In Short

The Situation: The sanctions placed on Russia, a major exporter of commodities, as well as Russia's own blockade of Ukrainian exports, such as wheat, have caused a significant knock-on effect in the commodities markets, creating extreme volatility through supply shortages and large price spikes. This is on top of commodities supply chain disruptions caused by the global pandemic.

The Result: The sanctions and following blockade have also led to significant decreases in liquidity, a days-long commodities exchange shutdown, and large variation margin calls, leaving market participants scrambling for financing. These effects will likely lead to heightened scrutiny by regulatory agencies and the possibility of regulatory reform and increased law enforcement activity.

Looking Ahead: Market participants may need to seek alternative means of financing their hedges and should focus on operating well within the confines of current legal and regulatory limits, especially given ongoing derivatives market volatility.

Russia's invasion of Ukraine has disrupted the supply of many commodities. Prices of a number of commodities increased substantially from December 2021 to March 2022: crude oil prices and wheat prices increased by more than 50% while natural gas prices and coal prices increased by 200%. The 42% price spike of nickel led the London Metals Exchange (LME) to cancel various trades and suspend trading on several occasions. LME also suffered technology failures leading to further halts and resulted in traders withdrawing from the market after experiencing an erosion of trust.

The Russian invasion has exacerbated the effect of existing supply chain disruptions caused by the global pandemic and has caused countries to reevaluate their export commitments for key commodities, leading to upheaval in commodity-related financial markets. Volatility has increased while, at times, market participation has decreased. There are several evolving implications of these developments for derivatives markets and their participants. These conditions can bring to the fore regulatory and enforcement interest in financial activity conducted by market participants, making it more difficult than ever to execute hedging and other trading strategies.

This Commentary discusses the practical considerations firms should assess related to the market challenges caused by Russia's invasion of Ukraine. Firms active in commodities and related derivatives markets should prepare for ongoing margin calls and increased enforcement activity.

Responding to Margin Calls

Historic proportions have become the norm in variation margin calls for futures market participants as of late. As a result of more volatile underlying products, initial margins have also increased significantly. The margin calls, which usually require cash or cash-equivalent securities like U.S. treasuries, have financially strained market participants on the "wrong" side of the market. Of late, the "wrong" side of the market has generally included producers seeking to "lock in" or "hedge" elevated prices for commodities not yet available for sale by means of "short" futures. Although hedging is often a prudent or sage course of action, as the illiquid commodity rises in value, these hedges (or short positions) deteriorate in value and give rise to losses commensurate with the price increase on a one-for-one basis. These losses must be satisfied daily (or more frequently) by way of meeting variation margin calls. It is important that market participants be able to provide the liquidity to fulfill the margin call, as the CFTC re-affirmed the ability for margin to be called immediately as recently as May of this year and upheld the liquidation of contracts 20 minutes after the delivery of a margin call.

Compounding the financial stress from margin requirements established by futures clearinghouses, futures commission merchants (FCMs) and foreign broker equivalents typically require, by contract, additional customer margin and grant themselves broad discretion to demand margin.

Pursuant to these provisions, brokers have made large margin calls. Certain market participants utilized traditional bank debt to finance margin payments. The challenge with this response is that it is impossible to predict how much liquidity will ultimately be necessary due to a short hedge that poses unlimited liability. This challenge is exacerbated when there is no immediate means of monetizing the underlying commodity in the hands of a producer.

For their part, clearinghouses, FCMs, and markets generally appear to be weathering the storm tolerably well—setting aside the disruptions in the nickel/London Metals Exchange market. But the line between financial stress for certain market participants and financial contagion for the system as a whole is a thin one. And the line is made all the more narrow by the existence of massive amounts of private, physically settled forward contracts (which are for the most part unregulated).

Should margin calls continue, or should market participants wish to mitigate such a risk, market participants may benefit from the considerable flexibility afforded to them through other financial instruments. This flexibility may be realized through many strategies.

One strategy traces to the Dodd-Frank Act's margin requirements for non-cleared swaps. End-users hedging actual economic exposure are exempt from the uncleared margin requirements of the Commodity Futures Trading Commission (CFTC) for swap dealers as well as from the parallel margin regimes for swap dealers regulated by the "prudential regulators," which include the Federal Reserve Board (FRB), the Federal Deposit Insurance Corporation (FDIC), and the Office of the Comptroller of the Currency (OCC). As such, end-users may freely negotiate credit support arrangements with trading counterparties. End-users employing this strategy should be mindful that swap counterparties are often sophisticated risk managers. Because of that, end-users are unlikely to find favorable credit support terms using off-exchange swaps in lieu of futures, but the point remains these are purely commercial arrangements not dictated by regulation.

Another alternative for producers seeking to hedge their production may be to use a strategy that involves purchasing put options that, like short futures or swaps, decline in value as the price of the underlier rises. Importantly, the value of the options will not fall below zero because they confer the right, but not the obligation, to sell at the strike price. The option buyer pays a premium as the purchase price of the option, but this sets the maximum loss on the trade. This strategy, employed by some producers at the onset of the Ukrainian conflict, may help to explain the move to options on futures immediately following the invasion.

Effecting an exchange for a related position is a strategy available to market participants that have already transacted in futures contracts with spiraling losses. This strategy involves a special off-market transaction offered by exchanges in which an equal and opposite futures contract is arranged, effectively canceling the original exchange-traded position. The original position is then replicated by an off-exchange instrument, taking the form of a swap or forward contract.

Heightened Enforcement Risks

The CFTC will likely give greater focus to certain commodity market participants. Consistent with past periods of market turmoil, this focus is often prompted by demands from aggrieved market participants and consumers. The result may be congressional hearings, additional pressure on financial regulators, as well as CFTC market studies and investigations commensurate with the length and severity of the extreme market activity. The response of Congress and the CFTC to the crude-oil price spikes in 2008 provides an analogous corollary.

In light of market conditions stemming from the ongoing crisis in Ukraine, market participants can expect the CFTC's vigorous pursuit of certain misconduct, including: (i) insider trading; (ii) market manipulation; (iii) disruptive trading; and (iv) position limit violations.

First, the CFTC considers volatile markets ripe for fraud and insider trading. The CFTC prohibits insider trading on the basis of material, nonpublic information in breach of an existing duty, or that was obtained by fraud or deception. Likewise, the CFTC prohibits insider trading by way of misappropriating material, nonpublic information. Recently, the CFTC and the Department of Justice brought insider trading actions for misappropriating confidential block trade order information against market participants in connection with tips from certain brokers. Insider trading enforcement is likely to continue to be a focus of exchanges, regulators, and criminal law enforcement bodies given the current market volatility in less liquid markets, where it is at least plausible that inside information could lead to larger price swings and associated profit opportunities.

Second, the CFTC has a history of scrutinizing market manipulation in times of low supply. Supply shortages make it easier to successfully carry out a squeeze or a corner and create artificial prices. A squeeze occurs when an investor seeks to control enough of a commodity's supply to drive the price up by the activity of others. A corner occurs when an investor secures a degree of control of a commodity in order to personally control the price of the commodity or arrange for the delivery of more commodities than are available. As a result of supply shortages, some manufacturers have sought to arrange for a sufficient supply of a commodity to maintain production or increase production to meet increased demand. Those manufacturers may inadvertently procure such a large percentage of supply as to draw unwanted attention for its impact on market prices and potentially face a market manipulation inquiry.

Third, the CFTC indicated that the bar may be lower for charging a disruptive trading violation when markets are thinner. For example, if a market participant whose trading ordinarily constitutes five percent of a given futures market on an average day suddenly constituted 50% of a given market, its trading could more easily move the market even if its strategy remained the same. Market participants could thus stand out given the CFTC's data-driven approach to uncovering market misconduct, which has been of particular use in recent CFTC spoofing investigations and settlements.

Fourth, position limits may be more of a focus at the CFTC, particularly if aggravating factors are present in light of supply constraints. Although position limit violations are typically handled by the futures exchanges and result in relatively small financial penalties, the CFTC also brings position limit actions in more serious instances. Market participants should therefore be mindful not to run afoul of position limits.

(For additional background information on DOJ and CFTC enforcement approaches to commodities fraud and market manipulation, as well as how companies can prepare themselves, please see our previous Jones Day White Paper exploring those topics in greater detail.)

Two Key Takeaways

  1. The sanctions imposed on Russia have led to tremendous volatility and large margin calls in futures markets that have caused trades to be cancelled or suspended and traders to withdraw from the markets. Different strategies may help market participants respond to margin calls.
  2. The volatility of the commodities markets resulting from Russia's invasion of Ukraine is likely to prompt the CFTC to focus on misconduct, creating a heightened risk of regulatory enforcement.