The successive financial bailouts of the past decades, as necessary as they have been, have created a growing expectation: whenever markets are in trouble, central banks must intervene. Once narrowly focused on traditional banks, they provided emergency lending to support markets. ranging from treasury bills to high yield corporate debt.
Now some are suggesting that they are supporting commodity markets as well. This is something that officials should do everything possible to avoid.
Commodity trading and financing play a crucial role in the global economy. Traders buy oil, metals and the like from producers and deliver them to consumers where, when and in the form they need – a process that at any one time involves holding hundreds of billions of dollars of bulky and sometimes toxic assets, much of which paid for with borrowed money. To hedge against price declines, and often to speculate, these firms also use financial derivatives, which require them to deposit a certain percentage of their exposure as cash collateral or margin – again, mostly borrowed.
This reliance on loans creates vulnerability: if prices rise sharply, the amount of financing needed to displace more expensive products and meet rising margin requirements can become daunting. This is exactly what has happened in recent weeks, thanks to a confluence of events, including Russia’s invasion of Ukraine and the resulting international sanctions. Prices for some items soared more than 100%, while margin demands increased 10x amid extreme volatility. Coupled with ongoing supply chain issues, which add to the volume of goods in transit, this has put a strain on traders’ finances. To save a major trader and avert a cascade of defaults, the London Metal Exchange had to shut down for a week and reverse some $3.9 billion in trades.
Fears are growing that a funding crunch could disrupt the flow of materials to end users such as power plants and automakers, further dampening economic growth and worsening inflation. It has encouraged pundits and traders – including a group representing companies such as BP, Shell, Vitol and Trafigura – to call for taxpayer support, in the form of emergency lines of credit from the world’s biggest central banks. .
Such an unprecedented intervention would be difficult to justify. On the one hand, trading companies remain amply profitable and their funding problems are largely their fault: many of them operate with too little capital to absorb losses, an approach that increases returns in times of prosperity but makes them unduly fragile. The prospect of bailouts would only encourage such excessive leverage, at taxpayer expense.
Beyond that, commodity markets can handle a lot on their own. To some extent, tensions are already easing, with some companies shrinking and others negotiating new lines of credit. Even the biggest trading companies, such as Glencore, are much smaller than Lehman Brothers when it closed in 2008, and don’t have a similar mismatch between short-term borrowing and long-term investing. Although disruptive, past failures – such as those of US energy trader Enron and Swiss grain merchant Andre & Cie, both in 2001 – have not had systemic consequences, as other participants have stepped in to fill the gap. breach.
That said, authorities can do a lot to make markets more resilient. They can pressure participants – including the clearinghouses that sit in the middle of most transactions – to raise more equity. They may require more margin in calmer times, to mitigate increases needed in times of crisis. They can impose conservative position limits on derivatives, to prevent a single trader from becoming too dangerous. They can also design better circuit breakers to pause trading when prices move too fast, so participants have time to assess the situation and line up funding if necessary.
It is possible to imagine scenarios in which central banks might have no choice but to intervene in commodity markets – for example, if a complete cut off of Russian energy exports sends prices into the stratosphere. So far they have been reluctant, and rightly so.