07 October 2022

Bruegle's Lehmann: Volatile energy markets expose the fragility of Europe’s capital market infrastructure

Energy providers have traditionally protected themselves against wholesale-market volatility by trading on futures markets, increasing certainty about supply and prices for end-consumers. But with current energy-market uncertainty, energy providers are required to provide more collateral against the risk they will not be able to meet their commitments, implying the need for substantial liquidity. This threatens to further erode solvency in the energy sector and ultimately to disrupt physical supply.

Several countries have therefore offered substantial liquidity support to their energy providers, most notably Sweden and Finland (on 4 September; €35 billion), and the new United Kingdom government jointly with the Bank of England (on 8 September; £40 billion). Such support will inevitably be piecemeal, and could further fragment energy markets, because the fiscal headroom and political willingness to support the sector varies from country to country. At European Union level, the European Commission has said it is working on a reform of how the financial system interacts with Europe’s energy sector. This could have wider ramifications for Europe’s capital markets union.

A post-crisis push for central clearing

Via forward contracts and futures, energy providers commit to supply energy at a certain time and price. Traders guarantee to their counterparties the fulfilment of such contracts by holding an initial margin on deposit. As the underlying spot price goes up or down, that safety margin on a futures contract is adjusted through regular collateral calls, providing the same level of protection to counterparties at all times.

While futures contracts are regularly traded bilaterally on so-called over-the-counter (OTC) markets, they have increasingly moved to exchanges where trades are cleared through central counterparties (CCPs). This is also true for energy contracts, even though for these instruments clearing is largely voluntary under EU regulation. In cleared trading of energy contracts, the CCP sits in the middle of every transaction and becomes the buyer to every seller and the seller to every buyer. In this way, it ensures delivery of contracts. Initial margins, and margin calls as prices evolve, ensure that each member is protected through adequate collateral over the duration of the contract. CCPs now have a central role in defining margin policies and administering collateral calls.

In energy markets a considerable share of trades are cleared within the EU. Apart from ICE Clear Europe, which is based and supervised in London, German-owned European Commodity Clearing (ECC) and Sweden’s Nasdaq OMX Commodities Europe hold dominant positions. These CCPs and the exchanges that own them also play important roles in the physical delivery of energy on spot markets. This prominent role of EU CCPs in the clearing of energy contracts is very different from the situation with financial derivatives, for which the EU’s 15 CCPs play only a minor role and the bulk of trades are still cleared via two large CCPs in the UK.

Implications for financial stability

In both energy and financial instruments, CCP clearing supports financial stability. Complex webs of bilateral exposures and counterparty risks have been replaced by aggregated exposures managed by the clearing houses, which reap the benefits of netting and liquidity. The experience of stress in derivative markets during the onset of the COVID-19 pandemic seems to have vindicated this general policy assumption. As was well-known when CCP rules were drawn up, clearing houses re-distribute risks but may also themselves become a source of financial-system stress.

In principle, a CCP is highly protected. Given a ‘matched book’ of positions there is limited market risk in a CCP but plenty of counterparty credit risk. In the case of a member defaulting, the clearing house will allocate a ‘waterfall’ of losses successively to the collateral pledged by the firm, to its contribution to a default fund, contributions to that fund by other clearing members and ultimately to its own equity base. This seems to provide ample protection. Nevertheless, while tasked with a quasi-public good of financial stability, CCP governance is in fact geared towards safeguarding the interests of clearing house members (typically banks), among which large losses would be mutualised. Therefore, CCPs can and in exceptional circumstances do fail, as last witnessed in the collapse of the Hong Kong Futures Exchange in 1987, which presented the local government with a massive bill.

Margining requirements imposed by the CCP on its members are generally related to the level and volatility of underlying prices, which in European gas and power markets have risen steeply since February 2022 (Figure 1). While banks and other financial firms dealing in financial derivatives generally have access to central bank liquidity facilities, energy traders or other non-financial firms do not. To date, European banks have largely met the liquidity needs of energy traders through revolving credit lines. As the credit quality of the energy sector has been downgraded, this access to liquidity is by no means assured. Any credit constraints could quickly aggravate supply bottlenecks...

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