Discover more from Without Warning
Could the Fed Rescue Commodities Markets?
Section 13(3) need not bind.
The chaos in commodities markets—volatile prices, margin calls, price spirals, trading/exchange dysfunction—has thrust central bank crisis intervention back into the news. The main instigation was the letter from the European Federation of Energy Traders (EFET) this week calling for central bank (or other government/public) liquidity support for the wholesale energy markets.
EFET is a lobbying group which represents the likes of big energy producers (BP, ExxonMobil, etc.), commodities trading houses (Vitol, Trafigura, etc.) and other financial institutions (Citadel, Goldman, Merrill Lynch, etc.).
Commodities markets are in better shape in the U.S. at present, but still volatile. And they can get worse if US/EU/etc. sanctions ratchet further. Moreover, as shown in the few companies listed above, several players in European commodities have U.S. presences as well. (As always, a good place to start for the Fed is with central bank swaps, but these have seen no volume in recent weeks.) Last week, the SEC put out a staff statement reminding dealers “to remain vigilant to market and counterparty risks.” It encouraged market participants to “collect margin from counterparties to the fullest extent possible,” get further visibility into their counterparties’ portfolios, stress test their exposures, and more.
Could the Fed, in theory, set up a 13(3) facility to provide support to commodities markets? There are many constraints on the Fed’s Section 13(3) authorities, but just a handful of them would be especially relevant for such a commodities facility. I’ll take each of them in turn. But the answer is Yes.
The Fed board must confirm a finding of “unusual and exigent circumstances”
Russian invasion of Ukraine; official and market-driven sanctions on Russian oil, commerce, payments; LME shutdown; initial margins as high as 80% in some cases; gas prices skyrocketing; etc.
Bloomberg’s Javier Blas: “The Bloomberg Commodity Spot index earlier this month posted a weekly jump of more than 13% — the largest one-week price increase in data going back more than 60 years ago . . . The commodity market is trading risk, rather than supply and demand fundamentals. Liquidity is thin.”
Next. (Though, I don’t think the need/desire is there quite yet for the Fed. Things would have to get worse before we get to a space where the Fed obviously should set up such a facility. Nevertheless, the unusual and exigent standard could already be met.)
Any 13(3) lending must be “secured to the satisfaction” of the Fed (and “protect taxpayers from losses”)
The Fed must, essentially, expect no losses. This seems easily manageable in this case. In the case of producers, their hedges are typically partial—i.e., they have a much bigger pipeline of the asset (long) than they do in derivatives (short). For the trading houses and financial institutions, they have all kinds of easily pledged financial assets.
Lending against an incipient commodities “harvest” is classic classic central banking (“elastic currency”), and lending against financial assets is classic modern central banking.
(As an aside, the no-expected-losses standard only gets easier to meet to the extent the Fed gets any first-loss protection from the Treasury via its Exchange Stabilization Fund. The ESF, which had about about $50 billion in 2008 and $95 billion in 2020, has about $200 billion at the discretion of the treasury secretary, with approval from the president. Not clear the ESF would need to be involved, but modern 13(3) does require prior approval from the treasury secretary.)
The Fed “shall obtain evidence that such participant in any program or facility with broad-based eligibility is unable to secure adequate credit accommodations from other banking institutions”
This is much easier than is commonly assumed. For one, “obtain evidence” is not the same as “prove” (see, e.g., p. 12). The Fed can cite general market conditions to meet this standard, and need not do so at the individual borrower level. That is, the Fed doesn’t need to cite BP’s specific experience in credit markets to make the company eligible; it can simply cite the financial strains occurring in commodities financing markets in general and open a facility that BP can access.
In the Fed’s 2015 update to its Regulation A—its rule that implements Section 13(3), among other statutes—the Fed said the following:
Even in cases where the Fed has required each borrower certify that it lacks “adequate credit,” the Fed has taken care to remind the borrower that this does not mean no credit/markets access; it just means abnormal credit conditions. A particularly extreme version of this was the Fed’s 2020 Paycheck Protection Program Liquidity Facility (PPPLF), which came with a neutralizing effect on banks’ capital and liquidity ratios. The Fed specifically called out the capital benefit as making PPPLF credit “more adequate” than private market credit, and offered it as something borrowers could cite on their certifications:
The evidence commodities markets are lacking adequate credit is there:
The moves on commodity trader debt come amid a liquidity crunch; with commodity prices rising sharply and at their most volatile in years, traders have been under pressure from banks and brokers to post margin calls
At the current price of nickel, the brokers themselves wouldn’t be able to pay their margin calls, they told the LME. Four or five of the brokerages that are LME members would have failed, a shock that could have devastated the global metals industry. The price move on March 8 “created a systemic risk to the market,” the LME said two days later. The exchange had “serious concerns about the ability of market participants to meet their resulting margin calls, raising the significant risk of multiple defaults.”
Finally, the two constraints that would give the Fed the biggest burden of proof/political headaches in this scenario:
“any emergency lending program or facility is for the purpose of providing liquidity to the financial system”
The requirement that any Section 13(3) emergency lending be through a “program or facility with broad-based eligibility”
“any emergency lending program or facility is for the purpose of providing liquidity to the financial system”
The Fed would just need to make clear here that the emergency facility was not simply a response to the national spike in gas prices or other commodities prices. A 13(3) facility being used just to fight inflation would clearly be in violation of the statute.
The Fed would also need to be clear that this isn’t the Fed stepping in because banks increasingly dislike the reputation risk of climate-unfriendly lending or anything like that. This facility would be to meet the financial market liquidity aspect of the current commodities crisis: the spiking margin calls, price spirals, and breakdowns in trading. (From Bloomberg: “The World’s Biggest Commodities Markets Are Starting to Seize Up”)
To wit, the Fed’s 2015 Regulation A update says 13(3) lending needs to be for an “identifiable market or sector of the financial system.” Commodities clearing/trading easily fits that bill.
(As an aside, Regulation A is not strictly binding in the way Section 13(3) itself is, but, in this scenario, there’s not a clear reason to deviate from it.)
Indeed, the letter from the European Federation of Energy Traders that sparked this whole discourse specifically calls for government liquidity to flow directly to clearinghouse members “to allow them to buffer the impact of clearing houses margin calls (via cash payments) on market participants.”
(On emergency facility implementation: While it makes sense that industry players would try to say “look, the money’s not for US; it’s for our dumb banks that always need to be rescued and are squeezing us in this moment of global turmoil,” any such liquidity need not be structured that way. While it’s likely banks/other financial institutions would act as agents for the Fed to get the money where it needs to go and quickly, the loans need not be directly to the clearing members. Indeed, this would alter the structure of the Fed’s collateral-taking and would possibly complicate the banks’ risk/leverage. Lots of interesting design choices here… but easily tackled ones.)
Any Section 13(3) emergency lending be through a “program or facility with broad-based eligibility”
This one would be the trickiest. Indeed, we got a little preview of this during the pandemic crisis.
Tl;dr: There was significant controversy over the Main Street Lending Program (MSLP)—a 13(3) facility designed to encourage loans to mid-sized firms, which were too small for capital markets access and too large to be sufficiently aided by small business grants.
In late-April, the Fed and Treasury modified the terms to expand the eligible pool of MSLP borrowers, and the specific changes led to controversy that the Fed had done so to specifically target the oil & gas sectors.
In an August hearing of the Congressional Oversight Commission, Bharat Ramamurti—then a commissioner and now a deputy director on Biden’s National Economic Council—put it like this to Boston Fed President Rosengren:
A few weeks later, the Fed announced major changes to the program. Many of those changes lined up exactly with what members of the oil and gas industry had requested. That did not appear to be a coincidence. Shortly before the changes were announced, President Trump publicly promised that oil and gas companies would be taken care of. And then shortly after the changes were announced, the Energy Secretary went on TV and bragged about how he and Treasury Secretary Mnuchin had succeeded in getting the Fed to make changes that the oil and gas industry wanted.
In the line of questioning, Rosengren defended the modifications and pushed back on the notion that they were specifically for oil & gas:
This is a broad-based program. It has been a broad-based program from the start. 13(3) facilities require broad-based kinds of terms, and so it is not targeted at specific firms or specific industries. 13(3) facilities are not available for that kind of lending.
New details on this saga have also emerged thanks to Nick Timiraos—in his fantastic new book, Trillion Dollar Triage (p. 244):
. . . GOP senators pushed Mnuchin to offer a lifeline. In response to the pressure, the Treasury asked the Fed about creating a “distressed energy liquidity facility.” No way, said the Fed, shutting the idea down. [Director of the Fed’s Division of Financial Stability Andreas] Lehnert’s one-pager on the proposal pointed out the Fed could not help individual industries. “This is a terrible idea,” he concluded.
It’s true that the Fed can’t lend to a specific industry IF the rescue has nothing to do with solving a financial market liquidity problem (see above). That is, the Fed can’t set up a 13(3) targeted at one industry just because Larry Fink went out and made everyone with capital turn their backs on it. (In some sense, this problem is also prevented by the need for the Fed board to find “unusual and exigent circumstances.”)
Section 13(3) only requires that lending be broad-based. The Fed’s 2015 Reg A update defines this as assuring that at least “five persons are eligible to participate in the program or facility.” This standard would be easily met.
So, Lehnert was right that an oil and gas liquidity facility (the GOLF?) would have been at least inconsistent with Reg A, and quite possibly with Section 13(3). However, in Rosengren’s defense of the MSLP, it’s not clear he needed to be so defensive/explicit that the expanded terms of the MSLP were not intended to provide more effective accommodation of the oil and gas industry (though they very well may not have been).
For instance, the Fed’s TALF facility explicitly included as eligible collateral backing the asset-backed securities it purchased “commercial loans secured by vehicles and the related fleet leases of such vehicles to rental car companies.”
Does this inclusion constitute a bailout of the rental car industry? Or just a rescue program’s inclusion of another section of a targeted market that the Fed would have otherwise missed? Feels more like the latter to me.
I’m still not starting a blog, so I’ve turned off replies on here. But any thoughts are more than welcome on Twitter or via email. @stevenkelly49 - firstname.lastname@example.org