Financial stability shaken by liquidity challenges in energy derivatives markets

In autumn 2022, the collateral requirements for energy derivatives increased energy companies’ short-term financing needs substantially. The Bank of Finland monitored the situation and assessed the financial stability risks related to energy derivatives markets.

Strong volatility in the prices of gas and electricity caused significant challenges for energy companies’ liquidity, i.e. their ability to meet their payment obligations. The growing collateral requirements in the derivatives markets also increased energy companies’ short-term financing needs.

The Bank of Finland considers it important to support this need for liquidity so as to avoid extensive liquidity problems that would undermine financial stability.

Collateral decreases the counterparty risk in derivatives transactions

Energy companies use derivatives, such as futures, to hedge their future profits against movements in the market price of energy. For example, an electricity producer can enter into a futures contract whereby it undertakes to sell electricity at a predetermined price in the future. The buyer of the electricity futures contract, in turn, undertakes to purchase electricity in the future at the fixed price.

Derivatives transactions are subject to counterparty risk, i.e. the risk that the other party to the derivatives contract is unable to fulfil its obligations. In order to manage counterparty risk, derivatives contracts are often subject to collateral requirements.

For example, the seller of an electricity futures contract may have to place additional collateral when the market price of electricity rises. If the seller is unable to supply the electricity it has promised, the collateral is transferred to the buyer who can then purchase electricity at the prevailing market price.

A significant share of derivatives transactions are conducted via central counterparties. As the term suggests, a central counterparty interposes itself between the so-called clearing members, becoming the buyer to every seller and the seller to every buyer. The task of the central counterparty is to manage counterparty risk by, for example, collecting collateral and maintaining a default fund.

Energy crisis increased collateral requirements to record high levels

In 2022, the collateral requirements of energy derivatives contracts cleared by central counterparties increased to record high levels due to the exceptionally strong volatility in electricity and gas prices as a result of the energy crisis. The situation escalated particularly in late August and early September when energy futures prices reached new highs.

The high collateral requirements strongly increased the short-term financing needs of electricity companies engaged in derivatives trading.

In early September, it was feared that financing needs would expand so much that they could create liquidity problems for energy companies engaged in derivatives trading.

Many countries, including Sweden and Finland, offered liquidity support in the form of loan and guarantee programmes to the companies engaged in derivatives trading. The Bank of Finland considered the support measures to be important, as they helped prevent extensive liquidity problems for energy companies, which could have undermined financial stability more extensively.

Energy derivatives markets could undermine financial stability as a whole

Energy derivatives markets could threaten financial stability if the liquidity problems of one or more companies engaged in derivatives trading spread to other parts of the financial system.

Problems could spread if, for example, a default by one of the central counterparty’s clearing members causes losses, and subsequently liquidity problems, for other clearing members.

In derivatives trades that have undergone central counterparty clearing, a default by one clearing member will trigger a default procedure.

The larger the losses caused by the default of the clearing member, the higher the likelihood that the collateral and additional collateral placed are insufficient for covering the losses. In this case, the other clearing members will have to participate in covering the losses.

Bank of Finland assessed possible financial stability risks in energy derivatives markets

In autumn 2022, the Bank of Finland analysed the potential effects on the banking sector, in particular, of contagion from the energy derivatives markets.

The spreading of problems to the banking sector would be highly risky for various reasons. These reasons include the domestic banking sector being large relative to the size of the economy. The domestic banking sector plays a major role in channelling funds to the real economy.

Domestic banks do not themselves operate in the Nordic energy derivatives markets. The risks to the domestic banking sector from a default by one or more participants in the energy derivatives markets are therefore indirect.

Numerous Nordic energy companies are engaged in trading in Nordic energy derivatives markets. In centrally cleared energy derivatives markets, a default by one or more energy companies could cause losses to other energy companies engaged in derivatives trading.

Extensive liquidity problems in the energy industry would, in turn, increase the credit risks for banks that have provided financing for the energy companies. The Bank of Finland thus assessed, in the course of the autumn, domestic banks’ claims on energy companies and lending to the energy industry.

Turbulence has calmed down for now but monitoring continues

The situation in the energy derivatives markets calmed down in September as futures prices levelled off and public support measures alleviated immediate fears of default. However, the root cause of the problems – the energy crisis – has not yet receded.

The Bank of Finland continues to monitor collateral requirements, market indicators and banks’ exposures to the energy sector.

The Bank also monitors developments in the international regulatory environment for energy derivatives markets and assesses regulatory proposals from the perspective of financial stability.