Commodity derivatives markets and financial stability

Thank you for the kind introduction, Will [Acworth], and thank you to FIA for the opportunity to participate in this conference.

It’s a real honor to give a keynote address here. Central bankers like me are not the usual leadoff speakers at conferences on commodity derivatives. But central banks around the world have become increasingly attentive to commodity derivatives markets following the developments of recent years. Today I’d like to share with you the reasons central banks’ interest has grown, some lessons we’ve learned about the role of commodity derivatives markets in the broader financial system and some thoughts on what those lessons might mean for your own work.

I need to start with a couple of disclaimers.

First, the views I share are mine and not necessarily those of the Federal Reserve Bank of Dallas or the Federal Reserve System.

Second, the Federal Reserve is the nation’s central bank. We support a strong economy for everyone in the United States. We supervise banks, promote financial stability, operate parts of the payments system, promote community development and set monetary policy. My focus today will be on financial stability as it relates to commodity derivatives markets. Because we are in a communications blackout period ahead of next week’s Federal Open Market Committee meeting, I will not discuss current or prospective macroeconomic conditions or monetary policy, including how such topics may or may not relate to commodity derivatives markets. You should not draw any inference from my silence on those topics.

With those disclaimers out of the way, let me return to the recent experience in commodity derivatives markets.

Central banks have long looked to derivatives markets for information that may help forecast commodity prices. The Fed also gained some supervisory responsibilities for central counterparties (CCPs) in derivatives and other markets after the Global Financial Crisis. But the volatility in recent years drove central banks to widen our perspectives and more fully consider the many connections between commodity derivatives markets and the broader financial system and economy.

This was not a new interest for me. I grew up in Chicago, which as you know is a global center for commodity derivatives trading. The first time I can remember really thinking about the derivatives markets was October 20, 1987, in the middle school cafeteria. Some classmates whose parents worked on the downtown trading floors shared stories of what their parents said had happened the day before—scary stories, worrisome stories, but also fascinating ones.

The stresses of Black Monday centered on equities and equity derivatives, of course. But S&P 500 futures, a product that was only five years old in 1987, grew out of Chicago’s long history of trading in commodity futures. Before long, I was learning everything I could about those markets as well.

Like Houston, Chicago is a place where geography creates a nexus for trading in physical commodities.[1] With that physical trading comes a need for institutions and markets that support financing and risk management. So my early education on commodity derivatives markets was as much about the city’s railroads, waterways and grain elevators as about the trading floors. And an appreciation for the intersection between the physical and the financial continues to inform my perspective on the lessons from recent years.

In my career, I’ve continued to study how markets help people transfer risks of various sorts. Before coming to the Dallas Fed, I had the privilege of leading the Federal Reserve Bank of Chicago’s work on financial markets, including research and policy analysis on derivatives.

I’ll argue today that commodity derivatives markets play a key role in helping the economy produce sufficient supplies of commodities and allocate these supplies where they are needed most. That’s because derivatives markets enable producers and consumers to discover prices and hedge risks—especially in times of volatility and uncertainty. The past few years highlighted the importance of guarding against vulnerabilities that could disrupt this process of hedging and price discovery. Such disruptions could amplify shocks to the real economy.

This is a broader perspective on financial stability than the traditional focus of many central banks on deleveraging, credit losses and funding stresses at financial institutions.[2] But the perspective I’m offering does not contradict that traditional focus. Indeed, it is consistent with central banks’ growing recognition of the importance of market functioning across a range of markets.[3] It also, I think, shapes the trade-offs that regulators and industry should consider in assessing how best to manage risks. And it emphasizes central banks’ need to deeply understand the practical realities of commodity derivatives markets and to engage with the industry. So I hope our discussions today will be the downpayment on an ongoing dialogue.

Perspectives on recent volatility

I’ll start by reviewing the volatility in commodity derivatives markets in recent years. I suspect the data I show will be familiar to you. But we each interpret data in our own way, and my interpretation will set the stage for the lessons I’d like to draw.

This chart shows the prices of futures in six representative commodities: crude oil, wheat, nickel, natural gas in the United States and the Netherlands, and power in the U.K. They are indexed to their levels just before the pandemic. What stands out is the enormity of the disruption in energy prices in Europe. This began in late 2021 as tensions with Russia increased and peaked in 2022 after Russia’s invasion of Ukraine. The volatility in European energy markets so dominates this chart that you can barely see the very notable shocks to other commodity markets, even if you squint.

So let’s zoom in. Here I’ve removed the European energy markets so we can better see the movements in the prices of the other commodities. And those movements, too, are rather remarkable.

We can see the gap in nickel prices after a short squeeze led to a multiday trading halt on the London Metal Exchange (LME). This was a serious breakdown of hedging and price discovery.

We can see the fluctuations in U.S. natural gas prices. Although limited export capacity buffered U.S. prices against the extreme pressures from overseas, those pressures still passed through to a degree.

We can see the price of wheat rising 70 percent in just over a week as Russia’s invasion disrupted the breadbasket of Europe. If I zoomed in a little more and showed intraday data, we’d also see wheat futures hitting price limits on five consecutive trading days. In a narrow sense, reaching price limits meant there was a barrier to price discovery and hedging. People couldn’t trade futures on those days at the fundamental value as reflected, for example, in options markets.[4] But price bands can also safeguard against the more extreme breakdowns in market functioning that may occur when there are insufficient limits on volatility or inadequate position surveillance, as the experience at the LME demonstrated.[5]

And if we look earlier, before the shocks from the war, we can see the price of WTI crude oil plummeting during the pandemic. On April 20, 2020, as you know, oil even dropped below $0. Let me say a little about that negative price. Some people saw it as a sign the market was not working properly. The negative price did put stress on exchange-traded funds (ETFs) that track oil futures, because an ETF’s price can’t go negative.[6] But to me, the negative price was mainly a reminder that commodity derivatives ultimately price real, physical commodities in the real, physical world.

The WTI futures contract, if you hold it to expiry, is a contract to receive or deliver actual oil at a particular place: Cushing, Oklahoma. In the spring of 2020, oil stockpiles had been growing as pandemic shutdowns sharply curtailed the world’s use of energy. As the April contract approached expiry, there wasn’t enough space available in the Cushing tanks for all the deliveries that would need to happen on the outstanding futures. The negative price didn’t mean that oil, in some generic sense, was worth less than nothing. It did mean that if you could take oil out of Cushing—actual oil in a particular place—you could get paid to do so. There was no free oil or free lunch, just a price signal.

At many points in the past several years, one could have been forgiven for seeing the volatility as something entirely out of the norm. Certainly, the geopolitical and public health developments of recent years were quite extraordinary. And if you had looked at a chart of power and gas prices, like this one, you would have seen a long flat line followed by some incredible spikes. It would have seemed natural to call this a new age of volatility.

But let’s look at a longer history. Here are the prices of the same six commodities I’ve been examining, back as far as I could find data on Bloomberg. I’ve put this chart on a logarithmic scale so we can more easily visualize rates of change. Although the past few years stand out to a degree, they don’t look all that unusual. There has been extreme volatility before. Wheat prices nearly doubled in the second half of 1972 and doubled again in six weeks in the summer of 1973 after massive purchases by the Soviet Union. Crude oil prices collapsed in 1986 as OPEC production quotas broke down. And so on.

Volatility is common in commodity derivatives markets. You might even say it’s the reason these markets exist. The supply of and demand for commodities are subject to constant shocks, large and small. Production and consumption must adjust in response to these shocks. That means prices must change. Without volatility, there wouldn’t be trades to make, risks to transfer or new prices to discover. The question we should ask about volatility in commodity derivatives markets is not whether it’s a problem, but whether the markets are effectively serving their purpose when volatility strikes.

Price signals and risk transfer

I’ll take the natural gas markets in the U.S. and Europe as a case study to address that question. This chart shows the spread between benchmark natural gas futures in Europe and the United States. Fundamentally, this spread exists because there is limited capacity to ship natural gas between North America and Europe. When the spread widens, there is only so much anyone can do to arbitrage it in the near term. Again, what’s being priced is not natural gas in some abstract sense, but natural gas in particular places at particular times.

For that very reason, the spread between U.S. and European gas futures provides critical price signals that influence the production and distribution of natural gas in the physical world and critical support for risk management at the companies involved in that value chain.

As the chart shows, volatility and price pressures emerged in the front-month spread in late 2021 amid tensions with Russia. The rising spread signaled that anyone able to ship gas to Europe might profit by doing so. Traders could also use futures to hedge the risk that the price might fall by the time ships arrived—though, as I’ll discuss in a minute, the stresses in European markets made hedges difficult to execute at times. And to the extent that gas users in Europe had hedged their input requirements, the rising futures price helped offset the shock they were facing.

Absent these price signals and hedging opportunities and their influence in reallocating commodity supplies around the world, the energy challenges in Europe during 2022 would likely have been even more severe. In this sense, dysfunction in commodity derivatives markets could have amplified the initial shock. As we say in central banking circles, market dysfunction represented a vulnerability to financial stability.

Derivatives can also support longer-term price discovery and hedging. The gray line is the spread between European and U.S. futures 24 months out. This spread was slower to rise than the front-month spread, but it eventually peaked at more than $150 per megawatt-hour. The movements in long-dated contracts signaled that market participants expected price differences to persist—an incentive to increase the capacity to ship gas to Europe.

According to the Energy Information Administration, liquefied natural gas (LNG) export facilities are now under construction with base nameplate capacity of 7.5 billion cubic feet per day. Those projects will increase U.S. export capacity 66 percent. Regulators have approved another 19 billion cubic feet of export capacity not yet under construction.

In thinking about price signals, it’s also necessary to consider externalities. The production, transportation and use of natural gas and other commodities can have positive and negative externalities related to national security, carbon emissions and other factors. For market prices to provide appropriate price signals, they must incorporate these externalities in some way. However, such externalities generally go beyond the responsibilities of the Federal Reserve.[7]

LNG plants represent multibillion-dollar investments that can take a decade or more to pay off. For an investment on that scale, the ability to hedge output prices can be crucial in managing risks. Hedging can also be important for the smaller and shorter-term investments that are typical in some other commodities, such as farmers’ investments in the crops planted in their fields.

As the Federal Reserve and other central banks assessed financial stability aspects of commodity markets during and after the 2022 volatility, market participants’ ability to use derivatives for hedging as well as price discovery was a central consideration. In the spring of 2022, the Federal Reserve’s semiannual Financial Stability Report included a special box examining stresses in financial markets related to commodities.[8] We emphasized that these stresses had the potential to “disrupt the efficient production, processing and transportation of commodities by interfering with the ability of commodity producers, consumers, and traders to lock in prices and hedge risks.”

One way we’ve examined how effectively commodity derivatives markets are serving their purpose is by measuring market liquidity. A great deal of hedging, of course, takes place over the counter (OTC) or is embedded in sale-and-purchase or tolling agreements. But trading conditions for these arrangements can be difficult to observe. Exchange-traded derivatives, though they differ from OTC arrangements in many respects, are more transparent and can provide some insight into the conditions hedgers might face more generally.

For example, this chart shows estimates of price impact in benchmark U.S. natural gas, crude oil and wheat futures. The cost of entering and exiting positions rose significantly by this measure when volatility was elevated, such as at the onset of the pandemic for crude and in 2022 for natural gas and wheat.

However, it is natural for market liquidity to fall when volatility rises, because the risks of intermediation are higher at such times. Consider this plot of price impact against return volatility in Henry Hub natural gas futures. Comparisons like this of market liquidity versus realized or implied volatility suggest that on most days and in most U.S. markets, market liquidity was not much worse than we would expect given the level of volatility. Illiquidity occasionally appeared to amplify volatility in U.S. markets, particularly around some of the most extreme spikes in energy prices in 2022. But from a financial stability perspective, in the U.S., we did not see a broad, fundamental breakdown in the process of intermediation.

Lessons learned

What should we take away from the recent experience in commodity derivatives markets?

One view I have heard is that the U.S. markets survived an extreme stress test—a pandemic plus a war—with little disruption.  Therefore, the thinking goes, the past few years should reinforce confidence that U.S. markets are resilient and that there is little to worry about.

There is something to this view. Overall, market participants managed through this episode.

But the very first chart I showed you demonstrates that the confident perspective is incomplete. Compared with the shock to European energy markets, the shocks in U.S. commodities markets were so small you can hardly see them when you plot U.S. and European prices together. Europe, not the U.S., had the truly severe stress test. The recent experience therefore provides only limited comfort about the resilience of the U.S. commodity derivatives markets.

The range of plausible shocks is simply very wide. Prices can go negative. Prices can rise by a factor of 28 in a short time. The improbable is not impossible.

The events of both 2020 and 2022 also provided reminders of how sharp increases in volatility can trigger further problems. In particular, market participants can face a rapid-onset and stressful demand for cash.[9] Large price swings lead mechanically to large variation margin (VM) calls to cover mark-to-market losses. Elevated volatility also means initial margin (IM) must cover more risk. Depending on where IM requirements started, CCPs may need to increase them when volatility rises.

Globally, daily VM calls across all CCPs rose $115 billion in a few weeks in February and March 2020, while IM requirements rose $300 billion. Then, as pressures on energy markets increased, total IM globally rose almost $100 billion from early 2021 through early 2022. Some clearing members applied IM multipliers for clients on top of the CCP increases.[10]

The resulting cash needs created further stresses. In March 2020, some participants sourced cash by hurrying to sell assets or borrow against them, part of the dash for cash that stressed financial markets at that time.[11] In 2022, some commodities traders drew on credit lines, adding to banks’ exposures to the sector just as risks rose.[12]

Margin calls also fed back and created challenges to the functioning of commodity derivatives markets themselves. In market outreach, we’ve learned how rising margin requirements for exchange-traded derivatives led market participants to move some activity to OTC markets. This may have contributed to decreased market liquidity on exchanges. It also increased counterparty credit risks, as OTC commodity derivatives generally are not centrally cleared.

In evaluating options for mitigating these vulnerabilities, we should not forget that commodity derivatives markets serve a useful purpose. They support the efficient production and allocation of commodities. Ideally, solutions can align with that purpose.

For example, margin calls arise for a good reason: to reduce counterparty credit risk. Without the risk management that CCPs provide, exchange trading of standardized products would be significantly more difficult, if not impossible.

Nor would it do for CCPs to limit margin calls and thereby fail to manage the risks they themselves face.

And modeling approaches that reduce the procyclicality of IM can be taken only so far. When volatility is very high, IM must be very high to cover the risks. So increases during severe stress are inevitable unless IM is set very high at all times—which might not be conducive to smooth market functioning.

Instead of seeking to reduce the size of margin calls, it may be more productive to enhance market participants’ readiness to respond to them. For example, CCPs can ensure they communicate clearly about margin models.[13] And clearing members, clients and CCPs themselves can ensure they have established and tested sufficiently large liquidity facilities. Indeed, the importance of operational readiness for rapid liquidity demands is a repeated lesson of financial stress episodes in recent years.[14]

To take another example, centrally cleared derivatives markets have grown increasingly concentrated in the years since the Global Financial Crisis.[15] Concentration can make it more difficult for some customers to obtain needed services, particularly if customers need to be ported after a large clearing member’s failure. Concentration can also amplify liquidity and credit stresses if a major participant suffers losses. A recent report by the Financial Stability Board noted the vulnerabilities associated with European banks’ substantial and concentrated credit exposures to commodity traders and the concentration among trading firms themselves.[16]

But concentration can arise from the healthy workings of a competitive market. It is not surprising to see some firms succeed and grow while others are less successful and shrink. Economies of scale could make larger firms more efficient. And the risk environment may even contribute to economies of scale, as some aspects of the technology and human capital required for risk management and resilience are essentially fixed costs.

As an economist, I suspect I’m professionally obligated at this point to observe that concentration, like most things in life, has benefits and costs that ought to be weighed against one another. Measures to ensure a level and competitive playing field can soften this trade-off. That is, a strategy that supports a diverse, resilient market ecosystem may simultaneously mitigate vulnerabilities and reinforce markets’ ability to serve their economic purpose. For example, in 2020, as part of the transition to the standardized approach for counterparty credit risk (SA-CCR), the federal banking agencies allowed an offset for client collateral in calculating the supplementary leverage ratio.[17] Analysts viewed this step as reducing barriers to competition.[18]

Conclusion

To sum up, the volatility of recent years posed a meaningful challenge for commodity derivatives markets but one that the markets, for the most part, rose to meet. These developments highlighted the economic importance of commodity derivatives markets in both normal times and times of stress. They also highlighted the potential for a very wide range of shocks, the need for operational readiness to respond to liquidity risk and the benefits of a diverse ecosystem of market participants.

As I noted, a deep understanding of the market—gleaned in part from ongoing dialogue with market participants—is essential so the Federal Reserve and other regulators can make the best decisions to support a strong, stable financial system that best serves the economy’s needs. I look forward to learning from today’s discussions and to continuing to engage with all of you over time. Thank you.

Notes

I thank colleagues in the Federal Reserve System for helpful comments.

1. See Nature’s Metropolis: Chicago and the Great West, by William Cronon, New York: W.W. Norton, 1991.
2. See "Financial Stability Monitoring" by Tobias Adrian, Daniel Covitz and Nellie Liang, Federal Reserve Bank of New York Staff Report No. 601, revised June 2014.
3. See, for example, “Market dysfunction and central bank tools,” by the Bank for International Settlements Markets Committee, 2022, and “Preventing and responding to dysfunction in core markets,” by Lorie K. Logan, and “Looking through a glass onion: lessons from the 2022 LDI intervention,” by Andrew Hauser, speeches at the Workshop on Market Dysfunction at the University of Chicago Booth School of Business, March 3, 2023.
4. “Surging Wheat Futures Shine Spotlight on Daily Price Limits,” by Optiver, March 11, 2022.
5. See “Independent Review of Events in the Nickel Market in March 2022”, by Oliver Wyman, January 2023.
6. “What’s the Point of an ETF That Goes Off-Script?” by Shuli Ren, Bloomberg, April 23, 2020.
7. See the discussion of the Federal Reserve’s mandate in “Central Bank Independence and the Mandate—Evolving Views,” by Jerome H. Powell, remarks at the Symposium on Central Bank Independence, Sveriges Riksbank, January 10, 2023.
8. “Financial Stability Report: May 2022,” by the Board of Governors of the Federal Reserve System.
9. See “The Financial Stability Aspects of Commodities Markets,” by the Financial Stability Board, February 20, 2023, and “Central Clearing and Systemic Liquidity Risk,” by Thomas King, Travis D. Nesmith, Anna Paulson and Todd Prono, Federal Reserve Bank of Chicago Working Paper No. 2019-12, December 2019.
10. International regulatory organizations have intensively studied margin dynamics during the pandemic and European energy stresses. See Financial Stability Board (2023); “Review of margining practices,” by the Basel Committee on Banking Supervision, Committee on Payments and Market Infrastructures and Board of the International Organization of Securities Commissions, September 2022; and "Margin dynamics in centrally cleared commodities markets in 2022," by the Basel Committee on Banking Supervision, Committee on Payments and Market Infrastructures and Board of the International Organization of Securities Commissions, May 2023.
11. “Holistic Review of the March Market Turmoil,” by the Financial Stability Board, November 17, 2020.
12. Financial Stability Board (2023).
13. See Basel Committee on Banking Supervision et al. (2022).
14. “Remarks on liquidity provision and on the economic outlook and monetary policy,” by Lorie K. Logan, speech at the Texas Bankers Association, May 18, 2023.
15. See “Analysis of Central Clearing Interdependencies,” by the Basel Committee on Banking Supervision, Committee on Payments and Market Infrastructures, Financial Stability Board and International Organization of Securities Commissions, August 9, 2018, and “Concentration in cleared derivatives: the case for broadening access to direct central counterparty clearing,” by Nahiomy Alvarez and John McPartland, Journal of Financial Market Infrastructures 8 (3), 1–28, 2020.
16. Financial Stability Board (2023).
17. “Standardized Approach for Calculating the Exposure Amount of Derivative Contracts,” by the Office of the Comptroller of the Currency, Board of Governors of the Federal Reserve System, and Federal Deposit Insurance Corporation, Federal Register 85(16), 4362-4444, January 24, 2020.
18. “Too much, too young: improving the client clearing mandate,” by David Murphy, Journal of Financial Market Infrastructures 8(3), 29-50, 2020.