ECB Investigates Use of Derivatives by Energy Companies

The European Central Bank (ECB) is investigating trillions of euros worth of derivatives used by energy companies to make bets on future power and fuel prices, to find out if such activity risks financial stability. ECB’s inquiry is prompted by Germany’s rescue of top gas importer Uniper, which like other energy firms hedged its exposures with derivatives worth tens of billions of euros, far higher than the value of the energy it sold. The rare investigation becomes the first such move in the European Union to see if such moves pose a wider risk to financial stability.

ECB officials has been concerned that energy companies have been acting like traders without the regulatory oversight applied to banks. There has also been a broader concern if energy companies’ use of complex instruments threaten financial stability.

Because of that concern, the central bank has widened its scrutiny to examine potential domino effects, including on the banks which it supervises.

The ECB fear that derivatives pose a risk because of the regular demands for lodging cash security to underpin trades, so that trading by energy firms could also damage banks.

One of the discussions centered on Uniper’s use of derivatives, especially regarding whether those compounded the company’s problems when Russia cut off gas supplies to Germany. Uniper reported a €40 billion loss for the first nine months of 2022, the biggest in Germany’s corporate history.

As gas prices soared this year, some traders and banks asked the ECB to help brokers and clearing houses, as they grappled with a liquidity crunch, estimated at €1.5 trillion.

While ECB President Lagarde said the bank was willing to provide liquidity to banks, it would not do the same for energy firms.

Still, indirectly, central banks could be left on the hook as a last resort lender. They could extend credit to banks, which then lend it to energy companies to cover trades.

Germany’s financial regulator BaFin said that the risks in derivatives trading by energy companies has long been under scrutiny and warned that any such company that had not applied for the relevant financial license was breaking the law.

EU policymakers have also suggested extending tough rules applied to banks to energy firms that trade derivatives.

Energy companies say derivatives are mainly used to protect themselves against swings in prices. If the market price falls far short of or soars past an option price, the cost of keeping this trade can jump for both sellers and buyers.

To ensure that deals are not derailed by price movements, traders lodge security, often cash, with clearing houses processing the deals. With recent price spikes, the demands for such ‘margin calls’ rocketed.

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