US bank reforms risk derailing commodity markets

The US banking reform bill risks sucking liquidity out of the commodity market and derailing the recovery in the asset class.

The FinReg deal, agreed last week, will prohibit banks from making derivatives-based bets with their own funds, which could require some of the big institutions to spin off their proprietary trading arms.

The banks will be able to trade interest rate swaps, currency and certain types of credit derivatives to hedge exposures, but will need to establish separately capitalised affiliates to trade derivates in what the lawmakers perceive to be riskier areas, such as metals, energy swaps and agricultural commodities.

These derivatives will then have to be traded on open exchanges in order to regulate the over-the-counter (OTC) derivatives market.

Craig Pirrong, professor of finance, and energy markets director for the Global Energy Management Institute at the Bauer College of Business at the University of Houston, warns that the move risks seriously impairing liquidity and raising costs for investors.

‘Spinning off commodities will make it more expensive for dealers to make markets,’ he says.

‘Some may consider it is not worth the bother so this will reduce the liquidity of the commodities derivatives market and make it costlier to hedge.’

Overstated risk

Pirrong insists that the regulators have overstated the risks from commodity trading and the extent to which the banks trade them is a classic example of using a sledgehammer to crack a walnut response.

He points out that $41 billion of commodity derivatives were traded in the first quarter out of a total of £4 trillion derivative contracts.

‘Commodities are a rounding error,’ he says. ‘Equity and commodities gross positive values total $118 billion compared to a $4 trillion total or about 3% of that total.’

However, while the restrictions on commodity trading are not a big deal for the banks, the ramifications of the bill could be significant for commodities markets.