The successive financial bailouts of the past few decades, necessary as they were, have created a growing expectation: Whenever there’s distress in markets, central banks must step in. Once focused narrowly on traditional banks, they’ve provided emergency lending to prop up markets ranging from Treasurys to high-yield corporate debt.
Firms trading oil and other commodities remain amply profitable, and their financing challenges are largely their own doing. The prospect of bailouts would only encourage risky activities at taxpayer expense. Jae C. Hong/Associated Press
Now, some are suggesting that they backstop commodities markets, too. It’s something that officials should do everything possible to avoid.
The business of trading and financing commodities plays a crucial role in the global economy. Traders buy oil, metals and the like from producers and deliver them to consumers in the place, time and form needed – a process that at any given moment entails holding hundreds of billions of dollars’ worth of bulky and sometimes toxic assets, much of it paid for with borrowed money. To hedge against price declines, and often to speculate, such companies also employ financial derivatives, which require posting a certain percentage of their exposure as cash collateral or margin – again, mostly borrowed.
This dependence on loans creates a vulnerability: If prices rise sharply, the amount of financing needed to move more-expensive commodities and meet increasing margin requirements can become daunting. That’s exactly what’s been happening in recent weeks, thanks to a convergence of events including Russia’s invasion of Ukraine and the resulting international sanctions. Prices of some items have spiked more than 100 percent, while margin demands have shot up as much as 10 times amid extreme volatility. Together with ongoing supply-chain snarls, which add to the volume of commodities in transit, this has placed intense strains on traders’ finances. To rescue one large trader and avert a cascade of defaults, the London Metal Exchange had to shut down for a week and cancel some $3.9 billion in transactions.
Fears are growing that a shortage of financing could disrupt the flow of materials to end users such as power plants and auto manufacturers, further stunting economic growth and worsening inflation. This has emboldened experts and traders – including a group representing companies such as BP, Shell, Vitol and Trafigura – to call for taxpayer backing, in the form of emergency credit lines from the world’s largest central banks.
Such an unprecedented intervention would be hard to justify. For one, the trading firms remain amply profitable, and their financing challenges are largely their own doing: Many operate with too little loss-absorbing equity, an approach that boosts returns in good times but renders them unduly fragile. The prospect of bailouts would only encourage such excessive leverage, at taxpayer expense.
Beyond that, commodities markets can handle a lot on their own. To some extent, the strains are already easing as some firms shrink and others negotiate new lines of credit. Even the largest trading firms, such as Glencore, are much smaller than Lehman Brothers was when it folded in 2008, and don’t have a similar mismatch between short-term borrowing and long-term investments. Albeit disruptive, past failures – such as those of U.S. energy trader Enron and Swiss grain merchant Andre & Cie, both in 2001 – haven’t had systemic consequences, as other participants have stepped in to fill the breach.
That said, there’s plenty authorities can do to make markets more resilient. They can press participants – including the clearinghouses that stand in the middle of most trades – to raise more equity. They can require more margin in calmer times, to mitigate the increases needed when crises hit. They can impose prudent position limits on derivatives, to prevent any single trader from becoming too dangerous. They can also design better circuit breakers to pause exchanges when prices move too much too fast, so participants have time to assess the situation and line up financing if necessary.
It’s possible to imagine scenarios in which central banks might have no choice but to intervene in commodities markets – for example, if a complete cutoff of Russian energy exports sent prices into the stratosphere. So far they’ve been reluctant to, and rightly so.
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