Trading On margin

Explained: how banks could save energy companies from collapse

The chimneys of the Total Grandpuits oil refinery are seen just after sunset, southeast of Paris, France, March 1, 2021. REUTERS/Christian Hartmann

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LONDON, Sept 13 (Reuters) – European financial regulators are considering relief measures to defuse a crisis for energy suppliers as electricity prices rise following Moscow’s cut in supplies.

The European Union’s market watchdog is considering how to ease the requirement for energy companies to hoard increasing amounts of cash to back derivatives contracts, a solution leaving the banks on the hook. Read more

WHAT IS THE PROBLEM?

Energy companies have sought to hedge against price increases through derivatives linked to the future cost of energy. But no one expected prices to skyrocket the way they did.

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Corporate derivatives, which hedge against higher prices, could now be their downfall.

In order to keep these contracts open, companies must make a cash “margin”, but this has ballooned with rising prices following Russia’s invasion of Ukraine.

This margin is deposited with a clearing house, which holds the liquidities necessary for the operation of the market.

Rising prices on positions held in clearing houses – and the demands for liquidity they have triggered – have companies scrambling to find cash, threatening solvency. Read more

HOW COULD IT BE SOLVED?

The European Commission, which is due to propose an emergency package on Wednesday, said rules could be changed to relax the cash deposit requirement. He could, for example, take a bank guarantee instead. Read more

Using EU carbon emission allowances could also work, according to market participants. Each quota or permit to pollute, exchangeable between companies, is equivalent to one ton of carbon dioxide.

In the meantime, many European countries are offering state-backed loans and guarantees to help businesses get by until a regulatory fix is ​​in place. Read more

The EU’s European Securities and Markets Authority is also considering the use of “circuit breakers” or temporary halts in energy contract trading following large price moves, giving markets a break.

WILL BANK GUARANTEES WORK?

Only with a derogation from the existing rules.

Typically, a bank, for a fee, agrees to make a payment if an energy company fails. It is similar to letters of credit from banks that are widely used in the physical oil trade in the United States.

EU rules on derivatives already allow bank guarantees as margin for certain companies – provided they are backed by collateral. This makes them expensive.

A waiver to this rule expired in 2016. This should be reintroduced.

DON’T BANKS NEED MORE CAPITAL?

Collateral should only be given to energy companies and banks should not be allowed to use collateral from other banks, said a clearing industry official familiar with the discussion.

Clearers can argue that this intervention will not hurt banks because a simultaneous collapse of banks and energy companies is highly unlikely.

Banks should therefore be able to avoid burdensome capital requirements to cover the collateral they offer, the argument goes.

In practice, however, much will depend on the European Central Bank, which regulates major eurozone lenders. If they are cautious, the banks could be asked to increase their capital.

WHY ARE CLAIRERS NERVOUS?

Clearinghouses fear any move to weaken their defenses, especially after the London Metal Exchange’s clearing arm had to nearly double its default fund earlier this year due to soaring nickel prices.

Clearing industry officials say bank guarantees should only be offered if they are “fully committed” and “on demand“, meaning a bank must agree to pay immediately to ensure the clearer doesn’t get stuck with the bill.

WILL EU EMISSION QUOTAS WORK?

Until a certain point.

Allocations are popular and highly traded. Power companies need them to comply with EU carbon trading rules, which means there is a ready market for them.

But the value of the EU’s benchmark quota contract has fallen nearly 30% in the past month, in part due to fears over the economic fallout from the war.

Policymakers are already considering selling more such allowances to raise up to 20 billion euros ($20.35 billion), in part to pay for alternatives to Russian gas.

But that would put more permits on the market, likely lowering prices.

($1 = 0.9826 euros)

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Additional reporting by Susanna Twidale, editing by John O’Donnell and David Evans

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