The Problem of Commodity Inflation Whose Price Moves Are Increasingly Disconnected From Fundamentals
The introduction of circuit breakers is seen as a potential solution.
One aspect of the energy and geopolitical crisis has gone completely under the radar since the start of the war in Ukraine. However, this aspect is crucial to understanding the galloping inflation of commodities in recent months. The extreme volatility of prices is causing dysfunctions in the financial commodities markets, which in turn are artificially fuelling the rise in prices in the real economy.
A large proportion of the players linked to commodities - producers, traders, or manufacturers - rely on futures markets to hedge against unfavorable price trends. While these financial instruments should play a cushioning role, they have become one of the causes of the exuberant movements observed in the markets.
Commodity futures markets have globally lost 25% to 30% of their liquidity. Why? Because price volatility has significantly increased clearing houses' initial margins.
The initial margin is a guarantee that must be placed with the clearing house before a position can be established. On gas, one must send 60% of the contract value as margin, which means that a certain number of players are driven away. And the vicious circle is set in motion since the lack of liquidity increases the size of the variations which increases the margin calls ...
In such a context, market movements become disconnected from reality. In the gas market, there were three peaks, in September and December 2021 and in March 2022, and none of them corresponded to a fundamental change between supply and demand. All three spikes were related to companies that could no longer pay their margin calls and were forced to roll over their position before defaulting.
The same thing happened with metals. Nickel went from $30,000 to $100,000 a ton in a matter of hours simply because of a massive short sale that went wrong with the invasion of Ukraine. We are in an unprecedented situation where healthy economic and industrial players, whose prospects have even improved, may have been put in trouble because the unprecedented increase in initial margin calls resulted in exceptional cash flow requirements.
The introduction of circuit breakers as a potential solution
Another problem is that financial commodity markets are linked to the real world, either through a physical delivery system or because they are used as a reference for pricing in commercial contracts. When derivatives markets malfunction, they end up passing on their higher cost to the physical market and the real economy.
In the case of gas, a key determinant of electricity prices, the peaks have artificially increased the price of electrons and ultimately the production costs for European industry. The clearing was put in place to take the systemic risk attached to derivative contracts out of the banks and confine it to a place where it is better managed and monitored, but its operation needs to be adjusted to limit its perverse effects.
Some propose, for example, to improve the predictability of margin calls, whose pricing models are not known by financial actors, or to study ways to mobilize the assets of healthy actors. Others propose introducing circuit breakers or a credit insurance system to reduce the level of margin calls.
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