JONES DAY TALKS®: Derivatives Market Volatility Brings New Concerns and More Regulatory Scrutiny

A turbulent global economy leaves financial institutions and other market participants in challenging positions as they try to hedge and protect their interests in an increasingly uncertain environment.

Jones Day partner Josh Sterling talks about the regulatory and legal issues faced by market participants in the volatile economic landscape.

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Read the full transcript below:

Dave Dalton:

Markets hate nothing more than uncertainty. Here in mid 2022, we're dealing with the lingering effects of a pandemic, supply chain issues, inflation at a 40 year high, rising interest rates, and of course, the conflict in the Ukraine. All that adds up to a lot of uncertainty and imposes challenging scenarios for companies and financial institutions and investors trying to protect their interests and the commodities and derivatives markets. It turns out there are some regulatory and legal issues players in these markets need to be aware of also. Stay here for some timely insights from Jones Day partner Josh Sterling. I'm Dave Dalton. You're listening to JONES DAY TALKS®.

Josh Sterling has 20 years of experience in the derivatives and securities markets, both as lead counsel to major companies and as a senior federal financial regulator. Josh represents clients that are active in the derivatives markets with matters before the US Commodity Futures Trading Commission or the CFTC, the US Securities and Exchange Commission, that's the SEC, and various self-regulatory organizations. And in fact, prior to joining Jones Day, Josh was director of the CFTC's Market Participants Division. Regular listeners know that Josh is an active and popular voice and contributor to JONES DAY TALKS®. Josh, thanks for being here today.

Josh Sterling:

Thanks, Dave. Always happy to be here talking to you.

Dave Dalton:

The last time I saw you and probably the last time we talked was in San Francisco back in March, Digital Assets Week, and Jones Day was a sponsor there. And that was quite the showing for Jones Day. You, Abradat, Dorothy Giobbe was there, Mark Rasmussen, and quite a crew from Jones Day. How did that event work out? It looked from a lay person's standpoint, I was there kind of watching, listening, interviewing people. In fact, we got a great video from you that tracked very well. We'll link to that from this podcast. But what were your impressions of that event? Did it work out how you'd hoped?

Josh Sterling:

Well, yeah, Dave, I thought it was great. Anytime you could get together and learn by listening from experts, it's a good thing. We were very happy to sponsor that program. It was put on by Juliet Media. We had a lot of people talking about where things were in March for digital assets. I think as we sit here in late June, particularly the last three weeks, the story for digital assets has taken an abrupt turn. We're in an area where about two-thirds of the market value, at least your cryptocurrencies, has fallen off.

But I think a lot of that conversation wasn't so much about froth, but about how the technology is really going to work over the long term and some good lessons there. I have to add to the murderers row of Jones Day lawyers you mentioned, we also had Nick Wittek in from Frankfurt and make the typical joke that he flew all the way from Frankfurt and his arms were quite tired when he landed.

Dave Dalton:

You know what? We talked to Nick also. In fact, Nick sat down with us twice, and that was kind of a last minute thing. I didn't know Nick was going to be in town and he was gracious enough to find us a couple of slides. Anyway, more specifically today, Josh, we're talking about volatility in the commodities markets and what the risks and issues are there. Let's just kind of lay it bare. We're in a weird time right now and markets hate nothing more than uncertainty. Here we are in the midpoint of 2022, aftermath of COVID, supply chain issues, the conflict in Europe, lots of factor into an investment decision. Tell us what's happening, generally speaking, in the commodities markets and why.

Josh Sterling:

Yeah, happy to do that. The story of this year in the commodities markets is all about supply chain and supply chain disruptions. That theme began, of course, with the global response to the COVID pandemic, where a lot of the developed world was effectively shut down. That, barely stated, wreaked some havoc on supply chains. Supply chains were normalizing, but then we had a situation earlier this year where essentially two major commodity exporting countries were more or less sort of taken off the block, in the case of Russia, due to international sanctions, which are continuing to ratchet up, there's a lot of talk about that, and then with Ukraine, which, of course, is defending itself from an illegal incursion by Russia, a war of aggression, and is sort of taking a lot of their productive capacity offline as well.

Not only in the example of crops, things that they mean to grow, but are involved in an armed conflict, but the foods that have already been harvested are essentially blocked by the Russian military, as I understand it. You look at two large exporters of a variety of important commodities. That would include oil and natural gas. It would include coal. It would include sunflower oil, which is a major additive for cooking, and of course, wheat. There are more commodities, but those are some of the major ones. When those come offline, you have to look to other sources of it if they're available or alternatives.

The example of sunflower oil, obviously the availability of that is decreasing dramatically. There's an increase in demand for substitutes like safflower oil and other things. We're experiencing these effects. Really we're talking about a major hit to the energy supply and the food supply. And that has a cascading effect out from their nearest trading partners to trading partners far away. What we'll see is a dramatic swing in availability, meaning scarcity of those things relatively speaking, and that is going to throw off the physical commodities markets, so the actual stuff that gets shipped or isn't shipped, I should say.

It's going to have a corresponding effect on the derivatives markets, where companies that produce those things or ship or use those things go to hedge their risks and their costs. It's beginning to get very expensive to do that. When I say it's beginning to get very expensive, I mean, it actually has been quite expensive for several months now to protect yourself against price swings on the upside.

Dave Dalton:

I like the example you gave about sunflower oil a second ago. And then it's not just that, it's people finding substitutes. The way these issues kind of spider web out, nothing is potentially protected from this stuff. There are issues and implications and repercussions that no one would think of right off the bat. It never dawned me. I don't know where sunflower oil is used, but suddenly someone's got to find something else, and therefore that market's impacted. And that's something people don't typically think about.

Josh Sterling:

Yeah, that's absolutely right. Markets for substitute goods are experiencing volatility and pricing and a general price upswing as well. And then there are things you don't think about at all. I'll give you an example. Ukraine is a major exporter of important ingredients for fertilizers, including to the United States. While you would say to yourself that the upper Midwest, which is a huge bread basket, as we all know, blessing this country to have so much good land for growing crops, you need fertilizer.

If there's not enough fertilizer available or it's prohibitively expensive, you're going to fertilize less and that's going to affect your crop yields. That can affect your crop yields here in the bread basket of America. That will have a knock on effect as well. Again, we're going to see perhaps lower yields out of those plantings and harvestings, and so the price will be higher for those goods when they come to market. As people look to hedge the risks of that, they will have increased difficulty or cost in doing so.

Dave Dalton:

We're going to talk about ripple effects that you might not expect, that you didn't see coming. There's volatility in commodities markets from things that aren't necessarily sourced from Russia or the Ukraine because people look for substitutes, et cetera, cetera. We're living in that kind of scenario right now.

Josh Sterling:

Yeah, that's absolutely right. The markets are behaving in ways that people would not have expected at the beginning of the year. That's led to increased challenges, not only to source the goods you need to run your business, but it's also led to challenges, again, in the derivatives markets when you go to hedge. It's becoming very expensive to hedge, for example, the downside risk, a decrease in price when the price of the actual good keeps getting higher and higher.

The reason for that is when you put on a hedge position, you say, "Okay, I need to protect against the downside risk of what I'm obligated to deliver," if the cost of the good is going higher and higher and higher, then the position you have, which is effectively a short position in the market, assumes that you're going to have to buy the good to deliver out at an incredibly high price. There are companies out there that are facing major producers, major suppliers that are looking at hundreds of millions of dollars of costs in terms of margin calls to keep open their short hedge positions.

Dave Dalton:

That's exposure. That makes somebody very vulnerable, doesn't it?

Josh Sterling:

It really does. You need to have cash or liquid securities perhaps to be available to sort provide to your broker to hedge those positions. You might find a situation in which if you're looking for a credit facility or to borrow money to do that, it might be incredibly hard to do that. What you have happening is there has been sort of a thinning out of our markets that means that there are fewer participants in the markets. When you have fewer participants in the market, that can contribute to larger price wings. Think of it about it's a shallower ocean, the waves are going to be bigger, relatively speaking.

To extend that metaphor, when you look at the sea of the commodities markets, you're starting to see really, really high waves because there's just fewer people out there trading. What's begun to happen is folks that would have to pay tens or hundreds of millions of dollars to protect themselves from price swings exiting the market and finding other ways to hedge. Indeed, at Jones Day, we've worked with some companies on ways to sort of hedge their risks without being in a market where they have to provide hundreds of millions of dollars of cash, borrowed or not, to keep their hedges open. We can achieve transactional solutions to this that are sort of tactical for a client reserve their cash and do other things.

But the bottom line is, even if it's true that you find a way to address the problem, you're still looking to buy, sell, ship, deliver, and use commodities in a market and in an economy where they're much less available.

Dave Dalton:

Have you ever seen it like this before? Our listeners know about your background with the CFTC and so forth and what you've done. You ever seen a situation or an environment like this? It's got to be a tough time to be a commodities trader, let alone a derivatives trader, right?

Josh Sterling:

Yeah, absolutely. I have. I was in government back in early 2020 when the orders came down that we were going to slowly spread by staying home and not traveling or going to work and such. There were some pretty immediate reactions to that. The economy had been doing really well at the time, so things were freely moving. Production was up, consumption was up.

And in particular, one of the spring contracts, futures contracts for West Texas Intermediate crude oil responded in a very odd way, which was there was so much oil coming out of the ground and being refined and being available that when it would show up to be stored, if the storage place for that oil, the delivery spot, Cushing, Oklahoma, it was priced futures contracts, you would have to actually give someone cash and the oil for them to take your oil. There was so little storage capacity left that it became uneconomic to provide the oil at that delivery point.

Dave Dalton:

You got to repeat that, Josh. Make sure everybody heard that. That's astounding, that situation you has described. You had to deliver the oil and then pay them to take it at this storage facility. Is that what I heard?

Josh Sterling:

That would've been true under that futures contract. At one point, it was $34 a barrel or something. I can't quite remember the exact price. But the thought of that is a mind bender. But when you step back, what that is is a very strong market signal to stop producing, take it offline. And that takes a while to work itself out, which is why you would get... The contract for a period of time went negative. That was a bit unusual to see for anyone. For those of us in government, we had to do a lot of learning about what that meant. The government, when I was at it, the agency looked hard at whether there were malefactors in the market that were exacerbating that or causing that to happen.

But from what I can recall, what it really was was a situation where people stopped using what was coming out of the ground on mos and that showed up as a pricing. That was unusual, and we may see things in the future that are similar to that. I was at a conference earlier down in Houston at the Futures Industry Association and our good friends there put on. Walt Luke and his team just do a great job of those things. I remember seeing a slide there from one group of speakers showing that it's possible for us natural gas by March of 2023, we may have exhausted our stores or nearly exhausted our stores in natural gas because there's only so much of it.

But fast forward to October and the way it's being priced is there could be, wait for it, an excess supply that could exceed storage capacity. We could see something like that all over again. Now, that's a projection, forward prices. It could be wrong, but it just shows you not only is that a huge swing, but it's such a huge swing. It reflects we might run low on gas. And then all of a sudden, we might have too much gas. You couldn't write a bunch of rules to smooth that out. I don't think the government could do too much about that. But market signals like that will create an incentive for people to try to get more natural gas online, if that's even possible.

It will discourage people from using natural gas if it's too expensive. If there's a way to curtail excess supply going into October, that will happen. But when you step back, it's crazy to see.

Dave Dalton:

Josh, let's talk about interest rates for a second. As we sit here towards the end of June 2022, the Fed got real aggressive with bumping rates, what was it, 75 basis points or something. There's talk of maybe more tightenings coming later this year. How does that ultimately affect the derivatives markets and what a client might want to do to protect himself herself?

Josh Sterling:

Yeah, absolutely. Interest rates do seem to be on the rise. That's a fact. I expect it'll continue as an effort to try and fight inflation. You're breaking out the economic or central banking playbook that was used most famously by Paul Volcker about 40 years ago.

Dave Dalton:

Reagan's guy, right?

Josh Sterling:

Yeah. There's an expectation that that will continue until inflation begins to respond by coming down. That will generally resolve. It certainly did in the 1980s in a recessionary period. We may be getting ourselves into a recession here. Rate increases could lead to that. Now, I am not an economist, nor am I a central banker, so I'll leave it at that. But basically what this will mean is that the cost of borrowing money will go up. I think that that rate dynamic will have an effect on how people look to hedge their interest rate risks.

Hedging your interest rate risks, the risk that rates can go up or down adversely, always important for a lot of people that frankly borrow money in the economy and seek to hedge their rate risks if they have a floating rate borrowing in the derivatives markets. I think that you'll basically see even more activity in the rates markets. That might be a market where we sort of see a greater degree of activity for people to hedge their risks. When you do see that, you tend to see a deeper market, and so maybe the waves won't be quite as large. I could be completely wrong about that, but that's my sense.

Dave Dalton:

No one would fault you for being wrong because this is a very odd time we're living in. That's for certain. But what you said seems to add up for me. Josh, let's talk about other than trading the future's markets, are there any alternatives to hedging commodities related risks? What might be the options there if someone doesn't have the stomach or appetite for wading into derivatives?

Josh Sterling:

Yeah, absolutely. As we talked about in the future's markets, so margin costs for keeping a short position open to hedge yourself against downward price movements, has been getting, in some cases, pretty uneconomic. The cost of that can vary a lot. Margin costs are dictated by two things. One is what the clearing house for futures positions you have open requires of your broker, your futures commission merchant, known as an FCM colloquially, and then the FCM's own assessment of your credit risk as one of its customers. But the clearing house increases margin requirements. Your broker probably will too.

Your broker may independently increase your margin requirements because the industry you're in, your credit profile, those sorts of things. There are options different from being in the futures market tho hedge your risks. If you're a commercial company, you could instead seek to hedge your risks through a swap transaction, which would not be in a futures exchange. If you are a commercial company, then there wouldn't be a regulatory requirement for you to margin that position to a set amount given bank or a number of banks if you're putting on multiple hedges, breaking it up, might be wanting to give you more favorable terms than a future's broker in the futures markets where they're responding to more direct regulatory requirements.

It's not to say that it's free or it's cheap, but it could be more economic to do something like that. Sometimes it can be difficult though if you have a features position on to get out of it quickly. We've been working with some companies to sort of create offsetting positions, wherein you have a trade one way that is incredibly expensive and you have a trade another way that can tend to cancel that out. There are a number of techniques, and we actually ran through some of these in a client commentary we put out just a couple weeks ago about responding to market volatility.

One thing we've seen as well, so we've talked about using swaps instead of futures, we've talked about offsetting futures positions, we've worked on this and we've seen it in the market as well, people are instead of using futures or in addition to using futures entering into options trades. A little bit different and can be somewhat more economic. There are ways to sort of chip at this problem that it's getting more expensive to hedge. I wouldn't say any of them is a total no cost solution. They're just sort of perhaps a little bit more efficient, a little less capital intensive. We've had a whole team of our colleagues in New York and various money centers working on these kinds of transactions for our corporate clients.

Dave Dalton:

Thanks for mentioning that commentary. We will link to that also. Listeners to this podcast can find a link to the commentary that Josh just referred to and you can go and read that. Thanks, Josh. I'd read it. It was quite good, so I'm glad we're bringing it back up to the surface. That's terrific. Let's talk about possible red flags. It's hard enough trying to run things and operate efficiently and so forth in this sort of market, but I'm certain there are kinds of activities could give rise to a CFTC exam. What might that be, or what should people be careful about?

Josh Sterling:

Yeah, no, thanks for that, Dave. Certainly that's another part of that commentary. You sort of have the everyday risk of, well, it's getting very expensive to hedge out there. What are our alternatives? We just talked about that, trying to do an offsetting position, using options, getting out all together, or to a great extent using swabs. There is an increased risk of CFTC enforcement and I think there's an increased risk of inquiries about trading activity by the exchanges on which you trade, so the futures exchange. I was actually on a panel at that FAA Conference in Houston with representatives of two of the major exchanges, CME and ICE Futures US, and we talked about that.

Their expectation was, and it was the sense of others at the industry, that there probably will be more investigations of trading activity. And that's for a few reasons. As we've talked about, the markets are thinner. There's more volatility. You sort of have larger waves and shallower seas. Whenever you sort of see outsize trading activity in a thinner market, that can lead to more questions about what's going on there. The questions that regulators will be asking sort of go around through all the classic issues about whether this is an orderly and fair market.

Is someone trying to manipulate the price, trying to manipulate the price during the trading day, during the closing period, the last 15 or 30 minutes when prices are being set and the trading for the day is shutting down? Are there efforts to manipulate? Are strategies going on that are intended to disrupt the orderly functioning of the market? If someone engaged in the most commonly known these days version of disruptive trading which is called spoofing, are they're trying to move the market in one way by putting in a bunch of orders they never mean to execute, while they're sort of sneaking in on the opposite side of the market to get the benefit of that fake activity?

Is there sort of any disruptive strategies going on in the market? They look very closely at that. Another thing people don't always think about in the derivative markets, but I think regulators will look at is, are people trading on the basis of material non-public information? Is there insider trading? Insider trading is still a new concept in the futures markets, barred from the securities markets where, look, it's stocks, it's bonds, they have intrinsic value. Those are capital appreciation markets, capital raising markets. People shouldn't try to profit on things they know about an asset. Derivatives markets are price discovery markets.

How much is something going to cost? That's really it. If you're trying to figure that out, you would normally want all available information in the market, including stuff that not everybody knows. That is being tested. It's been tested over the last 10 years or so since Dodd-Frank. Regulators will be looking closely at, okay, who are the large actors in this market right now? What has their trading activity been? And what's the basis for that trading? Are they getting information from others in the market that had a duty not to disclose it? And are they trading on that basis?

Basically taking the classic insider trading theories of misappropriation and applying it to the derivative markets, that's been done in a few cases in the last 12 years, or they might be looking, as they've done more so in the last couple years, at are you taking that information and giving it to someone else? Are you tipping somebody else? Is someone using that tip in a way to trade and profit? There's going to be a lot of policing around that. Regulators are very interested in that. It's not only the derivatives exchanges that are going to look at that, but it's CFTC as well. And finally, you can criminally violate our commodities laws and so you'll see US attorney's offices involved too. That has been the case in the past.

Dave Dalton:

Well, the insider trading thing, you said it very well, but I always associate that with the equity markets, the stock markets, and so forth. It never dawned to me. There are always bad actors out there, so I guess I shouldn't be shocked, but I'd never heard about that in this context. What can someone do to stay out of trouble? Everyone wants to stay out of trouble. What do you do to make sure you stay clear in terms of your practices and internal controls and so forth? What should a company do?

Josh Sterling:

From my time in government, I observed among companies that I was responsible for regulating different cultures and different tones to the top about the extent to which we're going to follow the rules. Some organizations I used to regulate, my sense was may have looked at things as well, it's simply a cost benefit analysis. Is the cost of a penalty three years from now less than the cost of me paying to implement a program to follow the rules better today? If it's economic to take the penalty later, we'll just do that. I literally saw that once in a communication from a company when I was in government.

That obviously got walked over to the Division of Enforcement. It became a focus. Other people really do mean to get it right. When you talk to the management of those companies, that attitude permeates down to the trading desks as well. Really having the right attitude and the right tone at the top is very important. The way you achieve that is through good training and good education of your traders. When I say traders, I'm not just talking about hedge funds and banks. Some of the largest trading platforms, desks in the world are at corporates and not just in the agribusiness or the oil industry or something.

They're everywhere. Educating your traders on what's right, what's wrong in the evolving views of the regulators and the prosecutors out there. Showing people some ripped from the headlines examples of people being criminally prosecuted for engaging in manipulative, disruptive trading or insider trading is a very effective way of communicating that. My understanding is that the tools companies have to surveil their own trading to look for red flags has dramatically improved over the last decade. You can use that to catch it on the back end too.

Those are all important things that sort of come together to create a framework where you have many approaches to trying to minimize and catch inappropriate behavior, suspect behavior. You really need to sort of a multi-pronged approach to try to minimize the chance that you're going to have bad actors. And if you do, to sort of catch them and then figure out what you're going to do. Are you going to do an internal investigation? Are you going to report the wrongdoing to the government in advance so you get self-reporting credit for any investigation that comes down the line? But giving yourself the space to respond before the regulators start calling is important.

Dave Dalton:

This, Josh, has always has been very informative. We could probably leave it right there. But I always ask you when we close, is there any key takeaway, anything else you want to say? Is there one thing a listener to this program should go away with?

Josh Sterling:

Yeah. Well, I'm pretty confident that those listening who have been and are in the commodities and derivative markets today don't need me to tell them that it's really volatile and that's putting stresses and strains on how they trade. Never come to the JONES DAY TALKS® Podcast for advice on how to put on economically sensible trading strategies.

Dave Dalton:

They're standard lanes here at JONES DAY TALKS®, right?

Josh Sterling:

That's right. What I would say is the things I worry about the most and indeed wwe're engaged in and some investigations of our clients is taking those steps to try to identify where your weaknesses are and your compliance and control framework and really try to work hard to get ahead of any problems in derivatives tradings that you might have. If those problems do arise, to be able to respond to them with a really good and crisp playbook. We've seen cases recently where the CFTC is charging companies with making false statements in the course of trying to close out investigation or to try and get a new product or a new strategy approved.

One way you can really lose credibility going into dealing with the government is if you're sort of speaking to them too fast and without all the facts and without being clear about what you know. I really think there are two messages here. One is continue to focus on all the tools you have available in your organizations to sort of try to prevent a violation of the rules or the law from happening. That's one. And I would say the second one is if you do have a situation where you think that there's a possibility that the rules or the law has been broken, really try to have a centralized playbook that allows you the space to gather the information and to respond to the regulators in a complete way.

It's very clear that you're telling them what you know and what you don't. You want to have a really crisp playbook on how to respond so it can go as smoothly as possible. Nobody wants to be in that situation. But if you are, you want to get out of it as clean a way as possible.

Dave Dalton:

For sure. Josh, stellar is always. Thanks so much for your time today. We'll leave it right there. But I have a feeling we're going to talk again soon, right? Anytime. You've got a blank check with us, my friend. Let us know when you want to talk more about this or anything related and you're always a great resource for our listeners. Josh, thanks so much for being here.

Josh Sterling:

Thank you.

Dave Dalton:

You can find a complete biography and contact information for Josh Sterling at JonesDay.com. While you're there, be sure to visit our insights page for more podcasts, plus videos, publications, blogs, and other timely content and information. Subscribe to Jones State Talks on Apple Podcasts, Spotify, and wherever else you find your podcast, which is almost everywhere. JONES DAY TALKS® is produced by Tom Kondilas. As always, we thank you for listening. I'm Dave Dalton. We'll talk to you next time.

Disclosure:

Thank you for listening to JONES DAY TALKS®. Comments heard on JONES DAY TALKS® should not be construed as legal advice regarding any specific fact or circumstances. The opinions expressed on JONES DAY TALKS® are those of lawyers appearing on the program and do not necessarily reflect those of the firm. For more information, please visit JonesDay.com.