Key point summary 1. The vast majority of transactions to buy and sell commodities are conducted in the physical forward markets.

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1 Cross-Border Physical Commodities Coalition White Paper Regulatory treatment of Commodity forward contracts for physical delivery The Cross-Border Physical Commodities Coalition is a diverse group of participants in the physical commodity markets, such as producers, commercial users, merchants and traders, who work together to promote efficient commodity markets, including the sale and purchase of physical energy, agricultural and metals commodities, by working with regulators to address issues unique to physical commodities in the global markets. 1. Introduction Every day, billions of euros of agricultural, energy, metal and other commodities are bought and sold on the basis of commodity forward contracts providing for physical delivery. Commodity physical forwards link the commodity producer, merchandiser and consumer. They facilitate efficient, low-risk transactions across borders and time. Forward contracts are essential for the exchange of a commodity on specification, on time and at an agreed price. They are the foundation of international commerce. Yet there is a worrying trend towards regulating commodity physical forwards in the same way as financial instruments. Such regulation could bring commodity physical forwards within clearing, trading and additional reporting requirements designed for OTC derivative contracts. It could subject commodity physical forwards to position limits, position reporting requirements and rules on inside information designed for commodity derivative contracts. It could give rise to additional, unnecessary and overburdensome risk management requirements including collateralisation and capital requirements. The trend towards regulating commodity physical forwards as financial instruments is driven by misconceptions about the economics, structure, component parts, use and users of commodity physical forwards. There is no evidence that such regulation is or would be appropriate for commodity physical forwards. Such regulation could significantly disrupt international commerce and cause unprecedented market dislocation globally. This paper makes the case against the ill-considered application of financial regulation to commodity physical forwards in any regulatory context by any jurisdiction. In particular, this paper provides an overview of the global physical commodity markets and the primary types of transactions through which commodities are bought and sold. It summarises the key characteristics which are typical of commodity physical forwards and describes how commodity physical forwards are entered into and delivered. It explains why and in which circumstances commodity physical forward contracts may be fully or partially cash settled. Furthermore, the paper distinguishes between commodity physical forwards and commodity derivative contracts. It contrasts the characteristics of typical commodity physical forwards and commodity derivative contracts including differences in users, risk management and regulation. It challenges the misconception that commodity physical forwards and commodity derivative contracts are substitutes for each other and should therefore be subject to the same regulation. Lastly, the paper summarises the costs and consequences of extending financial regulation to the physical market and advocates for a differentiated and proportionate regulatory treatment of commodity physical forwards. It makes the case why commodity physical forwards should be neither considered nor regulated as financial instruments and, consequently, mandated to comply with clearing, trading, reporting and position limits requirements applicable to derivative contracts. 1

2 Key point summary 1. The vast majority of transactions to buy and sell commodities are conducted in the physical forward markets. These markets are essential to enable commodities to be delivered on specification, on time and at a pre-agreed price, which in turn allows producers, consumers and merchandisers to plan the buying and selling of commodities. This is important given the heavy logistical requirements and investment in infrastructure needed to manage the supply chain that allows commodities to reach end consumers. 2. A series of physical activities must take place to enable each commodity physical forward transaction. Even if an increasing number of commodity physical forwards are entered into on electronic trading platforms, the fundamental nature of the commodity physical forward markets has not changed. Analysis that focuses on the transaction formalities or the method or venue for transacting will therefore fail to observe the most important factors that distinguish physical transactions from financial derivatives. 3. Parties to commodity physical forward contracts must always be able to make or take delivery of the underlying physical commodity. Although the vast majority of commodity physical forwards result in the physical delivery of the underlying commodity, there are circumstances where it makes sense for such contracts to be fully or partially cash settled, for instance (i) where counterparties have multiple offsetting positions with each other, (ii) where there is a failure in the delivery of the commodity, or (iii) to adjust the quantities of product purchased to match forecasted changes in commercial needs. In these cases, cash settlement allows parties to avoid costly inefficiencies and reduce environmental and other liabilities arising from redundant deliveries of commodity. Cash settlement in these circumstances does not transform the transaction into a speculative investment and does not alter the original intent to make or take delivery of the underlying commodity. 4. Commodity physical forward markets and commodity derivative markets have different functions. The function of the commodity derivative markets is to transfer price risk to allow market participants to manage price risk or to make speculative investments, whereas the function of the commodity physical forward markets is to allow the transfer of ownership of the underlying physical commodity on specification, on time and at a pre-agreed price. 5. Commodity physical forward markets and commodity derivative markets have distinct users. Parties to commodity physical forward contracts must be able to and must stand ready to make or take delivery of the underlying physical commodity. Therefore users of commodity physical forwards must ascertain whether they have access to the ancillary infrastructure and the logistics necessary for physical delivery to take place. Participants in the commodity derivative markets include any entities wishing to engage in hedging or speculative investments in those markets. 6. Transactions in commodity physical forwards and in commodity derivatives give rise to different kinds of risk. Physical transactions give rise to counterparty performance risk which does not apply to financial transactions therefore the tools used in the financial markets to manage credit risk are not sufficient to manage the risks of physical transactions. 7. Transactions in commodity physical forwards and in commodity derivatives are and should remain subject to different regulatory regimes. Commodity physical forwards are subject to broad-based laws, statutory obligations and regulations that reflect their use by commodity producers, traders and consumers for buying and selling physical commodities. Every aspect of the physical transaction is regulated. Financial instruments, such as commodity derivatives, are subject to different regulation that reflects their use by financial market participants to manage price risk or make speculative investments. 8. Commodity physical forward markets and commodity derivative markets are not substitutes for each other. Physically delivered futures contracts are not substitutes for the physical characteristics of the physical product; commodity physical forward markets cannot be used to substitute activity in the futures markets, given the logistics requirements inherent in commodity physical forward transactions. 9. Commodity physical forwards are not financial instruments and should not be regulated as such. The application of financial markets regulation to commodity physical forwards would mean that nonfinancial commodity market participants whose main activity is the buying and selling of physical commodities would be obliged to comply with burdensome financial regulation that was not designed for these market participants. Ultimately, the effect of such regulation would be to substantially increase the cost of physical commodities for processors, manufacturers and consumers. 2

3 2. The global trade in physical commodities 2.1. Overview of global physical commodity markets Every day, billions of euros of agricultural, energy, metal and other commodities are bought and sold by commodity producers, commodity merchants and commodity consumers worldwide. The term commodity is conventionally understood to cover a broad base of physical goods that can be delivered, including agricultural and soft commodities, base and precious metals, energy such as coal, gas, oil, electricity and crude oil refined products. The scope of the definition of commodity varies across jurisdictions. In EU legislation, commodity has been defined as any goods of a fungible nature that are capable of being delivered, including metals and their ores and alloys, agricultural products, and energy such as electricity. 1 In the United States, commodity is partly defined by opposition to financial instruments, with direct reference to a list of hard and soft commodities. 2 Other jurisdictions such as Singapore have adopted more flexible definitions, including financial instruments and indices within scope. 3 For the purposes of this paper, we understand commodity as including the broad base of commodities listed above, but as excluding financial instruments and indices. The definition of financial instrument also varies across jurisdictions. In the EU, the term is expansively defined to cover a wide range of derivative instruments in addition to securities, moneymarket instruments, indices, and units in collective investment undertakings. 4 In the United States, financial instrument is broadly defined as a financial contract 5, whereas in Singapore the definition is more prescriptive and leaves room for interpretation by regulators. 6 In this paper, the term financial instrument is used to describe cash instruments such as securities, loans or deposits, as well as derivative instruments such as options, futures and swaps, but importantly excluding commodity forward contracts for physical delivery. Participants in physical commodity markets include producers, processors, consumers, commercial users and merchants handling commodities. Producers and processors use the markets to sell their output, whereas processors, consumers, and commercial users use them to purchase their inputs. Any commodity bought or sold has specific characteristics relating to its physical qualities, the time of its delivery and the place where it will be available. The ability to define these is essential to the buyers and sellers of commodities and plays a pivotal role in allowing commodity market participants to be able to plan accordingly. Producers, merchandisers, consumers and other commodity market participants are spread around the globe. Physical transactions therefore necessitate the transportation of commodities from producers to consumers. Complex infrastructure has been put in place around the globe in order to manage the logistics of the supply chain that connects producers and consumers in different parts of the world. For crude oil to reach consumers, infrastructure must be in place to allow for the exploration, production, transportation, refining, storage and distribution of oil. For natural gas, this includes infrastructure for exploration and development, production, treatment, transportation, compression, storage, pressure reduction and generation / distribution of gas (including LNG). Physical transactions inherently carry with them all the aspects of the logistics of the supply chain that connects producers and consumers Transactions in physical commodities 1 Article 2(1) of Commission Regulation (EC) No 1287/2006 of 10 August 2006 implementing Directive 2004/39/EC of the European Parliament and of the Council as regards record-keeping obligations for investment firms, transaction reporting, market transparency, admission of financial instruments to trading, and defined terms for the purposes of that Directive, OJ L 241, [ MiFID implementing Regulation ]. 2 Commodity Exchange Act 1a(9), 7 U.S. Code 1a(9) [link]. 3 Securities and Futures Act (Chapter 289, 2006 Rev Ed) Part I 2(1) [link]. 4 Annex I, Section C of Directive 2004/39/EC of the European Parliament and of the Council of 21 April 2004 on markets in financial instruments amending Council Directives 85/611/EEC and 93/6/EEC and Directive 2000/12/EC of the European Parliament and of the Council and repealing Council Directive 93/22/EEC [ MiFID ] [Link]. 5 Dodd-Frank Wall Street Reform and Consumer Protection Act, Section 151(8) [link]. 6 Securities and Futures Act (Chapter 289, 2006 Rev Ed) Part I 2(1) [link]. 3

4 Spot contracts for physical delivery Some physical commodities are bought and sold on the basis of spot contracts for physical delivery with immediate delivery of the commodity from buyer to seller. In EU legislation, a spot contract is defined as a contract for the sale of a commodity, asset or right, under the terms of which delivery is scheduled to be made within the longer of (a) two trading days or (b) the period generally accepted in the market for that commodity, asset or right as the standard delivery period. 7 In the United States, spot commodity is described as the actual commodity distinguished from a futures contract and is sometimes used to refer to cash commodities available for immediate delivery. 8 In Singapore, spot commodity trading includes the purchase or sale of a commodity at the spot price where physical delivery is intended. 9 In this paper, spot markets are understood to mean markets in which goods are cash settled at current market prices and for prompt delivery. Given the specification requirements of buyers and sellers of most physical commodities, spot markets are rarely used for the physical delivery of commodities. It is often not feasible to rely solely on spot transactions, as there will inevitably be only a limited amount of a commodity of the desired specification at the required location available on the spot market. And even where feasible, reliance on the spot market is risky. For producers, total reliance on the spot market may create unacceptable volatility and provide insufficient assurance of offtake. The availability of supply may place constraints on offtake infrastructure, thereby limiting the ability to move production to consumers. For consumers, the importance of maintaining consistent supply together with the time needed to deliver commodities from where they are produced to the point of consumption makes it highly risky and unwise to rely solely on the spot market. For merchandisers, spot markets will often not provide the necessary certainty of activity to allow making investments in the infrastructure and logistics needed to connect producers and consumers. Therefore, spot contracts for physical delivery are broadly used only in a few commodity markets, such as the power and gas markets, where infrastructure is available to facilitate the delivery of these commodities. In other commodity markets the use of spot markets for physical delivery is mainly confined to trading limited amounts of commodities that participants have been unable to buy or sell through longer term commitments. Forward contracts for physical delivery Given the above-mentioned limitations of the spot markets, forward markets are necessary to meet the needs of market participants wishing to undertake physical transactions. In fact, the vast majority of physical market transactions are conducted on the basis of forward contracts for physical settlement. Essentially, a commodity physical forward is a contractual agreement between the buyer and seller for the forward delivery of physical assets. Commodity physical forward contracts allow counterparties to agree terms (including the purchase price) for physical commodities today so they may then be stored, loaded and transported to an agreed delivery point at a forward date. These contracts are essential to allow producers, consumers and merchandisers to plan the buying and selling of commodities as well as the related logistical requirements, in the future. Commodity producers are thus enabled to pre-sell commodities prior to harvest, generation or extraction, which is essential for the producer s cash flows, planning and investment. Commodity consumers are enabled to buy commodities for forward delivery, which is essential for the consumer s supply chain, manufacturing, inventory and sales. Commodity merchants are enabled to underwrite investments in the logistical infrastructure, such as transportation or storage facilities, because physical forward contracts provide them the certainty over the necessary levels of activity to make those investments. Commodity physical forwards are indispensable for the exchange of a commodity on specification, on time and at a pre-agreed price. Derivative contracts for physical delivery 7 Article 38(2) of the MiFID implementing Regulation. 8 U.S. Commodities Futures Trading Commission, a guide to the language of the futures industry [link]. 9 Commodity Trading Act (Chapter 48A, 2009 Rev Ed) Part I, 2 [link]. 4

5 In very limited circumstances, physical market transactions can be conducted through the futures market. However, the percentage of physical market transactions conducted through this market is marginal as the overwhelming majority of futures contracts are cash settled. In fact, futures markets are mainly used for risk management, hedging or speculative purposes. Physical transactions in the futures market are delivered into central regulated delivery points or hubs that are often inaccessible or costly and difficult to access for producers and consumers. It is not efficient to use these markets for the physical delivery of commodities, which is why market participants do not rely on the futures market for this function Commodity physical forwards Characteristics of commodity physical forwards A commodity physical forward is a contractual agreement between buyer and seller for the forward delivery of physical assets necessitating carriage through commerce and change(s) of custody. These contracts have existed for centuries reflecting the fact that commodities need to be shipped around the world from producers to consumers on a daily basis. Commodity physical forwards may be based on common templates or established general terms and conditions depending on the customs of the particular physical commodity market. Commodity physical forwards will often reference underlying or related agreements on transport, delivery, security, tax treatment, specifications and inspection of the commodity being bought and sold. They will usually include provisions to protect counterparties and offset losses in the case of default, force majeure or other termination event. Commodity physical forwards are usually physically delivered although contracts may often be netted or may be settled in cash in specific prescribed circumstances. Execution of commodity physical forwards Commodity physical forwards are entered into bilaterally. While the methods of communication for entering into commodity physical forwards have evolved with the introduction, first, of the telephone and now computers, electronic trading platforms and other electronic devices, the bilateral nature of commodity physical forwards has not changed. Regardless of whether electronic trading platforms or other electronic trading mechanisms are used to enter into commodity physical forwards, a series of physical activities must take place to enable each commodity physical forward transaction, such as the loading of the commodity on to a vessel, the transportation of the commodity to its delivery point and the transfer of the commodity to the buyer s facility. Commodity physical forward contracts remain physical transactions, and as such, they carry with them all aspects of the supply chain and related logistics that connect producers and consumers. Most importantly, the identity of one s counterparty is critical in commodity physical forward transactions because of the necessity of ensuring delivery of product that meets agreed specifications, that is properly sourced in compliance with applicable laws, with taxes (if any) paid on time, and at the agreed delivery locations. Analysis that focuses on the transaction formalities, the transaction method or venue for transacting will therefore fail to observe the most important factors that distinguish physical transactions from financial derivatives. Settlement of commodity physical forwards Unlike parties to futures contracts and other derivative contracts, the parties to commodity physical forwards enter into such contracts with the knowledge that they must be able to, and must stand ready to, make and take delivery of the underlying commodity in accordance with the terms of the relevant transaction. The primary effect of a commodity physical forward is to transfer ownership of the underlying commodity and not just to transfer the price risk of the underlying commodity. As a result, physical forward contracts contain complicated terms relating to the mechanics of delivery that would not be found in a commodity derivative transaction. Although the vast majority of commodity physical forwards result in the physical delivery of the underlying commodity, there are circumstances when such contracts are fully or partially cash settled to address issues that are specific to the physical markets and the production and delivery of physical commodities. These circumstances include, among others: 1. Physical constraints or events that limit a seller s or a purchaser s ability to make or take delivery of a contracted commodity; 5

6 2. Changes in anticipated market demands that reduce or eliminate a party s need for commodities that it has contracted for pursuant to one or more commodity physical forwards; 3. Parties having entered into multiple off-setting independent commercial transactions for the purchase and sale of commodities that would result in redundant delivery obligations; 4. The failure of the underlying commodity to meet the specifications set forth in the applicable commodity physical forward transaction; and 5. A default by a party pursuant to the terms of a commodity physical forward transaction and, on rare occasions, the occurrence of a force majeure event with respect to a party. If parties were unable to cash settle their commodity physical forwards to address these circumstances, they would be subject to costly inefficiencies that would have an adverse impact on their businesses and on the commercial markets within which they operate. It would not be efficient or cost effective for a party to be required to take delivery of a commodity it no longer needs for its business and to incur the costs required to store and resell such commodity. It would not be efficient for parties to deliver differing quantities of the same commodity to each other for the same delivery period under separate contracts. It would not be efficient for a seller or purchaser to be declared in default under a commodity physical forward because it has become impossible for such party to make or take delivery of all or a portion of the contracted quantity of commodity. Cash-settlement of all or a portion of an affected commodity physical forward, however, is an efficient and cost-effective solution to the issues raised by such circumstances. When utilised in these circumstances, cash settlement is not speculative in nature and should not cause a commodity physical forward to be deemed a financial instrument. Typical circumstances when commodity physical forwards may be cash settled 1. Net Scheduling In the course of entering into contracts for the delivery of commodities during a particular month, situations often arise in which two counterparties have multiple, offsetting positions with each other. These situations arise as a result of the effectuation of multiple, independent commercial transactions. In such circumstances, the parties may, but are not obligated to, terminate their contracts to the extent that such contracts offset. To accomplish this, the parties net schedule the physical delivery of the underlying commodity. Net scheduling of deliveries eliminates unnecessary and duplicative deliveries (and the related environmental risks and costs) that would be present but for the net scheduling. As a part of the net scheduling process, the parties agree on the appropriate payments to be made with respect to the quantity of commodity that was delivered and those portions of the contract quantity that were offset. By eliminating redundant deliveries of product or reducing the number of parties in a physical delivery chain, net scheduling provides numerous commercial benefits. Net scheduling permits the parties to: (i) reduce potential environmental liabilities as less product is transported and fewer parties are involved in the delivery chain, (ii) reduce their respective credit exposures to each other, (iii) reduce the overall costs that otherwise would have resulted from redundant deliveries (e.g. transportation costs, demurrage costs, inspections costs, etc), (iv) reduce the amount of operational overhead necessary to effect their transactions and (v) reduce their overall exposure to potential claims and liabilities that are part and parcel of commercial commodity transactions. 2. Delivery Failures or Deficiencies In the physical markets, a supplier or purchaser may fail to make or take delivery of all or a portion of a commodity that is the subject of a commodity physical forward. The reasons for these failures are numerous: product can be lost in the ordinary course of transport; transportation capacity may be unavailable or constrained; or the supplier or purchaser may have unexpected physical constraints that limit its ability to produce, ship or receive product. Understanding that delivery and receipt failures are foreseeable occurrences, many commodity physical forward contracts provide that a failure to deliver or receive will result in a cash settlement between the parties. The cash settlement process allows for the affected parties to cover in the market and avoid potentially inefficient physical cures. For example, if a party purchases 500,000 barrels of crude oil from a supplier for delivery by vessel and, due to lack of transport, mechanical issues limiting delivery or other circumstances, only 425,000 barrels of crude oil are actually delivered, it is more efficient for the parties to enter into a cash settlement for the missing barrels than to require the supplier to charter a new vessel to deliver the missing barrels or to trigger a default with respect to the supplier under the contract. 3. Termination and Off-set Resulting from Changes in Market/Business Demand Producers, processers, commercial users and merchants enter into commodity physical forwards to meet the forecasted commercial requirements of their businesses. As the forecasted requirements of their businesses change, these parties typically adjust the quantities of product that they have purchased on a forward basis to match their revised 6

7 forecasts. This is often achieved by negotiating a termination or off-set of all or a portion of the commodity physical forwards entered into with suppliers which may result in the payment of a cash settlement between the parties. Typical scenarios that may lead to termination or off-set: Scenario A A refiner has purchased on a forward basis a specific slate of crude oil products necessary to produce the types and grades of refined products that the refiner anticipates will be demanded by its customers. If the refiner later determines that the demand for certain types of refined products has changed, the refiner will, instead of taking delivery of the crude oil it has purchased, enter into one or more transactions with its crude oil supplier that offset the refiner s forward purchases of crude oil from the supplier and which may result in a cash settlement between the refiner and that supplier. The refiner will then revise its slate of crude oil purchases to better align its purchases with its production needs. Scenario B Anticipating heightened demand for its products, a petrochemical manufacturer entered into a commodity physical forward to purchase additional platinum to be used as a catalyst in the production of its products. Shortly before the delivery of such platinum, the petrochemical manufacturer determines that, due to changes in its customer base, the additional anticipated demand for its products will not occur. In lieu of taking delivery of platinum that it no longer requires, the petrochemical manufacturer negotiates the termination of its platinum contract which results in a cash settlement payable between the petrochemical manufacturer and its platinum supplier. Scenario C Based on long term weather forecasts, an independent power producer believes that the upcoming summer will be unusually hot and that demand for power in the summer will be higher than normal. To address this expected increased demand and to fix its natural gas costs, the power producer enters into a commodity physical forward for additional quantities of natural gas to be delivered to its power plants during the summer. By early spring, the long term weather forecasts have changed and the independent power producer determines that the upcoming summer will not be as hot as originally thought and that demand for power in the summer will be closer to normal ranges. As the independent power producer no longer needs all of the additional gas for which it had contracted, the independent power producer will negotiate a reduction of its deliveries by terminating certain supply contracts and negotiating a cash settlement of those contracts. As evidenced by the foregoing examples, decisions to cash settle commodity physical forwards are driven by real world issues that are inherent in the physical markets. The fact that commodity market participants choose to utilize cash settlement mechanisms to address these issues does not alter the original intent of the parties to make and take delivery of the underlying commodities and should not cause commodity physical forwards to be treated as financial instruments. Commodity market participants do not use cash settlement as a tool for speculation or as a substitute for entering into financially settled derivative transactions. 3. Physical commodity forwards versus commodity derivatives 3.1. Users Counterparties to commodity physical forwards include producers, processors, consumers, commercial users and merchants handling commodities. Producers and processors use the markets to sell their output, whereas processors, consumers, and commercial users use them to purchase their inputs. Merchants handling the commodity manage parts or all of the supply chain linking producers to consumers, and must therefore both purchase and sell. In reality, counterparties active in the physical commodity forward markets often engage in multiple aspects of the physical value chain and are therefore likely to play several of these roles at once. On the other hand, counterparties to commodity derivative contracts include any entities wishing to engage in hedging or speculative activities in those markets. Unlike participants in commodity physical forward markets that must be able to transport, make or take delivery of the physical commodity, participants in the commodity derivative markets are not subject to the heavy logistics requirements inherent in the trading of physical commodities. Indeed, the most critical factor that distinguishes commodity physical forward transactions from financial transactions is the significant ancillary investment in infrastructure and logistics required for 7

8 any physical transaction to take place. Participants to commodity physical forward transactions must ascertain that this ancillary infrastructure, such as facilities to transport or store the commodity, is created and maintained. This requires direct capital investment or contractual commitments generally undertaken in the medium or long term. Market participants will also need to have access to the infrastructure, either through direct access to the physical asset or through a contractual right to use the physical asset Risk management and regulation Transactions in commodity physical forwards and in commodity derivatives give rise to different kinds of risk. This reflects the divergent functions performed by the commodity physical forward and the commodity derivative markets the purpose of the physical markets is to enable the delivery of physical commodities from producer to consumer, whereas the function of the commodity derivative markets is to allow market participants to manage price risk or to make speculative investments. Risk in commodity physical forward markets vs. risk in commodity derivative markets Both physical and financial transactions give rise to credit risk, and it is therefore logical that best practices used in the financial markets to manage credit risk have also been adopted in the physical forward markets. However, the counterparty risk inherent in physical transactions is much broader in scope than mere credit risk. Physical transactions also give rise to counterparty performance risk, which is the risk that the seller will not deliver the contracted quantity on specification and on time, or that the buyer will not take delivery. Given this additional risk factor embedded in physical transactions, the tools used in the financial markets to manage credit risk are not appropriate to manage the risks of physical transactions. For instance, even if central clearing of commodity physical forward contracts is feasible under certain conditions, it does not eliminate performance risk, but only transfers it from one counterparty to another. It is therefore not obvious how clearing would reduce risk in these transactions, where there is no fungibility of the commodity in question. Regulation of commodity physical forwards vs. regulation of commodity derivatives These different risks ingrained in the physical and financial markets have led to the development of varying risk management practices and distinct regulatory approaches in these markets. Commodity physical forwards are subject to broad-based laws, statutory obligations and regulation that reflect their use by commodity producers, traders and consumers 10 for buying and selling physical commodities. Each aspect of the physical transaction from the inventory, loading, transportation, storage and delivery to the controlling of the quality, quantity and environmental impact of the commodity is subject to an entire body of oversight and responsibility that has been in place for decades. Regulation affecting commodity physical forwards will therefore include maritime and land transport law, customs inspection as well as health, safety and environmental regulation of industrial installations storing and processing the commodity. The commodity may also be subject to additional regulation as to its specification. Commodity physical forwards may also be subject to regulatory reporting obligations for specific physical commodity markets. 11 Where a counterparty gains access to ancillary infrastructure through a contractual commitment, it will be subject to additional requirements of its contractual counterparty to assure its creditworthiness. Commodity derivatives such as futures and options on futures are subject to very different regulation that reflects their use by a wide range of financial market participants (including investors) to either manage commodity price risk or as a speculative investment, and the specific risks that this type of trading gives rise to such as investor protection risk, systemic risk and the risk of market abuse. Market participants that provide commodity derivative services to customers are subject to code of conduct obligations and other rules. Commodity derivatives admitted to trading on a trading venue are subject to rules prohibiting insider dealing and market manipulation. Commodity derivatives may also be subject to position limits, position accountability and position reporting requirements. Commodity derivatives are also subject to regulation to minimise counterparty credit and systemic risk including 10 In relation to consumers, it is relevant to note that retail transactions are generally exempted from applicable statutory requirements. References to consumers in this paper should therefore be understood to mean non-retail consumers. 11 For example, Article 8 of Regulation (EU) No 1227/2011 of the European Union and of the Council of [25 October 2011] on (REMIT) OJ L 326 (8 December 2012). 8

9 initial and variation margin requirements and requirements for clearing contracts by an authorised central counterparty. Commodity derivatives are also subject to wide-ranging regulatory reporting obligations for market and prudential supervision purposes Non-substitutability The commodity derivative markets and commodity physical forward markets are not substitutes for each other. Physically delivered futures contracts are only a partial substitute for forward physical transactions. Financial derivatives are not substitutes for the physical characteristics of the physical product. Futures contracts are constrained on delivery locations as well as commodity specifications, which may not fit the needs of the parties to the physical transaction. Similarly, commodity physical forward markets cannot be used to substitute activity in the futures markets, because of the logistics requirements inherent in commodity physical forward transactions and the need to be able and ready to make and take delivery of the underlying commodity. 4. Costs and consequences of extending financial regulation to the physical market Extension of derivative market regulation to the physical market A wide range of regulation has been imposed on (or proposed for) the derivative markets following the 2008 financial crisis. Following the collapse of major financial institutions and the wider risk that this posed to the financial markets, these reforms have focused on the OTC derivative markets and the reduction of systemic risk in the financial markets. G20 commitments have been implemented in key jurisdictions to introduce requirements for central clearing, reporting and risk management of OTC derivatives. These new requirements have had significant implications for non-financial counterparties who use derivatives to hedge risks related to their commercial activities. Regulation of OTC derivative markets has effectively led to the spread of financial markets regulation to cover commercial market participants. An increasing preoccupation with transaction formalities and the way in which contracts are executed has contributed to the failure of some decision-makers and regulators to acknowledge the fundamental distinctions between commodity physical forwards and commodity derivatives. As a result, there has been an increasing tendency to mistakenly apply financial regulation to parts of the commodity physical forward markets. Costs of regulating commodity physical forwards as commodity derivatives Financial markets regulation was neither designed nor intended for non-financial commodity market participants. The application of financial markets regulation to commodity physical forwards would mean that non-financial commodity market participants whose main activity is the buying and selling of commodities would be obliged to comply with burdensome financial regulation. Consequently a company that buys and sells petroleum products and engages in no financial trading except for hedging would be subject to complex financial regulation on central clearing, position limits and position reporting. The aggregate impact of regulating commodity physical forwards as commodity derivative contracts would be to Unduly restrict the commercial activity of non-financial commodity market participants by limiting their ability to use commodity physical forwards due to burdensome financial regulation; Increase the concentration of trading and delivery in clearinghouses, which would create a new and unnecessary source of systemic risk should a clearinghouse fail 12 ; 12 Transactions by themselves do not present systemic risk; rather, the institutions which enter into transactions may present systemic risk. Systemically important institutions may enter into commodity forward transactions, but commodity forward transactions do not present systemic risk and, to date, no institution has been the source of systemic risk as a result of its entry into commodity forward transactions. While financial market regulations aim to establish more stable markets, mandating the central clearing of commodity forward transactions could unintentionally give rise to systemic risk should the resulting clearinghouse fail, in addition to the disruption of international commerce and unprecedented market dislocation that requiring central clearing would cause. 9

10 Reduce liquidity in commodity physical forward contracts by restricting participation in the physical markets; Dissuade commodity market participants from trading with entities in regions where financial market regulatory requirements are applied to commodity physical forwards; Increase operational and risk management costs for non-financial commodity market participants; and Increase the cost of physical commodities for processors, manufacturers and, ultimately, consumers. 5. Conclusions: The way forward The function of the commodity physical markets is to enable the buying and selling of physical commodities on specification, on time and at a pre-agreed price. Every day, commodity producers, merchandisers and consumers rely on these markets to deliver and receive physical products. As explained in this paper, commodity physical forward markets are fundamentally different from commodity derivative markets, as relates to the functions, users, risks and regulation applicable to each of these markets. It is of utmost importance that any regulatory regime for commodity physical forwards gives due consideration to these differences. Inappropriate application of financial market regulation to the commodity physical markets can cause unnecessary risks and costs and impose real hardship on commercial and industrial users as well as consumers. Regulators and decision-makers are therefore urged to treat commodity physical forwards as distinct from financial instruments and to apply proportionate requirements tailored to the specific characteristics of these markets. Consequently, clearing, trading, reporting and position limits requirements designed for commodity derivatives should not be applied to commodity physical forwards. Regulators are further encouraged to provide guidance that clearly distinguishes between commodity physical forwards and financial instruments, such as commodity derivatives, in order to provide much needed legal certainty to non-financial commodity market participants that rely on the commodity physical forward markets to buy and sell commodities. 10