The Tipping Point

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The over-the-counter commodities market is booming again with levels of trade are heading back to the peaks seen in 2008.This happy ship though is heading into choppy waters. Lawmakers and regulators on both sides of the Atlantic have not forgiven and forgotten the fact that over-the-counter (OTC) traded credit derivatives swaps nearly brought on the collapse of financial markets a couple of years ago. They are only weeks away now from bringing in regulation that will re-write the rule book on how off-exchange trade is conducted. By Vanya Dragomanovich

When it comes to financial instruments based on commodities, on-exchange traded commodities such as gold or copper futures are just the tip of the trade iceberg. The bulk of this massive edifice is made up of OTC transactions, bilateral deals between counterparties, usually banks on the one side and industrial companies hedging their exposure to commodities on the other. Those deals are not reported anywhere and are cleared through clearing houses that are not regulated like exchanges. Unlike listed derivatives, OTC contracts are not backed by the credit worthiness of the clearing house, although the parties have to offer some form of collateral.

Commodity OTC products such as swaps, forwards and options have been increasing in popularity with speculators including hedge funds over the last few years, with the gross market value hitting a peak in 2008 of $2.2trn. This number dropped off significantly in 2009, mainly because commodity prices fell, but now that most of the commodities markets have recovered, the big commodity banks say that trade flows are close to 2008 levels.

Nervous regulators

While this is good news for investors, regulators continue to be nervous about OTC markets and the lack of transparency they represent, arguing that they pose a serious risk to the entire economy. The Lehman Brothers case is a good example of what could go wrong again. After the company declared bankruptcy, close to $400bn worth of credit default swaps were presented for settlement. However, once offsetting bilateral trades were netted, only $6bn changed hands. The offsetting trades were invisible to the outside world and the implication of this interconnection was that if one player defaulted they could potentially precipitate a crippling domino effect that has the capacity to bring the whole industry down.

Another aspect of OTC derivatives that regulators are unhappy about is that the actual valuation of an OTC contract is down to each broker-dealer. This state of affairs stems partially from the nature of the instruments which are always individually tailored, but as there is no active marketplace or exchange, traders find it difficult to obtain market data for valuation of similar contracts. Many institutions, including major hedge funds, were sore-pressed in the winter of 2008-2009 to provide accurate valuations of their OTC portfolios.

Policy makers in the US and Europe are pushing for very similar changes; they want to see individual transactions being reported, the introduction of mandatory central clearing and higher collateral requirements for some types of deals.

In the US two different bills are currently being reconciled and the final version could potentially be signed into law before Congress breaks up for the summer at the beginning of July. In Europe, the European Parliament will vote on proposed changes to the derivatives market in June. The regulation will be tailored to affect the two main types of participants in the OTC markets, but in different ways. On the one hand are what is typically referred to as commercial players or companies which use OTC products to hedge commodity exposure, and on the other are banks which provide the products and dealers and hedge funds that trade them. The burden of regulation will largely be carried by the banks and speculators while commercial hedgers will be mostly allowed to continue business as usual.

A number of banks and trading houses are less than happy with the proposals. A group of them have written a letter to global regulators proposing less direct supervision and suggesting alternatives that involve less regulation and more voluntary changes such as data repositories for non-cleared OTC derivatives, assisting global supervisors with oversight and surveillance activities and clearing for standardised derivative products.

This [proposed change] could destroy the OTC market, says one commodities OTC trader in a London The reason why the futures market is much smaller than the over-the-counter market is because you have to be a clearing house member to trade on-exchange. Our clients trade over-the-counter because this means they dont have to pay clearing costs. If these costs are imposed on them they will simply stop trading, he said.

Another criticism of the proposals on the table is that increased regulation could result in the OTC trade moving away from New York and London into less regulated jurisdictions. Limiting the flexibility of these markets may lead to reduced or inadequate corporate risk management, or the movement of these transactions to friendlier, offshore jurisdictions, says a report from PriceWaterhouseCoopers.

Currently the amount of collateral needed for a derivative transaction, the circumstances in which it should be posted, and the form of such collateral, are negotiated between counterparties. A contract can also be tailored to include less liquid collateral that a user may have as part of its ongoing business operations.

To achieve greater transparency, current proposals would require conducting OTC transactions on exchanges or through clearinghouses. Yet these entities typically require posting a substantial amount of cash collateral or other highly liquid instruments in amounts in excess of the fair value amount of the derivative contract. As such, these proposals would reduce corporate liquidity, thereby lowering return to shareholders and driving up the cost of capitalall at a time when credit is tight and earnings are under severe stress, PriceWaterhouseCoopers says.

If the new rules are brought in as proposed, they will eat away on bank and trading houses profits and may reduce some of the volume of trade on the speculative end, but if one looks at the main reason why OTC commodity products exist it becomes clear that volume will not evaporate. Protection from volatility

OTC commodity derivatives came into being as companies tried to protect themselves from the wild price fluctuations commodities are prone to. It began with agricultural producers trying to fix the price of grain and livestock months before the harvest or of cattle maturing, but now hedging has spread across most industries.

A mining company wanting to hedge against a fall in copper prices for instance, will choose an OTC instrument rather than an on-exchange future, while a car company will typically hedge its large purchases of raw materials such as steel, aluminium and platinum, or an airline its purchases of jet fuel. In all cases, the hedge, though costly, buffers the company from jumps in prices and gives it some predictability for its balance sheet.

According to the International Swaps and Derivatives Association, more than 90% of Fortune 500 companies use customised OTC derivatives to manage specific financial risk, as do half of the midsized companies in the US and thousands of smaller companies. This trading landscape, however, is bound to be affected by the new regulation. What this might do is just get rid of some of the smaller players in the market, particularly some smaller hedge funds, and make room for bigger institutions and bigger hedge funds. On top of that commercial hedgers may not be affected at all, says Edward Meir, senior commodity analyst at MF Global, an energy commodities brokerage.

Some players are beginning to embrace change even before it is written into law. ICAP Energy, a unit of the biggest interdealer energy swaps broker ICAP Plc, says it would start delivering OTC oil prices on a new electronic trading platform using technology provided by InterContinental Exchange (ICE).

The difference between futures, which are traded on the exchanges, and derivatives such as swaps, forwards and options, is that for futures, a clearinghouse is the middleman between buyers and sellers. Although the central clearing counterparty can be a bank or a simple clearing entity, exchanges have their own clearing houses and an increasing number of those are present in the commodities space, such as the ICE, the Chicago Mercantile Exchange (CME) which is planning on expanding its OTC commodity clearing activities to include energy derivatives, and Singapore Exchange.

Rising trade volume

At present there is no indication that trade in OTC commodities is declining ahead of the anticipated new regulatory era. Official statistics provided by the Bank of International Settlements are available only twice a year, with the next set of data due to be published in June.

Anecdotal evidence, however, shows that the market is booming. This is particularly the case with gold, which is drawing inflows from investors spooked by the Greek sovereign debt crisis and the insecurity surrounding the euro. In London, where all of the gold is traded over the counter, the major houses such as HSBC, Barclays, JP Morgan, the Bank of Nova ScotiaScotiaMocatta, Deutsche Bank and Socit Gnrale are reporting roaring business. The latest London Bullion Market Association data, for instance, published in June is demonstrated record high clearing levels for gold transactions in the City.

We had very heavy activity all of this year, particularly in the last couple of weeks, brought on by the sovereign risk, says James Steel, commodity analyst at HSBC. I dont see anything that will interrupt this trend, the currency markets remain volatile and sovereign risk remains in place, he adds.

There is a similar situation in metals derivatives, which is dominated by a similar group of banks. There is no central data on the amount of flow in OTC metals but if you look at the levels of trade on the London Metal Exchange that is a good proxy for the overall market and those levels have been rising, says a trader at Royal Bank of Scotland Sempra.

Commodities, both on the counter and over the counter, will remain an attractive investment as longer term forecasts for global economy continue to be positive. The OECD recently reported that growth is picking up in the OECD area, at different speeds across regions, and at a faster pace than expected in the organisations previous Economic Outlook, although it pointed out that there are bigger risks to the global recovery given the instability in sovereign debt markets.

The OECD expects strong growth in developing economies and the rapid rebound in world trade to underpin global growth at 4.6% in 2010 and 4.5% in 2011. This will bode well for demand for industrial metals such as copper, aluminium, zinc and steel and energy products such as oil, gas and electricity. Gold will remain a favourite for investors as some European countries continue to sail close to the wind with their sovereign debt. Although the outlook for gold remains solid the same could not be said about other precious metals, which were sold as risk aversion emerged, according to Robin Bhar, analyst at Credit Agricole.

Separately, one segment of the market that will instantly benefit if the reforms go ahead are clearing houses and exchanges that provide clearing for OTC derivatives, the two most obvious ones being the ICE and CME. ICE recently reported a net profit of $101m or $1.36 per share for the quarter, up from $72m and 98 cents per share. The CME reported a 21% rise in net income and the best quarterly results since 2008.

The OTC commodity business could become less profitable for banks on a per trade basis, but volumes are likely to continue to rise as prices for commodities are set to ascend again, and although percentage returns going forwards will likely be lower, OTC trading will still be a profitable business.