In the most recent edition of its regular market conduct and transaction reporting-focused ‘Market Watch’ publication, the UK Financial Conduct Authority (“FCA”) provides a review of commodities firms’ compliance and governance structures, with particular regard to market abuse controls. In addition, Ofgem this week published an open letter to market participants setting out its views on various issues relating to the implementation of the Regulation on Wholesale Energy Market Integrity and Transparency (“REMIT”), including more detail on various types of behaviour that could constitute market manipulation. Each of these publications merits review by market participants as they draw attention to what, in the regulators’ views, are a number of compliance shortcomings that appear endemic across commodity markets.
In its sample of twelve firms across the oil, energy, metals and soft commodities sectors, the FCA found inconsistent implementation of relevant UK and EU laws and highlighted the often inadequate nature of the compliance frameworks that firms had in place. Key areas which fell short of the regulator’s expectation included management and governance structures, reporting of suspicious transactions, benchmark regulations, market abuse monitoring and risk assessments. Insufficient or inefficient compliance infrastructure could result in considerable fines for firms, especially those that find themselves becoming regulated for the first time as investment firms under the new Markets in Financial Instruments Directive ("MiFID II”), for which final draft regulations are expected this month. Regardless of the regulatory status of commodity firms, the FCA’s concerns are indicative of the increased scrutiny, and corresponding risk of enforcement action, that all market participants now face. Commodity firms should therefore review all current regulations affecting their business and ensure they develop, and can demonstrate to a regulator, a strict internal compliance programme and adequate controls for the prevention of market abuse.
Market Abuse Controls
The FCA is particularly concerned that firms’ management staff believe ‘commodity markets are ‘too deep, too liquid, and there are too many participants’ to be manipulated.’1 Only where training programmes were compulsory and relevant did the FCA feel that firms appropriately demonstrated their front offices were prepared to evaluate market abuse risks. Moreover, the FCA generally found that trader/broker ability to analyse their role in preventing abuse of inside and market sensitive information to be inadequate.
Market abuse risk awareness was found to be poor in general. The FCA reported a lack of knowledge surrounding the facts of recent market abuse cases impacting the commodity markets, including high-profile manipulation cases such as the Libor, FX and Gold fix cases, which cost firms billions of dollars. Instead, firms have implemented communication surveillance and systems monitoring via automated or manual systems, but lack a process to allow for comprehensive review of the data collected for potential market abuse or other infringements.
The FCA states that firms with compliance and internal audit functions who were integrated with the front office and attended regular meetings with their trading teams generally had a good knowledge of trading issues and could demonstrate effective management of risks, while those compliance groups who were separated from their trading teams were less effective at recognising market abuse.
The FCA lauded firms who tied compensation to positive “cultural” factors, such as completion of training, use of appropriate language in communications, and treatment of colleagues. They found that such firms used compensation to ‘send a strong message about the firm’s compliance culture.’2
Compared to investment banks, the FCA found that overall there was a lack of intraday risk monitoring despite the prevalence of intraday risk in commodities markets, and that credit risk was often left un-hedged. Those firms with no ‘Credit Valuation Adjustment’ desks showed a particularly poor performance in managing credit risk.
REMIT and other Regulatory Developments
When viewed in the context of wider regulatory changes in Europe, the recent ‘Market Watch’ takes on even more significance for commodity market participants. For example, the UK’s electricity and gas regulator, Ofgem, has also published an open letter on 8 September relating to the prohibition of market abuse in the wholesale energy markets under REMIT.3 This letter also follows an industry consultation, and highlights, amongst other things, more detail on a range of behaviours it has witnessed that risk being categorised as market abuse offences under REMIT. It is worth reiterating, as Ofgem did, that there is no requirement for a market participant to have intended to manipulate the market in order to contravene REMIT market manipulation offences. Moreover, reporting of transactions under REMIT commences in less than thirty days, and the 2014 Remit Report highlights that the EU Agency for the Cooperation of Energy Regulators (“ACER”) expects an increase in cases following the start of data collection.4 ACER’s report states that of the thirty-three new cases reported to ACER in 2014, eighteen of them involved potential market abuse.5
The industry will see a large number of European rules entering into force over the next 24 months. When the final MiFID II draft rules are published this month, firms will have more guidance as to whether they will be considered investment firms, which in turn determine to what extent they are regulated. Some provisions in the recast Market Abuse Directive and Regulation (“MAD II/MAR”) will apply from 3 July 2016,6 while other requirements will apply on 3 January 2017, the MiFID II deadline, due to the cross-linkage with MiFID II. An FCA report on benchmarks published in July 2015 indicated that no firms had completely implemented changes in response to the UK’s new benchmark rules. The EU Benchmark Regulation remains in draft form but will likely be finalised by the end of this year.
This FCA ‘Market Report’, together with the other publications referenced above, reflect an increasingly assertive view from the FCA and Ofgem that the commodities markets should be more firmly supervised by regulators to ensure that controls are implemented. Market participants should prepare for more enforcement actions and resulting fines if internal policies and standards do not meet the stringent criteria set out in these regulations. Investment in a vigorous compliance program is critical to managing this evolving legal risk.7
1 Pg. 3, Market Watch No. 49, Commodities Trading Thematic Review, FCA September 2015. Available at: http://www.fca.org.uk/static/documents/newsletters/market-watch-49.pdf.
2 Pg. 3, Market Watch No. 49.
3 Open letter on prohibition of market abuse under the Regulation on wholesale energy market integrity and transparency (EU) No 1227/2011 (REMIT), Ofgem, 8 September 2015. Available at: https://www.ofgem.gov.uk/publications-and-updates/open-letter-prohibition-market-abuse-under-regulation-wholesale-energy-market-integrity-and-transparency-eu-no-12272011-remit.
4 Pg. 43, ACER’s annual report on its activities under REMIT in 2014, published September 2015. Available at: http://www.acer.europa.eu/Official_documents/Acts_of_the_Agency/Publication/REMIT%20Annual%20Report%202015.pdf.
6 Article 39(2), Regulation (EU) No 596/2014 of the European Parliament and of the Council on market abuse, OJ L 173/1, 12.6.2014.
7 The FCA webpage publishing market abuse actions indicates the types of fines that can be expected from an infringement of these rules.