Trading Windows: A View on a Transparent World?

A key feature of the price assessment processes utilised by price reporting agencies (PRAs), such as Platts, Argus and ICIS in the oil and gas markets, is the "Market-on-Close" (MOC) approach. An important part of the MOC process is the role which the trading "window" plays in the formulation of the final prices published by the relevant PRA for each oil benchmark. Although PRAs provide information about their price assessment processes, an appreciation of what that entails is not universal in the market. "Trading in the window" can mean different things depending on the PRA referred to and the reference price in question; each PRA operates its own methodology and these vary according to the market.

This client alert seeks to provide an introduction to the role PRAs play in the oil and gas markets and the broad price assessment methodologies they employ in determining daily benchmark prices – including the role of the trading "window".1 It also highlights the current regulatory review of PRAs and touches on a point of interest in connection with the review of the Markets in Financial Instruments Directive (MiFID).

The Role of PRAs PRAs are information publishers (typically operating within news organisations) which provide price data and reference prices (often referred to as "indices" or "benchmarks") to the markets based on physical and financial trading activity reported to them.

These prices are then used by traders in physical and financial commodities in a number of ways:

  • for spot physical trading activity;
  • for hedging of physical trading activity;
  • to settle floating price deals;
  • under long-term contracts which need to be priced on a regular basis throughout the term; and
  • as reference prices for other derivatives contracts, including some futures contracts.

The aim of a PRA is to provide the market with its assessment of the prevailing market price during the applicable pricing period for its various benchmarks, achieving a degree of price transparency which market participants (large and small) can rely on. Where PRA benchmarks are successful, liquidity in the relevant market centres on them – and in and around their related trading windows. For these key benchmarks, market participants rely on the integrity of the data used and of the assessment processes and methodologies applied.

Pricing Methodologies – the "Trading Window" approach The trading "window" is a constituent part of MOC methodologies, a price assessment process favoured by some of the larger PRAs. Generally under a MOC methodology, the PRA assesses prices by reference to data submitted voluntarily to it by market participants relating to (a) transactions concluded and (b) where relevant, bids and offers published on its systems. Submission of this information can take place via telephone, trader’s squawk boxes, instant messenger services, or directly by subscribers via web-based screens visible to all other subscribers (e.g. the Platts eWindow, which is an on-line real-time communication tool used by reporters and traders in connection with the MOC process).

Under the MOC process, PRAs do use pricing submissions received throughout the entire day, but the most important period is the final defined period of time (the "window") within the trading day over which the PRA monitors market activity to establish the price. Typically the price established in this way is the price assessed at the end of the window.

Traders are invited to submit open bids and cargoes for sale in the lead up to a specified cut-off time, after which no new bids or offers will be accepted by the PRAs. This can have the effect of narrowing spreads at or towards that point. During the window, the PRAs watch the market on or very nearly on a real time basis to gather data on transactions concluded during this most liquid period of the trading day. PRAs then use the prices of concluded trades, and where relevant, of unfilled bids and offers, to establish the published price for the day. If liquidity is relatively low, the bid/offer spread information may become more relevant in that assessment.

One of the arguments in favour of this methodology is that instead of relying only on the subjective impressions of reporters telephoning traders for information, there is a formal mechanism (i.e. the "window") built into the price discovery process.

However, use of the "window" approach is not universal. Some PRAs adopt an entirely subjective approach (i.e. telephoning contacts and making a call on the relevance of the information gathered based on first-hand extensive trading experience of reporters); others use a formulaic approach (relying on data submitted in writing by a panel of traders).

Even where a PRA follows a MOC approach, it will often apply a subjective judgment to set specific prices so as to smooth what it may perceive to be the otherwise undue impact of particular transactions or market features (e.g. variances between crude oil qualities, cargo sizes, vessels, ports and the relative creditworthiness of buyers and sellers from transaction to transaction).

PRAs have wide discretion to exclude bids, offers or transactions which they believe to have been submitted abusively or in bad faith. The way in which this and other discretions are exercised in practice – and the problem of transparency in relation to it – is the subject of various consultations on the role and potential oversight of PRAs (which are briefly referred to below).

A feature of the price assessment process currently common to all is that market participants have no obligation to submit bids, offers or trade data to PRAs: this is done voluntarily (and some market participants may not do so at all). There is also no general obligation on market participants submitting data to submit all potential data in their possession. This is also the subject of the consultations highlighted below.

The Platts "eWindow" Price Discovery Mechanism The trading "window" can, in some contexts, refer to more than just the period of time over which an assessment is primarily based. To take Platts as an example, in 2007 it developed its Editorial Window, or "eWindow", through which trading companies can submit indicative bids and offers on a screen visible to other subscribers to that service in real-time. eWindow bids and offers will have one of three action tags associated with it – "Hit" or "Lift", which are orders entered by other participants (or their authorised brokers) that can be executed by following the procedure below, or "take", which are non-executable orders entered by Platts editors which participants may mark interest on, which may be entered into offline bilaterally.

If a party wishes to execute a transaction which is shown on the eWindow system, then this is possible, as the eWindow platform is linked to ICE (the interpretation of these arrangements and their precise interaction in the contract formation process is a matter of interpretation of all the circumstances, on which some may have differing views). In order to execute a transaction in this way, a trader may do so by clicking through from a single screen on either the "Hit" button or "Lift" button next to the desired order, a pre-confirmation window then appears which then requires the trader to confirm the deal. Once the deal has been confirmed then a further trade confirmation window will appear.

Platts views a refusal to enter into a trade in the manner described above with suspicion, as the bids/offers submitted through the eWindow should be reflective of the actual price at which that trader would enter into trades. Parties which do not stand by a bid or an offer submitted through the eWindow platform are sanctioned by Platts, first by having their bid/offer submissions removed from the day’s price formation database, and secondly, by being barred from entering further bids/offers on the eWindow platform for a period of time specified by Platts.

Regulatory Review There is an on-going review as to how far regulators could, or should, go in terms of regulating PRAs. In part, this debate has been complicated by the different roles that PRAs play. Up to now, the focus of most of that discussion and resulting reports and recommendations primarily has been the price assessment methodologies PRAs employ and the price reporting element of their role.

Over the past year, there has been a series of consultations concerning possible regulation of PRAs and, more generally, the formulation of benchmark prices across the financial and commodities sectors. This resulted in the publication by IOSCO of its final report detailing "Principles for Oil Price Reporting Agencies" in October 2012 (the IOSCO Principles). This report stopped short of recommending formal regulation in favour of self-regulation. IOSCO intended to conduct a review of PRA compliance with the IOSCO Principles over an 18-month period (up to April 2014). Following that review, IOSCO suggested that it might recommend that market authorities would prohibit the use of benchmarks provided by non- compliant PRAs in commodity derivatives contracts.

Although this may represent a softening of IOSCO’s original position, the issue of formal regulation of PRAs has since been raised again within the EU (roughly coincident with the Libor/Euribor review). A recent consultation by the European Securities Markets Authority (ESMA) and the European Banking Authority (EBA) on "Principles for Benchmarks-Setting Processes in the EU" closed on 15 February 2013. This consultation followed the IOSCO approach of setting out non-binding principles, stressing they are intended as a means to provide a "common framework to work together and provide a glide path to future obligations that are likely to be binding".

In neither the IOSCO Principles nor the ESMA/EBA consultation is it recommended that market participants be compelled to submit data to PRAs.

IOSCO has just closed another consultation on the wider issue of "Financial Benchmarks" (on 11 February 2013). A final report is due in April.

This is an area that is still very much on the move.

Regulatory and Tax Status of Window Trades A key question for some will be whether transactions conducted in the "window" would be regarded as "financial instruments" for regulatory purposes. If so, this would have multiple consequences (including the application of derivatives reform regulation under the EU Market Infrastructure Regulation and, perhaps, the application of the proposed EU Financial Transaction Tax).

A "financial instrument" for these purposes is defined under MiFID. MiFID, however, is under review and a new category of "financial instrument" may be proposed to include some trades, potentially including physical trades, conducted on an "organised trading facility" (OTF). There is some way to go before the draft legislation is settled, but we now have a reasonably good idea of the likely OTF definition, which is very broad indeed. A question some have begun to consider is whether there is a danger of an unintended legislative consequence: if a PRA’s window trading facility were regarded as an OTF, trades concluded within it could be characterised as "financial instruments".

This may depend on the outcome of negotiations between the European Parliament and the European Council, to whom this issue and the potentially serious and undesirable consequences flowing from it, have been highlighted by many market participants. But if the politicians do not address this issue, the analysis will likely turn on the question whether a PRA’s facility is in fact an OTF.

The key issue here is whether transactions are concluded within a system operated by the PRA. If transactions are concluded outside that system, this may be sufficient to avoid an OTF treatment. This, of course, leaves open the question: how far does a PRA’s "system" extend? That is a matter for analysis in each given case and will depend on a precise analysis of the relevant contractual framework.

As we highlighted at the outset, each PRA is different and their prices, windows and related facilities need to be analysed with their specific features in mind.