The Futures and Options Association (FOA) says the European Capital Requirements Directive should not be imposed unamended on the commodities industry.
The FOA says it has long held the view that the quantum of risk posed to the financial system by commodity market participants, the commercial nature of their underlying business and the kind of assets held by them call for a differentiated prudential regime.
More particularly, says the Capital Requirements Directive (CRD), designed for deposit-taking and investment businesses, is not aligned to the risks faced by commodity market participants; and the regulatory framework does not take adequate account of the differences between commercial business and investment business.
The FOA’s position is the result of consultation with its members and is supported by a report commissioned by it from KPMG. In this report, KPMG observes that the capital requirements based on Pillar I of Basel 2 appear to be aligned specifically to the structure and practices of the banking industry and as such are not proportionate to the risks and market practices of specialists in the commodity derivatives markets.
“This report vindicates our longstanding view that the CRD should not be applied to commodity market participants in unamended form,” says Anthony Belchambers, Chief Executive of the FOA. “That said, it is equally important that the need to set a proportionate regulatory regime for one group of market participants should be extended to other market participants, where appropriate, and should be sufficiently risk-based to meet the need for fair and proportionate treatment of all commodity market participants.”
The report highlights several specific areas of concern relating to the core Pillar I risk categories of market, credit and operational risk:
Market risk calculations for commodity firms are impacted by a combination of spot price volatility on the physical underlying and seasonal peaks in commodity price, neither of which is considered by the current, bank-focused requirements.
Calculations for credit risk fail to consider settlement periods of at least 15 days often seen in physical markets, with significant penalties imposed on firms exceeding a 5 day settlement period. The relatively low number of industrial counterparties with external credit ratings creates further penalties, with no allowance made for the long established market experience of specialist firms within their own markets.
Existing capital calculations provide an incentive for commodity firms to adopt the less sophisticated Basic Indicator Approach over the more advanced Standardised Approach for operational risk.
EEC regulators have already expressed the view that some form of “light touch” regime may be appropriate for commodity market participants, and the FOA hopes that this paper will provide additional focus for the ongoing review currently being undertaken by the Committee of European Banking Supervisors (CEBS) and the recent Call for Evidence on the same issue by the European Commission.
Bill Wellbelove, Director, KPMG says the report noted wide consistency of views across the firms that participated in the survey. “Some were more advanced in their thinking than others, but there was general agreement on the difficulties in translating the financial sector risk framework for the commodities sector,” he says. “Our brief was to outline issues not to devise solutions, so we await with interest the outcome of the review that is now in progress at the EU Commission. We are very grateful to the FOA for giving us the opportunity to work on this report.”