The Financial Stability Board identifies spikes in demand for funding liquidity, experienced by commodities firms as a result of sharply higher margin calls, as a primary source of potential contagion in global financial markets.
Drawing attention to huge volatility in commodity and energy trading markets during 2022, the FSB finds that liquidity became strained with higher pricing leading to higher margin requirements and to liquidity providers widening bid-ask spreads.
Writing in a newly-published report, The Financial Stability Aspects of Commodities Markets (FSB, 20 February 2023), the FSB concludes that these factors collectively “lowered market liquidity, likely exacerbating volatility, and thus led to a negative feedback loop” (p 14).
This volatility over the past 12 months has been closely linked to Russia’s invasion of Ukraine in February 2022, which created huge upward pressure on the pricing of key commodities and major volatility in physical and derivatives markets.
This followed on the back of earlier and extended periods of price volatility associated with the pandemic, and subsequent supply chain bottlenecks, along with selected geopolitical instability in other parts of the world.
For the most part, the FSB finds that the commodities ecosystem was able to absorb much of this pressure, with minimal disruption to market functioning. But the system did creak on occasions, such as with the decision of the London Metal Exchange to suspend trading in nickel markets in early March 2022.
Traders with short exposure to nickel faced huge margin calls as the nickel price climbed by 69 per cent in one day on 7 March and by over 270 per cent in the three trading days to 8 March. Between 4 and 7 March, clearing members posted more than US$16 billion in margin to LME Clear (p 15).
Initial margin (IM) collected by CCPs rose by close to US$100 billion in the year to February 2022 across all derivatives markets, mainly against exchange-traded derivatives (ETDs).
The rise in IM in March 2020 during the pandemic exceeded this figure, at approximately US$160 billion, but the latter figure represented a surge in volatility across a wide range of derivatives classes, whereas the February 2022 figure is heavily driven by margin calls against commodity and energy derivatives contracts, particularly at European CCPs (p 17).
The FSB notes that while IM calls in March 2020 were mostly for bank clearing members, in February 2022 there was a higher percentage of non-bank clearing members, including clearing for commodity and energy firms.
For variation margin, FSB finds that VM for commodities and energy trades almost doubled, mainly in European CCPs where it peaked at approximately US$70 billion (ibid).
Highlighting the close interlinkage between commodity markets and the wider financial system, the FSB notes that global banks are major providers of funding liquidity to commodity firms, as well as clearing and other services.
One potentially damaging consequence of these events is that some commodity traders have attempted to reduce the funding liquidity risk linked to sudden and large margin calls by moving their trading activity from exchange-traded and centrally-cleared commodity derivatives markets to largely uncleared OTC trading relationships.
While this may reduce the impact of sudden high margin calls driven by huge volatility in commodity pricing, the FSB fears that this shift from centrally-cleared to bilateral OTC relationships will result in greater credit risk and a higher risk of systemic contagion triggered by the failure of a counterparty.
An associated concern is that in pushing the market from centrally-cleared ETDs to bilateral OTC relationships, this may drive greater activity to more opaque commodities trading markets where it is problematic to build clear oversight of the size of exposures across jurisdictions and the network of intermediaries involved.
Last week, the European Securities and Markets Authority (ESMA) similarly highlighted the risks that a migration from ETD to OTC presents for the market. OTC markets typically offer lower liquidity than their ETD counterparts, it notes, and do not offer the price discovery, and levels of pricing transparency, delivered by lit markets. Moreover, uncleared trades, by definition, do not benefit from the centralised risk management offered by a central counterparty.
Today, the FSB also published its list of work priorities for 2023.
