For decades, policy makers have focused on the most transparent side of commodity markets — futures and options — and paid little attention to the murkier corners: above all, privately negotiated over-the-counter derivatives and physical markets. Any extra oversight fell on what was already quite regulated and transparent. That failure to dig into the opaque allowed top commodity trading houses, such as Vitol Group, Trafigura Group, Glencore Plc and Cargill Inc., to expand without the burden of extra regulation.
The Russian invasion of Ukraine, and the resulting jump in commodity prices, has since catalyzed attention toward “the resilience of corners of global financial markets that were little known by the broader public only a few weeks ago,” as the IMF put it.
It wasn’t just the broader public. Regulators themselves knew little. The Bank of England was rather candid about it: “The assessment of risk was made more difficult by the relative opacity of commodity derivatives markets” and the fact that some “material physically settled transactions are not reportable to trade repositories.”(3)The British central bank added that several “important” commodity firms weren’t subject to transparency regulations put in place after the global financial crisis.
What’s coming is likely similar to what Wall Street faced after 2009: a lot more supervision. More regulation was a given after energy traders asked for help. In a letter to governments and regulators, the lobby group for European energy traders warned in March of “intolerable cash-liquidity pressure” across the sector and asked for tax-payer money support. Central banks, including the European Central Bank(4)and the Fed, said no to the bail out. Only the German government decided to use a state-owned bank to support its utilities, some of which are big traders. But policy makers were rather alarmed that the energy traders, which have always lobbied for self-regulation, asked for help.
Now, the Financial Stability Board, a body created in 2009 by the G-20, has promised an “in-depth analysis” of the vulnerabilities surfacing from Russia’s war in Ukraine, “with a particular focus on commodity markets.” In a letter last week, Klass Knot, the chairman of the FSB and head of the Dutch central bank, highlighted two areas of interest for regulators:(2)the link between commodity traders and the banks which finance them, as well as the potential for a big commodity trader to go belly up if raw materials prices spike again.
Commodity-trading houses rely on bank loans to buy oil, metals, and foodstuff, which means they often risk very little of their own equity but their health is linked to that of the banking industry financing it. As the IMF put it, banks “play a crucial role and have significant exposures” in commodity markets, “including by providing liquidity and credit to a small group of large energy trading firms that operate globally, are largely unregulated, and are mostly privately owned.”(6)
Let me emphasize a few words of those words: “small group of large firms,” “unregulated,” and “privately owned.” That’s the kind of stuff that makes policy makers sweat — they point to concentrated risk in an opaque corner of the market that’s received little attention until now.
The Fed via its Dallas branch put a similar emphasis when ruling out a bail out. “The threshold for central bank intervention in unregulated markets is high,” it said(1). Instead, it recommended the sector to shore up its finances rather urgently. “It would be prudent for firms active in commodities markets to proactively assess and further strengthen their liquidity profiles.”
Now regulators need to follow up — and resist the likely lobby efforts from the industry.
A first step is increasing understanding. As the Bank of England put it, many corners of the commodity-trading sector are opaque. Before any regulation is applied, there needs to be greater transparency. So shine the light on over-the-counter derivatives markets, mandating disclosures similar to the ones already in place for futures and options markets. The recent chaos in the nickel market was exacerbated because regulators didn’t realize the size of the OTC positions, having wrongly assumed that looking at the positions on the London Metal Exchange was enough.
Physical markets need disclosures, too. Here’s one idea: G7 countries could agree to set up a register of international oil transactions. Revolutionary? Well, that’s what they agreed to do in 1979(5). This was never implemented because oil traders defeated every attempt of regulation.
Regulators also need to examine the amount of risk commercial banks are taking by underwriting the commodity-trading industry, and especially whether traders are backing the loans they take with enough of their equity. Commodity traders may need to raise more capital to stay in business, as the Fed has already suggested.
For the last decade, commodity traders have been under the microscope of law enforcement agencies, with the U.S. Department of Justice in particular clamping down on bribery and money laundering. It’s about time financial regulators put them under the magnifying glass too.
(1) Bank of England, Financial Policy Summary and Record of the Financial Policy Committee meetings on 9 and 18 March 2022
(2) European Central Bank, Confidential memo on “Funding issues related to the functioning of energy markets”, March 30, 2022
(3) Financial Stability Board, “To G20 finance ministers and central bank governors” letter, April 2022
(4) International Monetary Fund, ‘Global Financial Stability Report’, April 2022
(5) Commodity Financing Markets Shaken by Russia Invasion; Monitoring for U.S. Financial Stress, Federal Reserve Bank of Dallas, April 2022
(6) G7, Declaration, June 29, 1979
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Javier Blas is a Bloomberg Opinion columnist covering energy and commodities. He previously was commodities editor at the Financial Times and is the coauthor of “The World for Sale: Money, Power, and the Traders Who Barter the Earth’s Resources.”
More stories like this are available on bloomberg.com/opinion
