The pricing of global commodities has come to rely heavily on the role of financial institutions and derivative instruments in recent years. The financial crisis and the increasing volatility of commodity prices, however, exposed the weaknesses of physical and financial commodity markets. In response to the crisis, the European Union (EU) introduced a new regulatory framework that builds on the G20 commitments to provide more stability to commodity markets. To achieve these objectives, EU regulation intervened on three aspects of commodity trading. First, it increased market access obligations for market players engaged in commodity trading by narrowing existing exemptions and imposing certain trade limitations. Second, it restricted the usage of Over the Counter (OTC) derivatives by extending mandatory clearing. Third, it strengthened cross-market (physical/financial) supervision to prevent market abuses and indices manipulation. These measures marked a paradigm shift in EU financial regulation and in its understanding of market failure. Whereas pre-crisis regulation mainly addressed related informational asymmetries and barriers to competition, post-crisis legislation introduced new elements that specifically tackled systemic risk and price volatility.
Keywords: Commodity Trading, Financial Regulation, G20, European Union, Price Reporting Agencies, Over The Counter Derivatives
JEL codes: G15, K22, P48
Suggested citation: Marengo, Umberto, The Effects of the Financial Crisis on EU Financial Regulation for Commodities (May 14, 2015). Review of Environment, Energy and Economics (Re3), http://dx.doi.org/10.7711/feemre3.2015.05.002
What drives commodity prices?
The high volatility of commodity prices in recent years raised the question of how much of price movements can be attributed to fundamental “physical factors” versus “financial factors” [Note 1]. Some explain the sharp swings in commodity prices as a result of changing market fundamentals [Note 2] and expectations about future fluctuations in supply and demand. Whilst acknowledging the role of physical factors, others have also stressed that the behaviour of commodity prices, is difficult to reconcile with the balance of demand and supply [Note 3] . For example, since index investors use commodity markets as collateral for unrelated investments, price formation could be influenced by events that are not connected to the commodity itself [Note 4].
Economic theory suggests that commodity markets may be subject to three types of market failures that produce erratic prices: first, market players (especially consumers) may not be given access or understand to all relevant information about a financial commodity product; second, in particular circumstances market player may collectively behave irrationally [Note 5] overshooting prices up or down (“herding”); and thirdly, poor regulation may allow market players to take excessive risk and abuse their dominant position. Whereas pre-2008 regulation mainly addressed market failures related to informational inefficiencies, the crisis led the EU to review its legislation on the basis of a new understanding of market failures [Note 6].
Capital market regulation
Prior to the financial crisis, the EU’s main objective in capital market regulation was mainly to help firms to operate across Europe by removing stock market monopolies [Note 7] and informational asymmetries between financial institutions and consumers. The Directive on Market Infrastructures (MiFID I) specifically addressed the failure of markets in providing customers with adequate information about financial products [Note 8]. The financial crisis led to an expansion of the scope of EU regulation that focused on reducing systemic risk, price volatility, and herding behaviors. To this purpose, three new regulatory instruments were introduced in EU legislation with a direct impact on commodities: position limits, position management obligations, and circuit breakers.
The introduction of position limits and circuit breakers in Europe mirrored similar provisions imposed on US commodity traders by the Dodd Franck Act [Note 9] and conformed to the Principles for the regulation and supervision of commodity derivatives markets draw up by the global association capital market regulators (the International Organization of Securities Commissions – IOSCO) and endorsed by the G20 in 2011 [Note 10]. The instrument of position limits allows regulators to put a cap on the size of transactions to avoid the risk of a few large operators squeezing the physical market, or creating unreasonable upward or downward pressure on prices [Note 11]. To reduce price volatility and herding behaviours, Member States have also been required to ensure that trading venues set up mechanisms (i.e. circuit breakers) that can temporarily halt trading, or constrain it, in case of sudden price movements caused, for example, by automatic electronic trading [Note 12].
In addition to these new measures aimed at tackling “market exuberance”, the recast MiFID II introduced provisions further to reduce informational imbalances by setting up stricter pre-trade and post-trade transparency requirements for trading venues (position management). Investors have been granted non-discriminatory access to trading venues, increased transparency on current bid and offer prices, and on the depth of trading interests at those prices, with some regulated exceptions [Note 13].
Finally, the new MiFID II set up tighter obligations for commodity firms, which in some cases have significantly expanded their operation in recent years to become providers of financial services. Whereas MIFID I granted a broad exemptions [Note 14], MiFID II required commodity firms to prove that their financial operation are strictly related to physical transactions to benefit from exemptions. Firms engaging in commodity trading either on own account or providing services to third parties have to demonstrate that they act “on an ancillary basis” to their main business to be exempted from MiFID obligations [Note 15] and their operations are objectively measurable as reducing risks directly related to [their own] commercial activity.
OTC derivatives regulation
In the 2000s, the volume of OTC commodity derivatives products increased exponentially and the financial crisis exposed the weaknesses of the OTC market. Lack of information about OTC transactions made it difficult to ascertain the precise exposure of large financial institutions to OTCs positions during the crisis and led to financial instability. At the 2009 Summit in Pittsburgh, the leaders’ final declaration laid out the principles to reduce the potential for systemic risk created by OTCs:
“All standardised OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories.” [Note 16]
In the aftermath of Lehman Brothers’ bankruptcy, the European Commission introduced sweeping legislation to increase transparency and reduce systemic risk by moving OTC from a predominantly bilateral transactions to a more centralised clearing and trading system [Note 17] .
Commodity-linked OTCs are highly standardised contracts (predominately swaps and forwards contracts) where the price is privately negotiated between the two parties or through a dealer. The European Market Infrastructure Regulation (EMIR) forces market players reduce OTC usage and trade the remaining OTCs “in the clear” through clearinghouses. With regard to the commodities, stricter limitations applied to financial players compared to those imposed on “physical traders”, but overall the new legislation had a sweeping impact on the market. In response to the EU’s new legislation, the major London-based International Commodity Exchange converted all existing OTC cleared product into an economically equivalent futures or options contracts [Note 18] . This decision reduced the OTC share of the commodity market, moving trading towards exchanges, where trades and prices are publicly available [Note 19].
MiFID II and MIFIR also increased transparency standards in the OTC market by requiring all investment firms to make public post-trade disclosure of all derivatives reported to trade repositories and give national authorities the power to impose position limits on OTC derivatives, including commodities. Furthermore, under MiFIR all OTC eligible for clearing must be traded on a regulated venue. In this respect, MiFIR gave ESMA powers regularly to review the classes of derivatives that must be traded on a regulated venue - a key technical decision that will give ESMA the leeway to calibrate the degree of regulatory pressure on the markets in the coming years.
Finally, EMIR set the requirements for clearinghouses and trade repositories based in the EU and abroad. In the coming years, the recognition of equivalence between US and EU CCPs will be a key regulatory issue. In this respect, the EU¬-US Transatlantic Trade and Investment Partnership (TTIP) currently under negotiation may provide a framework to increase regulatory interoperability [Note 20].
The physical-financial market nexus: market abuse, Price Reporting Agencies, and indices
The EU polices market abuses by supervising cross-market operations between the physical and the financial layers of commodity trading. The rise in commodity prices and volatility in the mid-2000s fuelled suspicion of malpractices in the management of commodity indices and pricing. Maker operators have called into question the standards of conduct of PRAs and their methodological robustness [Note 21]. For example, some oil market players have pointed to the weaknesses of the crude oil price discovery mechanism and to the lack of transparency in the interaction between the financial and the physical layers of the market. The scandal of fraudulent fixing of interest rates benchmarks (LIBOR and EURIBOR) and the allegations of oil price manipulation by PRAs, put pressure on the EU to review their regulatory framework for market abuse, PRAs and financial indices integrity.
The first EU-level directive on market abuse (MAD) introduced in 2003 applied in its entirety only to financial instruments traded on a trading venue such as commodity futures. After the crisis, the EU extended the scope of market abuse regulation to address cross-market manipulation (i.e. manipulations of the physical spot market to affect financial markets). While MAD I only covered transactions in financial instruments, the recast 2014 MAD I [Note 22] considered as “market manipulation” also spot commodity non-wholesale transactions or behaviours that have a “manipulative effect on the price or value of a financial instrument”. For example, under MAD I there were no provisions preventing a market player from accumulating physical assets to create a shortage, entering into a futures contract in relation to those same assets and then requiring physical delivery of the stock piled assets to satisfy the derivative contract [Note 23].
A final key element in the functioning of commodity market is the regulation of Price Reporting Agencies (PRAs) - such as Platt’s and Argus. These PRAs publish benchmarks that are used as a reference for transactions in a large number of physical commodity markets, exchanges, and OTC contracts. Their price assessments are thus essential for market operations. For their assessment, PRA rely on a mix of voluntarily reported OTC transactions, on futures market trends, and on their professional judgment [Note 24]. The methodology and conduct of PRAs thus deeply affects physical commodity markets and the financial system as a whole.
Up until recent years, PRAs have operated in a regime of self-regulation. The high volatility of commodity prices after 2008 brought the role of PRAs under scrutiny. At the Korea Summit in 2010, G20 leaders called on the IEA, the IEF, the OPEC and the IOSCO to reassess PRAs regulation [Note 25]. Building on the G20 mandate, IOSCO published a set of general principles on PRAs’ standards of conducts and price assessment. PRAs were invited to increase transparency by disclosing all criteria and procedures used to develop their price assessment “including guidelines that control the exercise of judgment, the exclusion of data as well as the procedures for reviewing a methodology”. However, IOSCO formulated only general recommendations and announced a review process over the eighteen months following their publication [Note 26]. Proposals for a more pervasive oversight system were discussed at IOSCO but were set aside after strong pressure from commodity traders and PRAs. When some IOSCO members suggested that commodity traders should be required to submit all their transactions to PRAs, the industry threatened to boycott the system and not to report any transaction to PRAs at all [Note 27].
In Europe, following the LIBOR/EURIBOR scandal, in September 2013 Commissioner Michael Barnier proposed new sweeping regulation on benchmark integrity that for the first time addressed marked design for both physical and financial commodity trading [Note 28]. Under the proposed rules, national and EU regulators would be granted wide discretionary powers in benchmark supervision. Regulators will be authorised to seize documents, levy fines, demand market information, gain access to traders’ systems, suspend trading of the financial instrument that references a benchmark, freeze assets, and correct mistakes. Benchmark contributors and administrators (such as PRAs) could also be subject to a legally binding code of conduct and could become legally liable for any losses in derivative makes resulting from incorrect prices [Note 29].
The proposal EU regulation on indices also set up specific rules for PRAs. Benchmark administrators would be required to document and justify any discretion they exercised in assessing prices. These measures would represent the end of PRAs self-regulation and would radically transform the pricing mechanisms for commodities [Note 30].
Finally, in recent years the European Commission scaled up its enforcing activities. In 2013, the Commission undertook investigations into possible cartels in relation to a number of oil and biofuels products published administered by Platt’s, the leading global PRA [Note 31]. Although it is too early to gauge the legal impact of the Commission proposal on indices and benchmarks on commodity markets, there is already evidence the price assessment mechanism is being adjusted. In 2012, the three largest PRAs proposed to adopt a new self-regulation code. The code posed lower obligations to PRAs than the European proposal but it is an unprecedented move [Note 32]. Platts announced in August 2013 that it will subject itself to external audit and, for the first time it, will make public the requirements for market players to operate on its trading window” [Note 33].
The proposed EU Regulation on “indices used as benchmarks in financial instruments” is currently being negotiated between the EU Council and Parliament. The principle underpinning this norm is that market manipulation can be the result not only of illicit individual behaviours but also of inadequate market structures. If adopted, the new rules on indices and market abuse will provide EU authorities with a legal framework specifically tailored to regulate all three layers of the commodity markets (futures, forward, and spot).
The 2008 crises exposed the vulnerability of all major economies to financial events beyond their control [Note 34]. The scope, speed and severity of the crisis provided a strong incentive for the major world economies to cooperate on all items of the financial regulatory agenda. Although there is no unequivocal evidence correlating the financial crisis with commodity price volatility, the financial crisis did provide a new political stimulus that accounts for the EU’s success in overcoming national differences and implementing of a more uniform and coherent pan-European regulatory framework on issues like futures markets, OTCs, market abuse, benchmarks and PRAs.
The crisis also changed the EU’s normative basis for market regulation and produced a paradigm shift in EU legislation. Commodity market regulation was included into the broader EU process of financial reform and coordinated at G20 level. Post-2008 EU financial reform reinforced the existing regulatory framework addressing informational asymmetries, but it also prioritised new market failures. Systemic risk prevention, the reduction of potentially negative effects of “irrational market exuberance”, and of inefficient market structures, become a new priority for EU financial regulation, and these measures are set to have transforming impact on commodity market trading in the coming years.
[Note 1] For a more detailed discussion see Diego Valiante, Price Formation in Commodities Markets: Financialisation and beyond (Brussels: CEPS-ECMI Task Force Report, 2013), 33 fl.
[Note 2] Christopher Knittel and Robert Pindyck, “The Simple Economics of Commodity Price Speculation,” MIT Center for Energy and Environemental Policy Research, April 2013; Paul Krugman, “The Oil Non-bubble,” The New York Times, December 5, 2008.
[Note 3] Bank of England, “What Can Be Said about the Rise and Fall in Oil Prices?,” Quarterly Bulletin Q3 (2009): 215–25; IOSCO, Task Force on Commodity Futures Markets - Final Report (Madrid, March 2009).
[Note 4] For example, the investment strategies of certain investment funds correlate commodity prices with the SP500 stock market index through automatic algorithmic trading. See for reference: Michael Master, Testimony of Michael W. Masters before the Committee on Homeland Security and Governmental Affairs United States Senate (Washington, DC: US Congress, May 20, 2008); Salvatore Carollo, Understanding Oil Prices: A Guide to What Drives the Price of Oil in Today’s Markets, Wiley Finance Series (Chichester, West Sussex: Wiley, 2012); Luciana Juvenal and Ivan Petrella, “Speculation in the Oil Market,” Working Paper - Feder Bank of St Louis, 2012; Isabel Vansteenkiste, “What Is Driving Oil Futures Prices? Fundamentals versus Speculation,” ECB Working Document N. 1371, 2011; Ing-Haw Cheng and Wei Xiong, “The Financialisation of Commodity Markets,” National Bureau of Economic Research Working Paper, November 2013.
[Note 5] Robert J. Shiller, Irrational Exuberance, (Princeton, N.J: Princeton University Press, 2005).
[Note 6] For a more detailed analysis of post-crisis EU financial reform see: Lucia Quaglia, “The European Union and Global Financial Harmonisation,” EUI Working Paper SPS 2012/04, 2012.
[Note 7] Nathalie Aubry and Michael McKee, “MiFID: Where Did It Come From, Where It Is Taking Us?,” Journal of International Banking Law and Regulation 22, no. 4 (2007): 177– 186.
[Note 8] Council of the European Union, Directive 2004/39/EC of the European Parliament and of the Council of 21 April 2004 on Markets in Financial Instruments Amending Council Directives 85/611/EEC and 93/6/EEC and Directive 2000/12/EC of the Parliament and of the Council and Repealing Council Directive 93/22/EEC (MiFID), Official Journal of the European Union (Brussels, 2004).. For an in-depth review of MiFID I see: Jean-Pierre Casey, The MiFID Revolution (Cambridge, UK; New York: Cambridge University Press, 2009).
[Note 9] For a detailed review of CFTC position limits see DavisPolk, CFTC Re-Proposes Position Limits for 28 Physical Commodity Futures, Options and Swaps and Revised Aggregation Standards (Davis Polk & Wardwell LLP, 2013).
[Note 10] IOSCO, Principles for the Regulation and Supervision of Commodity Derivatives Markets - Final Report (Madrid, September 2011), 5.
[Note 11] See for reference Diego Valiante and Lannoo Karel, eds., MiFID 2.0 - Casting New Light on Europe’s Capital Markers. Report of the ECMI-CEPS Task Force (Brussels: CEPS, 2011), 211.
[Note 12] Trading control mechanism on algorithmic trading were introduced after the 2008 banking liquidity International regulators targeted electronic trading after the 2008 bank liquidity crisis. CFTC and SEC, Findings Regarding the Market Events of May 6, 2010, September 20, 2010.
[Note 13] Exceptions include position taken by non-financial counterparties, for non-liquid markets, and for orders above a certain threshold.
[Note 14] Article 2.1(k) and 2.1 (l) of MiFID I exempted all firms whose “main business” consisted of “dealing on own account in commodities and/or commodity derivatives” and who traded on own account “for the sole purpose of hedging”.
[Note 15] The criteria for establishing when an activity qualify as “ancillary to the main business” are defined by ESMA’s technical standards (MiFID II, Art.2.4), and no longer by national regulators.
[Note 16] G20, “Leaders Final Statement: The Pittsburgh Summit,” September 25, 2009.
[Note 17] Council of the European Union, Regulation (EU) No 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC Derivatives, Central Counterparties and Trade Repositories (EMIR), Official Journal of the European Union (Brussels, 2012).
[Note 18] Mark Woodward, “ICE Clear Europe: The Regulatory and Clearing Landscape,” June 3, 2013.
[Note 19] MiFID II granted some temporary exemption to certain energy derivatives: risk mitigation techniques shall not apply to physically settled oil and coal OTC derivatives (“C6 energy derivatives”) entered by non-financial counterparties and such derivatives shall not count towards the clearing threshold until at least 2018 (MIFID II, Art. 99.3a-b).
[Note 20] Klaus Deutsch, Transatlantic Consistency? Financial Regulation, the G20 and the TTIP, EU Monitor (Frankfurt am Main: Deutsche Bank Research, July 9, 2014).
[Note 21] Complaints came from Pannonia Ethanol, a Hungarian ethanol company, from France’s Total, and from the GFMA, the association of global financial market participants. See for reference: Ajay Makan, “Oil Markets: The Danger of Distortion,” Financial Times, August 5, 2013.
[Note 22] Council of the European Union, Proposal for a Directive of the European Parliament and of the Council on Criminal Sanctions for Insider Dealing and Market Manipulation (MAD II) (Brussels, 2014).
[Note 23] Similar provisions to prevent spot market abuse were already in place only for the spot gas markets under REMIT: Council of the European Union, Regulation (EU) No 1127/2011 of the European Parliament and of the Council of 25 October 2011 on Wholesale Market Integrity and Transparency (REMIT), Official Journal of the European Union (Brussels, 2011).
[Note 24] PRA’s standard of conduct and methodologies have been heavily criticised. Javier Blas, ‘Total’s Oil Trading Arm Warns over “Inaccuracies” in Price Benchmarks’, Financial Times, 9 October 2012.
[Note 25] IEF et al., Oil Prices Reporting Agencies. Report to G20 Finance Ministers, October 2011, 2011, 6.
[Note 26] IOSCO, Principles for Oil Price Reporting Agencies - Final Report (Madrid, 2012), 9–10.
[Note 27] Javier Blas, “Regulatory Reforms for Oil Market Quashed,” Financial Times, September 26, 2012.
[Note 28] European Commission, Proposal for a Regulation of the European Council and of the Parliament on Indices Used as Benchmarks in Financial Instruments and Financial Contracts, COM (2013) 641 Final (Brussels, 2013).
[Note 29] European Commission, Commission Staff Working Paper - Impact Assessment. Accompanying the Document Proposal for a Regulation of the European Parliament and of the Council on Indices Used as Benchmarks in Financial Instruments and Financial Contracts, SWD (2013) 336 Final (Brussels: European Commission, 2013).
[Note 30] ESMA and EBA, Final Report ESMA-EBA Principles for Benchmark-Setting Processes in the EU, June 6, 2013.
[Note 31] For references on the investigation see: Ajay Makan, “Oil Majors at Centre of Unregulated Trade,” Financial Times, May 15, 2013.
[Note 32] Argus, Platts, and ICIS, “Draft Independent Price Reporting Organisation Code as Released by Argus, ICIS and Platts on 30 April 2012,” April 30, 2012.
[Note 33] The decision came after the Commission launched its investigation over allegations from a Hungarian energy company that Platts’ discriminately excluded certain market players from its assessment: Ajay Makan, “Oil Markets: The Danger of Distortion”, Financial Times, August 5, 2013.
[Note 34] John J. Kirton, “G8 and G20 Financial Crisis Governance,” in The European Union in the G8: Promoting Consensus and Concerted Actions for Global Public Goods, ed. Marina Larionova, (Ashgate, 2012), 190; John J. Kirton, Marina Larionova, and Paolo Savona, eds., Making Global Economic Governance Effective: Hard and Soft Law Institutions in a Crowded World, (Ashgate, 2010), 293.