Regulatory action may see commods traders migrate

News Date: 08/05/2009 Outlet: Financial Times Contact: Blas, Javier

Prices were outrageously volatile. While traders attributed the sharp market movements to supply and demand, most politicians and consumers were sure that speculation was the culprit. The public became incensed.

That was the Berlin wheat futures market in 1896. The pressure led to tighter regulation – including a ban on futures – that, in the account of a contemporary US diplomat, transformed “one of the most influential markets” into the “rank of a small provincial market”, helping activity in the nascent US and UK grains markets to soar.

Is that, more than a century later, the future awaiting the US commodities markets?

Traders, lawyers and bankers worry that as US and UK watchdogs hold meetings on Wednesday to review market supervision, they similarly risk encouraging regulatory arbitrage – the move by traders to a more benign regime – should any changes be poorly received.

But not everyone agrees that trading is going to fly from one market to another as it happened in Berlin.

The main concern is that the Commodity Futures Trading Commission, the US watchdog, imposes tougher speculative limits, thereby pushing traders to migrate to London, where the Financial Services Authority appears far less convinced about such restrictions.

The FSA is itself on Wednesday meeting big oil companies, banks, hedge funds and brokers to review whether London’s market regulations need to change.

“Will there be regulatory arbitrage? Most likely, for one simple reason,” says Peter Haveles, a partner at lawyers Kaye Scholer in New York. “This scheme of position limits is directed at speculators, and it doesn’t matter to them on which exchange they trade.”

Gregory Mocek, a partner at lawyers McDermott Will & Emery in Washington and former head of enforcement at the CFTC, agrees, saying that aggressive US regulatory action could “have a positive impact on foreign exchanges”.

Meanwhile, some commodity traders in the US are warning that heavy-handed regulation could destroy local markets.

An unsigned paper opposing trading limits circulating in Houston’s natural gas hedge fund community warns that “domestic liquidity will suffer terribly” as CFTC rules grow more onerous. “While the US natural gas market could very well die, the other commodities, like oil and copper, would certainly find homes in foreign markets,” the paper says.

Not everyone agrees. A dissenting view argues that the risk of regulatory arbitrage between US-based commodities markets and London is exaggerated.

For a start, the CFTC could opt for relatively painless changes. Wall Street’s banks are pressing for lesser adjustments and the watchdog appears aware of regulatory arbitrage risk. Gary Gensler, the CFTC’s chairman, last week said he wanted to address excessive speculation, not eliminate it. “Let me be clear: the CFTC recognises the importance of speculators to the effective operation of futures markets.”

On top of this, the US is by far the world’s largest crude oil consumer and a key producer of agricultural raw materials, so its commodities markets are likely to draw the lion’s share of trading from producers and consumers, helping to keep speculators at home.

The FSA could also tighten the UK’s regulation, de facto eliminating any arbitrage. Even if the City watchdog has been so far sceptical about the CFTC’s moves, it also says it is keeping the regulatory regime “under ongoing review”, opening the door to changes.

More importantly, explains Carlos Conceicao, partner at lawyers Clifford Chance in London and former head of wholesale markets enforcement at the FSA, “as regards major financial centres, we are talking about differences of degree and shade of regulation, rather than a binary choice between regulation and non-regulation”.

Rather than regulatory arbitrage between the US and the UK, some worry that the real danger is that any crackdown by the CFTC and the FSA will trigger a flight to smaller, but rapidly growing, commodities hubs, such as Dubai, Shanghai or São Paulo.

That is one of the menaces that Mr Mocek foresees. “There are numerous exchanges and over-the-counter venues around the globe, including the hot domiciles like Brazil and the vulnerable markets of Dubai that could dramatically benefit from the regulatory arbitrage that could result from aggressive US regulatory action,” he says.

The number of commodity exchanges has grown over the last decade as more and more countries deregulate their economies and remove price controls. In addition, emerging countries such as China or Brazil are either large commodities consumers or producers, further improving the attractiveness of their markets.

Nevertheless, Michael Lewis, head of commodities research at Deutsche Bank in London, says that in terms of market turnover there remains a high degree of market concentration, such that the lion’s share occurs in the US, Japan, China and the UK.

“Indeed we estimate that these four countries alone constitute more than 90 per cent of global commodity turnover that occurs on an exchange,” he says. “As a result, we believe any legislation that attempts to curb speculative activity will only need to target a handful of exchanges,” reducing the regulatory arbitrage risk.

And while traders could still migrate to less supervised commodities hubs outside the UK and the US to take advantage of regulatory arbitrage, they will have to balance any benefit with another arbitrage: political risk in foreign commodity exchanges.

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