‘Speculators’ are not to blame for surges in commodity prices – rather commodity derivatives markets reflect what's happening on the ground, according to a commodities regulator and several experts on a panel at IDX on 19 June.
Speaking about volatility in the US energy markets in recent years, Summer Mersinger, a commissioner at the Commodity Futures Trading Commission, stressed the importance of educating policymakers and the public on the critical role derivatives markets play in internalising the impact of market swings and acting as shock absorbers.
“We saw a period of volatility that started with COVID and continued afterwards. What has come out of that is that derivatives markets worked well, there were no major disruptions, margin calls were met, and the derivatives markets acted as a shock absorber to these price swings,” Mersinger said.
“This is an important narrative to get out to people and to make sure they understand, so you don't have the reaction of ‘the reason we're paying so much for fuel is because of those speculators in the derivative markets’. We have tried to be conscious about providing that narrative and education.”
Speaking about when West Texas Intermediate (WTI) crude oil futures prices fell into negative territory in 2020, Mersinger stressed that this happened because of falling demand and limited storage facilities, not because of a failure in the markets.
“There were some people who said the markets were broken. We had to explain that this was not a failure of the market. When nobody's using oil, eventually you're going to run out of storage and you're going to have to pay someone to store that oil, which is how the prices ended up negative,” Mersinger said.
“The market recovered, the prices crept back up, but it is important to explain why things happen and why the derivatives markets really are just a reflection of what's happening on the ground.”
To this end, Mersinger said the CFTC’s Energy & Environmental Markets Advisory Committee is preparing two papers, one on critical metals and minerals and the other on the status of the physical energy infrastructure in the US, highlighting where there may be problems and how that might be reflected in the derivatives markets.
“One of the things we are really focused on right now is the energy transition,” Mersinger told the audience. “We are going to [need] a lot of metals and minerals. Some of these do not have derivatives markets, or the markets that do exist are not as liquid, so what will that mean for prices?” Mersinger said.
“Getting ahead of the narrative of blaming the markets for driving up prices, we want to talk about what's really behind the price. It’s all about helping people to understand that derivatives markets are not driving the price, they're reflecting the price.”
Other panellists discussed recent events in the European energy markets, particularly after Russia invaded Ukraine, and rapidly rising prices that led to European regulators imposing a price cap and other emergency measures.
Vincenzo Anghelone, senior advisor compliance regulation EMEA at Shell, stressed that the rise in commodities prices was not because of speculators, but rather caused by changes in market fundamentals, economic conditions and geopolitical drivers that caused imbalances in the supply and demand of physical commodities in the spot markets.
“I found it refreshing that all the reports that we have seen since that time from the main regulators – ACER, ESMA and so on – converge on the fact that the market was resilient even though prices were extremely high. They also confirmed that what we saw in the energy markets was not a result of speculation. Data proves that the prices of commodities are shaped by supply and demand,” he said.
Increased scrutiny
The panellists also discussed the increased scrutiny of commodity markets and participants in Europe and the UK and how the markets differ from financial markets and other product classes.
One key difference is that the UK and Europe do not have a dedicated professional regulatory body focused on commodity derivatives markets in the way that the US has, noted Chris Borg, a partner at law firm Reed Smith.
“We inherit commodity regulation from regimes that are designed for securities markets, which gives rise to anomalies and failures to understand what's going on in the market,” he said. He pointed to the EU Regulation on Wholesale Energy Market Integrity and Transparency (REMIT II), which has borrowed some regulatory rules from MiFID and MAR, originally designed with the securities markets in mind. That leads to some anomalies, which become apparent when you look closely, for example, at the new front-running rules under REMIT.
Borg added that there are a number of things about the commodity derivatives markets that make them different from other financial markets.
“One is liquidity – commodity markets are not as liquid as they could be. They are constantly driven by the need to concentrate liquidity to facilitate effective price discovery. That's just not the same as other markets. Ensuring fair and efficient pricing is the fundamental job of regulators in this sector. They need to focus on this rather than constantly revisiting the idea of prudentially regulating commodity firms as if they were financial institutions.” he said.
“We have a market where participants are invested in the means of production and distribution and must hedge their considerable price fluctuation risk in liquid and efficient derivatives markets in order to deliver a secure supply of commodities for the real economy at prices which do not drive unacceptable levels of inflation. The regulatory regime needs to address this in a proportionate manner, and especially in ways which do not unduly drive up costs for end consumers or impair liquidity.”
Speaking about recently proposed macroprudential policies for Non-Bank Financial Intermediation, which aim to limit “excessive credit growth and to strengthen the overall resilience of the financial sector to withstand systemic shocks”, Borg warned there is a danger that the proposals could further impact liquidity, increasing volatility and instability.
“The danger with the proposals that we're seeing around Non-Bank Financial Intermediation regulation as applied to the commodity sector is that by increasing the costs of accessing derivatives markets, they could do what we saw in the energy sector in 2022,” Borg told the audience.
“During that time, high volatility led to increased margin calls for derivatives. As a result, some firms took their liquidity out of the market. They assumed the price risk, rather than hedging it, increasing insolvency risk, because the cost of hedging was prohibitive. What did that do? That drove more volatility in derivatives markets, it's a vicious cycle,” he added.
“We need to ensure that the regulation that we adopt is proportional and doesn't actually cause or exacerbate the problem it seeks to address. This is the debate that we're entering into now.”
