Potential Commodity Regulation Changes in 2017
In the aftermath of the 2008 financial crisis, many regulatory changes took effect in the United States and Europe. The Dodd-Frank Act of 2010 changed the regulatory environment for commodities in the U.S. dramatically. More regulations in financial markets in the U.S. caused many commodity businesses to depart U.S. shores for more friendly jurisdictions with fewer rules. However, it is probable that the regulatory environment will change with the election of a new President and the two houses of Congress from the same political party in 2017.
Prelude to Recent Regulatory Legislation
The increased regulatory environment in the United States and Europe was a reaction to the crisis as legislators attempted to create a set of rules and regulations for banks and market participants to prevent systemic risk in the economy. Systemic risk is the risk of collapse of the entire financial system or a market rather than the failure of one institution, group or component of the system. Following the housing and European sovereign debt crisis legislators, economists and regulators set out to address the problem of too-big-to-fail.
Many argue that banks and other related financial institutions had become too big, or such integral parts of the financial system that their failure would create a domino effect in the U.S. and global economy. In the aftermath of the events of 2008, the U.S. government and others around the world bailed out some of the world’s leading institutions. TARP or the Troubled Asset Relief Program was a U.S. government program that authorized expenditures of up to $700 billion to aid banks and other institutions.
The government designed this legislation to allow the U.S. Treasury to purchase toxic debt or ‘troubled assets’ to avoid the potential of bankruptcies. TARP was a temporary fix that ended in 2014 when the Treasury sold the last of its purchases of the debt.
President Barrack Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act into law in 2010. The Act resulted in a total overhaul of the regulatory environment in the U.S. and added many new rules and regulations for the financial and commodity markets and their participants. The mission of the regulation was to end too-big-to-fail by putting in place financial safeguards and capital controls on institutions. The Act increased requirements for reporting and stress testing of balance sheets in the interest of greater market transparency.
Additionally, the legislation aimed to protect consumers from abusive financial service practices. Proponents of the Act argue that the government must monitor and control financial institutions to prevent financial calamities. The Act expanded the regulatory oversight of markets by existing government agencies like the Securities Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) and it created other new agencies to regulate markets.
Opponents of the legislation argue that the Act just creates a web of bureaucracy and that if a financial institution gets itself into trouble government should allow it to fail. Many believe that the Dodd-Frank Act has created an environment that hurts the people it is trying to help as the increased oversight, reporting requirements and compliance costs for banks has restricted lending practices.
Banks in the Commodity Business
The new era of regulation in the aftermath of 2008 had a direct effect on the commodities business. First, commodity swaps or a financial transaction that exchanges a fixed for a floating price for a financial settlement between two counterparts must now go through a clearing organization like the ones that operate in the futures markets. Swaps are derivative transactions traditionally between two parties, a buyer, and seller, in the over-the-counter market where each counterparty to the swap takes on the risk of the other’s performance.
However, under the Dodd-Frank Act, swaps came under the jurisdiction of the CFTC, the regulatory body that is the watchdog for U.S. futures exchanges like the CME and ICE. The Act also calls for increased reporting requirements in the futures markets as well as new restrictions in the interest of increasing market transparency and reducing systemic risk.
With the repeal of the Glass-Steagall in 1999 that separated commercial and investment banking activities, many banks in the U.S. became directly involved in the commodities business. As the banks increased their lending activities to the raw material sector, many took equity stakes in commodity production and infrastructure. Banks and financial institutions became owners or equity partners in energy pipelines, commodity processing and storage facilities and other components of the raw materials business.
Additionally, financial institutions set up trading desks to service customers with physical and derivative instruments and took risks when it came to proprietary positions in commodity markets. As the banks entered these businesses, many traditional commodity merchant businesses in the U.S. and Europe found themselves unable to compete with the financial institutions with vast financial capabilities. At the same time, experienced traders and logistical personnel in the commodities business moved from merchant companies to the banks that went on a hiring spree to attract those with specialized skills in the raw material markets.
In many ways, the commodities business became the domain of the banking sector and the merchant business either became highly specialized or exited the market.
The banks enjoyed a profitable period in the commodities business as a bull market in prices began in around 2004. The prices of many commodities rose to all-time highs and business volumes increased as double-digit growth in China resulted in infrastructure building and the stockpiling and financing of raw materials. New production projects increased the need for banking expertise in the sector.
However, after the 2008 financial crisis when the regulatory environment changed, financial institutions came under the scrutiny of Congress and regulators. Commodities tend to be more volatile assets than stocks, bonds, and currencies. Therefore, regulators and legislators argued that financial institutions needed to set aside more capital to remain in the raw materials businesses. The banks had developed a strong supply chain in commodities from producer through consumer including logistical, infrastructure, as well as proprietary trading activities.
Many regulators and critics of the financial sector argued successfully that the banks should not be involved in the commodities business to such a great extent. As capital charges and compliance costs rose and the institutions found themselves under the hot lights of regulators and Congress, many departed the business. They sold their interests to other companies mainly outside of the United States in friendlier jurisdictions from a regulatory perspective like Switzerland and Asia.
Commodity Merchant Business Moves to Other Jurisdictions
Dodd-Frank and other regulatory changes in the United States and within the European Union has caused a migration of the global physical commodities businesses to Switzerland and Asia. In Switzerland, regulations and tax rates are more favorable. In Asia, China continues to be the demand side of the fundamental equation for commodities. With over 1.37 billion people, China has been the world’s leading raw material consumer for quite some time.
Before the banks entered the commodities business in 2000 there were many merchant businesses in the United States servicing raw material demand around the globe. However, a combination of a brain-drain and the dominance of the banks when it came to financial capability caused the merchant business to come to a halt. As the banks left the market after 2010, a lot of the business departed the shores of the U.S. As an example, JP Morgan had become a huge player in the international commodities business.
In 2014, the bank sold its commodities trading unit to Mercuria, a Geneva-Switzerland-based trading company. In the same year, Goldman Sachs sold its metals warehousing business to Reuben Brothers, a Swiss private equity group.
The 2016 Election
The ramp up regulations in the U.S. occurred under the administration of President Barrack Obama. However, in early 2017 the forty-fifth President of the nation will be Donald J. Trump who campaigned on a platform of fewer regulations. Candidate Trump told the American people that for each new regulation, his administration would get rid of two existing sets of rules. The Dodd-Frank Act was a target of the candidate’s criticisms during the campaign. As he assumes the Presidency with both houses of Congress from the same party it is likely that there will be dramatic changes in the regulatory environment for the financial industry as well as for many other businesses in the United States.
Potential Regulatory Changes on the Horizon in 2017 and Beyond
While parts of the Dodd-Frank Act are likely to survive over the coming months and years, others will not. The clearing of swap transactions is likely to continue to be an area that regulators will refine to provide stability to financial markets. However, the chances are that the Act of 2010 will be simplified dramatically giving more emphasis on supporting business and financial institutions by removing a lot of the bureaucratic requirements that have inhibited business and economic growth. The trick for regulators and legislators is to strike the right balance of making the regulations support business and economic growth while at the same time protecting consumers and the markets from manipulation and systemic risks.
The Dodd-Frank Act of 2010 and departure of the commodities business from the shores of the United States was a reactive rather than proactive approach to regulation. During the campaign of 2016, President Trump promised the American people that regulation would change to support business. Therefore, big changes in the regulatory environment in Washington DC are on the horizon.