Dodd-Frank: Impact on Commodity Hedging Markets


As a direct response to the U.S. financial crisis that occurred in the United States during 2007-2008, the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) was signed into law in 2010.   Dodd-Frank is seen as the most comprehensive reform of Wall Street since the reforms that followed the Great Depression.  One specific result of its new rules will be changes to how the derivatives market functions and operates, and this in turn will have an impact on how commodity hedging will be done in the years to come.

Dodd-Frank and Derivatives
Referencing directly from the U.S. Department of the Treasury website, Dodd-Frank was drafted and enacted to do these specific things:

  • Promote a safer, more stable financial system,
  • Put into place a dedicated “Watchdog” for consumers,
  • Bring the derivatives market “out of the darkness and into the light of day,” and
  • Provide new tools for winding down failing firms without putting the economy in jeopardy.

Specifically, in terms of derivatives, the third item in the list above is the subject of this note.  And while derivatives include instruments structured for credit, foreign exchange, equity, and interest rates, the most volatile underlying asset class is commodities.  Dodd-Frank catalyzed a game-changing evolution in a market segment that is inherently volatile, and it bears further examination.

What has changed?

  • The over-the-counter (“OTC”) market functions differently than in the past. Standardized swaps now have to be cleared and exchange traded, and this is designed to serve two purposes.  First, counterparty credit risk is expected to be reduced because more swaps will be traded on exchanges.  Also, the centralized clearing of trades can be a potential risk mitigating activity.  Second, there is more transparency in this particular market due to the fact that Dodd-Frank dramatically increases reporting requirements.
  • The largest dealers in the OTC derivatives market have to now report to regulatory oversight bodies, for the first time in U.S. history. Either the Securities and Exchange Commission (“SEC”) or the Commodity Futures Trading Commission (“CFTC”) will regulate large dealers, market participants, clearing houses, exchanges, swap execution facilities, and trade data warehouses.
  • Reporting requirements for swaps have been greatly increased, which should provide markets, investors, and regulators much more data than they had previously been provided.
  • Finally, there are new capital and margin rules in place that are designed to reduce market risk, by forcing dealers to set aside capital to support the trades they are executing. Capital costs money, and it is this last new regulation that could have the biggest impact in terms of cost for the commodity derivatives market.

Impact on the Commodity Derivatives Market
The jury is still out as to the impact on trades that are not cleared on an exchange.  Most derivatives trading happens between banks.  But there are exceptions to this generalization.  In cases where commodities are involved, oftentimes the trades include a participant that is a company, not a bank.  For example, an oil and gas company can hedge its price risk by using commodity derivatives, and airlines hedge their commodity price risk with derivatives, as well.  This means that there still will be a market in parallel to the new, centrally regulated exchange-driven market.

Impact on Volume
Data drawn from the Office of the Comptroller of the Currency illustrates the size of the commodity derivatives market in the United States.  Volume did not drop off in 2010 when the law was signed, but the rulemaking process has not been completed as yet.  This refers to the vast effort that takes place in government to draft the rules and regulations called for by the stature calls.  There has been a leveling off of notional volumes, however, as shown below, from 2013 on.

Navigant

U.S. Office of the Comptroller of the Currency
Quarterly Report on Bank Derivatives Activities (Q4 Data 2003-2015)

Impact on Cost
According to a JP Morgan Chase report, there are and will be cost impacts.  Collateral that must be posted will grow dramatically, and collateral means cost. There are costs to acquire collateral, such as buying U.S. government securities, and there are costs to keep the collateral on balance sheet.  The increase in demand for certain types of collateral will cause its cost to go up as well, and posting cash margin ahead of trade execution can be expensive as well. Added complexity and regulatory scrutiny has caused banks and other participants in this market to spend money on more people and more complex IT systems.

The Importance of Liquidity
Liquidity is essential for markets to operate in an orderly manner.  One emerging theme in the early stages of the Dodd-Frank regime is that it might have an unintended consequence that causes liquidity to decline, and to be concentrated in fewer players. Dodd-Frank and the addition of the “Volcker Rule” statute stopped banks from trading for their own account, in addition to expanding the oversight of commodity derivatives activity. The market has become less liquid, and it has become harder for companies to structure hedges.  Fewer banks in the market mean fewer potential counterparties to execute commodity hedges with and against, and this is troubling.

So which banks have exited?  JPMorgan Chase, Barclay’s, Morgan Stanley, and Goldman Sachs have traditionally been the largest traders of commodity derivatives, but three of them have exited their physical trading businesses just in the last couple of years.  Only Goldman Sachs remains.  These are very important developments because banks and traders have always gained substantial market intelligence from their physical desks, and vice versa.  One of the primary reasons that a bank engages in trading and market making activities is to understand the fundamentals of actual markets in real time.  Physical desk activity feeds their ability to make markets for hedging activity in financial commodity contracts.  Plus, concentration into one bank like Goldman Sachs is not conducive to risk mitigation at all.  All signs point to liquidity reduction, and this means fewer choices for energy companies seeking to hedge their exposure to commodity price fluctuations.

Path Forward
Some of the business that banks have exited, as a direct result of Dodd-Frank, can and will be picked up by other banks, and by merchant trading firms like Trafigura, Mercuria, Glencore, and Louis Dreyfus.  However, the cost and liquidity concerns summarized above are very real today.  The typical oil and gas company, as an example, can expect to have fewer counterparties with which to do business.  Plus, for several reasons highlighted, the cost to execute commodity derivative trades, in order to hedge, will be higher.  If Dodd-Frank is making it more expensive for banks and traders to do the work, then where will they pass the additional costs to?  They will pass them to their clients and customers in many cases.  Regulation most often increases the cost to do business and rarely causes it to decrease.

What can an energy company do to better quantify its commodity price exposure as it operates in the post Dodd-Frank world?  Applying much more detail, using stochastic models such as Monte Carlo Simulation and Finite Difference Models, will enable them to be more judicious in the use of hedges.  If the thesis of this note is true, at least in the short run, then the cost to do commodity hedging will be higher.  Less liquidity also contributes to higher costs to hedge.  Therefore, market participants should counter higher costs by doing less hedging, but with more effective and surgical hedging instruments and strategies.  In other words, they need to get more bang for the buck, by using a much more detailed, rigorous, and analytical approach in modelling the risks and volatility that they face.