Regulation trends impacting the commodity trading sector

in Commodities Trading, Financial Services, 23.04.2015

On 19 November 2014, the United States Senate Permanent Sub-Committee on Investigations (PSI) published a nearly 400-page-long report on Wall Street banks and their involvement in physical commodities trading and storage activities. How do such reports affect regulators?

While one can disagree about the facts and results as they are presented in this report, what cannot be denied is the fact that such reports and public hearings increase the pressure on regulators to come up with new regulations addressing risk management, behavior and conduct, mixing banking and commerce as well as safeguards in general. Some constituents may argue that existing and future regulations are mainly geared towards financial institutions. In my view, this is ignoring the commodities sector’s dependency on financial institutions for providing trade finance. It also does not take account of the fact that it is better to get involved while there is still time to get involved in shaping future regulations impacting the commodity trading (CT) Sector.

How could regulations have a direct or indirect impact on commodity trading companies?

  • Capital requirements (Basel III and IV) – impacting mainly financial institutions, limiting the ability to provide balance-sheet loans, including trade finance facilities and therefore indirectly impacting the commodity trading (CT) sector. Should the exemption for certain commodity derivatives no longer apply under MIFID II, the CT sector might face capital requirements similar to those of financial institutions under the Capital Requirements Directive IV (CRD IV).
  • Regulations covering OTC derivatives (Dodd-Frank and EMIR) – in the US, the Dodd-Frank act, and in particular Title VII, has increased regulations covering OTC derivatives with the ultimate aim to enhance transparency by introducing organized trading facilities, central clearing, central margin and central reporting, to name only a few cornerstones of the regulation. In the European Union, EMIR (the European Markets Infrastructure Regulation) is the EU equivalent. Both acts will provide for far-reaching changes in the imminent future.
  • Market Conduct, Transparency and Consumer Protection (MiFID II and REMIT) REMIT, the Regulation on Energy Market Integrity and Transparency, an EU regulation influencing electricity and gas products, aims at reducing insider trading and market manipulation. Another EU regulation, MiFID II (Markets in Financial Instruments Directive II), is mainly geared towards financial institutions providing investment services by e.g. reducing exemptions, increasing the scope of products covered and tightening reporting requirements. MiFID II compliments other regulations such as REMIT and EMIR in the EU and could therefore have both direct and indirect impact on CTs. Switzerland has responded to these acts (EMIR and Dodd-Frank OTC Derivative regulations) by developing its own Swiss Financial Market Infrastructure Act (FinfraG).

What next?

The pace of new and potential regulation has increased, regardless of whether such new regulation will impact the CT sector directly or indirectly. The pressure on regulators is higher than ever. Major stakeholders such as financial institutions are directly impacted by a wave of regulations. Specifically, banks will have to consider the counterparties/clients they do business with, not only from a balance sheet, market, credit and operational risk perspective but increasingly, also from a reputational, conduct, legal and compliance risks perspective, which are harder to capture given their qualitative nature. A “wait and see” strategy may not be the right approach. Instead, it is a good idea to to prospectively enhance and and implement governance and control frameworks to address reputational, conduct, legal and compliance risk beside market, credit and operational risks early on. Annual testing should be considered in order to ensure operating effectiveness and to re-assess the design of such governance and control frameworks. In my view, companies should give consideration to their legal structure and ring-fence physical assets from the trading business to limit the influence of potential regulations to the areas that these are geared to. With companies pro-actively enhancing their processes and controls, governments and regulators will feel less pressured to introduce ever more stringent laws and regulations beyond what is currently on the horizon.

 

 

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