Analysis-With a looming liquidity crunch, Europe's energy crisis may worsen.
Europe's issues sourcing oil and gas this winter as a result of a disagreement with Russia may be aggravated by a new crisis in the market, where prices are already skyrocketing: a liquidity shortage, which might push them much higher.
However, European governments have only recently rallied to give financial assistance to power companies on the verge of bankruptcy, in an effort to relieve pressure on a market whose flawless operation is critical to keeping people warm.
"We have a broken futures market, which causes issues in the physical market, leading to higher pricing and more inflation," a senior trade source told Reuters.
The issue was initially brought to light in March, when a group of leading traders, utilities, oil companies, and bankers wrote to authorities requesting contingency measures.
This was caused by market participants scrambling to cover their financial exposure to increasing gas prices via derivatives, hedging against future price surges in the physical market, where a commodity is supplied, by taking a'short' position.
Market participants often borrow to establish short positions in the futures market, with banks providing 85-90% of the funds. The traders' personal money are used to cover 10-15% of the value of the short, known as minimum margin, and are put in a broker's account.
However, if funds in the account fall below the minimum margin requirement, in this case 10-15%, a'margin call' occurs.
As the price of electricity, gas, and coal has climbed in the last year, so has the price of shorts, requiring oil and gas giants, trading businesses, and power utilities to tie up more cash.
Some, particularly smaller enterprises, have been forced to cease trade entirely as energy costs skyrocketed following Russia's invasion of Ukraine in February, exacerbating a wider global shortage.
Any decrease in the number of participants diminishes market liquidity, which can lead to even greater volatility and sharper price spikes that can harm even big players.
Since late August, governments around the European Union have stepped in to assist utilities such as Germany's Uniper.
However, with winter price increases on the horizon, there is no indication of when or how swiftly governments and the EU would support banks or other utilities who need to hedge their bets.
According to top bankers and traders, exchanges, clearing houses, and brokers have increased initial margin requirements to 100%-150% of contract value from 10-15%, making hedging prohibitively expensive for many.
On Dutch TTF gas futures, for example, the ICE exchange charges margin rates of up to 79%.
Although market players believe that rapidly evaporating liquidity might significantly restrict trade in fuels such as oil, gas, and coal, resulting in supply disruptions and bankruptcies, authorities maintain that the danger is low.
Equinor, Europe's largest gas trader, warned this month that European energy businesses, excluding those in the United Kingdom, require at least 1.5 trillion euros ($1.5 trillion) to offset the cost of exposure to surging gas prices.
This compares to the $1.3 trillion worth of subprime mortgages in the United States in 2007, which precipitated a worldwide financial collapse.
However, one European Central Bank (ECB) policymaker told Reuters that the worst-case scenario would result in losses of 25-30 billion euros ($25-30 billion), adding that the danger resided with speculators rather than the market itself.
'THE NEED TO HEDGE'
Nonetheless, some traders and banks have sought authorities such as the European Central Bank (ECB) and the Bank of England (BoE) to issue guarantees or credit insurance to brokers and clearing houses in order to reduce initial margining requirements to pre-crisis levels.
According to those familiar with the discussions, doing so would help attract players back into the market and enhance liquidity.
The ECB and BoE have met with many large trading firms and banks since April, according to four trading, regulatory, and banking sources, but no specific measures have emerged from the talks, which were previously unreported.
"It's too much of a single point of failure for a bank. Banks have reached or are on the verge of exceeding their liquidity and counterparty risk thresholds "According to a senior banking source involved in commodities finance.
Banks have a certain amount of cash that they can tie up to a specific industry or player, and price surges and a decline in players are now testing those thresholds.
This month, ECB President Christine Lagarde stated that she would support fiscal measures to give liquidity to solvent energy market players, including utility businesses, and that the ECB was ready to lend liquidity to banks if necessary.
Meanwhile, the UK Treasury and Bank of England announced this month a 40 billion pound ($46 billion) funding program for "exceptional liquidity requirements" and short-term support to wholesale energy providers.
According to a Treasury official, the restrictions are being implemented at the proper time after carefully monitoring the market and in accordance with European counterparts.
However, the energy and commodity markets remain opaque, with physical exchanges hedged with financial instruments based on internal regulations established by the many corporations involved.
Furthermore, because no regulator or exchange keeps a central registry of deals, it is hard to view the entire picture, according to sources at many prominent commodities firms.
For some, though, the indications are plain.
"Open interest and volumes have decreased dramatically as a result of what is occurring on the margining front," Trafigura's chief economist, Saad Rahim, said last week at a conference.
"It will eventually have an influence on physical amounts traded because physical traders need to hedge."