Keynote Address by Commissioner Scott D. O’Malia, 2014 Bank of Canada International Economic Analysis Workshop on Financialization of Commodity Markets

Impact of the Dodd-Frank Act on Commodity Futures and Swaps Markets

March 21, 2014

I want to thank Bahattin for inviting me to speak at this workshop. The topic of today’s workshop is “Financialization of Commodity Markets.” As we all know, commodity prices have experienced an unprecedented rise from the early 2000s. During this time, investors poured large amounts of investment capital into the commodity markets. As such, there has been much written about whether the increased presence of financial investors in the commodity markets led to higher commodity prices and volatility, the so-called “financialization of commodities” debate. Many of today’s distinguished panelists have and will offer their insights on speculative activity in the commodity markets and its relationship to the financialization of these markets.

I would like to use this speech to frame the discussion of the impact of the Dodd-Frank Act and Commission regulations on commercial end-users who have historically used the commodity futures and swaps markets for risk mitigation and hedging. In this regard, I will first discuss the importance of hedging in the commodity markets, especially given volatile commodity prices. Next, I will discuss the impact that Dodd-Frank and Commission reforms have had on hedging in the commodity markets, including the “futurization” of swaps. I will then discuss the potential impact on hedging of upcoming Commission rulemakings. Finally, I will touch on the importance of the Commission’s utilization of data in its oversight of the commodity markets.

Importance of Hedging in the Commodity Markets

It is important to remember that the futures markets originated as a way for buyers and sellers to hedge price risk in the grain markets.¹ Today, notwithstanding investor participants in the commodity markets, participants from producers to manufacturers to commercial end-users continue to rely on the futures and swaps markets in order to hedge their commodity price risk, which is essential in order to operate, invest, and grow their businesses.

As we all know, commodity prices are not static. A good example of this price risk is natural gas. Even with the boom in natural gas production,² this long and harsh winter reminds us that increased demand and supply disruptions can result in regional price spikes despite what seems to be an endless supply of natural gas. For example, the extreme cold temperatures this winter greatly increased demand and impacted production, storage, and transportation supplies for natural gas, causing cash prices in the Northeastern U.S. to hit record levels in late January.³ Chart 1 shows that ICE day-ahead cash prices for Northeast natural gas spiked to over $120 per million British thermal units at the end of January before falling back to more reasonable levels. The March – April natural gas spread has been similarly volatile this winter as shown in Chart 2. This spread widened to $1.208 on February 20 before narrowing. Given the increased demand and supply issues for natural gas, storage levels of natural gas are the lowest in 11 years as shown in Chart 3. As of March 7, working gas in storage was 49 percent below last year’s level and 46 percent below the five-year average.

Weather also brought the worst drought in decades to Brazil this winter, causing coffee crop losses of up to 30 percent.⁴ May coffee futures peaked at $2.0975 a pound on March 12, the highest level since February 2012.⁵Weather is not the only factor that can cause volatility in commodity prices. The PED⁶ virus, which has killed an estimated 5 million pigs in the U.S,⁷ has sent lean hog futures prices to record highs.⁸ Even the Crimean conflict contributed to increased wheat and corn prices this month.⁹

Given the volatility in commodity prices, hedging is an important function in the commodity markets so that participants can efficiently operate their businesses. Chart 4 provides an example of a potential consequence when a business does not hedge its exposure.¹⁰ Unfortunately, in this example, Clean Currents closed its business because this past winter’s “extreme weather … sent the wholesale electricity market into unchartered territories” and Clean Currents did not hedge this exposure.¹¹ In this regard, the Commission must be mindful of the impact of its rules on the cost of hedging for end-users so that they are able to engage in legitimate hedging activities. I will next discuss the impact of the Commission’s swaps rules on hedging in the commodity markets.

Dodd-Frank Impact on the Commodity Markets

As you know, over the past several years the Commission has been busy implementing the Dodd-Frank Act. The Commission has completed 68 final rulemakings and 8 exemptive orders and the Commission staff has issued approximately 172 no-action relief letters and 34 guidance and advisories. The Commission now has 98 provisionally registered swap dealers, 19 temporarily registered swap execution facilities, and 4 provisionally registered swap data repositories. In a rush to complete the rulemaking process, the Commission preferred speed over precision. As a result, the Commission’s swaps rules have introduced unnecessary complexity, vagueness, and costs into the markets, including the commodity markets. These consequences have, in certain instances, led some hedgers to seek out alternatives, such as swap futures. This trend is commonly referred to as the “futurization of swaps.”

On October 12, 2012, the joint CFTC-SEC rule defining the term “swap” became effective,¹² which triggered compliance requirements for a number of Commission swaps regulations. To avoid compliance with burdensome and costly swaps regulations, customers of both CME and ICE demanded that the commodity markets move to listed futures instead of swaps. In response, on October 15, 2012, ICE converted its cleared energy swaps into futures and CME began listing energy futures contracts.

Following this shift, CME Group and Eris Exchange launched interest rate swap futures in December 2012.¹³Singapore Exchange began offering commodity futures for trading in April 2013.¹⁴ ICE launched credit index futures in June 2013.¹⁵ Earlier this year, Greenwich Associates noted that “a clear trend exists towards growing demand for FX futures in lieu of traditionally bilateral FX derivatives.”¹⁶ Market participants have cited the complexity and cost of complying with the new swaps rules as major drivers to the futures markets.¹⁷Unlike the swaps markets, the futures markets have clear rules and provide market participants with regulatory certainty.

The Commission’s unjustifiably complicated swap dealer definition¹⁸ and unjustifiably expensive compliance requirements for market participants that meet this definition is one example of a Commission rule that has pushed market participants to the futures markets. In addition to brokers, many other market participants, including energy, agricultural, and commodity firms have to worry about being subject to this definition. Rather than providing a bright line test for determining whether a market participant is a swap dealer, the rule broadly applies the swap dealer definition to all market participants and then provides some limited conditional relief, but only if participants navigate through the complex set of hedging factors on a trade-by-trade basis and fall below the $8 billion de minimis level.

In a few years, the $8 billion de minimis level will fall to $3 billion if the Commission does not vote to change the threshold. Earlier this month, I asked the Commission staff how many additional entities would have to register as a swap dealer if the de minimis level moved to $3 billion today. The Commission staff could not answer this question. If the Commission cannot determine if an entity falls within the swap dealer definition, how can it expect end-users to navigate this complex rule?

Think about this in another way. If the Commission cannot identify swap dealers, how can it enforce this rule? The Commission’s data rules do not require a market participant to flag a trade as a dealing trade or a hedging trade. So, how will the Commission conduct compliance and oversight of this rule regardless of the de minimislevel? I suspect that the Commission will add all trades executed by a market participant and see how close the total is to the de minimis level, and then ask questions to determine whether the economic purpose of each trade was dealing or hedging. This solution will be a nightmare for both the Commission and the end-users.

To provide end-users greater certainty, I propose a modest fix that would allow end-users to exclude all cleared trades from the calculation towards the de minimis threshold. This fix would encourage end-users to clear their trades and would reduce regulatory compliance costs for those end-users who choose to do so.

Moreover, as I noted before, once an entity is subject to the swap dealer definition, the cost of complying with the swap dealer regulations is high. Swap dealers must comply with an array of complex and costly rules in areas such as minimum capital requirements, business conduct, and trade reporting – giving participants a strong incentive to stay away from being labeled as a swap dealer. Participants in the futures markets do not have to comply with such onerous rules.

The downside of futurization for participants in the commodity markets is reduced hedging flexibility because futures contracts, unlike swaps, cannot be individually tailored to meet specific risk needs. Given the volatility of prices in the commodity markets, and the different needs, risks, time horizons, and incentives for end-users in these markets, customized hedging is especially important.¹⁹ Because of the Commission’s rules, these participants will have to accept imperfect hedges, endure the higher cost of swaps, or forego hedging all together. All of these alternatives are unacceptable.

For example, smaller natural gas producers rely on customized hedging solutions to mitigate their exposure to volatile natural gas prices, which enables them to invest in their drilling programs.²⁰ There are more than 120 natural gas delivery locations in the U.S., which can vary significantly from the Henry Hub benchmark price traded on exchanges.²¹ In addition, producers may need the flexibility to enter into long-dated hedges; however, approximately 80% of Henry Hub futures volume is traded within a two-year maturation date.²² The lack of delivery locations and liquidity in long-dated hedges in the futures markets requires customized hedging solutions in many cases.²³ If end-users are forced to use swap futures because the cost of using swaps is too high, these participants will have a less perfect hedge, which could result in additional risk or reduced capital investment.²⁴

Upcoming Changes to the Commodity Markets

There are several upcoming Commission rulemakings that will impact hedging in the commodity markets. First, the Commission is considering a proposed futures block rule that will limit the availability of block trades, especially for energy futures. Exchanges have facilitated the transition from swaps to futures in the commodity markets by establishing extremely low threshold sizes for block trades in futures contracts. These thresholds are unlikely to stay at these levels with a Commission futures block rule. It remains to be seen how Commission rules would affect futurization in the commodity and other markets and the cost of hedging to end-users.

Second, the OTC margin and capital rules for uncleared swaps will increase the cost of hedging. It is important to note that the effort to establish a margin regime for uncleared swaps is a global effort. In September 2013, the Basel Committee on Banking Supervision and the International Organization of Securities Commissions released their final policy framework on margin requirements for uncleared derivatives.²⁵ These rules will spare end-users from mandatory initial and variation margin exchange. However, banks will be hit with new capital charges to offset the risk posed by OTC trades. Banks will pass these costs on to end-users. The Commission will need to finalize these rules, which will increase the cost of hedging for end-users in the commodity markets.

Third, the Commission staff is working on mandatory clearing determinations for additional interest rate swap contracts and non-deliverable forward (“NDF”) contracts. As I previously mentioned, it appears that there is already growing demand for FX futures in lieu of traditionally bilateral FX derivatives. Only time will tell if mandatory clearing and trading accelerate the move of NDFs to futures. While mandatory clearing for commodity swaps is likely a year or more away, commodity market participants should keep a close eye on clearing and trading in the interest rate, credit default, and NDF markets to determine how commodity markets may react in the future with the advent of mandatory clearing and trading. Commodity market participants should also watch for any impacts on the cost of hedging.

Finally, the position limits re-proposal has the potential to negatively impact end-users legitimate hedging activities. Setting position limits is not an easy task, especially with unusable data as I will discuss next. The Commission is supposed to stop excessive speculation and manipulation, but must also protect the essential price discovery process and hedging function in the markets. Unfortunately, the Commission’s position limits re-proposal may curtail end-users hedging activities as it scales back the bona fide hedging exemption. The current bona fide hedging exemption has been in effect since the 1970s and, from my understanding, has worked well in the markets. In developing a final position limits rule, the Commission must ensure that it does not impact longstanding and legitimate hedging activities.

Commission’s View into the Commodity Markets

I would like to next discuss the importance of the Commission’s utilization of data in its oversight of the commodity markets. Two fundamental goals of the Dodd-Frank Act were to increase the transparency and integrity of the swaps markets. To achieve these goals, Dodd-Frank required market participants to report information about each swap transaction to a swap data repository.²⁶ The Commission promulgated swap data reporting rules and swap dealers began reporting their trades in December 2012.²⁷

As important as data is, the Commission does not have a clear picture into the commodity swaps markets or financial markets, for that matter. Let me be clear. The data is extraordinarily difficult to use and the Commission is not utilizing this data effectively, or as it was intended. Without usable data, the Commission cannot conduct surveillance, set appropriate position limits, or analyze systemic risk in these markets. The swaps data is not merged with futures data and cannot be analyzed together. Despite the fact that market participants trade across markets and across jurisdictions with little effort; the Commission continues to struggle to develop its own oversight capacity, unless the Commission makes this a top priority.

However, I am pleased that the Commission is taking steps to improve the quality and consistency of its data. The Commission’s Technology Advisory Committee, which I chair, started to perform work on data harmonization back in 2011. Based on this effort, the Commission is currently working with the swap data repositories to harmonize the data within the credit asset class and will then move on to the interest rate asset class. Commodities, unfortunately, are well down the road.

In addition, based on my suggestion, the Commission formed a cross-divisional data team in January of this year to identify and fix our data problems. The Commission, based on the data team’s work, this past Wednesday put out for comment approximately 70 questions addressing several swap data reporting issues. Based on the comments and its own self-evaluation of the current reporting regime, the cross-divisional data team will make recommendations to improve swap data reporting to the Commission this summer.

I cannot emphasize enough how important it is for the Commission to improve its data quality and utilization so that the Commission has an accurate and complete picture of the swaps markets. Without this view, the Commission cannot surveil the markets for manipulation and other abusive trading practices. In addition, the Commission will not be able to set credible position limits or determine whether end-users are hedging or speculating. The Commission’s ability to perform vital risk analysis will also be compromised.

Conclusion

It is probably appropriate that I conclude my remarks by emphasizing that it is crucially important for the Commission to improve and effectively utilize its data so that the Commission develops a complete picture of both the swaps and the futures markets. In many respects, many of the questions regarding the impact of financialization on the commodity markets would be answerable if the Commission had a complete picture of market participants and their trading strategies.

In addition, the Commission must be mindful of the impact that its regulations have on the cost of hedging in the markets. This is especially true in the commodity markets where a wide range of participants hedge because of the volatility in commodity prices and specialized business needs. If the cost of hedging becomes too expensive, these participants may choose not to hedge or enter into less perfect hedges, which impairs efficient business operations.

Therefore, looking forward, the Commission must strive to issue clear, consistent, and cost effective rules that are informed by data and that do not interfere with hedging in the markets. Finally, the Commission must re-visit rules that have proved unworkable or overly burdensome. I am encouraged that the Commission has taken the first step by re-visiting its data rules. I encourage the Commission to not stop there and continue to re-visit rules that have impacted legitimate hedging activities.

Thank you very much for your time.

Note: Presentation is available under Related Links.

¹ See Timeline of CME Achievements, available at http://www.cmegroup.com/company/history/timeline-of-achievements.html.

² Annual Energy Outlook 2013, U.S. Energy Information Administration, April 2013, page 79, available at,http://www.eia.gov/forecasts/aeo/pdf/0383(2013).pdf. The EIA report shows an increase in natural gas production since the mid-2000s and predicts a further 44 percent increase in production from 2011 to 2040, with shale gas providing the largest source of growth.

³ Freezes hit U.S. natural gas output, California supply, Reuters, February 3, 2014, available at,http://www.reuters.com/article/2014/02/06/energy-natgas-weather-idUSL2N0LB1I420140206. Supply constraints also contributed to price spikes. Northeastern Winter Natural Gas and Electricity Issues, U.S. Energy Information Administration, January 7, 2014, available at,http://www.eia.gov/special/alert/east_coast/pdf/energy_market_alert_Jan_7_2014.pdf.

⁴ Rains to end Brazil coffee drought, but damage done, Reuters, February, 13, 2014, available athttp://www.reuters.com/article/2014/02/13/brazil-coffee-rains-idUSL2N0LI1DY20140213.

⁵ Coffee, sugar fall on producer selling, cocoa eyes expiry, Reuters, March 14, 2014, available athttp://www.cnbc.com/id/101494777.

⁶ Porcine epidemic diarrhea virus.

⁷ Pork Industry Launches Three-Prong Strategy to Stem PEDV Spread, National Pork Board, March 11, 2014, available at,http://www.pork.org/News/4575/PorkIndustryLaunchesThreeProngStrategytoStemPEDVSpread.aspx.

⁸ Is virus-inflated U.S. hog market bubble about to burst?, Reuters, March 14, 2014, available at,http://www.reuters.com/article/2014/03/14/us-usa-pork-hogs-analysis-idUSBREA2D1YW20140314.

⁹ Wheat jumps 2 pct on U.S. weather, Ukraine concerns, Reuters, March, 14, 2014, available at,http://www.reuters.com/article/2014/03/14/markets-grains-idUSL3N0MB3CX20140314.

¹⁰ See Clean Current’s website, available at, http://www.cleancurrents.com/; Clean Currents turns off its lights after January’s polar vortex spiked energy prices, The Washington Post, February 3, 2014, available at,http://www.washingtonpost.com/business/capitalbusiness/clean-currents-turns-off-its-lights-after-januarys-polar-vortex-spiked-energy-prices/2014/02/03/8f9cde1e-8cf6-11e3-98ab-fe5228217bd1_story.html.

¹¹ Id.

¹² Further Definition of “Swap,” “Security-Based Swap,” and “Security-Based Swap Agreement”; Mixed Swaps; Security-Based Swap Agreement Recordkeeping, 77 FR 48208 (Aug. 13, 2012).

¹³ Deliverable Interest Rate Swap Futures, CME Group, available at, http://www.cmegroup.com/trading/interest-rates/files/dsf-overview.pdf. Eris Exchange to Launch New, Margin-Efficient Interest Rate Swap Futures, Eris Exchange, December 5, 2012, available at,http://www.erisfutures.com/EE/Eris_Exchange_to_Launch_New_Margin_Efficient_Interest_Rate_Swap_Futures.pdf.

¹⁴ SGX to Introduce Iron Ore Futures as Investors Bet on China, Bloomberg, April 5, 2013, available at,http://www.bloomberg.com/news/2013-04-05/sgx-to-introduce-iron-ore-futures-as-investors-wager-on-china.html.

¹⁵ Credit Index Futures on ICE, available at, https://www.theice.com/credit.jhtml.

¹⁶ Futurization of FX Derivatives, Greenwich Associates, January 14, 2014, available at,https://www.greenwich.com/greenwich-research/research-documents/greenwich-reports/2014/jan/is-spl-futfx-2013-gr. Why Regulatory Changes Will Drive FX Trading Volume to Futures, kevinonthestreet, January 14, 2014, available at, http://kevinonthestreet.com/why-regulatory-changes-will-drive-fx-trading-volumes-to-futures/.

¹⁷ Id. Futurization: Dodd-Frank Drives Swaps-to-Futures Migration, futuresINDUSTRY, January 2013, available at, http://www.futuresindustry.org/futures-industry.asp?iss=209&a=1531. Swaps Futurization Means Added Choice, Market Media, March 12, 2014, available at, http://marketsmedia.com/swaps-futurization-means-added-choice/.

¹⁸ Further Definition of “Swap Dealer,” “Security-Based Swap Dealer,” “Major Swap Participant,” “Major Security-Based Swap Participant,” and “Eligible Contract Participant,” 77 FR 30595 (May 23, 2012).

¹⁹ The Role of Banks in Physical Commodities, HIS Global Inc., 2013, at pages 4-5.

²⁰ Id. at 24-25.

²¹ Id. at 24.

²² Id. at 25.

²³ Id.

²⁴ Id.

²⁵ Basel Committee on Banking Supervision and Board of the International Organization of Securities Commissions, Margin requirements for non-centrally cleared derivatives, September 2013, available at,http://www.bis.org/publ/bcbs261.pdf.

²⁶ Sections 727 and 728 of the Dodd-Frank Act. Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. 111-203, 124 Stat. 1376 (2010).

²⁷ 17 C.F.R. parts 43, 45, and 46.

Last Updated: March 21, 2014

The Changing Structure of Energy Trading Markets[†]

Energy trading markets have been undergoing radical transformation lately. These transformations are set to accelerate in 2013 because of much anticipated implementation of new rules that will govern global swaps markets.  These  include  measures  such  as  position  limits,  mandatory  clearing  and  margin  requirements,  capital  requirements,  pre-  and  post- trade  transparency  through  position  reporting  requirements  to  trade  repositories,  as  well  as trading  standardised  swaps  on  designated  contract  organisations or swap execution facilities where multiple traders can place bids and offers, and real time  reporting  of  cleared  and  uncleared  swaps  to  the  centralised  swap  data  repositories.  These  changing  dynamics  present  new  challenges  not  only  for  financial  speculators,  who  buy  or  sell  any  asset  in  the  anticipation of a price change, but also for traditional energy companies that use previously unregulated  financial derivative instruments to hedge or mitigate commercial risk.

Extending Principles for Price Reporting Agencies to All Assessments[†]

Allegations of price manipulation in UK wholesale natural gas prices by some major power companies and financial institutions could not have come at a worse time for price reporting agencies (PRAs). Less than a month after IOSCO’s publication of principles for oil price reporting agencies, a price reporter at energy‐ industry data provider ICIS went public with the charge that natural gas prices are regularly manipulated by physical and financial traders, and that prices assessed by price reporting agencies do not accurately reflect the underlying physical market. Furthermore, he argued that poorly trained price assessors often developed close relationships with traders, which led them to routinely engage in Libor‐style price fixing exercises. Immediately following these allegations, UK Financial Services Authority (FSA) and energy regulator Ofgem launched investigations into the claims.

Market participants have long claimed that selective reporting by traders and inconsistent methodologies used by price reporting agencies can distort reported prices. These concerns were the basis of a report published by IOSCO in early October, to which the IEA, OPEC and the IEF, responding to a request from the G20, provided input.* The report suggested that “ the ability to selectively report data on a voluntary basis creates an opportunity for manipulating the commodity market data that are submitted to PRAs” and “the need for assessors to use judgement under some methodologies creates an opportunity for the submitter of data to deliberately bias a PRA’s assessment in order to benefit the submitter’s derivatives positions.”

A New Era in Swaps Markets?*

US CFTC Chairman Gary Gensler declared last month that a new era for the swaps marketplace would start on 12 October 2012, the effective date of the new US swap definition rule. This marked the beginning of the process of swap dealer registration and swap data reporting. Mandatory clearing by swap dealers and major swap participants is expected to follow in February. The new rules are intended to bring transparency to the swaps markets and lower their risks. While the 12 October date may indeed be remembered as a milestone, a close look at the new rules suggests that lingering difficulties remain and that the process of regulatory swaps market reform may still be undergoing teething pains.

Those difficulties should not come as a surprise. There is an inherent tension between, on the one hand, the political clarity of the perceived need for, and urgency of, financial‐market transparency and regulatory reform and, on the other hand, the very complexity of those market’s financial instruments, and hence the great difficulty of regulatory adjustments. When G20 leaders set the broad reform agenda to be implemented by the end of 2012 to reduce systemic risk and increase transparency in the OTC derivatives markets, they might not have fully appreciated the complex nature of the instruments they were dealing with. They might also have held exaggerated hopes that new rules could easily achieve consistency across nations and win consensual international support. Instead, regulators in different countries followed their own paths in designing the rules that were supposed to govern global swaps markets, without engaging into much‐needed cooperation among themselves.

Forecasting Price on Opaque Oil Markets*

The summer of 2008 saw a spike in crude oil prices to $147/bbl, followed by a steep correction in late 2008/early-2009.  A subsequent rebound over the last three years has brought the question of whether it is possible to accurately forecast prices over the medium and longer term.

Speculation Demystified: Virtuous Volatility

In recent years, the oil market has been characterised by rising, and at times, rapidly fluctuating price levels. From April 2012 to June 2012 alone, Brent crude oil prices gyrated between USD 125 and USD 89 per barrel. Higher volatility adversely affects oil exporting countries’ fiscal revenues and investment, reducing confidence in the economy, while it worsens inflation and growth prospects for oil importers.

In 2011, the Group of 20 (G20) nations called for policy options to combat increased volatility in commodity markets in general, and in oil markets in particular. In response, a G20 experts group emphasised the importance of improving data transparency in both financial and physical markets as well as phasing out inefficient fossil fuel subsidies. The experts group also urged the use of country-specific

monetary and fiscal responses to support inclusive growth in order to mitigate the impacts of excessive price volatility.

However, it is important to note that volatility itself is not the main problem. Instead, the main challenge would be elevated price levels combined with higher volatility. ...

My article appeared in print on September 20, 2012, on pages 34 and 35 of the IEA Energy Journal-Issue 3, Autumn 2012. You can read this article here (SSRN)

Treatise on the Definition of Swap*

Almost two years after the Dodd-Frank Act was enacted into law, on 10 July 2012 the US CFTC voted 4-1 to approve a 600-page final rule, jointly developed with the US Securities and Exchange Commission (SEC), to further define the statutory term “swap”.  Not only does the definition provide greater clarity on which financial products can be expected to fall within regulatory oversight, and thus become subject to reporting, clearing, capital and margin requirements, but passage of the rule also sets the compliance dates for a string of other Commission rules governing the $650 trillion over-the-counter global swaps markets. Those include rules on swap dealers (SD) and major swap participants (MSP) registration, SD and MSP swap data reporting and recordkeeping, registration of swap data depositories, large trader reporting for registered SDs and MSPs, real time reporting of swap transactions and pricing data, internal and external business conduct standards and position limits.

Volatility vs. Price*

In recent years, the oil market has been characterised by rising, and at times, rapidly fluctuating price levels. In the last three months alone, Brent crude oil prices have fluctuated in a wide range from $125/bbl to $89/bbl. Higher volatility will certainly impact both consumers and producers. Oil exporting countries can be negatively affected by the impacts of high volatility in oil prices on fiscal revenues, investment and confidence in the economy. Higher volatility can have negative impacts on inflation and growth prospects in oil importing countries as well. As a response to observed higher prevailing volatility, for example, G20 leaders called for policy options to combat excessive price volatility in commodity markets in general, and in oil markets in particular. In order to reduce volatility in oil markets, the G20 experts group emphasised the importance of improving data transparency in both financial and physical markets as well as phasing out of inefficient fossil fuel subsidies. They also urged the use of country-specific monetary and fiscal responses to support inclusive growth in order to mitigate the impacts of excessive price volatility.

Bank Losses Sharpen Focus on Proprietary Trading*

On 10 May 2012, JP Morgan, the largest US bank by assets, announced that poorly designed and executed hedging strategies had caused more than $2 billion in derivatives trading losses from transactions in London. Even more worrying is the fact that some regulators, including the US Commodity Futures Trading Commission (CFTC) and the US Securities Exchange Commission (SEC), have argued that since they do not yet monitor JP Morgan as a swap dealer, they became aware of the trading losses after JP Morgan’s announcement despite earlier media reports at the beginning of April that raised red flags over the London Whale’s $100 billion notional exposure in one credit index. Even the regulators, the US Office of the Comptroller of the Currency (OCC) and Federal Reserve Bank, failed to detect the risk posed by the massive hedging strategy, despite having more than 100 of their own staff embedded at JP Morgan, up until April, around the same time that Bloomberg and Wall Street news reports suggested that the UK-based trader at the bank was playing a dominant role in certain markets and distorting prices.

Margin Requirements in Futures Markets*

Despite scant evidence of a negative impact of speculation in the oil market, in seeking to prohibit excessive speculation and its possible effect on price volatility in futures markets, the US CFTC approved final rules on federal speculative positions limits on commodity futures, options and swaps positions of speculators for 28 commodities in October 2011. As we reported in previous OMRs, position limit rules are being challenged by the International Swaps and Derivatives Association (ISDA) and the Securities Industry and Financial Markets Association (SIFMA) in court. They are challenging the final rule based on whether the Commission overreached its mandate by pre‐emptively setting a position limit on derivatives contracts, amid almost non‐existent cost‐benefit analysis in the final rulemaking, as well as insufficient review of some of the comment letters, which they argue that the Commission was bound to take into account. The court still has to deliver its decision on the speculative position limit rule.

Speculation and Oil Prices

On 17 April 2012, Obama Administration proposed new initiatives to strengthen oversight of energy markets.   

The President's plan call on Congress to:

•  Increase funding to increase the number of surveillance and enforcement staff charged with oversight of the oil futures market;
• Allow the Commodity Futures Trading Commission (CFTC) to upgrade the technology used to monitor the energy markets;
• Increase the civil and criminal penalties for those convicted of manipulating the oil futures market;
• Provide the CFTC with additional the authority to raise margin requirements in oil futures markets to limit disruptions in the oil market; and
• Expand access to CFTC data so that analysts can better understand trading trends in the oil markets.

Here are some initial reactions from economists on the impact of speculation as well as on the possible impact of Obama’s proposal on oil prices:

John Cochrane: http://johnhcochrane.blogspot.com/2012/04/speculation-and-gas-prices.html
Jim Hamilton:    http://www.econbrowser.com/archives/2012/04/a_ban_on_oil_sp.html
Scott Irwin:        http://www.farmdocdaily.illinois.edu/2012/04/speculation_and_gasoline_price.html
Lutz Kilian:         http://www.cnn.com/2012/04/19/opinion/kilian-oil-speculation/index.html
                            and
                            http://www.voxeu.org/index.php?q=node/7892

Do Exchange Rates Matter?*

Oil prices have experienced large fluctuations in recent years.  The spike in crude oil prices in mid-2008 to more than $140/bbl, followed by a steep correction in late 2008/early 2009 and subsequent sharp rebound over the last two years have jolted the world economy and pinched consumers at the fuel pump. US dollar weakness in recent years is frequently cited as one reason for high oil prices. It is very common to see the financial press suggesting that a weak dollar has pushed oil prices higher. However, this explanation is challenged by the empirical observations that (a) a change in oil price tends to lead to a change in the exchange rate as predicted by economic theory and (b) the oil price has risen regardless of what currency unit one uses to measure the price of oil.

High Frequency Traders: Flash Crashers or Liquidity Providers?*

On 6 May 2010, major American stock indices and stock index futures nosedived by more than five percent before sharply recovering in less than 30 minutes. Since that infamous flash crash, high frequency traders (HFTs) have drawn the attention of regulators, exchanges and market participants, despite the fact that the crash was not triggered directly by HFTs, according to an official joint report released by the US CFTC and SEC. Nonetheless, fragmentation of trading venues and the establishment of the US Regulation National Market System and the European Union’s Markets in Financial Instruments Directive (MiFID) in 2007 requiring brokerages to find the best execution for customers, have led to the explosive growth of HFTs.

Who is Going to Regulate the Regulators?*

Considering the CFTC's policy on position limits, there are actually two questions that need to be answered.

The first is whether it is true that speculative positions affect prices. There are good economic reasons to reject this notion.  A futures position is a commitment to deliver a commodity by the short side and a commitment to take delivery of that commodity by the long side.  Those commitments are distinct from demand or supply of the product.  This is because the long side can immediately sell the commodity received to someone who wants to consume it.  Likewise the short side can buy the commodity immediately before delivering it per their contract.  For the long side, these constitute transfers of the commodity as opposed to demands for the purpose of consuming it.  Likewise, generally the short side satisfies its delivery requirement via a transfer rather than through engaging in its actual production.  Examinations of the effect that undertaking positions has on prices have consistently found no relationship between position changes and subsequent price changes.  This is precisely the result that the above economic reasoning predicts.  That is, unless long positions actually shift commodity demanded or short positions actually shift commodity supplied, then trading in futures should have no effect on pricing fundamentals.

Volcker Rule: Grounds for Divorce?*

In a narrow 3-2 vote on 11 January 2012, CFTC Commissioners proposed their own version of the Volcker Rule, which prohibits proprietary trading activities of banks and limits their investments in private-equity and hedge funds in line with the restrictions already proposed by the Federal Deposit Insurance Corp., the Federal Reserve, the SEC and the Comptroller of the Currency in October, 2011. The intent of the Volcker Rule is to reduce risk in the US banking system by limiting the excessive risk-taking activities of banking entities, defined as any insured depository institutions and their subsidiaries.

Blame Game Continues: Speculators v Regulators

On January 13, 2012, I presented at the International Workshop on "Financial Speculation in the Oil Market and the Determinants of the Oil Price", organised by the Fondazione Eni Enrico Mattei in Milano, Italy. My presentation was entitled "Blame Game Continues: Speculators v Regulators."

My presentation was based on the following articles that I co-authored:

• Fundamentals, Trader Activity and Derivative Pricing
• The Prevalence, Sources, and Effects of Herding
• The Role of Speculators in the Crude Oil Futures Market
• Speculators, Prices and Market Volatility
• Commodities and Equities: 'A Market of One'?
• Speculators, Commodities and Cross-Market Linkages
• Does 'Paper Oil' Matter? Energy Markets’ Financialization and Equity-Commodity Co-Movements

Swap Execution Facilities*

Regulatory bodies on both sides of the Atlantic will be busy in 2012 finalising rules on one of the most important requirements for bringing pre- and post-trade transparency to the over-the-counter derivatives markets by ensuring prices are posted to a wide variety of market participants, not just among dealers. Initially set by the G-20 leaders at their Pittsburgh Summit in September 2009 and later adopted in reform packages in the US and Europe, transparency would be achieved through the requirements that “all standardised OTC derivatives contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest.”

Seeking Common Ground on Oil Market Drivers*

As part of their remit covering joint activities set out in the Cancun Ministerial declaration of March 2010, the IEA, IEF and OPEC jointly hosted their second annual workshop on linkages between physical and financial oil markets in Vienna on 29 November 2011. Over 100 participants attended from across the spectrum of research institutions, major oil producers and consumers, the financial sector, regulators and policy makers. Participants reviewed recent studies on commodity price formation, the role of price reporting agencies, developments in regulatory reform in the energy derivatives markets, and emerging issues and key challenges. A full joint report on the workshop will be provided to IEF Ministers ahead of their next meeting in Kuwait in March 2012. The following represents the IEA’s version of key take-aways from the Vienna event.

Regulation beyond Mandate?*

In a contentious 3-2 vote on 18 October, the US CFTC Commissioners approved final rules on federal speculative positions limits on commodity futures, options and swaps positions of speculators for 28 commodities. These include NYMEX natural gas, crude oil, gasoline and heating oil, along with a number of metals and grains contracts.

Commodities: No Longer an Asset Class in their Own Right?*

Investors, seeking to diversify their portfolio and hedge against rising inflation, have increased their exposure to commodities by directly purchasing commodities, by taking outright positions in commodity futures, or by acquiring stakes in exchange-traded commodity funds (ETFs) and in commodity index funds. This pattern has accelerated in recent years. According to index investment data collected by Barclays Capital for US and non-US assets under management, commodity index investment has increased from $55 billion in late 2004 to $431 billion in July 2011.

Bahattin Buyuksahin's Research in the Media

Bahattin Buyuksahin’s research on the role of speculators in crude oil prices, with Jeff Harris of the Syracuse University, was the focus of an article on SeekingAlpha.com. The article discusses Buyuksahin and Harris’ research, summarizing their conclusion: “They do not dispute a correlation between speculative activity and oil price – the participants in the oil futures market increased dramatically during the oil price spikes of 2007-8 - but they do not assume causation..” ViewFull Article (1/5/12)

My Discussions on "Investor Flows and the 2008 Boom/Bust in Oil Prices" by Ken Singleton

On August 24, 2011, I discussed Prof. Ken Singleton's new research paper, entitled "Investor Flows and the 2008 Boom/Bust in Oil Prices" at the  U.S. Energy Information Administration's "Financial and Physical Oil Market Linkages Workshop"  in Washington, DC. You can find my discussions here.

Commodity Index Traders -- The New Whipping Boys?*

An August CFTC conference in Washington DC was organised to highlight and discuss recent academic research on key issues affecting commodity markets. The conference came at a time of intense debate surrounding recent CFTC rulemaking.  Several conference panelists argued that speculators in general, and commodity index traders (CITs) in particular, have affected the functioning of commodity markets and caused oil price swings that cannot be explained by energy market fundamentals – especially during the 2008 financial crisis.  However, in the presentations of that set of papers, we failed to see any detailed accounting for those very fundamentals.  In contrast, the few papers at the conference that focused on fundamentals found no clear-cut evidence of speculators driving prices away from their fundamental values.

Do Institutional Traders Predict Bull and Bear Markets?

I will be presenting our new research paper (joint work with Celso Brunetti and Jeffrey Harris), entitled "Do Institutional Traders Predict Bull and Bear Markets?", at the American University, Washington DC, on October 13,  at the International Monetary Fund  in Washington DC, on October 14, 2011 and at the European Central Bank in Frankfurt, Germany on November 10, 2011. 

Abstract:     
We analyze the role of hedge fund, swap dealer and arbitrageur activity in a Markov regime-switching model between high volatility bear markets and low volatility bull markets for crude oil, corn and Mini-S&P500 index futures. We find that these institutional positions reflect fundamental economic factors within each market. More importantly, institutional positions also contribute incrementally to the probability of regime changes displaying the synchronization patterns modeled in Abreu and Brunnermeier (2002; 2003). Conditioning on hedge fund activity and arbitrageur activity significantly improves our probability estimates, demonstrating that institutional positions can be useful in determining whether price trends resembling bubble patterns will continue or reverse.

OTC Market Regulations: Where Do We Stand?*

Market participants still await final rules which will govern global OTC derivatives markets. Meanwhile, according to the latest Bank of International Settlements (BIS) survey, total notional value of all OTC derivatives reached $601 trillion at the end of December 2010, of which $2.92 trillion (0.5%) was commodity–related derivatives. However, at their peak at end‐June 2008, the total notional value of commodity derivatives had reached a far higher $13 trillion, or 2.5% of the total market. Although the size of commodity‐related over the counter derivatives contracts is relatively small compared to the overall OTC derivatives market, new regulations will have important implications for commodity markets in general, and energy markets in particular.

Is WTI Weakness Purely Physical?*

Prices for crude oil benchmarks WTI and Brent have historically been related. In general WTI light sweet crude oil sold at a 5% premium to Brent crude oil between 1994 and 2010. However, this relationship between WTI and Brent crude oil totally collapsed in 2011. Brent crude oil sold at an average premium of $13/bbl in 1H11, or 13%, reaching $23/bbl in mid-June.

Volatility in Crude Oil Prices*

Prices for oil, like those for many other commodities, are inherently volatile and volatility itself varies over time. In recent years, the oil market has been characterised by rising, and at times, rapidly fluctuating, price levels. In the last nine months alone, crude oil prices have fluctuated in a wide range from $75/bbl to $125/bbl. However, careful examination of historical patterns shows that the volatility observed during 2008-2009 is actually lower than the peak observed in 1990‑1991.

Exchange Rates and Oil Prices*

US dollar weakness in recent years is frequently cited as one reason for high oil prices. It is very common to see the financial press suggesting that a weak dollar has pushed oil prices higher. Empirically, there is clearly an inverse correlation between oil prices and exchange rates – that is, other things being equal, oil prices rise if the dollar falls. An assessment of the dynamic conditional correlation (DCC) and of the one-year rolling average correlation between the daily change in the oil price and the daily change in the nominal effective exchange rate shows that this relationship has been relatively strong in recent years, although the negative correlation has been declining in recent months. What is less clear, though, is the direction of causality. Several econometric techniques suggest that causality may run from the oil price to the exchange rate, rather than the opposite.

How Transparent Are Crude Oil Derivatives Markets?*

Increased volatility, higher crude oil prices and the arrival of new financial participants in the crude oil market during the last decade have raised the question of whether financial players have an impact on commodity prices and price volatility. Unfortunately, limited publicly available data in both physical and financial markets makes it very hard to provide a definitive answer. Understanding the linkages between physical and financial markets on price formation requires more complete information on both than is currently available. Traders in derivatives markets rely on signals from current and expected physical fundamentals , but these signals can be distorted by imperfect or delayed information flows Therefore, it is crucial to have more timely and reliable information from physical markets in order to address the observed volatility as well as to determine the influence of different market participants on prices.

Does “Paper Oil” Matter? Energy Markets’ Financialization and Equity-Commodity Co-Movements

My coauthor Michel Robe and I presented our new research paper, entitled "Does 'Paper Oil' Matter? Energy Markets’ Financialization and Equity-Commodity Co-Movements", at Universidad Carlos III in Madrid on May 25 and at the ISTCE Business School's Annual Conference on Commodities and Energy Markets in Lisbon on May 27, 2011. 

Abstract:

We construct a uniquely detailed, comprehensive dataset of trader positions in U.S. energy futures markets.  We identify considerable changes in the make-up of the open interest between 2000 and 2010 and show that these changes impact asset pricing.  Specifically, dynamic conditional correlations between the rates of return on investable energy and stock market indices increase significantly amid greater activity by speculators in general and hedge funds in particular (especially, funds active in both equity and energy markets).  The impact of hedge fund activity is markedly lower in periods of financial market stress.  Our results support the notion that the composition of trading activity in futures markets helps explain an important aspect of the distribution of energy returns, and have ramifications in the debate on the financialization of energy markets.  

The Role of Financial Players on Financialisation of Commodities

On May 6 2011, I presented at the symposium of the Scientific Council, organised by AMF and CRE.  My presentation was entitled  "The role of financial players on financialisation of commodities." It was based on my two related articles:

• The Role of Speculators in the Crude Oil Futures Market
• Speculators, Prices and Market Volatility

Mechanics of the Derivatives Markets

This supplement to the April 2011 OMR is designed as a reference document for member governments and subscribers. It forms part of an ongoing work programme examining the mechanics of oil price formation and the interactions between the physical and paper markets. Further research will be forthcoming in the OMR, the MTOGM and in the form of stand‐alone papers in months to come. The work programme is being supported by contributions from member governments, most notably those from Japan and Germany. We are grateful for that support. Further impetus for this work comes from the joint work programme the IEA is undertaking alongside the IEF and OPEC secretariats, as requested by IEF, G8 and G20 Ministers.  

The work is overseen by David Fyfe, and the supplement’s main author is Bahattin Buyuksahin, to whom all enquiries should be addressed.

Volatility: How to Measure It*

Prices for oil, like those of many other commodities, are inherently volatile. In recent years, the oil market has been characterised by rising, and at times, rapidly fluctuating, price levels. In the last six months alone, oil prices have fluctuated in a wide range from $75/bbl to $125/bbl.

Volatility: Not Unique to Exchange-Traded Commodities*

Fluctuations in commodity prices, particularly in crude oil prices, have been hotly debated in recent years. Some argue that underlying market fundamentals, especially the unexpectedly strong demand shock attributed to continued strong economic growth in Asia and other emerging economies, is the main reason for the resurgence of commodity prices and for the fluctuations in prices since 2004. Others argue that speculative activity in commodity derivatives markets is the main force behind surging commodity prices. They further claim that commodities have become a new asset class in investors’ portfolios, and prices are now more affected by macroeconomic news rather than by commodity-specific physical market conditions.

Pre-emptive Moves Against Speculation*

Speculators have never been popular, and they may never have been as unpopular as they are today. Increasingly they are blamed for fluctuations in commodity prices, particularly in energy prices, even though a market lacking speculators to take the other side of price hedging transactions for physical market players would arguably be one that would be much more volatile.

Institutional Investors Embrace Commodities as New Asset Class*

Investor interest in commodities, including oil, has risen dramatically over the last decade and commodities have become a new asset class in institutional investors’ portfolio. Partly, this development is due to diversification benefits. In addition, the development of new investment vehicles, such as exchange traded funds, has allowed individual investors to get exposure to movements in commodity prices. Due to the storage and trading costs associated with direct physical investment in commodities, the main vehicle used by investors to gain exposure is via commodity indices (baskets of short maturity commodity futures contracts that are periodically rolled over as they approach expiry), exchange traded funds or other structured products. These instruments provide generally long-only exposure to commodities.