EU commodity trading firms face capital punishment

The notion of imposing capital requirements on firms that trade commodities has been advocated by some financial regulators in recent years. It has also been loudly cheered by banks, which argue non-bank commodity traders enjoy an unfair competitive advantage from not having to set aside regulatory capital against their assets.

Since the entry into force of Europe’s Mifid II legislation in July last year, this abstract debate has become very real indeed. Mifid II both removes and narrows exemptions to financial market rules that many commodity trading firms previously benefited from. That means such firms may be forced to comply with CRD IV – the European Union version of Basel III bank capital rules.

A variety of firms that trade commodities, including trading houses, utilities and oil majors, are extremely concerned about this. And some say they will have to exit the market altogether. The European Federation of Energy Traders reckons the resulting drop in liquidity for energy derivatives would cost the energy industry €4 billion ($4.5 billion) – the equivalent of a €20 rise in energy bills for every household.

The European Banking Authority (EBA) is expected to provide technical advice to the European Commission (EC) about the prudential regulation of Mifid II firms in September. Among other things, the EBA says it will work on the presumption that there should be “a level playing field” with banks and that the counterparties of commodity traders should be protected.

There is just one small problem with this, which is that trading houses, utilities and oil majors are not banks. Unlike banks, they do not accept retail deposits and their trading activities are usually confined to large, sophisticated counterparties.

There is just one small problem with this, which is that trading houses, utilities and oil majors are not banks

In early 2013, the Global Financial Markets Association, a financial industry trade group, commissioned a study to shed light on the systemic risk posed by commodity trading houses. But the report, written by Craig Pirrong of the University of Houston’s Bauer College of Business, found that trading houses didn't represent a source of systemic risk. This somewhat inconvenient report was never released. Nonetheless, there are plenty of real-world examples that back up Pirrong’s conclusion, not least the 2001 bankruptcy of Houston-based energy trader Enron.

Ultimately, the EC can decide whether to impose CRD IV on commodity trading firms as it currently stands, or to come up with an alternative regime more suited for these types of companies. Either way, it looks likely to press ahead with the idea, regardless of the damage it does to the energy market or whether it makes any real sense.