The European Commission has put forward recommendations on how to potentially increase the international role of the euro in traded energy markets, amongst other areas, in its staff working document on strengthening the international role of the euro—as part of the public consultation on the review of the Mifid11/Mifir regulatory framework.
Potential incentives may be offered to facilitate euro denomination in nascent commodity derivative contracts. These include a relaxing of position limits and pre trade transparency requirements—although it is not entirely clear how this can be sustainable for new contracts but not for incumbent ones—along with a mechanism to enable the transfer of OTC positions "on exchange".
While there is recent history of successful euro-denominated contracts across the markedly regional exchange and OTC traded European gas and electricity markets and in certain OTC petrochemical markets, the long-established crude oil and refined oil products markets are resolutely dollar-denominated.
Oil in euros?
Nonetheless, the Commission paper suggests that, in the case of "oil", there should be "engagement with PRAs and commodity exchanges" to discuss "the feasibility of establishing additional euro-denominated price benchmarks for refined oil products".
The difficulties associated with the creation of new contracts that might usefully embrace euro denomination are manyfold. Significantly more contract launches have failed than have been successful over the last 40 years of OTC and exchange traded markets history from inception.
The model where one or more market makers sponsor the ‘push’ of an initative—be it physical price linkage, a derivative or a whole marketplace—onto a target user base, rather than to respond to a market need, has been a classic and frequent cause of failure. Supply of an additional instrument has not, historically, tended to create its own demand in this context.
Searching for euro-denominated derivative contract opportunities in the refined oil products markets may well fall into this trap. Furthermore, the contracts that currently embed successful euro denomination tend to be broadly regional (national and intra-continental). Refined products markets in Europe are wholly global, with prices responding to both intra- and extra-continental factors and high levels of liquidity being significantly sourced from global arbitrage (e.g. spreads between locations in various parts of the world, even across the two main Ice and Nymex trading venues).
Liquidity crunch
While the Commission paper acknowledges that stakeholders who were consulted emphasised the need for new euro-denominated contracts to be "market driven", it also suggests that a benefit of "lower costs and risks of trading internally for EU businesses would ensue".
However, the effect of attempting to develop euro-denominated contracts in markets where dollar-denominated contracts currently operate could easily have the adverse effect of splitting liquidity, reducing it in both venues and, as a result, increasing the cost of risk management and decreasing market efficiency. The value of liquidity is often serially undervalued in certain non-market quarters.
There are clearly conditions existing where local or regional currency denomination in instruments make economic sense. These would include where a contract’s underlying physical commodity performs a regional, as opposed to global, function, where the contract is an ab initio undertaking and no alternative successful contract currently exists, and where a genuine demand-side need is apparent.
Bespoke solutions
Aside from markets dominated by local, national or intra-continental physical flows, such as gas and electricity, it is hard to see where useful and successful euro-denominated markets might be created. The slow burn of the recently created Shanghai Exchange oil contracts denominated in local Chinese currency may offer a lesson.
Even European pipeline gas has become a less clear-cut picture, given the increasing importance of international LNG flows and growing interconnected of the dollar-denominated US Henry Hub and Asian JKM prices. But, in a good example of both the market deciding and liquidity favouring incumbent contracts, European gas continues to trade in both euros, for the Dutch TTF market, and pounds sterling, for the UK NBP.
Indeed, whereas some purely international gas traders have voiced support for a single Euopean gas benchmark denominated in dollars to make global arbitrage easier, their European counterparts continue to prefer the existing TTF €/MWh and NBP p/th markets. Some of that is reluctance to move away from liquid instruments to a virgin contract. But it also plays to the specific conditions of the market—European gas traders have established expertise in managing EUR-GBP currency risk from many years of cross-channel trading and are unwilling to give up this competive advantage to purely dollar-experienced new entrants.
It will be important for the European Commission to ‘bark up the right tree’ in addressing this subject and to focus on, most likely regional, appropriate markets, given the hegemony of the dollar is unlikely to be easily overcome in markets where it is established. Otherwise, it risks directing valuable resources away from the more pressing issues and complexities of Mifid/Mifir in what is likely to be an ultimately futile effort.
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