Over recent years financial and wholesale energy market regulators have tightened their scrutiny over the functioning of commodities markets. New global regulations were introduced in order to reduce systemic risk, to increase market transparency, integrity and market conduct. These regulations included MiFID II, MAR, REMIT, EMIR and the Dodd Frank Act.
On energy commodities, ACER, the European Wholesale Energy Regulator, issued regulatory guidance on the prohibition of REMIT market manipulation focussing on Layering and Spoofing, Transmission Capacity Hoarding and Wash Trades. The guidance follows a record number of open cases and record fines in the European power and gas wholesale markets.
In this Insight, KRM22’s Director of Product Strategy for Regulatory Risk, Saeed Patel, looks at the changing regulatory landscape, how Market Surveillance solutions have evolved, and what the system of the future will need to provide to continue to meet the ongoing requirements.
The changes in regulatory landscape has seen new enforcement powers given to market supervisory authorities. Suddenly there is an increased focus on individual behaviour, managed through civil and criminal sanctions, rather than the firm alone. The market has, consequently, seen a rise in high profile probes launched for market manipulation and insider trading activity. Significantly, costly fines and convictions issued.
Individual accountability, culture and governance is the latest focal point of regulatory activity. The UK Financial Conduct Authority (FCA) has extended its Senior Manager and Certification Regime (SMCR) all solo regulated firms. These firms include commodity firms, and focus has been drawn to individual accountability. Responsibility for misconduct issues now lies with senior managers accountable for significant harm functions within the organisation.
This ever-expanding regulatory landscape, coupled with a changing geopolitical environment, means firms wish minimise uncertainty. They are turning to technology solutions with trade surveillance receiving a greater allocation of investment. A PWC Surveillance Survey 2019 reported $736.7m invested in surveillance technologies alone over the last 2 years.
Since the 2008 financial crisis, global regulatory fines imposed on capital market firms for failures in conduct risk have amounted to $321 billion. Commodity firms have not been immune from this. In 2013, Michael Coscia of Panther Trading, a proprietary oil trading firm based in London, received the first criminal sanctions under the US Dodd Frank Act. Panther Trading was found to have undertaken market manipulation using a spoofing and layering strategy in the oil derivatives markets. Authorities in both the USA and UK issued multiple regulatory enforcement actions. Critically, the Panther Trading case also represented the first commodities enforcement action in market abuse by the FCA.
Two weeks ago, the FCA published its latest Suspicious Transaction Order Reports (STORs) summary for 2019 which revealed a total of 5,455 STORs submitted, with the bulk (89%) relating to Equities. Whilst 140 STORs (2.6%) were related to Commodities, after stripping out insider trading for all asset classes, this figure rises significantly to 12.8% (105).
When we compare this to the 2018 FCA report, Commodities market manipulation accounted for 74. 2019 represents an increase of 30% in STORs generated. At KRM22, we believe this reflects FCA’s broadening of its supervisory focus on asset classes other than equities. We see this as raising the importance of combating market abuse through implementing effective market surveillance operations.
When we look at market abuse in energy markets, we can from the number of REMIT enforcement actions see a similar rising pattern. As of Q4 2019, there were record levels with 218 open cases under review. At KRM22, we believe this is a consequence of the combination of two factors:
Not only is the number of enforcement actions increasing, but the size of the fines is reaching levels that have a real impact on the business. Notable REMIT cases include:
As commodity markets are crucial to the real economy, they subject to increased political and public scrutiny.
In the last 15 years, there has been a significant growth in commodity markets, particularly with regards to commodity derivatives. According to the most recent data by Bank for International Settlements (BIS), commodity derivatives represents $3 trillion of outstanding over the counter (OTC) derivatives positions globally, with exchange-traded commodity futures and options open interest around $1 trillion globally, representing some 15% of all futures and options contracts.
Ak KRM22, we believe commodity markets pose a specific set of material challenges because they straddle the regulatory perimeter; action in the physical markets, and vice versa, affects financial market behaviour. This interaction of financial commodity markets with the physical market, combined with the physical market’s increasingly central influence on the real economy, gives rise to a range of specific conduct, reputation and environmental risks.
In Europe, financial regulators have data sharing agreements in place with wholesale energy market regulators. These agreements have lead to increased co-operation, representing a wider framework with physical commodity market oversight.
In the physical energy markets, price formation taking place in the underlying physical product, and delivery and storage mechanisms, have affected market integrity. Abusive behaviour can occur in the physical commodity markets which in turn can have an impact on financial market activity and prices.
The factors we have discussed are driving energy sector firms to increase the size and capabilities of their compliance functions. The depth of capability adopted by the firm depends on where they want to be on the compliance spectrum. There are different ways firms may choose to approach compliance, for example firms may;
Commodity firms are facing new obligations, affecting their trade surveillance requirements:
This increase in required functionality and data volumes represents a major incentive for the investment in a trade surveillance solution. Furthermore, MAR obligates firms that hold a dominant market position to invest in automated surveillance solutions.
We are operating in an environment of tighter regulatory constraints, low interest rates, sluggish economic growth and unpredictable events (Brexit, COVID-19/Coronavirus). These factors have resulted in margins for commodity firms coming under severe pressure. Firms have the choice to either reduce costs or to innovate. Innovation has become a tool to maximise potential commercial opportunities alongside identifying and reporting financial crime.
Additionally, firms are increasingly taking the view that it is strategically important to embrace innovation through next generation trade surveillance solutions. Examples of such solutions includes cloud and grid technology, real time analytics, artificial intelligence and cognitive computing. By leveraging the latest technology advancements, commodity firms are able to harness the power of data. They can go beyond simply detecting and reporting suspicious transactions. Firms can suddenly draw powerful business intelligence, including identifying operational risk of abnormal trading behaviour, or business opportunities by assessing the full order book of market transactions.
The rapid evolution of technology has led to a rise of RegTech solutions to help meet growing regulatory expectations. Regulators are embracing new technology too. The industry has welcomed the FCA’s “sandbox” environment project, which allows firms to test and fine tune their systems. In 2019, the FCA held its annual Innovation Day and several TechSprints. These initiatives provided the industry with opportunities to collaborate, and learn from new technology adoption best practice.
There is a growing expectation from regulators for firms to adopt AI and machine learning to improve the effectiveness of their trade surveillance solutions such as reducing false positives by having alerts that are optimally calibrated based on a firm’s risk-based approach. A recent FCA Market Watch was critical on firms using vendor supplied systems “out of box” and “industry standard” settings to calibrate their alert parameters with firms at risk to comply with MAR. FCA added that each firm is responsible for making its own judgements about alert calibration. FCA has previously stated that firms must take a risk-based approach for firming up their alert parameters. This approach is based on the scale, size and nature of the firm’s business activity relative its market position.
At KRM22, we believe implementing effective trade surveillance solutions in commodity markets is a challenging and complex undertaking. More vendors now provide trade surveillance solutions, with pre-configured algorithms to detect unusual patterns of behaviour.
Currently, third-party solutions under service the energy commodity markets, especially compared to the financial markets. Technology providers are playing catch up to satisfy energy firms’ requirements. For example, while the percentage of firms actively using trade surveillance technology has doubled since 2015, at 22%, it is still not considered prevalent among energy firms. This appears to due to the key challenges energy sector firms encounter applying trade surveillance solutions:
In conclusion, at KRM22 we believe the commodities markets will continue to be a growing area of regulatory focus. The slow adoption of automated market surveillance solutions, so we expect to see the rise in enforcement actions continue. However, company culture is changing behaviours due to new individual accountability regimes. We are seeing a change in senior management attitude towards investing in systems and controls. Firms are taking their obligations to safeguard the company and individuals from regulatory sanctions very seriously.