EU Energy derivatives markets: Structure and risks

Abstract

Energy derivatives markets were thrown into turmoil following Russia’s invasion of Ukraine, as the prices of natural gas and power soared amid high volatility and a significant deterioration in market liquidity. Prices surged in March 2022, before declining in Spring and then rebounding to reach historical peaks at end-August 2022. The sharp price increases triggered large margin calls on derivatives positions, resulting in liquidity stress for some firms using derivatives as hedges against price declines, energy utilities in particular. The liquidity demands were so high that some EU countries introduced public support mechanisms in the form of loans and public guarantees, and a few energy firms were bailed out. Therefore, it is crucial to understand the structure and functioning of energy derivatives markets. This article provides an overview of EU energy derivatives markets and assesses the risks for financial stability. Unlike other financial markets, non-financial corporates play a key role in energy markets by trading on exchanges and over the counter. The market is characterised by a high degree of concentration in clearing and trading activities, as evidenced by network analysis, and some energy firms hold relatively large positions in the market. In this context, liquidity and concentration risks are among the main vulnerabilities identified, along with data fragmentation and data gaps. The recent migration of some of this activity from exchange-traded to over-the-counter derivatives markets raises concerns over limited transparency and more bespoke margin and collateral requirements.