Curtailing Commodity Derivative Markets

Mandatory clearing of energy derivatives contracts have a negative wealth effect for the Dutch economy of around € 2.4 to € 3 billion. This is the conclusion of a study by SEO Economic Research on the effects of proposed European legislation to regulate financial markets. This study was commissioned by Energy Netherlands.

The research focuses on the regulation of Over-The-Counter (OTC) derivatives trading. The European Council consideres a proposal to regulate this trade, the European Market Infrastructure Regulation (EMIR). The core of this proposal is mandatory central clearing of OTC contracts. This means that credit risk from one counterparty to an OTC contract is covered by the maintenance of collateral with third parties, such as a bank acting as clearing house for OTC contracts. Mandating the coverage of credit risks through clearing should prevent credit risks to one party on the OTC market to spread to other financial players and markets.

The scope of EMIR is broad and covers include products based on derivatives trading as part of the energy market place. Energy companies buy and sell energy on futures markets to cover price risk in their physical output fluctuations. Viewed globally, this type of futures trading is only a fraction of the financial derivatives market and the role of financial parties herein is probably limited. This is for SEO Economic Research, contribute to conclude that systemic risk currently is only little or even absent in energy derivatives markets. This means that EMIR has a negligible positive effect on energy markets and above all causes costs.

It is even possible that EMIR workst counterproductive on energy markets. The mandatory clearing may lead to energy companies to hedge their future positions through customization – non-standardized contracts that are not publicly traded – and exit the energy exchange and OTC market. This reduces the liquidity of these markets and may thus increase rather than decrease price volatility.

Currently, the choice whether or not to clear OTC contracts centrally is part of the risk management of energy companies. This means that companies make a trade-off between covering credit risk, liquidity risk, and market risk. Regulation of the OTC market reduces the scope of companies in their risk management and causes substantial costs consisting of fees for the energy exchanges and the clearing house, interest rates for credit facilities and opportunity costs if funding of the collateral takes place at the expense of equity. These costs amount to approximately € 2.4 to € 3 billion if EMIR will affect the entire OTC trading of energy companies.

The research was also applied to a situation in which only speculative activities fall under the obligation of central clearing. This lowers the cost of EMIR energy companies, but the final cost for the sector remain substantial with around € 1.8 to € 2.4 billion.