Big, sweeping changes to any established market run the risk of unintended consequences, particularly when those changes result from multiple pieces of legislation and regulation, often written independently of each other and introduced more or less at the same time. The UK’s Financial Conduct Authority (FCA) now thinks it might have spotted some in the commodity markets, warning in a report published at the end of last month about the impact a retreat by investment banks may have on market liquidity and transparency.
None of this will come as any surprise to commodity derivatives users. Several banks have scaled back or pulled out entirely from physical commodity markets over the past year or so – a move that some have attributed to new regulations – and industry participants have been warning about the affect this may have on market dynamics for some time.
The regulatory changes are coming from several directions: the Dodd-Frank Act and Volcker rule in the US; the European Market Infrastructure Regulation, revised Markets in Financial Instruments Directive and Market Abuse Regulation in the European Union; and the Basel III capital and liquidity rules. And additional changes could be on the way, with the US Federal Reserve Board releasing an advance notice of proposed rule-making in January that could impose tougher restrictions on US financial holding companies trading physical commodities.
While stressing that it believes these measures are necessary and appropriate, the FCA notes the balance in commodity market participation is changing, with banks playing less of a role and other participants – specifically, commodity trading firms – taking up some of the slack. This comes with some potential challenges. For one thing, these firms tend to operate outside the UK, which could pose a challenge to the FCA’s market supervision.
More to the point, however, the FCA acknowledges that regulation has actually become a driver of market change, rather than being a response to it. The new market reality could mean fewer market participants, less liquidity, less customer choice, less transparency, competitive inequality and high barriers to entry. That’s not an ideal scenario for anyone – including the FCA. A comment towards the end of the paper perhaps sums it up best: the legislation has been implemented in response to decisions taken by the Group of 20 nations in 2009, but “markets have changed since then and the risks now are less about growing markets and a rising tide of speculative activity and more about a lack of liquidity and a retreat by classes of participants”.
So, what’s the way forward? It seems unlikely the regulatory to-do list will change any time soon, but it opens the door to new debate about the changes in commodities markets, and raises the very legitimate question of whether this is where we want to be.