Commodity futures markets are designed to help manage volatility in commodity prices. As prices rise and fall, commodity producers and consumers turn to futures markets to hedge those risks. But sometimes that volatility can be too much of a good thing.
That is what happened last year in the European energy markets. The price movements were so extreme that politicians intervened by setting a ceiling on prices. Although that ceiling has not yet been triggered – prices are currently well below the threshold – industry leaders are worried about the effects.
Speaking at FIA Boca on 16 March, senior executives at two leading European energy exchanges warned that this cap on prices – known as the "market correction mechanism" – will distort prices and drive hedgers into other markets. They also explained that the high prices for power and gas futures were not a sign that the markets were not working, as some politicians said. Instead the markets were simply doing their job – adjusting to a crisis in the supply of energy to Europe.
Peter Reitz, the chief executive of the European Energy Exchange, pointed to the impact of Russia's invasion of Ukraine as the main reason for the surge in energy prices. The abrupt reduction in the supply of gas from Russia, which accounted for roughly 40% of all gas imported by Europe, caused a huge spike in prices on futures exchange such as EEX, and because gas is one of the primary fuel sources for electricity generation, it also caused a huge spike in the price of electricity.
As Russia slashed pipeline gas shipments to Europe, European buyers purchased record volumes of liquified natural gas from other parts of the world, notably the US. But Reitz warned that if gas prices once again rise high enough to trigger the MCM and set a ceiling on natural gas futures, LNG supply will be diverted to other markets where the sellers can get higher prices. That would make the supply problem even worse, he said.
The MCM applies to futures for gas traded through the TTF network in the Netherlands. Those futures trade primarily on ICE Endex, the Dutch exchange operated by Intercontinental Exchange. But trading could move to other markets, warned Chris Edmonds, a senior executive at ICE who oversees the company's clearinghouse operations. For example, some market participants could switch to the over-the-counter markets, which are not subject to the price cap.
Another key factor is that futures markets do not function in isolation. Troy Kane, global head of derivatives and FICC development at Citadel Securities, told the FIA Boca conference that market makers like Citadel take price signals from many markets around the world and include the correlations in their pricing models. The more data they can bring into their models, the more precision they can use in their quotes.
Kane explained that when trading goes through exchanges and clearinghouses, the trading activity is reported to the public, and market participants can see how much risk is in the market. That transparency is critical to the ability of market makers to provide liquidity, he said.
But if politicians intervene in the pricing function of certain markets, as in the case of the MCM, that throws off the corrections and adds uncertainty to the mix. And if those interventions push trading out of the futures markets, there will be a loss of transparency.
The discussion did not criticize all forms of government intervention, however. Reitz noted that European governments provided credit lines to utilities facing huge margin calls on their electricity futures positions. These companies were "perfectly hedged", he said, in that they used futures to cover the risk that a fall in power prices would reduce their revenues from selling power.
When prices skyrocketed, they had to come up with billions of euros in cash to cover the margin calls on their short positions, and in some cases they had to turn to governments for temporary liquidity. These credit lines allowed the utilities to maintain their hedges and avoid the need to buy electricity at peak prices, which would have driven prices even higher, Reitz explained.
