EU capital rules for energy traders not as bad as feared – PwC

Commodity trading firms can slash Mifid II capital charges by 40% through optimisation of derivatives portfolios and application of new Basel rules, report finds

Stanislav Shcheredin, PwC

The impact of the European Union's reworked Markets in Financial Instruments Directive (Mifid II) on energy firms will not be as cataclysmic as market participants now think, a new report from New York-based consultancy PwC suggests.

EU energy companies have been up in arms over Mifid II, which could hit them with bank-like capital charges for trading derivatives. The charges could run into billions of dollars for larger firms and force many participants out of commodity derivatives markets altogether, industry groups say.

But the PwC report, released in February, says capital charges might be much lower than many firms expect. The heated debate over Mifid II so far, PwC says, has not taken into account optimisation techniques and upcoming regulatory changes that could alter the picture considerably. In particular, a tweak to Basel rules on counterparty credit risk may result in substantial savings for commodity trading firms, says the report, titled An opportunity, not a threat: how commodity traders can turn new rules to their advantage.

"The rules governing capital charges are likely to be updated in a way that will be key for both commodity traders and banks," says Stanislav Shcheredin, a London-based senior manager at PwC, who coauthored the report along with Andrea Wintermantel, a PwC partner.

According to PwC's analysis, the rule changes could allow capital charges to be reduced by as much as 40% on a "typical" energy derivatives portfolio – a portfolio belonging to a bank or an energy firm that consists mainly of exchange-traded positions with a minority of over-the-counter transactions.

Mifid II, which is expected to come into force in January 2018, has provoked anxiety in the EU energy industry because of its potential to hit commodity trading firms with a variety of regulations that have previously only applied to banks and other financial companies. Perhaps most significantly, commodities firms caught in the scope of Mifid II will need to comply with the fourth Capital Requirements Directive (CRD IV) after an existing exemption for commodities dealers expires, which looks likely to happen at the end of 2020. CRD IV requires firms to set aside regulatory capital according to the size and risk-weighting of their derivatives portfolio.

One of the biggest contributors to a portfolio's risk, particularly for firms in the commodities business, is counterparty credit risk, explains Shcheredin. "The credit standing of many commodity players has come under stress in the current commodity low price environment, and if the counterparties in your portfolio get downgraded then your regulatory capital charges will go up," he says.

That is why an upcoming change to the Basel Committee on Banking Supervision's rules on counterparty credit risk is so important for commodity trading firms, Shcheredin says.

At present, the permitted methods for measuring and calculating counterparty credit risk under CRD IV are the ‘current exposure method' (CEM) and the ‘standardised approach' (SA). But these methods have been widely criticised. "These approaches are not very granular and lack in risk sensitivity," says Shcheredin. "In particular, CEM was often criticised for how netting benefits are recognised as well as for treatment of margined transactions."

In 2014, the Basel Committee finalised a new standard to replace CEM and SA. Called the ‘standardised approach to counterparty credit risk' (SA-CCR), it is scheduled to take effect on January 1, 2017. The standard is one of a series of regulatory changes – addressing market, credit and operational risk – that make up the new iteration of banking rules sometimes referred to as "Basel IV".

SA-CCR will allow for more meaningful recognition of netting and better risk sensitivity, says Shcheredin. For example, under CRD IV, the CEM approach recognises netting only as a correction to the aggregate value of exposure calculated at the trade level – the so-called Potential Future Exposure. Under SA-CCR, netting is done in a more risk-sensitive way: a firm can fully offset long and short positions between transactions referencing the same commodity and partially offset positions across different commodities for certain products such as power and gas. The rules also distinguish between margined and unmargined trades, effectively allowing more capital relief on trades that are collateralised. "For example, we have seen significant capital reduction for exchange-traded derivatives," says Shcheredin.

PwC's report highlights a number of other techniques that commodities trading firms can employ to reduce their capital charges. For instance, bringing all of a company's intra-group trades into the same netting agreement can cut its capital charges by 10%, the report says. Increasing usage of collateral can also lead to "significant" savings, it says.

While many EU energy firms are seeking to avoid being Mifid-licensed, the PwC report suggests that getting licensed could actually benefit certain companies – if they are clever enough to take advantage of the new rules. "Some traders may want to take up an investment licence ahead of the planned changes to take advantage of the capital benefits and broaden the range of market activities they can pursue," the report says. "These include taking proprietary trading positions and providing portfolio management services to clients."

Shcheredin concedes that SA-CCR, since it has yet to be implemented, is still subject to change, so it is difficult to forecast the precise impact of the new standard on commodity trading firms and their portfolios. But he stresses that much of the regulation around capital rules is a moving target – and thus it may not be quite as onerous as the industry currently thinks.

"With CRD IV not likely to apply to commodity firms until 2021, there's a good chance that it won't be the current CRD IV requirements that commodity firms will need to contend with," he says. "The current methodology is very likely to change, and future regulation could in many ways be better."