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Derivatives Markets Under Sanction And Pandemic Pressure: How To Respond – Commodities/Derivatives/Stock Exchanges

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In Short

The Situation: The sanctions placed on Russia,
a major exporter of commodities, as well as Russia’s own
blockade of Ukrainian exports, such as wheat, have caused a
significant knock-on effect in the commodities markets, creating
extreme volatility through supply shortages and large price spikes.
This is on top of commodities supply chain disruptions caused by
the global pandemic.

The Result: The sanctions and following
blockade have also led to significant decreases in liquidity, a
days-long commodities exchange shutdown, and large variation margin
calls, leaving market participants scrambling for financing. These
effects will likely lead to heightened scrutiny by regulatory
agencies and the possibility of regulatory reform and increased law
enforcement activity.

Looking Ahead: Market participants may need to
seek alternative means of financing their hedges and should focus
on operating well within the confines of current legal and
regulatory limits, especially given ongoing derivatives market
volatility.

Russia’s invasion of Ukraine has disrupted the supply of
many commodities. Prices of a number of commodities increased
substantially from December 2021 to March 2022: crude oil prices
and wheat prices increased by more than 50% while natural gas
prices and coal prices increased by 200%. The 42% price spike of
nickel led the London Metals Exchange (LME) to cancel various
trades and suspend trading on several occasions. LME also suffered
technology failures leading to further halts and resulted in
traders withdrawing from the market after experiencing an erosion
of trust.

The Russian invasion has exacerbated the effect of existing
supply chain disruptions caused by the global pandemic and has
caused countries to reevaluate their export commitments for key
commodities, leading to upheaval in commodity-related financial
markets. Volatility has increased while, at times, market
participation has decreased. There are several evolving
implications of these developments for derivatives markets and
their participants. These conditions can bring to the fore
regulatory and enforcement interest in financial activity conducted
by market participants, making it more difficult than ever to
execute hedging and other trading strategies.

This Commentary discusses the practical considerations
firms should assess related to the market challenges caused by
Russia’s invasion of Ukraine. Firms active in commodities and
related derivatives markets should prepare for ongoing margin calls
and increased enforcement activity.

Responding to Margin Calls

Historic proportions have become the norm in variation margin
calls for futures market participants as of late. As a result of
more volatile underlying products, initial margins have also
increased significantly. The margin calls, which usually require
cash or cash-equivalent securities like U.S. treasuries, have
financially strained market participants on the “wrong”
side of the market. Of late, the “wrong” side of the
market has generally included producers seeking to “lock
in” or “hedge” elevated prices for commodities not
yet available for sale by means of “short” futures.
Although hedging is often a prudent or sage course of action, as
the illiquid commodity rises in value, these hedges (or short
positions) deteriorate in value and give rise to losses
commensurate with the price increase on a one-for-one basis. These
losses must be satisfied daily (or more frequently) by way of
meeting variation margin calls. It is important that market
participants be able to provide the liquidity to fulfill the margin
call, as the CFTC re-affirmed the ability for margin to be
called
immediately as recently as May of this year and upheld
the liquidation of contracts 20 minutes after the delivery of a
margin call.

Compounding the financial stress from margin requirements
established by futures clearinghouses, futures commission merchants
(FCMs) and foreign broker equivalents typically require, by
contract, additional customer margin and grant themselves broad
discretion to demand margin.

Pursuant to these provisions, brokers have made large margin
calls. Certain market participants utilized traditional bank debt
to finance margin payments. The challenge with this response is
that it is impossible to predict how much liquidity will ultimately
be necessary due to a short hedge that poses unlimited liability.
This challenge is exacerbated when there is no immediate means of
monetizing the underlying commodity in the hands of a producer.

For their part, clearinghouses, FCMs, and markets generally
appear to be weathering the storm tolerably well—setting
aside the disruptions in the nickel/London Metals Exchange market.
But the line between financial stress for certain market
participants and financial contagion for the system as a whole is a
thin one. And the line is made all the more narrow by the existence
of massive amounts of private, physically settled forward contracts
(which are for the most part unregulated).

Should margin calls continue, or should market participants wish
to mitigate such a risk, market participants may benefit from the
considerable flexibility afforded to them through other financial
instruments. This flexibility may be realized through many
strategies.

One strategy traces to the Dodd-Frank Act’s margin
requirements for non-cleared swaps. End-users hedging actual
economic exposure are exempt from the uncleared margin requirements
of the Commodity Futures Trading Commission (CFTC) for swap dealers
as well as from the parallel margin regimes for swap dealers
regulated by the “prudential regulators,” which include
the Federal Reserve Board (FRB), the Federal Deposit Insurance
Corporation (FDIC), and the Office of the Comptroller of the
Currency (OCC). As such, end-users may freely negotiate credit
support arrangements with trading counterparties. End-users
employing this strategy should be mindful that swap counterparties
are often sophisticated risk managers. Because of that, end-users
are unlikely to find favorable credit support terms using
off-exchange swaps in lieu of futures, but the point remains these
are purely commercial arrangements not dictated by regulation.

Another alternative for producers seeking to hedge their
production may be to use a strategy that involves purchasing put
options that, like short futures or swaps, decline in value as the
price of the underlier rises. Importantly, the value of the options
will not fall below zero because they confer the right, but not the
obligation, to sell at the strike price. The option buyer pays a
premium as the purchase price of the option, but this sets the
maximum loss on the trade. This strategy, employed by some
producers at the onset of the Ukrainian conflict, may help to
explain the move to options on futures immediately following the
invasion.

Effecting an exchange for a related position is a strategy
available to market participants that have already transacted in
futures contracts with spiraling losses. This strategy involves a
special off-market transaction offered by exchanges in which an
equal and opposite futures contract is arranged, effectively
canceling the original exchange-traded position. The original
position is then replicated by an off-exchange instrument, taking
the form of a swap or forward contract.

Heightened Enforcement Risks

The CFTC will likely give greater focus to certain commodity
market participants. Consistent with past periods of market
turmoil, this focus is often prompted by demands from aggrieved
market participants and consumers. The result may be congressional
hearings, additional pressure on financial regulators, as well as
CFTC market studies and investigations commensurate with the length
and severity of the extreme market activity. The response of Congress and the CFTC to the crude-oil price spikes in 2008
provides an analogous corollary.

In light of market conditions stemming from the ongoing crisis
in Ukraine, market participants can expect the CFTC’s vigorous
pursuit of certain misconduct, including: (i) insider trading; (ii)
market manipulation; (iii) disruptive trading; and (iv) position
limit violations.

First, the CFTC considers volatile markets ripe for fraud and
insider trading. The CFTC prohibits insider trading on the basis of
material, nonpublic information in breach of an existing duty, or
that was obtained by fraud or deception. Likewise, the CFTC
prohibits insider trading by way of misappropriating material,
nonpublic information. Recently, the CFTC and the Department of Justice brought insider trading
actions for misappropriating confidential block trade order
information against market participants in connection with tips
from certain brokers. Insider trading enforcement is likely to
continue to be a focus of exchanges, regulators, and criminal law
enforcement bodies given the current market volatility in less
liquid markets, where it is at least plausible that inside
information could lead to larger price swings and associated profit
opportunities.

Second, the CFTC has a history of scrutinizing market
manipulation in times of low supply. Supply shortages make it
easier to successfully carry out a squeeze or a corner and create
artificial prices. A squeeze occurs when an investor seeks to
control enough of a commodity’s supply to drive the price up by
the activity of others. A corner occurs when an investor secures a
degree of control of a commodity in order to personally control the
price of the commodity or arrange for the delivery of more
commodities than are available. As a result of supply shortages,
some manufacturers have sought to arrange for a sufficient supply
of a commodity to maintain production or increase production to
meet increased demand. Those manufacturers may inadvertently
procure such a large percentage of supply as to draw unwanted
attention for its impact on market prices and potentially face a
market manipulation inquiry.

Third, the CFTC indicated that the bar may be lower for
charging a disruptive trading violation when markets are thinner.
For example, if a market participant whose trading ordinarily
constitutes five percent of a given futures market on an average
day suddenly constituted 50% of a given market, its trading could
more easily move the market even if its strategy remained the same.
Market participants could thus stand out given the CFTC’s
data-driven approach to uncovering market misconduct, which has
been of particular use in recent CFTC spoofing investigations and
settlements.

Fourth, position limits may be more of a focus at the CFTC,
particularly if aggravating factors are present in light of supply
constraints. Although position limit violations are typically
handled by the futures exchanges and result in relatively small
financial penalties, the CFTC also brings position limit actions in
more serious instances. Market participants should therefore be
mindful not to run afoul of position limits.

(For additional background information on DOJ and CFTC
enforcement approaches to commodities fraud and market
manipulation, as well as how companies can prepare themselves, please see our previous Jones Day White
Paper
exploring those topics in greater detail.)

Two Key Takeaways

  1. The sanctions imposed on Russia have led to tremendous
    volatility and large margin calls in futures markets that have
    caused trades to be cancelled or suspended and traders to withdraw
    from the markets. Different strategies may help market participants
    respond to margin calls.

  2. The volatility of the commodities markets resulting from
    Russia’s invasion of Ukraine is likely to prompt the CFTC to
    focus on misconduct, creating a heightened risk of regulatory
    enforcement.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.

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