Nearly six years after the passage of the Dodd-Frank Act, the stricter regulations that have resulted from the law and other post-crisis legislation are still a major headache for risk managers in the energy and commodity markets, according to speakers at Energy Risk Summit USA in Houston.
"Clearly, the 6,000-pound gorilla in the room is regulation," said Saji John, Houston-based managing director and global head of commodity market risk at Citi, speaking at a May 17 panel discussion devoted to liquidity in energy markets.
The past several years have seen an exodus of banks from the commodity markets, with once-major dealers such as Barclays, Credit Suisse and Deutsche Bank either greatly scaling back their commodities businesses or shutting them down altogether. A major factor in the banks' decisions was the Basel III capital requirements imposed by the Basel Committee on Banking Supervision, which increased capital charges for over-the-counter derivatives transactions with less-creditworthy counterparties, rendering many of the deals previously done by bank commodity desks unprofitable.
Against that backdrop, banks have had to make tough decisions on where to allocate capital – a process that is still ongoing, according to Citi's John. "[Regulation] has had a lot of direct and indirect effect on liquidity, but I think the balance sheet effect is actually, in my opinion, much more profound," he said. "There are a lot of heads being put together to decide where to allocate the capital, so there is a rightsizing of business going on. The US banks and shops which had larger balance-sheet exposure to the commodity business are actually shrinking."
Other regulatory changes that have impacted energy and commodity derivatives markets include the Dodd-Frank swap dealer rules, under which companies that execute more than $8 billion in gross notional OTC swap trades per year must register as dealers. That threshold is set to drop to $3 billion in December 2017, a prospect that worries US energy firms, which fear it will harm liquidity as large market participants cut back trading to avoid registration.
"The feeling of being regulated is not pleasant when it's dictated the way it was for a company like ours that chose to be a swap dealer," said Gary Taylor, Houston-based chief risk officer at BP's North American gas and power trading unit, speaking at a separate panel on May 17. "We chose to make that investment, and it was certainly a culture shock," added Taylor, whose unit of BP registered as a swap dealer in 2013.
Conference participants also cited the ongoing uncertainty around the US Commodity Futures Trading Commission's position limits rule, designed to curb excessive speculation in commodity derivatives. The regulator is rumoured to be working to finalise the rule this year, ahead of the US presidential election in November. In the meantime, uncertainties remain around hedging exemptions to the limits and the actual levels of the limits themselves.
Peter Keavey, New York-based managing director of energy products at CME Group, suggested that markets would recover once such regulatory uncertainties are resolved. "I think we're closer to the end than the beginning on regulations in the US," he said, speaking on the May 17 liquidity panel. "I think we're probably a couple of years away. It's just a question of how fast the implementation of this regulation happens. I really think that the market always evolves and finds a way."
Other speakers, though, expressed concern about what might happen if regulators didn't get the rules right. "Doing the right type of regulation is kind of important," John said. "I think the pendulum has probably swung a little too far."