The unintended consequences of “one size fits all” regulatory reform

Blog | 30 April 2015


Commodity regulation is undergoing a once in a generation change driven by political concerns about the financial crisis and the price of food and energy. 

But making uncoordinated regional plans in the US and Europe to regulate commodities in the same way as foreign exchange and equities will have several unintended consequences. Namely it will:

  • drive up cost and reduce liquidity

  • reduce much needed opportunities for producers and buyers to hedge against risk

This is not intended, so why is it the case?

Regulation is driving up cost and reducing liquidity

Commodities are global but regulatory initiatives have been regional.  This is wrong headed.  Unilateral regional action borrowed from the fundamentally different financial market place will produce inconsistency and fragmentation and drive up costs. To give an example - under the EU proposal to regulate price benchmarks, regulated companies may not be able to use US and Asian benchmark pricing mechanisms unless the administrator compiling them is recognised in the EU or an EU administrator has endorsed them. That is madness.

The more we increase the scope of legislation, the greater the cost and knock on effect on the consumer. MiFID II will regulate a far wider range of market participants.  Under the proposed changes a trader will need to ensure that its commodity derivatives trading is ancillary to its physical trading business to be exempt. 

Under current proposals a trader must not have more than 0.5% of the EU market in any class of commodity or use more than 5% of its worldwide capital for commodity derivatives to remain exempt. Although hedging is excluded for this calculation, these are nevertheless stiff tests. This means that commodity houses which are currently exempt may need to become authorised and this includes a number of the big names in the market. Trading businesses that can, may take the path of least resistance and move to a less onerous regulatory environment such as Singapore. 

Regulation is reducing the ability to hedge

Commodity producers and users need to hedge price and currency risk. Hedgers need liquidity providers to take the risk. Traditionally, financial institutions have provided liquidity. But under MiFID II they are constrained by limits imposed on the positions they can take in commodity derivatives and they cannot benefit from the hedging exemption when calculating their position. ESMA is currently proposing position limits ranging from between 10% to 40% depending on the commodity and market.  Some specialist physical commodity markets such as molybdenum, have a very small number of players who will inevitably hit the bar. The new position limits may effectively prevent liquidity providers from contracting. 

Impact of regulatory change on energy markets

While the primary focus of the EU's attention has been on financial markets, the European Parliament in a recent press release on price benchmarks notes concerns regarding benchmarks that “influence energy and currency markets”. Concern about energy markets has been a consistent theme.

This has resulted in an active debate about regulation of energy markets. The questions include:

  • Scope of energy products to be regulated

  • Pros and cons of regulating “forwards”

  • Pros and cons of speculation

  • Authorisation of energy traders under MiFID II

  • Problems with price setting in energy commodities

  • Management of inside information – asset or abuse?

The answers will have a significant impact on the energy markets and at the end of the day the price at the pump. 

A better way forward?

In my view, the solution has to be a coherent international regime based on IOSCO Principles, not unilateral regional action borrowed from the fundamentally different financial services marketplace that will produce inconsistency and fragmentation.   

As we stand, the huge volume of regulation unleashed under political pressure seems unlikely to support the development of global trade in commodities. In fact, I would go further and say that it may present an active threat to the competitiveness of EU commodity markets.

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