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Risk of more commodity price shocks ahead, warns G20 watchdog

Kitco News

(Kitco News) The G20's financial watchdog warned that more commodity price shocks could be in store after COVID-related supply chain issues and Russia's invasion of Ukraine.

"The commodities ecosystem is heterogeneous, opaque, and has several key financial vulnerabilities," the Financial Stability Board (FSB), which is the BIS-affiliated advisory body that coordinates financial rules for G20 economies, said in a report published Monday

The FSB's latest overview of the commodity sector focused on risks to the wider economy after a very turbulent 2022. Following Russia's invasion of Ukraine and the COVID-19 pandemic, commodities like European natural gas and metals doubled in price, while others like oil and wheat saw significant gains, triggering a spike in cash or margin calls.

"The COVID-19 event, subsequent supply chain bottlenecks, and the Russian invasion of Ukraine in February 2022 led to a surge in the price of key commodities and extreme volatility in some commodities and related derivatives markets," the report said. "This induced a spike in margin calls, resulting in an increased demand for liquidity by commodities firms and other market participants to meet those calls, and the emergence of liquidity strains in some markets."

In order to meet the new demand for liquidity, some commodity traders were forced to increase their use of bank credit facilities or borrow additional funds, the report pointed out.

"The juxtaposition of this concentration and interlinkages in the commodities sector – along with large and leveraged commodities traders, less standardised margining practices and opacity in OTC markets – could all come together to propagate losses," the report said.

Overall, the FSB concluded that there was no major market disruption besides the London Metal Exchange (LME) nickel. And the impact on the rest of the financial system was limited.

But there are some red flags to be aware of, including concerns over large and concentrated positions. One development to monitor is the migration of activity from centrally cleared exchange-traded derivatives (ETD) markets to largely uncleared over-the-counter (OTC) markets.

The goal of this is to reduce the funding liquidity risks associated with sudden increases in margin calls, the report said. But there are drawbacks, according to the FSB.

"Such a move has also increased counterparty credit risks in the commodities ecosystem. There are also indications that certain players in European commodities markets may have reduced their hedging of commodities prices due to the increased margin calls. While this again reduces funding liquidity risks, it raises commodities firms' market risks," the report described.

The G20's financial watchdog highlighted three areas of concern — the concentration of the commodities ecosystem, widespread use of leverage, and geopolitical tensions.

"The use of leverage can lead to liquidity stress in the event of margin calls on derivatives positions and collateral calls on short-term borrowing," the report explained. "There is opacity in some areas of the commodities sector, including OTC derivatives markets where it is difficult to obtain a full picture of the size or network of exposures across jurisdictions."

On heightened geopolitical tensions and macroeconomic uncertainty in an environment of tightening financial conditions, the report noted the increased risk of more price shocks in the commodity space.

"In the event that this happens, several important channels of contagion could become salient. CCPs and clearing members would need to make further margin calls, banks may choose to limit their credit exposures, and market participants might cut back their trading in both cleared and non-cleared markets," the report said. "These actions … could exacerbate liquidity mismatches in markets, thereby propagating shocks in commodities markets and perhaps the financial system more broadly."

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