and EU proposed regulations on over‐the‐counter derivatives markets. Although there are differences between these two regulatory frameworks in clearing, membership of central clearing houses, margin requirements, swap execution facilities and position limits, a working group has already been set up to harmonise these regulations. Without consensus, some policy makers in the US already raised the probability of revisiting proposed rules and how to meet Dodd‐Frank Act requirements for improved prudential safety. Apart from different proposed rules, a recent ruling by the federal appeals court against the so‐called proxy access process on the basis of flawed economic analysis will potentially force regulators to revisit some of their proposed rules. For example, as the February OMR suggested, the CFTC did not provide a cost‐benefit analysis for its proposed speculative position limit rule, which the Commission is planning to take up in September. We anticipate that some of the rules may be challenged on the basis of a lack of cost‐benefit analysis, as well as inadequate consideration of public comments, which could lead to further delays in the implementation of the rules.

Of course, any legal challenges risk further difficulties and delays in reaching international consensus among regions, especially in Latin America and Asia. Traditionally, both regions had much smaller derivatives markets than those in the US and Europe. However, given the nature of global OTC markets, they have already either started implementing their own financial regulatory reforms or have been waiting to see the changes in the US and Europe before finalising their own rules. Given the slow progress in the US and Europe, it might be very challenging for some of these countries to meet the deadline of end 2012.

In Latin America, both in Brazil and Argentina, most derivatives are traded on exchanges (estimated at 90% and 70%, respectively). Brazil has only one central clearing house where all futures are traded and some OTC derivatives are cleared. Furthermore, derivatives that have not been cleared must be reported to a local trade depository. Likewise, exchange traded derivatives in Argentina are all centrally cleared and the Central Bank requires all financial institutions to provide quarterly statements about their derivatives activity. Neither country is planning to introduce mandatory clearing, a key measure in both US and Europe regulation for financial entities according to the Financial Stability Board’s OTC Derivatives Market Reforms Report on Implementation, dated April 2011. This might raise the question whether financial market participants in the US and Europe are likely to migrate their OTC transactions to these countries.

Although most Asian countries support the G20 commitments on OTC markets regulations, legislators have taken a wait‐and‐see approach as rules are being finalised in the US and Europe. According to the International Swaps and Derivatives Association (ISDA), Asian countries might not be able to meet the G20 deadline of end‐2012 to implement OTC market regulations. However, there is substantial variation in the speed of implementation across countries. Japan already enacted legislation requiring mandatory clearing and is working on its regulatory implementation and reporting rules to trade repositories. In Korea, the government finalised its plan for mandatory clearing but is waiting to see final rules in the US and Europe before proposing legislation for approval. A central clearing house will be established in mid‐2012. Clearing OTC derivatives through a Central Counterparty Clearing House (CCP) as well as reporting of OTC transactions to trade repositories is expected to start next year in Hong Kong. The Singapore exchange meanwhile already launched a clearing of interest rate swaps last year. India has already established the Clearing Corporation of India to act as a CCP as well as trade repository. Although there is no firm timetable for implementation, consideration of OTC derivatives regulations in China, Australia and Indonesia is already underway.

Slow progress on agreed reforms to meet the end of 2012 deadline, as well as the apparent lack of international consensus between regulators on how to achieve the key elements of the reform agenda, could undermine the impact of new regulations even in countries where more stringent rules are to be implemented due to regulatory arbitrage opportunities. It is even suggested that different regulatory regimes will lead to fragmented markets, which will eventually lead to weaker institutions and greater risk to the global economy. On the other hand, some market participants dismiss the idea of regulatory arbitrage based on observed close cooperation among regulators for more harmonisation in the last three years.

*IEA Oil Market Report-August 2011