Blog: How the war caused a commodity cash-call crunch – POLITICO Europe

Financial regulation is sometimes like a game of whack-a-mole: You solve one problem and another one pops up behind it.

Since the 2008 financial crisis, global authorities have been forcing banks, acting on behalf of investors and companies, to clear standard derivatives trades through central clearinghouses.

Clearinghouses guarantee a trade and manage the risks — so that even if one side of a trade goes bust, the losses don’t spread across the financial system. In this middleman role, clearinghouses are essential to the resilience of the financial system and ask for “margin,” or collateral, to cover the riskiness of a trade.

Russian President Vladimir Putin’s war, however, has put this model to the test, particularly for commodities. Russia and Ukraine play pivotal roles as global commodity and energy exporters, especially in wheat, corn, oil, natural gas, platinum, gold and palladium.

In turn, the conflict has led to huge swings in commodity prices, which means clearinghouses demand higher margins as the price moves against traders’ positions — known as “margin calls.” A similar dynamic played out in March 2020, at the start of the pandemic.

“Once the invasion happened, and over the next couple of weeks, we really saw markets move in extreme ways, both price and volatility,” said Lee Betsill, chief risk officer at the CME Group, a derivatives exchange in Chicago.

“When implied volatility is double, triple or even more, and prices rise by 40 to 70 percent, initial margins are going to increase,” he told a gathering of the derivatives industry in Madrid this week.

That turmoil has brought fresh scrutiny to the pressures that those cash calls can create beyond the clearing plumbing for derivatives. While these instruments can be used to make risky financial bets, they also allow companies and investors to lock in a certain price and protect their business against unexpected volatility.

Energy spillover

In the current commodities-led crisis, the risk of any spillover is most obviously apparent in the energy sector.

The European Association of CCP Clearing Houses, alongside industry groups for the energy industry and traders, warned in a letter in April of “intolerable cash liquidity pressure” for energy companies hedging their risks.

The organizations called for “emergency funding mechanisms” from governments, central banks and even development banks should the cash crisis get too much.

“It is not infeasible [sic] to foresee a situation in which generally sound and healthy energy companies, with significant and valuable asset portfolios, are unable to access cash to meet these unprecedented margin requirements,” the letter warned.

The situation would only be “exacerbated” if Russian oil or gas is shut off or restricted, with prices likely surging and margins increasing as a result, the letter said.

Not everyone is panicking. For the derivatives industry, Eric Litvack, chair of the International Swaps and Derivatives Association (ISDA), said he wasn’t concerned about clearinghouses “running hot” or setting inappropriate margins.

But he did cite “the degree to which central clearing has become central to not just our financial markets but to where those financial markets meet at the limits with producers and consumers of non-financial commodities — energy and so on,” he told journalists on the sidelines of the ISDA Annual General Meeting in Madrid.

He also pointed to the “risk of potential instability if there is a disruption to those markets.”

“As more producers and consumers hedge their production and consumption in a clearinghouse, any stress in the clearinghouse or any stress in the market has knock-on effects on the broader economy,” he added.

Regulatory warnings

For their part, global regulators have been a bit more alarmist. Klaas Knot, chair of the the Financial Stability Board, an international standard-setting body, told the ISDA conference that commodity price swings could create “financial strains” that ripple across the system.

“We have seen in March that very volatile commodity prices may give rise to financial strains — through large margin calls, leveraged positions and concentrated exposures,” said Knot, who’s also president of the Dutch central bank.

“Such strains, by impairing the financing of the supply of key energy, base metal and food commodities, may have a disproportionately large macroeconomic impact,” he added. “There may also be spill-over effects onto the broader financial system.”

Verena Ross, chair of the European Securities and Markets Authority, similarly described the recent trading turmoil in nickel markets as a “wake-up call” for transparency on risky positions.

ESMA is already considering improvements to clearinghouses’ toolkits for dealing with a crisis. These fixes would try to prevent margin hikes from making a market spiral worse — or in financial jargon, have a “procyclical” effect — and could require extra buffers to be built up to cover any sharp increases. 

Still, for regulators, higher margins during a period of intense volatility also show the system is working.

Martin Moloney, secretary-general of the International Organization of Securities Commissions (IOSCO), a global club of markets watchdogs, told POLITICO that margin hikes had been “proportionate” following the invasion of Ukraine.

“The commodities traders suffered a lot of liquidity strain in that period. But isn’t that what’s meant to happen in a period like this, when the prospects for commodities is hugely uncertain?” he asked.

Central clearing is there to protect against the risk that the other side of a deal doesn’t come through, he pointed out.

“Our system is meant to control counterparty credit risk. Therefore, margins go significantly up in that period [of uncertainty],” he said. “That’s how the system was meant to work.”

“Clearly, [procyclicality] could be too high, in which case, you’re sucking in too much liquidity from the rest of the system and you’re destabilizing [it],” he added. “But you’ve got to get that balance right between managing counterparty risk and managing liquidity in the system.”

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