The invasion of Ukraine by Russia at the end of February 2022 triggered two main periods of stress in natural gas derivatives markets with sharp spikes in prices and volatility. Prices doubled in March 2022 before stabilising between April and June. Then prices spiked again at the end of August. The stress reflected the reduction in the supply of natural gas from Russia and increased demand relating to the build-up of inventories ahead of the winter.
A key question for policymakers and regulators of financial markets has been whether there are any systemic risks inherent in the functioning of commodity markets that may cause further turmoil. In addition, it is important to learn lessons from the stress events in order to further strengthen the trading and clearing ecosystem. In my role at ESMA, I focused last year particularly on the stability of central counterparties (CCPs) relevant for EU financial stability. Given that CCPs are of systemic importance - due to their central role in markets and the related concentration of risks - the continuation of their critical operations is essential. In this article I will look deeper into the role of CCPs in natural gas markets during the last year, given that the stress events were particularly strong in Europe.
In analysing the events of the last year, we can conclude that CCPs remained stable and were able to continue their critical operations. Also, trading on natural gas derivatives markets generally remained orderly despite the high volatility and the sharp reduction in liquidity.
While CCPs remained stable, the high prices and volatility resulted in significant liquidity stress in the clearing eco-system. As price volatility surged, margin requirements on derivatives positions increased in line with CCP risk models. It was challenging for some non-financial corporates (NFCs) to obtain liquidity on a short-time horizon to meet these margin calls. In some cases, those liquidity strains resulted in public intervention, with governments providing liquidity support through public guarantees.
Therefore, relevant policy questions to ask are, for example, whether there are weaknesses in the gas clearing ecosystem that contributed to the liquidity stress, whether CCPs are sufficiently taking into account the nature of energy firms as clearing members, and whether the range of eligible collateral is appropriate.
Specifics of energy derivatives markets.
While gas markets display some characteristics common to traditional financial markets, there are also important differences. First, commodities markets in the EU are relatively concentrated at all levels, including the trading, clearing and funding levels. Second, a large share of the trading activity is carried out by non-financial companies, including energy utilities and independent commodity trading firms. Third, the relative activity of financial intermediaries, such as banks, is lower. Nevertheless, banks are essential players as providers of credit and liquidity services to the non-financial corporates, and as such link the commodities markets to the financial system. Also, physical delivery and storage of the underlying commodity are an important characteristic of commodities markets.
Key vulnerabilities observed during 2022
The specific features of gas markets can help explain several vulnerabilities observed during 2022. I would like to discuss the following:
- Margin calls put liquidity stress on clearing members and clients, in particular on non-financial companies
The use of derivatives, including gas derivatives, requires the posting of initial margins by counterparties at the inception and during the lifetime of the derivative contract to protect against the default of a counterparty, and the posting of variation margins on a daily basis to reflect the current market value of the trade for the counterparty with a mark-to-market loss. Following the invasion of Ukraine and the steep increase in prices, counterparties had to post variation margins and additional initial margins to compensate for the heightened volatility and prices.
The peak margin increase called for by EU and UK CCPs clearing commodities was 10% on the day of the invasion, i.e. an amount of 18 billion euros. The peak in August was even higher, with an increase of 11%, or 29 billion euros.
The FSB published a report in February 2023 on commodities markets and financial stability. It outlined that there is little data available on how clients in the commodities market funded their margin calls, however, market intelligence suggests that some commodities traders increased their use of revolving credit facilities (RCFs) or by borrowing additional funds. There is also some evidence of commodities traders successfully applying for additional credit lines, though some of these loans came with high associated interest rates and restrictive covenants. Additionally, a few commodities traders cut back their dividends to conserve cash or sought other financing, such as via private equity.
Nevertheless, generally margin calls led to funding stress and liquidity strains for clearing members and clients, in particular for non-financial companies, as their balance sheet is typically less liquid than that of other financial firms. Also, non-financial corporates may have limited access to funding sources. In some cases, governments had to step in and provide guarantees or capital injections into troubled companies.
- Some banks limited credit to comply with prudential requirements
As mentioned, banks’ role in the broader commodities ecosystem consists of the provision of credit and funding liquidity to commodities firms as well as financial institutions. Furthermore, banks provide settlement services as clearing members of CCPs to pass margins from commodities firms to CCPs. They also act as counterparty of NFCs in over the counter (OTC) derivatives trades, allowing their clients to hedge their positions with derivatives.
While banks initially increased their lending in the first quarter of 2022 to support commodities traders in meeting margin calls, at a certain moment some banks ceased extending more credit to smaller or financially weaker commodities traders. According to market sources, a main reason has been to control exposures and meet prudential risk requirements. This put further stress on non-financial companies in need of liquidity.
- Market participants cut back trading in cleared and non-cleared markets
In the EU, more than 70% of positions on futures exchanges are related to NFCs, especially energy firms. During 2022, EU trade repository data suggests that NFCs changed their trading pattern.
A first visible change has been a move away from exchange trading and central clearing towards OTC trading and bilateral clearing. While most trades in natural gas derivatives are still taking place on trading platforms, a substantial shift towards the OTC market is visible since the summer, in particular for NFCs. The migration can take place, for example, by closing-out the original exchange positions and creating a new physically-settled OTC contract. These firms may have migrated to reduce margin requirements and benefit from more flexibility provided by bilateral contracts. Though the move may reduce liquidity stress, firms may trade off liquidity risk for counterparty risk, and contribute to a reduction in market liquidity.
A second change would be generally a reduction in trading activity, including a reduction in hedging activity by energy firms, in particular for longer maturities. As the FSB report points out, the decline in hedging can be illustrated by the cut back in open interest in commodities derivatives markets. Reduced hedging by commodities firms exposes them to higher market risk. A side effect is that reduced hedging activity impacts market liquidity with lower depth and wider bid-ask spreads.
- Concentration and interlinkages in the commodities sector may exacerbate (potential) shocks
The natural gas market in the EU is concentrated at all levels. Trading tends to be concentrated in a few firms which account for most of the trading volumes. EU trade repository data shows that the top 5 net positions of EU NFCs account for more than 50% of average daily value (ADV) with an increase since February 2022. At contract level, the top 5 net positions of EU NFCs on single futures account for more than 400% of ADV on longer maturities
A risk related to this concentration is that some of those entities may try to liquidate their positions at the same time as providers of market liquidity, such as proprietary trading firms, may withdraw from the market in times of stress, resulting in a significant reduction in liquidity offered to market participants in times where it is needed most.
There is also a high degree of concentration at clearing level, where a few clearing members account for most of the clearing activity performed by EU entities on behalf of EU and non-EU clients. Analysis shows that the banks with the largest amount of clearing activity have a large number of clients (low concentration ratio), while banks with a low amount of activity tend to have a small number of clients (high concentration). Many energy firms also use a small number of clearing banks (high concentration), though this is not the case for all companies. Some clearing members play a key role in transmitting margin requirements. Here the risk is that the dependencies are high, and, for example, operational or financial unavailability may cause substantial stress and potential hampering of the fulfilment of margin and settlement obligations.
From a clients’ perspective, some firms use only one clearing member, which are mainly firms with smaller exposures except for one outlier. There could be potential contagion effects between clients and clearing members if the client or clearing member fails.
Concentration in trading and clearing services provision means that the vulnerabilities identified above could be amplified if large shocks were to be accompanied by a lack of preparedness by market participants in terms of liquidity risk management, as we saw in the last year.
ESMA’s crisis responses
ESMA has actively monitored the stress developments and has developed a comprehensive set of activities, either as part of existing word or as new activities, to further understand vulnerabilities in the commodities markets and reduce any identified risks, as appropriate under its mandate. In addition, it has actively coordinated with public and private stakeholders to discuss findings on which there are shared mandates or overlapping interests. I will highlight a few of these activities.
ESMA’s monitoring activities involved extensive analysis into several areas, notably the concentration within the commodities market, in particular the gas market, as well as the move from exchange to OTC trading and clearing. The results are outlined in the recently published FSB paper as well as in an upcoming ESMA paper.
As part of its anti-procyclicality work, ESMA performed an analysis considering the latest crisis, with a further focus on considering the benefits of margin transparency. The results will be incorporated as part of the development of a new regulatory technical standard (RTS) on anti-procyclicality measures that was published for consultation last year. Similarly, our regular CCP stress test incorporated an analysis of the resilience of CCPs under the real-life shock events, applying in an ad hoc analysis the actual shocks in the commodities markets. This resulted in a heatmap reflecting vulnerabilities in the EU CCP landscape that have been discussed with the relevant national competent authorities and CCPs. As part of ESMA’s annual CCP supervision peer review, the clearing member due diligence and client access requirements also considered membership criteria and NFC clearing members.
A dedicated activity has been a review of the list of eligible collateral under EMIR. Following this review, the list of eligible collateral has been temporarily extended. The relevant RTS came into force from 30th of November.
Finally, ESMA developed an advice to the European Commission on the market correction mechanism (MCM) as required by the Regulation that the European Council of December 2022, which aims to protect EU citizens and the economy against excessively high prices. ESMA published a preliminary data report in January 2023 indicating that the adoption of the MCM Regulation will not come without consequences on market participants’ trading behaviour and may have an effect on the ability of all market participants to effectively manage their risks. The MCM is also expected to impact the relevant CCPs and the clearing ecosystem as the use of less reliable price sources for the CCP’s margin calculations and default management may affect the CCP’s ability to manage risks, and may result in an overall increase in margin calls.
Although prices have currently come down to pre-invasion levels, ESMA will continue monitoring the developments.
For further information on WFEClear: The WFE’s Clearing and Derivatives Conference 2023, see https://wfeclear.wfecm.com/
The views, thoughts and opinions contained in this Focus article belong solely to the author and do not necessarily reflect the WFE’s policy position on the issue, or the WFE’s views or opinions.