Exceptions to the rule

With commodity markets set to fall within the scope of more EU regulation, trade associations are concerned that this extra burden on market participants could stifle trade. By Stella Farrington

Creating a level playing field in which financial instruments can be traded in any EU country under the same set of rules is the eminently sensible objective underpinning the Financial Services Action Plan (FSAP), set to bring some changes to commodity trading by next year.

But creating a uniform regulatory background for an enormously diverse set of trading instruments is fraught with potential difficulties, and some trade bodies fear commodity firms could be disadvantaged. On the one hand there’s the threat of the blanket approach, where commodity firms will be subjected to financial market regulation inappropriate to them, burdening them with extra costs and even forcing some smaller firms out of the market. At the other extreme is the fear that so many exemptions will be allowed that the benefits of regulated markets will be severely diluted.

The plan – an ambitious raft of 42 directives intended to create a single EU market in financial services – means commodity derivatives trading could, for the first time, fall under the scope of regulation that currently applies only to the banking community.

Much lobbying is currently taking place by trade associations such as the European Federation of Energy Traders (EFET), the Futures and Options Association (FOA) and the International Swaps and Derivatives Association (Isda) to try to ensure regulation is imposed on commodities firms fairly.

“The mood music from regulators is pro-harmonisation, and that makes a huge amount of common sense,” says Anthony Belchambers, chief executive of the FOA. “But there has to be differentiation. Everyone wants a level playing field, but that doesn’t mean we should all wear the same-sized boots. We need to be more sophisticated in applying harmonisation.”

A small independent power plant, for example, will not need the same risk management procedures as a multinational bank; nor would it be able to raise the same amount of capital to hold as collateral against credit risk.


This is the major concern some trade associations have with the Markets in FinancialInstruments Directive (MiFID) which is scheduled to enter into force in April2006, replacing the Investment Services Directive (ISD). Unlike the ISD, MiFIDdoes bring commodity trading under its scope, but currently there are exemptions.These exemptions mean commodity derivatives trading is not subject to capitaladequacy requirements, but also means that these firms cannot have a ‘passport’ to trade anywhere in the EU. EU firms must currently go through the lengthy and often costly process of applying for a licence to trade in certain other EU countries. Rules differ according to which country the firm operates in, and which it wishes to trade with, and legal advice must be sought for every different country to be entered. These exemptions will be reviewed in 2006, and if they are removed, the capital adequacy requirements placed on commodity derivative exposures will be those of banking regulations Basel II.

“The worry is that the risk management systems of commodity companies may not be sophisticated enough to run the most advanced Basel II capital treatment approaches. If a firm cannot use an advanced approach, its capital charge will be higher,” says Emmanuelle Sebton, co-head of the European office and senior director of risk management at Isda. “Building these systems would be extremely costly for some firms,” she adds.

The FOA’s Belchambers agrees: “Interpreting and understanding the requirements is difficult enough, but then there are the technical and staffing costs associated with implementing them.”

Isda is separately lobbying for amendments to the Capital Requirements Directive to enable commodity firms to use physical commodities as collateral. The EFET shares the concerns.

“What’s most worrying is that capital adequacy requirements are designed for banks and are not well suited to energy companies,” says Juan José Alba Rios, head of regulatory affairs at the EFET. “They emphasise liquid assets such as cash and do not allow for a company to back its position with power plants, gas fields or the like. In the commodity world, many assets are not liquid. Obliging energy companies to meet a financial regulation in order to be able to trade the wholesale markets would push many of them out of the market,” he adds.

In addition to defining capital requirements for credit, Basel II regulations also define capital requirements for operational and market risks. On all three fronts, commodity firms may be faced with implementation issues.

Trade associations want to ensure that the regulation takes into account the different levels of risk associated with commodity trading and that it applies regulation proportional to the risk of the market and the market participant.

“Unlike in the financial markets, there are no small, private clients to protect in the wholesale energy markets,” the EFET’s Alba says.

The risks are obviously very different in the commodity world to the world of finance, and some would argue that it is easier to prevent systemic risk in energy companies than in banks. “Even when Enron went bust it was not an event of systemic proportions as far as physical production was concerned,” Alba says. “The lights stayed on and the oil continued to flow. The roles of physical energy regulation and finance should not be mixed,” he adds.

However, although many people are concerned over the potential removal of MiFID exemptions, there is no consensus on this, even within the commodity community. Some larger companies could be willing to comply with MiFID in order to gain the ‘passport’ to trade in any EU country.

“Some of the major energy companies do want the passport provided by the directive, and might conclude that the benefit of being able to trade anywhere in the EU without having to apply for a licence outweighs the disadvantage of complying with the capital adequacy requirements,” Isda’s Sebton notes.

The process of obtaining a licence to trade in certain other EU countries is not only costly and time-consuming, but it can be difficult to obtain the necessary legal guidance: the legislation is often confusing and open to different interpretations. Sometimes the license requirements are so constricting as to be prohibitive, traders say.

So there is an undoubted advantage for major energy companies to comply with MiFID and gain a trading passport, but smaller companies will be far keener to keep the exemptions.

“Ultimately, large financial institutions and energy companies will be able to comply with capital adequacy requirements, but it’s the small independent generator who would be in trouble,” the EFET’s Alba says.

But as more and more banks become involved in commodity trading, the difference in treatment between companies in the same market is becoming more of an issue. Banks could feel they are at a disadvantage being subjected to requirements commodity firms are exempt from.

Energy exchanges can also see the benefit of the passport, but remain cautious about other aspects of MiFID.

“Commodity derivatives and wholesale trading are getting more and more similar to financial markets, with specialised trading houses, more and more banks and even hedge funds entering the market, so including certain aspects of commodity derivatives trading in the FSAP makes sense,” says Stefan Niessen, head of corporate communications at Germany’s European Energy Exchange.

The FSAP passport would bring great potential benefit to exchanges who currently have to apply for a license whenever a customer joins from a new country.

The right amount of regulation
But while exchanges would welcome a passport to simplify this procedure, theyfear that excessive regulation could choke smaller companies and hurt exchangebusiness, or send companies away from exchanges altogether.

“We must be careful not to create a perverse incentive for people to avoid excessive regulation by returning to archaic methods of unregulated bilateral trading,” Niessen says. “If the regulation is too tight, this could motivate much of the market to stop using professional trading and clearing systems simply to avoid financial regulation.”

He says the ongoing debates on the directives will result in a middle ground being found between the two extremes of stifling regulation and having no regulation at all. EEX is lobbying for clearing houses to be taken into account under the Capital Requirements Directive.

“There is a good chance the new directive will consider that counterparty risk can be greatly reduced through clearing houses and that positions held via recognised clearing houses will be subject to significantly lower or even zero capital requirements, Niessen adds. “However, the lobbying process about this issue is still ongoing.”

Even once the directives have been finalised, implementation by national governments and parliaments will take time.

“I am afraid that, despite the legal obligations, member states will take some time before completing implementation of the directive,” says the EFET’s Alba. “The transient period could allow for two or three more years of business as usual, but the FSAP will be a step forward.”

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