DECEMBER 2015: Issue 103 forum

A QUARTERLY JOURNAL FOR DEBATING ENERGY ISSUES AND POLICIES

Energy trading in Europe is on the Liz Bossley sets the scene for the Forum CONTENTS verge of a fundamental transformation. by explaining the various regulations The implementation of a host of new and directives affecting EU commodity Energy Trading at the Crossroads regulations: the European Market markets and their intended objectives. We are better informed, but are we Infrastructure Regulation (EMIR), She highlights the difference between any the wiser? 4 Liz Bossley the Markets in Financial Instruments a ‘Directive’ and a ‘Regulation’. The Directive (MiFID), the Markets in former is a legislative act that sets a Financial regulation in the energy sector: jumping the gun 7 Financial Instruments Regulation target that all EU countries must meet, Marco Kerste and Bert Tieben but it is up to individual countries (MiFIR), the Market Abuse Regulation Cause and effect: the impact of (MAR), the Capital Requirements to decide how to translate this into European regulation 9 Regulation (CRR), and the Capital national law. A Regulation, in contrast, Peter Caddy Requirements Directive IV (CRD IV) is a binding legislative act and if it OTC derivatives market regulation and commodity derivatives 13 will have profound implications for how contradicts a country’s national law Orçun Kaya international oil companies, trading that law needs to be changed. Bossley argues that the cost of compliance MiFID II: the impact on commodity houses, brokerage fi rms, investment markets from a venue perspective 16 banks, price-reporting agencies, for banks and large multinational Ben Pott and Graham Francis companies to the various directives and futures exchanges do business. Regulatory change: impact on While there is a consensus among the and regulations being introduced is major energy companies and challenges they face 20 contributors to this Forum that the new large and is already posing serious Jonathan Hill regulations will change the landscape challenges to these institutions. For smaller companies, there is the risk that A new regulatory paradigm for by increasing the complexity of the EU commodity markets 24 trading business and the cost of they would be driven out of the market, Jonathan Farrimond and Paul Wightman which could be ‘regarded as collateral compliance, as well as increasing Risks to the proven effi cacy of reporting and capital requirements, damage in the war against market abuse energy markets 29 and systemic risk’. But to justify the Ian Taylor there remains much uncertainty as costs of ‘the heavier regulatory hand’, to whether these new regulations will Are regulators right to worry about these regulations must achieve their the oil benchmarks? 32 achieve their intended objectives. Of Peter Stewart objectives, which remains to be seen. particular concern are the unintended Regulation and the price-reporters 36 consequences of some of these Marco Kerste and Bert Tieben argue Neil Fleming regulations in terms of: reducing market that the current regulations are based Will MiFID II hurt industrial players liquidity, reducing the number of market on the premise that the energy sector in Europe? 43 players, the risks of regulatory arbitrage, poses a risk of contagion to the real Andreas Walstad and increasing the cost of hedging. economy. However, the authors argue The impact of fi nancial regulation on energy markets 45 Costs associated with these changes that this hypothesis has not been tested Andrew Tuson will ultimately be passed to end-users. in the preparatory stages of introducing

OXFORD ENERGY FORUM

Paul Wightman and argues that the dark pools in related assets, or move in related assets, or dark pools lesser markets with into third-country transparency requirements’. Jonathan Hill with an energy sector is grappling of regulatory unprecedented wave nancial crisis reforms fi initiatives. Post the nancial regulation to extend fi markets with physical commodity to take account relatively little tailoring posing of their underlying nature, cant implementation challenges signifi for the oil and gas production industry. nancial and structural The resulting fi yet the impacts are becoming clearer, impact on markets very much remains must now to be seen. Policymakers allow the impact of recent reforms on the oil and gas production industry and its crucial markets to be assessed before proposing any further changes. need to better there is a In particular, understand unintended consequences, end-user choice, and cost, complexity, liquidity. Jonathan Farrimond argue that the implementation of MiFID II and MiFIR will introduce fundamental changes to the structure nancial commodity markets. The of fi most notable change will be in relation to position limits. While position limits have been applied in the USA for many years, it is a new concept for European commodity markets. The authors argue that the ‘move from a regulatory framework which has largely excluded the use of position limits to a place where position limits apply to the vast majority of commodity derivatives is a bold move’. Regulators also face the challenge of setting appropriate limits for potentially thousands of contracts simultaneously. Given the size of the shift, the implementation risk is high and it is therefore important for regulators to ‘remain open to amending these initial limits in light of practical experience as the case may require’. focus on Graham Francis t and MiFID II, arguing that its implementation will have a profound impact on the intermediated commodity markets. This will pose many challenges for market participants, particularly for intermediaries, which will have to cant reorganization of undergo a signifi their businesses. The requirements to trade on venues, and the organizational requirements on intermediaries to trade on venues, will transform the trading landscape. A key issue raised by the authors is the host of transparency requirements, both which will pre- and post-trade, depend on a number of factors such as the nature of the instrument and the size of the order – equivalent to thresholds currently the block-size in operation. The authors argue that getting these thresholds wrong cant impact on would have signifi commodities markets as they could damage liquidity and may result in the trading of certain assets being driven The authors argue that outside the EU. venue trading will also be impacted by provisions on position reporting. Pott conclude that if ‘full pre- and Francis trade disclosure were to be required, many markets may well be starved for and trading would migrate to liquidity, business models. So far, however, however, So far, business models. of commodity central clearing limited. Kaya derivatives has been argues that while standardization not the only is a prerequisite, it is such as criterion and other factors cient pricing and effi liquidity, eligibility, Also, the are also key for clearing. clearing will author argues that central derivatives trading, increase the cost of passed on which will be eventually that to end-users. Kaya concludes overall the new regulations will, without doubt, fundamentally transform the derivatives markets, but the impact these regulations will have on pricing, and trading of commodity liquidity, derivatives remains unclear. Ben Pot article examines in details argues that since the

OXFORD ENERGY FORUM 2 Peter Caddy the new regulations. The authors’ The authors’ the new regulations. that while adverse research shows sector can have shocks to the energy rms within fi repercussions on other there is no the energy sector itself, of energy evidence that the default an externality companies would pose Their results also to the real economy. risks run from show that the contagion the energy sector, the banking sector to way around. The rather than the other the ‘political authors conclude that haste in implementing strict regulation nancial crisis is in the aftermath of the fi understandable, but continuing on this road without sound foundation is not’. ENERGY TRADING AT THE CROSSROADS AT TRADING ENERGY Orçun Kaya’s derivatives, the recent reform of OTC which consists of three main pillars: reporting all derivatives to trade repositories; clearing and trading derivatives all standardized OTC through organized exchanges; and increasing the margin requirements on non-cleared derivatives. Among these, the author argues that central clearing through a central counterpart (CCP) represents a fundamental transformation that would leave market participants no choice but to revise their risk management practices and fi nancial crisis, European energy fi trading regulation has moved from the ‘principles-based’ traditional UK-style approach, to a European ‘rules-based’ system. Caddy believes that European regulators are inherently suspicious of trading, and that the slew of regulations being proposed fails to distinguish ciently between the requirements suffi nancial markets and those of of fi physical commodities markets such as oil. This could damage market With respect to the proposed liquidity. EU benchmarking regulation, Caddy t the US says that this can only benefi and Asian markets, where regulators are clearly working to produce a more appropriate regulatory regime than in Europe.

INTRODUCTION TO THIS ISSUE DECEMBER 2015: ISSUE 103

Ian Taylor believes that the scope and is regarded as fully transparent by the trading is a sideshow will also be INTRODUCTION TO THIS ISSUE depth of energy market regulation main price-reporting agency involved, affected. He cites an open letter which has recently been, or is in it does not inspire the confi dence of published in October and signed by the process of being, implemented regulators. Simplifying the pricing energy trade groups across Europe across both the USA and the EU is structures could be one way of and a number of energy-intensive unprecedented and that the industry is renewing confi dence in the market and industries, which points to the entering ‘uncharted territory’. The Vitol of reinforcing the price assessments disproportionate capital, prudential, CEO says that commodity markets published by reporting agencies. and liquidity requirements that could have a proven record of enabling the be imposed. Energy and energy- Neil Fleming distinguishes between fl ow of raw materials, and as a price- intensive companies were largely market manipulation and attempts discovery mechanism for materials that exempted from the obligations under by market participants to manipulate are the building blocks of economic MiFID I, but the revised directive casts the price benchmarks published by activity. Taylor identifi es MiFID II and the net wider and could seriously affect energy price publications. Noting that the issue of ‘systemic risk’ as areas allegations do not constitute proof, both the market and the industrial requiring particular attention. He argues groups concerned. Walstad says that policy makers and regulators or even evidence, of manipulation, the industry’s calls for more fl exibility must ensure that the regulations they Fleming challenges the ‘default should be taken seriously. A longer promulgate do not have unintended assumption’ that market manipulation phase-in period of MiFID II for non- consequences, and in particular he is a systemic problem in commodities fi nancial fi rms would be one way to give highlights the need for regulators to markets, or that price reporting industrial players breathing space to distinguish between commodity and agencies are vulnerable to market adapt to the new requirements. fi nancial markets. Failing to do so could manipulation or confl icts of interest. He impair the effi ciency of energy markets, argues that contrary to the assumptions Andrew Tuson tracks the regulatory potentially resulting in additional costs made by many regulators about the changes that governments and to the end consumer. inherent superiority of automated price regulators have sought to introduce to discovery and averaging systems, the prevent the manipulation of fi nancial Peter Stewart seeks to understand price assessments produced by PRAs markets and to protect consumers regulators’ suspicions of the oil market are in reality protected and enhanced since the fi nancial crisis. He argues that by examining the evolution of the North by the expert judgement of pricing whilst the regulatory changes proposed Sea Brent benchmark, the most widely specialists. Fleming analyses the used price assessment. He argues may work well for fi nancial markets, anomalies and pitfalls that can result that regulators, traders, and price their application to energy markets in from automated systems, and argues reporters each have different agendas, fact poses risks to the orderly operation that true market transparency is the and use terms such as ‘transparency’ of those markets. Tuson says that product of non-static systems guided to mean different things. Stewart the proposed European benchmark by human intelligence, that have the notes that the Dated Brent market regulation does not suffi ciently address capacity to evolve as markets develop has evolved since the 1980s from a the difference between rate markets and to react to anomalous events as relatively simple market structure in and physical markets, and could they occur. which cargoes were traded at a fi xed result in the energy markets being price to one in which the fi xed price Andreas Walstad says that, while the damaged by creating distorted and value of the commodity is effectively regulatory debate around MiFID II unreliable prices. He argues that the discovered through the value of three has focused on the impact on large Market Abuse Regulation due to be separate derivatives instruments. companies with substantial physical implemented in 2016 may provide a While this structure suits the needs of and derivatives market exposures, more effective tool for managing the traders, and the assessment process industrial players for whom energy risk of manipulation.

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We are better informed, but are we any the wiser? Liz Bossley

Long before the banking crisis and of MiFID I. The scope will be widened the Libor scandal kicked off in 2008, ‘A DIRECTIVE IS A LEGISLATIVE ACT THAT to encompass MiFID II in January regulators were hard at work trying to SETS A TARGET THAT ALL EU COUNTRIES 2017. MiFID II and MAR have to be protect markets and investors from MUST MEET.’ consistent in what they say and from deliberate abuse and from structural when they apply, and therefore fl aws that could bring the whole should be considered together. meet. However, under the subsidiarity system down in a cascade of cross The Markets in Financial Instruments principle, it is up to the individual defaults. Regulation (MiFIR) updated and countries to decide how they transpose After 2008, the verdict on these efforts strengthened MAD I and led to the the directive into national law. The was ‘must try harder’ because the drafting of MAD II. directives that will be discussed in this regulatory grip that had been tightening article are: Known as the European Market slowly since the European Investment Infrastructure Regulation (EMIR), Service Directive of 1993 had done The Market Abuse Directive (MAD I) Regulation (EU) No 648/2012 on nothing to stop abuse or to give an (2003/06/EC) had been implemented OTC derivatives, central actionable warning of the banking bail in 2005 by the European Securities counterparties, and trade out that was about to be needed. and Markets Authority (ESMA), repositories is intended to fulfi l imposing administrative sanctions or Europe’s commitment to the G20 to Since then, the G20 leaders’ summits compensation mechanisms under increase transparency, to supervise have been attempting to restore global civil law on market abusers. the OTC derivatives market, and to growth, strengthen the international level the playing fi eld across all fi nancial system, and reform The Criminal Sanctions for Market European member states (MSs). international fi nancial institutions. Abuse Directive (MAD II) (2014/57/ EU) imposes additional criminal Regulation (EU) No 1227/2011 of A signifi cant step was taken in 2009 sanctions against abusers. the European Parliament and of the when the G20 leaders agreed that all The Market in Financial Instruments Council of 25 October 2011 on standardized OTC derivative contracts Directive (MiFID I) (2004/39/EC), wholesale energy market integrity should be cleared through a central which took effect in 2007, and its and transparency (Regulation on counterparty (CCP) and that over-the- updated version, MiFID II (2014/65/ Energy Market Integrity and counter (OTC) derivative contracts EU) aims to increase transparency Transparency or REMIT) adapts the should be reported to trade repositories and limit exposure in the OTC other market regulations to the (TRs) by the end of 2012. The objective market. cross-border characteristics of the was to increase transparency in the gas and power markets. market, in the hope of being able to A ‘Regulation’ is a binding legislative head off any future problems before act. It must be applied in its entirety A Directive is unlikely to result in a they spiralled out of control. across all EU countries. If there is a speedy response to a crisis national law that confl icts with the because it requires separate This article focuses on Europe’s regulation, then that national law must consideration and tailored drafting contribution to the global agenda, be changed. The regulations that will by each of the 28 European MSs which has taken the form of a series of be discussed in this article are: individually. A Regulation can execute Directives and Regulations. a call to action comparatively more The Market Abuse Regulation speedily because it defi nes the labelled (596/2014) (MAR) will replace Directives and Regulations consistent action to be taken across all MAD I in mid-2016 within the scope MSs by a specifi ed date. The fi rst point to get clear is the difference between European Directives ‘A REGULATION IS A BINDING LEGISLATIVE and European Regulations. Market abuse ACT. IT MUST BE APPLIED IN ITS A ‘Directive’ is a legislative act that ENTIRETY ACROSS ALL EU COUNTRIES.’ MAD II/ MAR address market integrity sets a target that all EU countries must and investor protection.

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Market abuse, in European parlance, Not only do MADII/MAR extend so positions and exposures are consists fi rst of insider dealing (when a regulatory oversight to new trading consequently more diffi cult to track. person trades in fi nancial instruments venues and fi nancial instruments, MiFID II / MiFIR recognizes a new actor while having inside information in including OTC commodity derivatives, – the Organized Trading Facility (OTF). relation to those instruments, not they also give regulators more Buyers and sellers of bonds, structured known to other market participants investigative powers (such as access fi nance products, emission allowances, and likely to move the price). Secondly, to premises or phone records), and and derivatives can interact on an OTF market manipulation is also abusive, sanctioning powers (for example, in a way that results in contracts, for for instance, the spreading of false EUR 5 million for an individual and example broker crossing systems or information, or entering into off-setting EUR 15 million or 15 per cent of annual inter-dealer broker systems. Running non-arm’s length trades at off-market turnover for a fi rm). an OTF is an investment service and prices while only informing price- In addition to clarifying and the operator must be licensed as an reporting agencies of one of the deals, strengthening these administrative Investment Firm in the same way as an while conducting trades in related sanctions, custodial sentences of RM or MTF. instruments. up to four years may be imposed Unlike operators of RMs and MTFs, MAD I gave the regulator the right to on individuals found guilty of insider OTF operators have discretion in investigate suspicious price moves, dealing or market manipulation, and placing bids and offers and in but it did not give suffi cient legal up to two years for disclosing inside matching orders, in accordance with certainty for the taking of administrative information unlawfully. It is intended clients’ instructions. For example, a measures or for the imposition of that MAR will give whistle blowers more client of an OTF may specify that it ‘effective, proportionate and protection under law. does not want its orders matched with dissuasive’ sanctions in all European The UK has opted out of MAD II and a particular counterparty with whom, for countries, although the UK Financial is instead introducing its own separate example, it may already have reached Conduct Authority (FCA) has taken a criminal sanctions. an internal dealing limit. large number of successful actions against offenders. RM, MTF, and OTF operators cannot MiFID/MiFIR trade using their own proprietary Signifi cantly for energy commodities, capital, except in the case of illiquid the MAR enters the diffi cult territory of MiFID/MiFIR address market effi ciency, sovereign debt instruments in the case regulating the physical commodity market safety, and transparency. The main objective of MiFID I was to create of OTFs. market. According to the FCA a common internal European market ‘Commodity markets are unique in how Otherwise OTFs are now held to and to promote competition amongst their market activities straddle the broadly the same standards as RMs trading platforms. regulatory boundary so that behaviour in and MTFs in terms of transparent and the physical market can affect the MiFID I took effect in 2007 – arguably fair, non-discriminatory, and orderly fi nancial markets and vice versa. This playing a role in triggering the fi nancial trading. physical market activity is an increasingly crisis by encouraging trade in OTC key infl uence on the real economy.’ markets. This is because MiFID I did ‘MiFID II AND MiFIR ARE TIGHTENING not adopt early proposals to oblige This introduces the prospect of a UP MARKET SURVEILLANCE ACROSS OTC trades to migrate to regulated regulator taking responsibility for ALL PLATFORMS TO IDENTIFY MARKET markets (RMs). Instead, MiFID I regulation of the troubled oil market; ABUSE.’ recognized the concept of multilateral for example, the Dated Brent price trading facilities (MTFs) that are not assessment, the 30-Day BFOE OTFs should not be confused with exchanges, but which were allowed (Brent, Forties, Oseberg, Ekofi sk) Systematic Internalizers (SIs). For to operate alongside RMs in an OTC market, the Dubai crude oil market, example, the head offi ce trading market. and Singapore gasoline. Any regulator function of a major oil company or that takes on responsibility for the Operators of MTFs are able to offer utility may act as a central dealer for its regulation of the physical oil market more exotic and tailored products asset teams or its overseas affi liates. cannot draw a line at Europe, because than those that are offered on RMs; In doing so the SI may deal on its oil is an intricately intertwined and very however, MTF transactions are subject own account or match external orders international market. to less onerous reporting provisions more effi ciently within its own greater

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corporate book. SIs do not have to be concerned is a Financial Counterparty abuse, but it is specifi cally aimed at licensed to carry out this activity. (FC), a non-Financial counterparty the wholesale energy markets (WEMs), above a dealing threshold (NFC+), or including their derivative markets. MiFID II and MiFIR are tightening up a non-Financial counterparty below a market surveillance across all platforms The interconnectivity of gas pipes and dealing threshold (NFC–). Whether the to identify market abuse. Trading electric wires across Europe makes company is NFC+ or NFC– depends venues of all kinds are being held to it diffi cult to assign the responsibility on the size of its notional position over high technical standards to ensure that to police and deal with market abuse a rolling 30-day average period. The they do not collapse when subjected to to a particular national regulatory threshold in the case of commodities high volumes or volatile prices. authority (NRA). So an Agency for the is greater or less than the fi gure of Cooperation of Energy Regulators But where the new rules are being felt EUR 3 billion. (ACER), a new governing body, has fi rst, and by most fi rms, is in the area FCs and NFC+ companies have to do been created to implement and monitor of transaction reporting and clearing. more than simply report deals. They REMIT reporting across Europe and This requires more detailed regulations, have to give up the trade to a Central to assess which NRA needs to be such as EMIR and REMIT, and needs Counterparty (CCP) for clearing. involved in any particular incident. It lengthy and detailed regulatory is the NRAs that are responsible for technical standards (RTSs). The risk mitigation requirements of EMIR setting and enforcing national penalties require parties to deal responsibly by: for market abuse. EMIR Confi rming trades promptly; The target entity under REMIT is the EMIR applies to futures, forwards, Marking trades to market on a daily ‘market participant’, which includes swaps, and options bipartite trades basis; ‘any person, including transmission in the OTC market, including Having a dispute resolution system operators, who enters into commodities. If a company is procedure in place; transactions, including the placing incorporated outside Europe (a ‘third Performing portfolio reconciliation at of orders to trade, in one or more country entity’) EMIR can still apply if regular intervals; wholesale energy markets.’ the foreign company is dealing with Performing portfolio compression, i.e. a European company. The latter will End-users of wholesale energy may netting off long and short positions have to oblige the non-European have a get-out clause if they only held with the same counterparty; counterparty to comply with EMIR enter into contracts for the supply and before they can trade. Similarly, if the Exchanging collateral to secure distribution of electricity or natural deal involves a European instrument, trades which cannot be cleared; and, gas for their own use and have a or if the activity concerned can have Applying higher capital adequacy consumption capacity of less than an impact on a European market, it is obligations on FCs. 600 GWh per year. within the scope of EMIR. However one important qualifi cation is The good news is that transactions made for contracts traded at organized EMIR requires three things of derivative carried out for hedging purposes marketplaces: these all have to be users, including users of commodity are exempt from the EMIR clearing reported to ACER. derivatives: threshold calculation, but the bad news

Reporting of risk; is that if one of a consolidated group of entities exceeds the threshold then The bottom line Clearing of risk; and, they all have to clear eligible trades, The cost of compliance with these Mitigation of risk. whether used for hedging or not. new Directives and Regulations Moreover, as any trader who has ever Each deal is reported to a trade will be enormous and it is already dealt with auditors will confi rm, proving repository (TR), which aggregates causing headaches for the banks, when a trade is a hedge rather than a it and passes it on to a national speculative punt is no easy matter. competent authority (NCA), through ‘TARGETED ENTITIES ARE PARTICULARLY ESMA which analyses it for signs of FRUSTRATED BY THE NEED TO REPORT international systemic risk. REMIT THE SAME INFORMATION TO DIFFERENT The extent to which EMIR applies REMIT is similarly designed to increase REGULATORS IN DIFFERENT FORMATS.’ depends on whether the company transparency and root out market

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large multinational energy companies, gone to the dark side and started As large trading companies such as and trading houses operating in the making speculative punts. Glencore struggle publicly with the energy markets. Targeted entities are consequences of low commodity Small-scale hedgers may be regarded particularly frustrated by the need to prices, it would be reassuring to have as collateral damage in the war against report the same information to different a regulator confi rm or deny fears that market abuse and systemic risk, but regulators in different formats. anything that reduces liquidity increases we are looking over another precipice Smaller companies who really only costs by widening bid–offer spreads. of systemic risk, this time involving the want to use the markets for hedging big private trading houses. It would The heavier regulatory hand we are purposes are likely to be driven away go a long way to silencing the critics now seeing must therefore achieve by the reporting requirements alone. if ESMA were able to either confi rm or its objectives to have any chance of That may be no bad thing, judging by scotch persistent rumours that have justifying the cost. the number of such companies who been circulating for months that we are end up in court complaining that they ESMA currently has a perfect about to see another Lehman Brothers had only authorized hedging and did opportunity to demonstrate the value of in the commodities market. Don’t hold not appreciate that their traders had the regulatory effort. your breath!

Financial regulation in the energy sector: jumping the gun Marco Kerste and Bert Tieben

The inclusion of energy OTC derivative the implementation, we focus on the trading, the actual extent to which trading in EMIR (European Market question of whether it was necessary to non-fi nancial companies contribute Infrastructure Regulation) strongly include energy OTC derivative trading to systemic risk has hardly been the builds on the assumption that the as part of the scope of EMIR in the fi rst subject of research. Policy discussions sector poses risk of contagion towards place. on EMIR have generally focused on the real economy. This hypothesis of regulation design and the necessity of practical rules. This does not mean systemic risk was not well tested as OTC trading and perception of systemic that it is illogical to assume that non- part of the regulatory preparation. We risk – role of regulation fi nd that empirical evidence does not fi nancial sectors contribute to systemic support the hypothesis, questioning the Let us fi rst look at the intentions of risk via the use of OTC derivatives. necessity of fi nancial regulation in the EMIR: it aims to curtail systemic risk In their 2011 paper ‘Regulating energy sector. from over-the-counter (OTC) trading by Systemic Risk: Towards an Analytical introducing a set of legally binding rules Framework’ (Notre Dame Law ‘THIS HYPOTHESIS OF SYSTEMIC RISK to improve the transparency of OTC Review, 86:4, page 1351) Anabtawi trading and diminish counterparty risk. WAS NOT WELL TESTED AS PART OF THE and Schwarcz defi ne systemic risk This latter task is achieved by making REGULATORY PREPARATION.’ as ‘the risk that a localized adverse central clearing an obligation. This shock, such as the collapse of a fi rm obligation also extends to non-fi nancial When assessing the net benefi ts of or market, will have repercussions counterparties (NFCs), depending regulation, it would be easy to take that negatively impact the broader on the type of OTC contracts and the the intended contribution as a given economy’. The function of banks as notional value of the contracts. starting point in terms of positive fi nancial intermediaries – being a impact. Alas, in our experience this With EMIR, the scope of fi nancial condition sine qua non for funding constitutes a typical example of regulation is thus expanded towards the consumption and investments of ‘jumping the gun’, as the intended non-fi nancial sectors, assuming many economic participants – implies contribution of regulation is not always systemic risk can be channelled from a close relationship with the real rigorously tested upfront. Where we non-fi nancial sectors to the fi nancial economy. In other words: a disruption expect that other contributors in this sector through the use of derivatives. of this function has a direct impact on issue will focus on the impact of EMIR Although the credit crisis indeed points activities in the real economy. This puts on energy commodity trading after at serious risks in OTC derivatives fi nancial institutions at the centre of the

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systemic risk discussion. But that is not striking that the impact assessment systemic risk within the energy sector the whole picture. is purely policy driven: the clearing compares to systemic risk within the obligation is preferred because, by fi nancial sector, as well as the degree In identifying systemically important defi nition, it reduces counterparty risk of contagion risk from the energy sector markets, institutions such as the for OTC contracts on an individual level. towards the fi nancial sector. This latter International Monetary Fund (IMF), the But this does not mean that systemic form of contagion risk formed the Financial Stability Board (FSB), and the risk at a market level is also tackled. primary reason for including energy Bank for International Settlements (BIS) At a certain point in the draft-making sector derivative trading in the scope point primarily to size, substitutability, process the phrase ‘systemic risk’ was of EMIR. and interconnectedness. And it is simply substituted for ‘counterparty because of meeting at least the fi rst To empirically test the degree of credit risk’, which underlines that and last of these three criteria, in contagion risk our research uses a there was hardly any analysis of the combination with the counterparty proxy for systemic risk; this is based nature of the problem that EMIR aims risk involved, that OTC derivative on the chance of companies defaulting to solve. Nor was this achieved by markets are often considered to be given that at least one other company the impact assessment executed an important component of systemic defaults, in other words, the expected as part of the regulatory process risk. This explains why regulations, fraction of ‘additional failing fi rms’. It following the offi cial publication of such as EMIR, relating to fi nancial also introduces an indicator for the EMIR. This cost–benefi t analysis still markets and specifi cally focusing causality of contagion risk, because ignored the nature of systemic risk as a on the role of derivatives in fi nancial the direction of the contagion is an phenomenon pertaining to the level of trading, are introduced. And, as a direct essential element underlying regulation. derivative markets as a whole, merely consequence, non-fi nancial sectors isolating costs and benefi ts that can Interestingly, linkages between are also brought under the potential companies in distress (in other words, scope of fi nancial regulation, given that be attributed to specifi c details of the the chance of failures spreading within commodity products such as energy regulation. a sector) are highest in the energy are the subject of OTC contracts. As such, there is no overall assessment sector. That is, higher than in the of the costs and benefi ts of EMIR, in construction, food, insurance, and even EMIR’s intended role in targeting terms of the reduction of systemic the banking sector. The extensive use systemic risk risk that it generates as an economic of derivatives might play an important benefi t, balanced against its economic role in this regard: energy companies EMIR explicitly focuses the clearing costs. More generally, the European are generally each other’s counterparty obligation on the curtailment of Securities and Markets Authority in derivative contracts. Another systemic risk. However, there is very (ESMA) continues to use systemic risk explanation is the high degree of vertical little factual evidence that the clearing as the main target for which EMIR is integration in the sector, with fi rms obligation will actually achieve this considered to provide the solution, controlling both production and networks objective, or that it will do this in a cost- without sound evidence of the problem for transmission and distribution. This effi cient manner. The draft regulation for as such, nor of its magnitude and the integration provides a channel for EMIR included an impact assessment best ways to tackle it. fi nancial contagion within the energy of different options to curtail systemic sector. Finally, there is a strong correlation risk. The Impact Assessment by the between the economic performances European Commission in 2010 initially Do non-fi nancial sectors contribute to of energy fi rms, as energy prices are referred to counterparty credit risk systemic risk? closely tied to the international price of and operational risk as such, but the As the proof of the pudding is in the crude oil. Changes in this price regulation clearly isolates the reduction eating, the question that thus remains constitute a fundamental indicator for of systemic risk as the prime target. is whether non-fi nancial sectors like the the economic wellbeing of the energy However, what exactly constitutes energy sector do indeed contribute to sector as a whole. systemic risk is left open. It is therefore systemic risk (as the banking sector does) and if so to what extent? To Risk of direct impact on the real economy? ‘EMIR EXPLICITLY FOCUSES THE answer this question, in our 2015 CLEARING OBLIGATION ON THE article ‘Systemic risk in the energy In testing the contribution to systemic CURTAILMENT OF SYSTEMIC RISK.’ sector – Is there need for fi nancial risk, the question is fi rst whether an regulation?’, we investigated how outcome in which risks are relatively

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intertwined in the energy sector – via systemic risk is the second question: the use of derivatives or not – causes whether there is contagion risk from ‘… THE EXACT CONNECTION BETWEEN a direct impact on the real economy. the energy sector towards the fi nancial SYSTEMIC RISK AND OTC TRADING BY The potential direct impact of OTC sector. This would imply an indirect NON-FINANCIAL SECTORS REMAINS commodity derivative trading by the impact on the real economy. We fi nd UNKNOWN.’ energy sector on the real economy is that, on average, contagion risk runs generally seen to operate via the price from the banking sector towards the a fi rst check of the need for fi nancial mechanism – and more specifi cally energy sector and not the other way regulation in the energy sector, and through the risk of price shocks due around. Moreover, compared to the it turns out to be negative. However, to speculation on energy derivative food and construction sectors, the further research into the nature of markets. Based on earlier research in energy sector does not stand out in systemic risk in the energy sector is our 2011 study Curtailing Commodity terms of contagion risk towards the needed. We conclude that currently, Derivative Markets, we conclude that banking sector. Because the use of from an economic point of view, both high systemic risk within the energy derivatives in the food and construction the need for, and the design of, EMIR sector is mainly a problem for the sectors is much lower than in the lack conclusive analysis with regard energy sector itself. The high expected energy sector, the results indicate that to the inclusion of at least the energy fraction of additional failing fi rms means the mere use of commodity derivatives sector. More generally, the exact that a localized adverse shock in the by fi rms in the energy sector does connection between systemic risk and energy sector will have repercussions not seem to be an essential element OTC trading by non-fi nancial sectors for more energy companies, and affecting the magnitude of potential remains unknown. The political haste potentially for the energy sector as a contagion. in implementing strict regulation in the whole. However, there is no empirical aftermath of the severe fi nancial crisis evidence that the defaults of energy Conclusion is understandable, but continuing on companies will pose a direct negative this road without sound foundations externality to the real economy. The hypothesis underlying regulation is not. of the energy sector – that the high use of commodity derivatives This article is partly based on: M. Kerste, Contagion risk to fi nancial sector – indirect implies relatively high contagion risk M. Gerritsen, J. Weda, and B. Tieben, impact from the energy sector towards the ‘Systemic risk in the energy sector – More important for the assumption banking sector – is not supported Is there need for fi nancial regulation?’, that the energy sector would pose by the empirical data. This provides Energy Policy, 78 (2015), 22–30.

Cause and effect: the impact of European regulation Peter Caddy

The European oil market is was either rigged or in the hands Risks of moving to ‘rules-based approach’ experiencing a veritable tsunami of new of odious speculators. The second for EU regulation legislation and regulation which has not was the 2012 Libor scandal which, As a consequence, oil trading is facing yet reached its full course and which although having nothing to do with oil, a new regulatory regime. Instead of the confi rmed, to those inclined to believe will have profound consequences on traditional ‘principles-based approach’ that markets are inherently immoral, the way oil is traded. of UK regulators, with an emphasis that action was needed to prevent on market integrity, the European The impetus for the new European fraud and manipulation. The distinction Union (EU) is instituting a ‘rules-based regulation comes out of two events. between fi nancial markets and trade The fi rst was the 2008 crude price rise in commodities was then deliberately to USD 147/barrel which destabilized muddied by some European ‘A RULES-BASED APPROACH PLACES THE the plans and aspirations of many governments to surreptitiously extend EMPHASIS ON THE IDENTIFICATION AND European political leaders and led fi nancial market regulation into the PUNISHMENT OF WRONG DOERS …’ to accusations that the oil market trading of commodities.

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approach’, more in tune with the cheaper locations, and new forms of produce a more appropriate regime customs of continental Europe than the contract to avoid the costs and risks than in Europe. UK. A rules-based approach places of the new regulation. An irony is that EMIR was a response to the G20 the emphasis on the identifi cation and the EU has exposed its consumers to leaders’ call in Pittsburgh in 2009 that punishment of wrong doers, on the the unintended consequences of oil all standardized derivative contracts assumption that this will produce a market regulation, despite not having should be traded on exchanges or ‘better’ market. prosecuted or secured a conviction for electronic trading platforms, where fraud or manipulation in the oil markets, There is an irony in that the USA, which appropriate, and cleared through even though there was intense political has traditionally taken a rules-based central counterparties. However, pressure to do so, and notwithstanding approach to markets, is now trying to policy makers failed to grasp the fact the ‘dawn raids’ on leading oil market establish a principles-based approach that there is no obligation to trade participants. to some regulation. The Commodity standardized derivative contracts Futures Trading Commission (CFTC), by the oil industry. And here lies the which is responsible for the secondary EMIR, REMIT, MAR, MiFID, CRR/CRD IV, … fundamental misunderstanding by legislation that emanates from Dodd– policy makers in their attempts to Trying to follow the course of European Frank, is continuing to write and regulate the market. Derivative trading regulation risks death by acronym. enforce more Dodd–Frank rules but in oil exists for a purpose – and that There is EMIR (European Market is also recognizing that rules can be purpose is not speculation. Speculators Infrastructure Regulation), REMIT over complicated and can lead to may be active in the market, but (Regulation on Energy Market Integrity companies fl eeing the market because derivatives exist to manage price risk. and Transparency), MAR (Market legal risks and compliance costs act Derivatives are, or have been, a cost- Abuse Regulation), MiFID (Markets as major deterrents to participation. effective means of managing price in Financial Instruments Directive), The rigid application of inappropriate risk. But they are not the only option MiFID II, the Capital Requirements regulation aimed at wrong doers can available to the industry to manage Regulation and Directive (CRR/ damage and even destroy market risk. And if they become too costly, or CRD IV) and the, as yet, unabbreviated liquidity, not because there are wrong too legally risky, then the industry will proposed European benchmark doers, but because the costs of manage its price risk through different compliance are borne by innocent regulation. This is in addition to the means, much as it did in the USA parties who face risks should they pre-existing legislation and regulation through most of the last century. accidentally fail to comply with what are surrounding market manipulation, often inconsistent and contrary legal manipulating a benchmark, and requirements. In those circumstances, exchange regulation. Distinguishing physical commodities from advise their legal counsel, it is better to fi nancial markets The most impactful legislation avoid the danger by fl eeing. will probably be MiFID II, and its The oil industry, and the oil market, is The European oil market regulatory consequences for the impact of CRR/ much misunderstood in Europe, often environment is in the process of CRD IV, followed by EMIR. REMIT, deliberately so. The 2008 price rise, for switching from the old Financial which affects gas and power markets, example, was not simply speculators Services Authority (FSA) ‘integrity was essentially in place anyway running out of control, but was a result of the market’ approach to the new through national requirements, and of the industry’s inability to produce Financial Conduct Authority (FCA) market manipulation was always illegal. suffi cient diesel to meet demand. approach designed to ‘identify fraud Similarly, the recent fall in crude It is unclear what impact the EU and market manipulation’ backed prices to around USD 40/barrel is a benchmarking regulation will have, by new European legislation. But consequence of the industry’s inability but it can only be to the benefi t of the costs imposed on the industry to stop producing diesel when there is the US and Asian markets, where through capital requirements, position more than suffi cient to meet demand. regulators are clearly working to limits, collateral obligations, and the The misunderstanding by policy provision of data that the regulators makers is caused by their inability to require to monitor and supervise the ‘DERIVATIVE TRADING IN OIL EXISTS FOR grasp the relationship between crude market will damage liquidity in certain A PURPOSE – AND THAT PURPOSE IS NOT oil and products, and between the forms of trading. The industry will seek SPECULATION.’ trade in crude oil and a refi ner’s call to lower-cost risk management vehicles, meet product demand. Policy makers

10 OXFORD ENERGY FORUM DECEMBER 2015: ISSUE 103

typically only ‘see’ the futures price been the undermining and potential is, if they participate in it at all, ancillary and therefore, almost by defi nition, destruction of the transparency and to their primary activity, even though everything else must be murky and effi ciency of derivatives in favour of less this will likely not legally be the case incomprehensible, even though it is transparent and less effi cient options, according to the new MiFID rules going in full view to the industry and anyone or the shifting of risk management to a through Europe. And here lies the rub. who chooses to subscribe to a price- different jurisdiction. Policy makers are defi ning activity in reporting service’s market reports. As a legal manner, in the expectation that Companies that buy and sell along a consequence, policy makers view they can then instruct it to occur in the supply chain in oil are not doing the world through a distorted lens and a prescribed manner. But they fail to so in order to speculate on upward or their responses become misplaced as understand that companies can avoid downward price movements. They are a result. such a prescribed manner by changing producing oil at the top of the supply their activity. Similarly, policy makers in Europe fail chain and then moving it, sometimes to understand the distinction between indirectly by trading it on, down the fi nancial markets and the trade in supply chain to the consumer. In doing Consequences of EMIR physical commodities – confusing so they are remunerated by taking the EMIR has inadvertently – indeed, fi nancial swaps with physical trade, oil from where it is in surplus, such as counter-intuitively for policy makers and confusing physical price at the well head, to where it is required, – already led to gas and power identifi cation with the generation of at the pump. Doing this carries inherent trade moving from MTFs (multilateral a pure fi nancial benchmark. This is price risk. trading facilities) to non-MTFs, or creating major problems with the into bilateral OTC (over-the-counter) implementation of MiFID II legislation: ‘ A MISUNDERSTANDING OF THE PURPOSE contracts. The result may be that from establishing position limits to OF THE DERIVATIVE MARKETS IN OIL LIES some small exchanges go out position reporting; from defi ning AT THE ROOT OF THE DIFFICULTIES IN THE of business. Probably, business ancillary activity to imposing restrictions EUROPEAN REGULATORY ENVIRONMENT.’ will become focused through one and costs on such activity; and in dominant exchange and there will defi ning what is, and what is not, a This risk can be mitigated through be a concentration of the liquidity derivative. There will probably be a variety of means, only one of through the companies that have similar problems of implementation which is hedging the commodity been prepared to absorb the costs when the EU benchmarking proposals through derivative contracts. A of the regulation. MiFID II is likely to become law. misunderstanding of the purpose of intensify this shift and extend it into oil. The capital requirement costs, the derivative markets in oil lies at the the management and compliance Price risk management root of the diffi culties in the European costs, and the regulatory restrictions regulatory environment. Policy makers Managing price risk is almost as on position limits will reduce liquidity think that derivatives determine the important as managing volume in standardized derivatives. There price of oil or ‘are’ the oil market. But risk for oil companies. It is ‘almost will probably be a movement of oil crude oil is rarely sold through the as important’ because it is easier derivatives trade to exchanges out futures markets. Even when physical than dealing with volume risk, not of the EU where banks, in particular, delivery is possible, as with the Nymex least because there are many ways will be able to trade without the same crude oil futures contract, most crudes of dealing with it. How and where restrictions imposed in Europe, that are linked to this price will trade companies manage their price risk and where trading costs will be at a price differential to account for is varied. It is not all through the lower. For oil companies, the focus quality, location, timing, and contract European derivatives market, it is will be on price risk management terms. Try calling a Canadian crude just that the derivatives markets have through non-standardized means producer in Alberta and asking if he proven to be the most effi cient and cost such as embedded options in is receiving the USD 50/barrel price of effective way of managing such risk. physical contracts, which will provide fi rst month Nymex futures for his barrel But if this ceases to be the case, then companies with the fl exibility to shift of heavy synthetic crude. the industry will revert to other ways trade fl ows, either through location of managing price risk. This will mean Oil companies are involved in the or timing, to a more optimal market. that the outcome of the new European physical supply chain. For companies Large oil companies are already writing regulatory environment will have in the supply chain, derivatives trading contracts in this manner and producers

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that refuse to offer this fl exibility will be activity amongst the political left and Parliament and Council, to the extent shunned or made to absorb the cost of parts of the political right. There is a that both have rewritten large parts bearing the risk of unhedged trade. communication paradox when the of the proposals. The Council text industry and policy makers meet. Any accepts and understands that trade In practice this will mean that buyers discussion within the industry on price in commodities is different to that in will face locational arbitrage that will identifi cation and market robustness fi nancial instruments, and so refl ects a be too costly to manage through will ultimately focus on the importance better approach. But the Parliament has derivatives. Producers might have to of liquidity, because liquidity brings better third-country regime proposals; sell on a delivered basis, taking the transparency and robustness to pricing these will be critical, as trade in risk of timing of delivery and freight and provides the stability of depth of commodities is global and not confi ned onto their own shoulders, and deals on market. But most of the policy making to a single national jurisdiction. an f.o.b. (free on board) basis will be infrastructure in the EU, whether at limited to commodity traders who may not be able to bear the price risk purely European Parliament level or within the Differences between EU and global through offsetting European-based Commission, is intrinsically distrustful of approach derivatives, but only through back-to- liquidity, as it is considered ‘excessive There will be unintended consequences back trades. This will inevitably result speculation’. Imposing restrictions from the EU’s benchmarking in producers having to accept lower and costs on liquidity is often seen as proposals because Europe seems prices, and consumers higher prices, a ‘good’ outcome by policy makers. intent on deviating from a globally because that will be the only safe Yet the new regulation, by affecting agreed and workable consensus on way for the commodity supply chain what the policy makers can ‘see’ oil benchmarks. The G20 leaders’ to carry the risk. It will also probably (standardized derivatives trades), will meeting in Seoul commissioned a result in variable pricing terms, or more have the unintended consequence work stream that produced a report pricing formulas, as commodity fi rms of driving price risk management known as the IOSCO Principles for Oil try to minimize their risk exposure and into formulations that offi cials cannot maximize their opportunities – the result ‘see’, such as bilateral physical supply Price Reporting Agencies in October of which will be less transparency. And contracts with embedded optionality. 2012. This report, produced by the all of this will increasingly occur outside International Organization of Securities Commissions (IOSCO), in collaboration the EU. MiFID II and European benchmark with OPEC, the IEA, and the IEF, regulation established a framework of best Intentions of EU policy makers – and MiFID II is law but has yet to come into practices for producing assessments consequences effect; its impact will become apparent which are referenced by oil derivative European policy makers had desired over the next two years. Not yet law, but contracts. to eliminate fraud and market in the process of becoming so, is the But IOSCO’s ‘principles-based manipulation, but their efforts will result European benchmark regulation. This approach’ is considered inappropriate in eliminating liquidity. It is the Vietnam regulation is in ‘trilogue’, the process by Brussels, which favours a ‘rules- War strategy in regulation: there may that seeks an agreed fi nal text from based approach’. The European be a ‘bad guy’ in the village, even if he the European Commission’s initial Commission, somewhat arrogantly, cannot be seen, so to eliminate him it is proposals, and amended versions of expects the world to follow its lead necessary to destroy the village. the text from the European Parliament in designing legislation to codify and the Council of Ministers. these principles, and indeed to go ‘EUROPEAN POLICY MAKERS HAD The Commission’s text on substantially beyond them. Signifi cantly, DESIRED TO ELIMINATE FRAUD AND benchmarking law was issued two the position of the US administration, MARKET MANIPULATION, BUT THEIR years ago and was a poor piece the US Congress, and the US regulator EFFORTS WILL RESULT IN ELIMINATING of legislative drafting. By failing to (the CFTC), is that no specifi c LIQUIDITY.’ understand the difference between regulation on benchmarks is necessary fi nancial markets and physical or even appropriate. The IOSCO In Europe this is not necessarily commodity trade, the text was full Principles for Oil Price Reporting considered to be a ‘bad’ outcome of errors and misunderstandings. It Agencies work and should be allowed because ‘trading’ is regarded as an was rightly criticized widely. The text to work. Poorly drafted legislation inherently suspicious, if not immoral, has been heavily amended by both will not work as intended, not least

12 OXFORD ENERGY FORUM DECEMBER 2015: ISSUE 103

because it has the potential to threaten companies and consumers that will volatility will increase; standardization what has hitherto been a secure fl ow suffer. of contracts will cease; physical of oil to consumers, by failing to allow commerce will remain off electronic the market to represent fundamentals Record of industry success in maintaining platforms; and inherent risk will be through a freely determined open supply injected into the market rather than market price. removed. Keep in mind that there has been In practice what does this mean? Well, no market-induced breakdown in unsurprisingly the Americans seem Probable consequences of regulation the supply of oil to the consumer in to be getting it right on benchmarks, recent history, even during times of Oil will still fl ow from producer to partly because they made their intense price volatility. This is a tribute consumer, but the direct costs of mistakes earlier in Dodd–Frank, to the industry, which has supplied regulation and the consequential and the CFTC have been trying to oil to the consumer when production, costs of carrying the new and implied rectify some of these mistakes. The transportation, and consumption risks will be borne by the consumer. CFTC has also seen the unintended have all been threatened by wars, Hopefully, for the consumer, the fall in consequences on liquidity in fi nancial political unrest, and misplaced policy. the price of oil will to some extent offset markets, especially for US Treasuries, The industry has gained little public these additional costs of regulation. of restrictive legislation. The European recognition for this. Ironically the Commission, as always, seems intent biggest threat to the cost-effi cient ‘WHEN POLICY MAKERS INTERVENE IN on making its own mistakes regardless supply of oil to the European consumer THE WORKINGS OF A FREE MARKET, of the impact on European citizens. now comes from a developing It is noticeable that it is the elected THE EFFECT IS INVERSELY regulatory regime that was supposed to European representatives, rather than PROPORTIONAL TO THE INTENT.’ provide the consumer with protection. doctrinaire offi cials, who are more concerned with the impact of bad It is feared that European regulation, The basic rule of much regulation regulation on people’s living standards. however well-intentioned, is having and continues to true, especially when Much will now depend on whether the will continue to have consequences applied to global trade: when policy Europeans and the US authorities can which are opposite to those envisioned makers intervene in the workings of create a workable third-country regime. by the policy makers. Liquidity will be a free market, the effect is inversely If they don’t, it is likely to be European reduced; transparency will decline; proportional to the intent.

OTC derivatives market regulation and commodity derivatives Orçun Kaya

In the wake of the fi nancial turmoil, market size, interconnectedness, Early commitment, lengthy implementation over-the-counter (OTC) derivatives limited transparency regarding The main pillars of the derivatives have become the focus of attention. the counterparty exposures, and market reforms are that: Indeed, the market size is gargantuan market participants’ insuffi cient 1 all derivatives trades should be with a notional volume of USD 630 risk management practices have trillion, and it dwarfs the exchange- reported to trade repositories, intensifi ed the impact of the fi nancial traded derivatives that have a notional crisis and thus are potential sources 2 standardized OTC derivatives should volume of only USD 65 trillion. To date, be centrally cleared and traded on of heightened volatility and systemic a signifi cant part of OTC derivatives organized venues, and risks. Against this background, the trades has been handled by a small 3 non-cleared derivatives should be number of dealers that are the G20 leaders agreed at their Pittsburgh subject to higher margining main counterparties of practically meeting in 2009 to undertake reforms, requirements. all other market participants. In intending to increase transparency and the eyes of regulators and policy reduce counterparty risk in the OTC The Dodd–Frank Act in the USA, the makers, the OTC derivatives’ derivatives markets. European Market Infrastructure

OXFORD ENERGY FORUM 13 ENERGY TRADING AT THE CROSSROADS

Regulation (EMIR), and the Markets in segment due to the tailored structure ever actually exchanged between Financial Instruments Directive (MiFID) of these contracts. In a nutshell, end- contracting parties. The exchange- in Europe are the main bodies of users of commodity derivatives aim to traded commodity derivatives in this legislation for OTC derivatives reporting, hedge their exposures to price changes vein present an integral picture for central clearing, and exchange-trading of the underlying raw materials such as the use of commodity derivatives in rules. The initial implementation deadline crude oil, natural gas, precious metals fi nancial markets. Up from 1.2 billion was set by the G20 for the end of 2012; as well as agricultural commodities in 2012 and 3.1 billion in 2013, almost however, it was not met by any of the and livestock. As derivatives market 3.6 billion commodity contracts were jurisdictions. Almost three years after regulation has been tightened up in traded on exchanges in 2014. This the targeted deadline, rule making and recent years, commodity derivatives corresponds to around 17 per cent of implementation of those rules have have experienced severe regulatory the total exchange-traded derivatives, been fi nalized only in the USA, and this treatment too. Both Dodd–Frank and which is certainly a signifi cant share. only recently. Meanwhile, cross-border EMIR requirements such as central Exchange trading of commodity rules and margin requirements for clearing, mandatory reporting, and derivatives has become widespread non-cleared derivatives are expected to higher capital charges for non-cleared in recent years and a divergence be fi nalized by the end of 2015. Europe derivatives apply to commodity between OTC versus exchange- lags even further behind, and reporting derivatives. That said, in both trading volumes is evident. Regulatory requirements did not start before 2014. jurisdictions there are exemptions for pressure to encourage trading on The clearing obligation is expected to certain products, such as physically exchange platforms seems to have take effect in 2016. Equivalence settled commodity swaps or forwards, created some impetus for greater use determinations have been progressing and counterparties. There is broad of these platforms. The high degree slowly also in Europe. Since the lion’s usage of commodity derivatives and of exchange trading of commodity share of derivatives trades takes place trading takes place on both organized derivatives may also point to an either in the USA or in Europe, other exchanges and on OTC markets. increasing role of institutional investors jurisdictions are waiting for the USA and Before the crisis, OTC commodity in this market segment. A large degree the EU to clarify their regulations and derivatives transactions expanded of standardization and fi nancialization cross-border agreements. For this exponentially and outstanding notional of commodity derivatives, in particular, reason, rule making has just begun in amounts jumped from USD 598 billion would make reporting requirements several jurisdictions and progress in 2000 to USD 13,299 billion in 2008. to trade repositories easier for these varies across regions. products. ‘AMONG THE OTC DERIVATIVES TRADED, Global implementation of these new THE COMMODITY DERIVATIVES MARKET rules is already far behind the planned Standardization alone is not enough for SHARE IS ALMOST NEGLIGIBLE …’ timetable. The uncertainty regarding the clearing eligibility schedule is of concern for market players and may lead to regulatory With the outbreak of the crisis, this Among the agreed reforms, the arbitrage. An even more important trend reversed and outstanding mandatory central clearing of OTC point for market participants is the amounts dropped steadily to derivatives by central clearing mutual recognition of central clearing USD 1,868 billion in 2014. Among the counterparties (CCPs) is a drastic rules, especially between the USA and OTC derivatives traded, the commodity change that forces market participants the EU. Little progress has been derivatives market share is almost to revise their existing risk management achieved on this front so far. This may negligible and stands at around 0.3 and collateralization practices. To result in double application of clearing per cent of the outstanding notional achieve more transparent, effi cient, and margining requirements, thereby amounts. That said, notional amounts and robust derivatives trading, CCPs causing prohibitively high derivatives are largely infl ated, so this means interpose themselves between the trading costs. they could be somewhat misleading trading counterparties and become indicators of economic relevancy. Put a buyer to every seller and a seller differently, counterparties are seldom to every buyer in a derivatives Large exchange-trading volume for required to pay out the full value of trade. Meanwhile, to maintain their commodity derivatives some derivatives in the OTC landscape; soundness, CCPs have stricter OTC derivatives markets are particularly for example, interest rate swaps have collateralization standards than bilateral relevant for the commodity derivatives huge face values but they are hardly trades, such as higher initial margin

14 OXFORD ENERGY FORUM DECEMBER 2015: ISSUE 103

requirements and more frequent of the commodity derivatives traded on Cost of central clearing will probably be variation calls, as well as contributions exchanges were agriculture derivatives. passed on to end-users to CCPs’ default funds (waterfall of Energy and non-precious metals Before the crisis, longstanding trading resources). derivatives constitute 28 per cent and relationships of counterparties with high 21 per cent of the trades, respectively. In recent years there has been a creditworthiness allowed fl exibility for Other sub-segments of commodity signifi cant move from bilateral non- bilateral derivatives trades. By contrast, derivatives, such as precious metals cleared trades to CCPs for certain asset CCPs have strict rules on initial and and other materials, have relatively few classes. In 2015, for example, around variation margin requirements and transactions. These are usually tailored 48 per cent of interest rate swaps have offer much less fl exibility to negotiate. been centrally cleared by the CCPs, products that are designed to meet the As a result, the cost of derivatives up from 34 per cent in 2011. Similarly, specifi c needs of counterparties and as trading will signifi cantly increase for a remarkable 21 per cent of credit a result are traded much less. Due to the centrally cleared products. In the default swaps have been centrally their lack of liquidity, CCPs will be less eyes of some observers, the additional cleared, up from 11 per cent in 2011. likely to offer clearing services for these costs will eventually be passed on However, central clearing of commodity products. This implies that a large to the end-users (buy-side clients) of derivatives has been very limited to proportion of the bespoke commodity derivatives contracts. In short, there are date. This is probably due to bespoke derivatives will remain non-cleared as three different types of transactions in features of commodity derivatives there will be no clearing house ready derivatives markets. The fi rst type of and their liquidity characteristics. and willing to clear them. transaction takes place between two Expressed differently, the recent dealers that trade for market making uptick in exchange trading may point ‘… IT IS LIKELY THAT THE TRADING and liquidity. These types of trades to the adaption of some commodity OF PARTICULAR COMMODITY are probably the least of concern for regulators. The second type of derivatives to the standard defi nitions DERIVATIVES WILL BE PROHIBITIVELY and confi rmation agreements. transaction occurs between a dealer EXPENSIVE …’ Standardization of the derivatives and a fi nancial end-user such as a contracts is a prerequisite for central pension fund, insurance corporation, or In order to promote central clearing clearing eligibility, yet it is certainly not asset manager that is trying to hedge and to ensure that suffi cient for risk in their portfolios. The third type the only criterion. For central clearing collateral is collected, policy makers of trade takes place between a dealer eligibility, liquidity and associated imposed substantially higher margin and a non-fi nancial end-user that aims effi cient pricing are a sine qua non that requirements and additional capital to reduce balance-sheet volatility, needs detailed elaboration. charges for non-centrally cleared eliminate uncertainty in their cash derivatives trades. To defi ne the fl ows, and mitigate risk for their future Liquidity creates a bottleneck for central cornerstones of the additional investment plans. The last two types clearing measures, the BCBS–IOSCO (Basel that try to hedge their business risks One of the key determinants of Committee on Banking Supervision are of particular concern for the policy a CCP clearing decision is the and the International Organization makers. of Securities Commissions) has degree of liquidity. Indeed, in case Figures from ISDA (the International released a framework and set the initial of a counterparty default, liquidity Swaps and Derivatives Association) margin requirements for non-centrally characteristics of derivatives are crucial may help to delve deeper into the for CCPs to manage the portfolio of cleared commodity derivatives to 15 composition of traders in the OTC the defaulting clearing member in per cent of the notional exposure. landscape. In 2013, around 16 per a timely and effi cient manner. As a After the full implementation of the cent of the derivatives trades took result, CCPs primarily accept liquid reforms it is likely that the trading of place between two dealers, down from derivatives that are less volatile and particular commodity derivatives will be 28 per cent in 2012. A striking 80 per have relatively robust reference entity prohibitively expensive and they might cent of the transactions meanwhile characteristics for central clearing. be unattractive at the free-market price. are between a dealer and a fi nancial The number of trades in commodity In this respect, market participants institution, and around 3 per cent are derivatives sub-segments sheds some using these instruments for hedging between a dealer and a non-fi nancial light on the liquidity characteristics of purposes may need to revise their end-user. If the cost of central clearing these assets. In 2014, almost one-third practices and business models. is passed on to fi nancial and non-

OXFORD ENERGY FORUM 15 ENERGY TRADING AT THE CROSSROADS

fi nancial end-users via higher spreads condition that notional amounts of 80 per cent are below the threshold etc., this could have implications for the their derivatives trades are below defi ned by EMIR. In this light, changes real economy. Expressed differently, the certain thresholds. Notwithstanding, in the hedging criteria as recently heightened hedging costs of fi nancial the European Securities and Markets recommended may have negative and non-fi nancial fi rms may lead to Authority (ESMA) has recently released consequences for NFCs that trade unhedged positions and thereby more a report recommending the removal commodity derivatives. volatile balance sheets and subdued of the hedging criteria for NFCs. The investment levels. background reason is to simplify ‘… THE NEW RULES AND REGULATIONS NFC defi nition along with the fact WILL FUNDAMENTALLY CHANGE THE that hedging may not be the most DERIVATIVES MARKETS …’ Uncertainty regarding the hedging criteria relevant criterion in determining the in Europe systemic relevance of NFCs. However, All in all, the new rules and regulations Taking into account the potential side the exemptions for NFCs that hedge will fundamentally change the a commercial risk are particularly effects of the new regulatory reforms on derivatives markets after their full important for the commodity derivatives the real economy, regulators on both implementation. It remains to be segment, considering that NFCs are sides of the Atlantic have introduced seen to what extent they will affect vital and important market participants. central clearing exemptions for non- the pricing, liquidity, and trading of More specifi cally, another report from fi nancial counterparties (NFCs) that commodity derivatives. ESMA shows that among different OTC engage in derivatives transactions to derivatives the share of the NFCs is All the usual disclaimers apply; in hedge or mitigate commercial risk. the largest in commodity derivatives: particular, the views expressed herein For example, NFCs are not subject they account for one-fi fth of the gross are my own and do not necessarily to the mandatory central clearing notional amounts traded. Of these, refl ect those of Deutsche Bank AG requirement under EMIR on the or Deutsche Bank Research.

MiFID II: the impact on commodity markets from a venue perspective Ben Pott and Graham Francis

Commodity derivative markets have immune to the effects of the 2008 crisis. crisis regulatory reform programme. been a cornerstone of modern fi nancial Over-extension and a speculative bubble Whereas bank reform has changed services since the Big Bang in 1986. have led to market participants’ failure, the face of participation, it is market- The ability of end-users to hedge their with knock-on consequences for specifi c reform – Market in Financial commodity exposures and anticipate investors. Whereas other markets have Instruments Directive (MiFID) II – which price movements has ultimately had experienced a withdrawal of liquidity as will have a more profound impact on a stabilizing effect on end-user prices banks had to rein in their trading books, the intermediated commodity markets. and, together with deepening liquidity the commodity sector has seen a more This paper sets out not just the future in these markets, has led to tighter dramatic change in participation – away challenges faced by participants bid–offer spreads, again leading to from the traditional broker dealer banks but also focuses specifi cally on the reduced costs for the end-users. This towards trading houses, often based reorganization and reshaping that is link between end-users and fi nancial outside of the European Union perimeter. required by these intermediaries – today’s brokers and trading venues. trading is perhaps unique in fi nancial However, commodity markets today are markets. It means that changes to the still experiencing the turmoil of the post- trading landscape can have direct Background consequences on the price at the ‘… COMMODITY MARKETS TODAY ARE MiFID II will be a key milestone in pump, or on the household energy bill STILL EXPERIENCING THE TURMOIL OF commodities trading markets. The at the end of the month. THE POST-CRISIS REGULATORY REFORM requirements to trade on venues However, commodity markets – like any PROGRAMME.’ (trading obligation), together with other fi nancial market – have not been the organizational requirements on

16 OXFORD ENERGY FORUM DECEMBER 2015: ISSUE 103

test takes them outside of MiFID II, The key differences between MTFs and OTFs but will instead need to prepare for Multilateral trading facility Organized trading facility MiFID II rules by taking a conservative (MTF) (OTF) view – whether they are likely to breach Product coverage All fi nancial instrument Non-equities only the volume thresholds set out in the Type of execution Non-discretionary only Discretionary regulatory standards (see below) or Restrictions Cannot execute against own Cannot execute against own not. capital or matched principal capital but can operate as matched principal In addition, there are concerns that the current main business activity test Participation Authorized participants only Can be unregulated is too narrowly focused on trading Conduct Limited application Full applicability of conduct activity – the test will see fi rms calculate requirements requirements including best execution their position in derivatives and EU allowances, and measure this against their overall position. This will then give intermediaries to trade as a trading additional regulatory capital they would a percentage fi gure which represents venue – either a multilateral trading have to hold would be in the region of how much of their trade is proprietary or speculative. Many in the industry facility (MTF) without discretion or USD 30 billion (see the article ‘EU believe that this test does not refl ect an organized trading facility (OTF) traders and energy groups braced for the political agreement for MiFID II, with discretion in execution – as well MiFID II guidance’ by Neil Hume, 23 which was meant to measure trading as the extension of the scope of September 2015, Financial Times). participants beyond the core fi nancial activity against the whole business of a Worse still, fi rms may not have much counterparties, will all lead to a company, not just its trading activity. time to prepare for this regulatory signifi cantly different trading landscape tsunami. Whilst the technical standards come 2017. For commodities markets OTFs – commodity brokers of the future specifi cally, the key changes will bring now allow for an enhanced monitoring From a venue perspective, the issue of fi rms with signifi cant ancillary trading period from July 2015 to 30 June 2016, classifying customers is less relevant. activities into scope, and introduce a and a starting date for notifying the The key challenges are of an altogether novel position limits regime. It will also competent authorities by 1 July 2017, different nature. carve up wholesale energy markets total market size is still unknown and between fi nancial markets and non- will be diffi cult to obtain. Even then, ‘THE VENUE CLASSIFICATION HAS AN fi nancial markets, traded only on OTFs fi rms will have to seek recognition or bilateral, and in products that ‘must from their regulatory authorities, which ULTIMATE BEARING ON THE NATURE OF physically settle’. is likely to take at least six months. THE INSTRUMENT BEING TRADED.’ Consequently, participants won’t be in a position to know if the market Firstly, the venue classifi cation has an Drawing a wider perimeter of regulated fi rms

Much has been written about the commodities fi rms coming into scope Volume thresholds set out in the MiFID II regulatory standards by losing their MiFID I exemptions – Product % including blanket exemptions for threshold commodity dealers and fi rms trading Derivatives on metals 4% on their own account. In combination Derivatives on oil and oil products 3% with the expiration of Capital Requirements Directive (CRD) IV Derivatives on coal 10% exemption from capital requirements Derivatives on gas 3% for commodity dealers in late 2017, the Derivatives on power 6% impact on corporate users of commodity Derivatives on agricultural products 4% derivatives will be signifi cant. Some Derivatives on other commodities, including freight and commodities 15% have estimated the total cost impact to referred to in Section C 10 of Annex I to Directive 2014/65/EU be in the region of £ billions – including Emission allowances or derivatives thereof 20% Shell which stated that the total

OXFORD ENERGY FORUM 17 ENERGY TRADING AT THE CROSSROADS

ultimate bearing on the nature of the transactions and monitoring for abuse, However, pre- and post-trade instrument being traded. Venues the set of requirements is less onerous. requirements, trading obligations, holding themselves out to be MTFs will Even more signifi cantly, REMIT position limits, and best execution soon discover participants in wholesale transactions do not count towards the reporting requirements would not apply energy products asking for an OTF MiFID II ancillary activities thresholds – a major incentive for participants to licence. This is simply because, at that which, in turn, may keep a fi rm outside deal in wholesale energy products that point, certain wholesale energy products of MiFID II and associated CRD IV are outside of the fi nancial instrument fall outside the scope of MiFID and requirements. defi nition. inside that of REMIT (the Regulation on Energy Market Integrity and The majority of organizational Transparency calibrations Transparency). Only OTF wholesale requirements would still apply to an energy products fall outside the OTF, such as market monitoring, Secondly, venues will have to abide by defi nition of a ‘fi nancial instrument’. access requirements and, potentially, a host of transparency requirements, Whilst REMIT still requires reporting of algo testing requirements (if required). both pre- and post-trade, depending

Energy commodity futures / forwards Each sub-class shall be determined not to have a liquid market as per Articles 6 and 8(1)(b) if it does not meet one or all of the following thresholds of the quantitative liquidity criteria Average daily Average daily For the purpose of the determination of the classes of fi nancial notional amount number of trades instruments considered not to have a liquid market as per Articles (ADNA) [quantitative liquidity 6 and 8(1)(b), each sub-asset class shall be further segmented into [quantitative liquidity criterion 2] sub-classes as defi ned below criterion 1] An energy commodity future/forward sub-class is defi ned by the following segmentation criteria: Segmentation criterion 1 – energy type: oil, oil distillates, coal, oil light ends, natural gas, electricity, inter-energy 2 – underlying energy 3 – notional currency defi ned as the currency in which the notional amount of the future/forward is denominated 4 – load type defi ned as baseload, peakload, off-peak or others, applicable to energy type: electricity 5 – delivery/ cash settlement location applicable to energy types: oil, oil distillates, oil light ends, electricity, inter-energy 6 – time to maturity bucket of the future/forward defi ned as follows: Natural gas/ EUR 10,000,000 10 Maturity Oil/ oil distillates/ Coal electricity/ bucket oil light ends inter-energy 0 < time to maturity 0 < time to maturity 0 < time to maturity 1 ≤ 4 months ≤ 6 months ≤ 1 month 4 months < time to 6 months < time to 1 month < time to 2 maturity ≤ 8 months maturity ≤ 1 year maturity ≤ 1 year 8 months < time to 1 year < time to 1 year < time to 3 maturity ≤ 1 year maturity ≤ 2 years maturity ≤ 2 years 1 year < time to 4 maturity ≤ 2 years (n–1) years < time to (n–1) years < time to (n–1) years < time to m maturity ≤ n years maturity ≤ n years maturity ≤ n years

18 OXFORD ENERGY FORUM DECEMBER 2015: ISSUE 103

on the nature of the instrument (liquid by ESMA being out of line with market set thresholds that are more refl ective vs illiquid) and the size of the order expectations and practice. of the current trading environment. In transmitted (greater or smaller than the absence of aggregating suffi ciently The latest set of technical standards ‘large in scale’) – the latter being the high quality data, a phase-in approach now sets out thresholds for determining equivalent of the well-known block- may be appropriate. Given that whether a given product is indeed size thresholds in operation today. An MiFID II will introduce robust reporting liquid. Products would only make that additional threshold is available where requirements from 2018 onwards a list if their average daily notional amount products are traded by voice or by more accurate calibration should be is above EUR 10 million or if they are RFQ; where an order exceeds this size possible in time. traded more than 10 times per day on (specifi c to the instrument threshold) average. The table opposite, Energy Getting the thresholds wrong could only indicative bids or offers have to be commodity futures/forwards, lists the clearly have signifi cant impact on the made pre-trade transparent. example of ‘liquid’ energy commodity commodities markets; in particular This complex web of thresholds futures as identifi ed by ESMA. it could damage liquidity in those should have become clearer once markets and may result in trading in To determine the ‘large-in-scale’ (LIS) the European Securities and Markets certain asset classes, especially where and ‘size specifi c to the instrument’ Authority (ESMA) published its seaborne, being driven out of the EU. (SSTI) thresholds, ESMA has opted for regulatory technical standards in late a percentile approach; in other words, September this year. Whereas block- setting expectations around how much Position reporting size thresholds used to be set by the trading of a given liquid product should exchanges, they are now defi ned Venue trading in Europe will also take place at sizes below and above the by the regulatory authorities. Initially, be impacted by the provisions on thresholds. The table below, Percentiles technical standards setting out liquidity position reporting. MiFID II requires and threshold fl oors, illustrates the case determinations and size thresholds participants to report their and their of energy commodity futures. were expected by July but were then clients’ positions to the venue in order delayed until late September. One key The hope now is that ESMA can fi nd for the venue to publish aggregate challenge was (and still is) the lack of a suitably comprehensive data set – positions and report onwards to the market data – a key factor that may including both on exchange and over- competent authorities a detailed have contributed to the draft thresholds the-counter (OTC) traded contracts position breakdown. The requirement in a December 2014 consultation paper – for the commodities markets, and is embedded in the legislative text itself

Percentiles and threshold fl oors (to be applied for the calculation of the pre-trade and post-trade SSTI and LIS thresholds for the sub-classes determined to have a liquid market) Sub- SSTI pre-trade LIS pre-trade SSTI post-trade LIS post-trade asset Trade – Threshold Trade – Threshold Trade – Volume – Threshold Trade – Volume – Threshold class* percentile fl o o r percentile fl o o r percentile percentile fl o o r percentile percentile fl o o r Energy commodity EUR EUR EUR EUR 60 70 80 60 90 70 futures/ 250,000 500,000 750,000 1,000,000 forwards** Energy EUR EUR EUR EUR commodity 60 70 80 60 90 70 250,000 500,000 750,000 1,000,000 options** Energy EUR EUR EUR EUR commodity 60 70 80 60 90 70 250,000 500,000 750,000 1,000,000 swaps** Agricultural commodity EUR EUR EUR EUR 60 70 80 60 90 70 futures/ 250,000 500,000 750,000 1,000,000 forwards** * Transactions to be considered for the calculations of the thresholds. ** Calculation of thresholds should be performed for each sub-class of the sub-asset class considering the transactions executed on fi nancial instruments belonging to the sub-class.

OXFORD ENERGY FORUM 19 ENERGY TRADING AT THE CROSSROADS

and is no longer subject to review by If venues and brokers fi nd themselves – it will determine to what extent ESMA or the competent authorities. in a position where they are not able intermediation, in today’s sense of However, the practicalities of the to get the position and transaction the word, can continue. If full pre- process could have a signifi cant impact reporting information, the question trade disclosure were to be required, on commodities markets today. of consequences will undoubtedly many markets may well be starved of have to be answered. Taking a hard liquidity, and trading would migrate to ‘VENUE TRADING IN EUROPE WILL ALSO line and expelling participants from dark pools in related assets, or move BE IMPACTED BY THE PROVISIONS ON the venue will only result in reduced into third-country markets with lesser POSITION REPORTING.’ and potentially fragmented liquidity, transparency requirements. ultimately harming end-users. As highlighted, the organizational form Under the proposed rules, a venue – A more successful approach would of the venue itself will be dependent including brokers – would be in be to require participants to self-report on the asset traded. In the case of possession of the complete position positions and, in the case of third- wholesale energy products, some breakdown of every single participant country participants, to fi nd a mutual OTC-intermediated business may on any given day. This raises serious approach for cross-border recognition migrate to OTFs to make full use of the questions around data confi dentiality, non-fi nancial product defi nition. especially in markets where trading is of trading fi rms, ensuring pooled fragmented across platforms. This issue liquidity can continue delivering best Beyond those key points, much of what becomes even more relevant for third- value for end-users. used to be determined by exchanges country fi rms; the obligation to report will now be set by regulatory authorities. positions rests with the venue, but the Trading venues of the future And therein lies a risk – whereas a likelihood of getting accurate information wrongly calibrated size threshold at from fi rms that are outside the scope of The future for inter-dealer brokers and one exchange might have encouraged MiFID II is likely to be remote. other intermediaries in the commodities traders to block their trades elsewhere, markets has been written – the path this is no longer possible. Now a Similar questions arise in the context towards reorganizing as a trading wrongly calibrated size threshold which of transaction reporting where the venue is set. However, big question has to be applied across venues will venues are required to report on marks will have to be answered before result in the disappearance of liquidity. behalf of non-MiFID fi rms but where the commodities’ space is ready for the data is unavailable to the venue Whatever happens next, and wherever MiFID II. itself (fi elds currently include a short these thresholds ultimately come out, selling fl ag, decision- and trader Key is the setting of transparency the face of the commodities markets is identifi cation, etc. …). thresholds and the liquidity calibration set to change signifi cantly.

Regulatory change: impact on major energy companies and challenges they face Jonathan Hill

Introduction order to rebuild trust and to encourage same regulations as other fi nancial improved market functioning in years markets, and the distinction between The international policy response to to come. However, the energy sector group funding activities for investment the fi nancial crisis in the 2000s has should rightly look for, and assertively in exploration and production, from presented an extremely challenging present, unintended consequences physical commodity trading. agenda for the energy sector. On where it foresees them, as a means the whole, this challenge should be of constructive response. These Not systemic cautiously welcomed. Through these concerns are: the result of commodity policy initiatives, society is demanding markets (including physical commodity The primary objective of the reforms, more of the fi nancial services sector in markets) being made subject to the led by the G20 group of countries, has

20 OXFORD ENERGY FORUM DECEMBER 2015: ISSUE 103

been to reduce systemic risk to the a new Regulatory Technical Standard July 2016 (when ESMA – the European fi nancial system. Our sector’s key is published) it gets darker in key Securities and Markets Authority – is response to this, which has largely localities as new questions emerge. In scheduled to publish the market size fallen on deaf ears to date, is so turn, even with the best of intentions, denominator) and yet MiFID II comes in fundamental that it must still be made subsequent guidance in the form of to force just six months later. Prudence and continually remade. Oil and gas ‘Questions & Answers’ documents dictates that companies who are in producers and their physical commodity leads to more questions, and so it goes any doubt as to whether they will be in markets aren’t big enough, nor do they on. The Q&As have no legal status, yet scope should ready a MiFID II licence have suffi cient leverage, to pose it would be a brave company which application, but they may well not be systemic risk to the fi nancial system. decided not to heed them. needed and this will lead to regret spend. The calls for delay are starting, Uncertainty is therefore the only Appropriate mitigation? certainty. A company inevitably reaches including one could infer from some regulators, but will they be listened to? The reforms are well documented a point when it must either press ahead and are covered by at least one with implementation, or not. In late The platform can be a moving one. other contributor to this edition of the 2013 the energy industry continued The interaction of MiFID (Markets Forum, giving a good overview of the a close dialogue with regulators and in Financial Instruments Directive) provisions. Let me not restate them. some were convinced that reporting and MAR (Market Abuse Regulation) Rather, let’s get straight to the reality of of exchange-traded derivatives under presents a further example. MAR dealing with the new requirements. EMIR (European Market Infrastructure comes into force in June 2016, Regulation) would be delayed, owing referencing the list of fi nancial The point on systemic risk remains to clear technical diffi culties. It was not, instruments in MiFID I. Six months later fundamental. Notwithstanding this, however, and a subsequent scramble MiFID I is superseded by MiFID II with a where there are risks which impact to implement the rules ensued. much wider list of fi nancial instruments market confi dence, they should be and hence the scope of MAR will be appropriately mitigated. Another example falls on those companies, due to a breach of the broadened signifi cantly. commodity threshold under EMIR, Challenge of implementation that are designated NFC+ (non- Compliance challenge The pace of reform and introduction Financial counterparty above a dealing No one said it should be easy. It of new directives is unlike anything threshold). These companies are to previously experienced in the fi nancial benefi t from a delay to central clearing certainly isn’t. There is considerable services sector. Political imperatives, [until late 2018] on treasury hedges, cost and the benefi ts are not always in support of real fi nancial concerns whereas those same companies will clear. arising from the 2008 crisis, have driven have to source personnel, set up new the timetables for the current reform systems and processes, and incur ‘ON THE FACE OF IT, HOW DIFFICULT CAN round. This has been good, because regret spend throughout 2016 in order IT BE TO REPORT, ON A DAILY BASIS, it has required timely response to comply with bilateral collateralization DETAILS OF THE TRANSACTIONS A and change from participants and requirements in early 2017 and then COMPANY ENTERS INTO?’ regulators alike, to start addressing the repeat the process in respect of central need to rebuild public confi dence. clearing too. Only those OTC (over-the- On the face of it, how diffi cult can it counter) hedges not capable of central be to report, on a daily basis, details clearing will be subject to bilateral ‘THE PACE OF REFORM AND INTRODUCTION of the transactions a company enters collateralization after 2018, meaning OF NEW DIRECTIVES IS UNLIKE ANYTHING into? It has, though, proven very diffi cult that much of the 2016 work will then be PREVIOUSLY EXPERIENCED IN THE across the reporting chain (submitter– redundant. Again, the timing and a lack FINANCIAL SERVICES SECTOR.’ repository–regulator) and both policy of appreciation of the impact on the oil and operational issues continue to and gas industry leads to frustrating On the other hand, grappling with the emerge. Participants are working on and expensive consequences. need to respond has been extremely ESMA’s level II validation for EMIR challenging, and has created much As MiFID II implementation reporting 18 months on, which means ineffi ciency. It seems that each time approaches, the key Ancillary Activity the value of the data at present held in more light is shed (for example, when test will be impossible to calculate until the repositories must be limited.

OXFORD ENERGY FORUM 21 ENERGY TRADING AT THE CROSSROADS

However, is it the right data? Dealing with more regulators is a allows an end-user exemption to Participants are certainly submitting the particular issue for companies active in mandatory clearing. data as requested, with considerable the wholesale power and gas markets, The projected costs of the margining effort. The original mandate from the who are likely now to be regulated by and clearing are very high, and these G20 was to monitor for emerging both the Agency for the Cooperation are in addition to the very high costs systemic risk, and the initial response of Energy Regulators (ACER) member generated by the prospect of posting from the regulators was to take position in their country of domicile for REMIT regulatory capital. Currently, there is an data from companies. The EMIR OTC (Regulation on Energy Market Integrity exemption in the EU Capital Requirement and Transparency) for physical reporting requirements, however, Directive for commodity trading fi rms business, and by NCAs for fi nancial are for a log of trade reports, which but it expires at the end of 2017. But business (under MAR, MiFID, and indicates a different purpose. It is looking at a commodity derivatives others). The two constituencies’ interesting that an industry-negotiated trading operation, if margin is posted or jurisdictions should not overlap and compromise with the regulators over collateralization made, what are the cooperation between them must be the requirements has led to position risks remaining which regulatory capital hoped for. Operationally though, it is reporting being implemented for could appropriately mitigate? exchange-traded derivatives in place a reality of the markets that there will of the trade reports. Can the original be considerable overlap and fi rms will The existing regime was designed for banks, and commodity fi rms were purpose be fulfi lled? Arguably, the have to be very precise in their dealings given exemption for various reasons, MiFID position reporting, which will on the boundary. including their risk profi le and the be implemented for commodity unsuitability of the regime to their derivatives markets from January 2018, Working capital impacts businesses. It is hoped the exemption looks more as if it could address this, The complexity of compliance and will be extended to 2020 and beyond, although given that commodities are uncertainties of implementation are but the political mood seems clear not systemic, its restricted scope would very signifi cant, but there are highly that capital rules will be applied to prevent this. material commercial impacts as well. our sector. The key point, however, As indicated above, this is a step is that commodity fi rms should not Energy market participants who exceed change in the amount of regulation be subject to the same capital rules an EMIR clearing threshold will be on the energy sector. The political as banks, as they neither pose the required to post margin in clearing imperative has mandated that there same systemic risk nor are they houses and to exchange collateral shall be position limits on every eligible for the same public funding on remaining OTC transactions. This in times of strain. This does not mean commodity derivatives contract, outcome may occur even where that good risk management practice meaning that there will be thousands. a corporate’s market activity is should not apply, just that it should be Everyone knows the application is too overwhelmingly in hedging (which may appropriate, and capital requirements wide, and that it would be far more be discounted from the calculation) are disproportionate. impactful to focus on the key contracts. due to uncertainty of how to classify Something as apparently basic as hedging in a compliant way. These Certain corporates active in the energy tracking position limit requirements costs may be very appreciable. sector are on record as forecasting the cumulative impact of all of these will be a very signifi cant compliance This is, moreover, required in all charges as being from several to challenge. In practice, ESMA sets asset classes, not just the one ‘many’ (a fi gure exceeding ten) the framework, but the 28 National which breaches the threshold. For billions of dollars. It is certainly true Competent Authorities (NCAs) set the corporates, as mentioned, this that application of the banking capital limits. Will their approaches align? has the highly signifi cant impact of rules to a major corporate’s oil and Will they coordinate when the limits bringing into scope corporate treasury gas business generates a completely change? This is also an example of hedging activity, since hedges have disproportionate outcome to the market how companies will have to work no exemption. This then makes risk they take. with far more regulators in more the treasury business of impacted jurisdictions; it is potentially a departure corporates uncompetitive, since they These corporations are large, yet from the passporting concept of incur costs which peers who do not the possible calls upon their capital reliance on the home state regulator, have oil and gas trading businesses are material even to them. Their key which was a key deliverable of MiFID I. will not have. In contrast the US regime mission is delivering energy and

22 OXFORD ENERGY FORUM DECEMBER 2015: ISSUE 103

that requires working capital for the infrastructure cannot have been fully valuable liquidity provision, it was not associated infrastructure. To illustrate, scoped, but it will certainly create essential. These vastly increased costs an oil and gas producer might allocate operational problems. Some markets are now spreading to more participant an annual capital investment in its cannot work within these numbers. types. It is highly likely that there will North Sea programme of a few billion be further withdrawals. In general, In addition, if you can get a hedge dollars. However, going forward, the markets thrive on liquidity – which will exemption it must be applied for in regulatory charges for its supply and be impacted to the detriment of the advance (up to 21 days). Inevitably corporate treasury operations which market. there will be times when this impacts seek to hedge the associated risks of orderly operations. Many point to small- and medium- supply, distribution, and funding, would sized physical participants for whom be likely to signifi cantly exceed this. Impact on markets the compliance burden alone will necessitate a rethink. Certain big utility Operational impacts The matters discussed above are corporates have also stated that they just a small subset of the changes to Keeping on the theme of will not tolerate the compliance costs. regulation of our fi rms and markets that consequences which, when looking are forthcoming in the next few years. These participant types are not at the original legislation and when But what is the cumulative impact of optional; they are the participants thinking about the purpose and all these changes? Certainly that is without whom markets cannot functioning of our markets, must surely something impossible to predict. exist. Certain policymakers have in have been unintended, brings me the past said they would welcome First there is the prospect of back to MiFID position limits. Hedging the disappearance of the energy participants relocating, which may in of physical activity should be covered trading sector. Do they hold the turn lead to markets relocating. Clearly by a hedge exemption to the position same sentiment for the EU oil and this would negatively impact Europe’s limits. This was the working assumption gas production industry? Alternative of the industry during the negotiations. competitiveness as a region. Some suggestions, however, on how This has been the practice since participants are already indicating their commodity pricing could be better position limits were fi rst brought in. intention to move jurisdiction to take achieved have not been forthcoming. advantage of differences. However, the Ineffi cient and ineffective pricing ‘HEDGING OF PHYSICAL ACTIVITY sense of doing business where clients will ultimately only lead to negative are based, and particularly where key SHOULD BE COVERED BY A HEDGE outcomes for producers and infrastructure is located, remains. Can EXEMPTION TO THE POSITION LIMITS.’ consumers alike. you sensibly trade European power from Singapore? Although in contrast, However, wholesale changes to the it may be possible to relocate capital What should happen next? MiFID ancillary exemption test look like market activities to other regions to bringing far more fi rms in to scope of Inevitably, the preceding sections eliminate the regulatory cost burden on the Directive than envisaged. In scope have focused largely on problems corporate funding for NFC+ groups. MiFID fi rms may not apply for a hedge identifi ed – the unintended negative exemption. The position limits will be So, for participants who stay put, what consequences. However, it remains the set in a range of 5–35 per cent, which they do know is that costs are highly case that the overall reform package is pretty broad for planning purposes. material, even to the largest amongst and its intent is to be welcomed. Remember that the limits apply to them. There have been withdrawals Improved transparency, appropriately every platform traded commodity from the markets, most notably bank calibrated, is a positive development derivative in Europe. Liquidity varies proprietary trading activity which has from which all can potentially benefi t. greatly between these contracts as been attributed to many factors, not Enhanced supervisory powers for do numbers of participants. Also, least of which is the reported impact of regulators so they can achieve the many of them reference pricing at key capital rules on the activity which made infrastructure points whereby positions it commercially unviable. ‘IMPROVED TRANSPARENCY, much larger than 35 per cent at delivery It could be argued, however, that banks APPROPRIATELY CALIBRATED, IS A are inevitable. trading proprietarily were voluntary POSITIVE DEVELOPMENT FROM WHICH The operational consequences of market participants and, whilst their ALL CAN POTENTIALLY BENEFIT.’ this for individual fi rms and for key presence was to be welcomed as

OXFORD ENERGY FORUM 23 ENERGY TRADING AT THE CROSSROADS

tough objectives they now have are transparency. This should be achieved however, fulfi l a vital role and it is also positive. before new reforms are advanced. right that where we see negative consequences, we must highlight them However, the number and extent of the Further, where negative unintended and work hard to seek understanding. changes is unprecedented. Given all consequences emerge, the community We need to do this to ensure they of the uncertainty they engender, time should respond quickly and make are put right, in order to safeguard is needed to assess impacts. We need changes to correct them. investment in the EU and to encourage to make the changes which have been energy businesses worldwide to Conclusion put in to effect work. For example, it continue to view the EU as an attractive is reported that the quality of the data The fi nancial services sector must region in which to do business. This set from the EMIR reporting remains accept the need to repair public is for the good of our economies, our unsatisfactory and yet it is supposed confi dence and accept the utility of consumers, and our quality of life. to be the basis of so much which is many of the reforms. Every participant, of key importance. Also, I recall that including those in the commodity This article is written in the author’s the data was intended to be used to sector, should embrace constructive personal capacity and should not be provide market, as well as regulatory, compliance. Energy markets do, taken as refl ecting BP’s views.

A new regulatory paradigm for EU commodity markets Jonathan Farrimond and Paul Wightman

From 3 January 2017, Europe’s ‘commodity dealer exemption’ available CRR (Capital Requirements Directive fi nancial commodity markets will under MiFID I whilst at the same time IV / Capital Requirements Regulation) march to a different regulatory beat. signifi cantly narrowing the current is legislation designed to ensure that The recast MiFID II (Markets in ‘ancillary activities’ exemption. The banks and other fi nancial fi rms hold Financial Instruments Directive) and political intent is clear: to bring more fi nancial resources suffi cient to protect its sister regulation MiFIR (Markets in commodity fi rms directly into fi nancial against losses relevant to the business Financial Instruments Regulation) have, regulation. risks they face. Whilst most specialist remarkably, been over fi ve years in commodity fi rms authorized under There are notable implications for a the making. But upon implementation, MiFID II would benefi t from certain commodities fi rm becoming MiFID- they are set to introduce sweeping exemptions from CRD IV/CRR, related authorized. In addition to the new changes to the structure and workings to ‘large exposures’ and regulatory organizational requirements and certain of EU fi nancial commodity markets – or capital treatment, these exemptions direct obligations to comply with, there rather, the entire European Economic are due to expire at the end of 2017, would be consequential effects under Area (EEA), as the legislation has ‘EEA and in any event these are not blanket a raft of other EU fi nancial regulations. relevance’ – impacting participants, exemptions; liquidity rules and ‘Pillar 3’ trading venues, and regulators alike. For example, under EMIR (European requirements (including remuneration Markets Infrastructure Regulation) code requirements) would still apply, ‘THE POLITICAL INTENT IS CLEAR: authorized fi rms cannot qualify for as well as potentially other capital ‘non-fi nancial counterparty’ status, TO BRING MORE COMMODITY FIRMS requirements in a fi rm’s home regardless of whether they are active jurisdiction. DIRECTLY INTO FINANCIAL REGULATION.’ in physical commodity markets or not, The cost implications for individually and thereby lose signifi cant relief from Many commodity fi rms with physical affected fi rms could be huge. Whilst the potentially onerous EMIR requirements operations that are currently engaged exact impact can’t yet be quantifi ed, such as mandatory clearing of over-the- in derivative trading but exempt from warning bells are beginning to sound counter (OTC) derivative contracts and fi nancial regulation face the spectre of from certain quarters. EFET (the wide-ranging risk mitigation techniques. being authorized, and therefore directly European Federation of Energy regulated, for the fi rst time. This is But it is capital requirements that have Traders) suggested in a press release because MiFID II will sweep away the commodity fi rms most worried. CRD IV/ dated 16 April 2015 (‘EFET calls for

24 OXFORD ENERGY FORUM DECEMBER 2015: ISSUE 103

action to prevent unintended powers to set the limits being granted month and ‘all other months’, which consequences of fi nancial market to the CFTC’s predecessor, the CEC participants will not be permitted to regulation for the European energy (Commodity Exchange Commission), exceed unless they hold a relevant market in developing MiFID II Level 2 under the Commodity Exchange Act. exemption, granted for hedging measures’) that trading activities in The CEC fi rst imposed position limits in activity only. certain energy markets could either be 1938 on certain grain contracts. Hedge exemptions will only be granted reduced or migrate to non-fi nancial In the case of the EU, however, with a to ‘non-fi nancial fi rms’, effectively markets in the face of the prospective few recent exceptions aside, regulators defi ned as fi rms that do not carry some cost increases. Individual companies and exchanges have largely eschewed form of fi nancial market authorization have made similar remarks. position limits in commodity derivative under European legislation. This would Yet these are only possible outcomes, markets in favour of a less formalized, therefore preclude commercial fi rms they are not foregone conclusions. though by no means necessarily a less that carried a MiFID licence, as well as Indeed, a more proportionate capital rigorous or less effective, approach. other fi nancial fi rms, such as banks, regime may yet emerge. The European In the UK for example, the body from utilizing hedge exemptions. Commission has until the end of 2015 responsible for the oversight and This could be problematic in some to produce a report and a possible supervision of commodity derivative cases. It is not yet clear how affected legislative proposal regarding capital exchanges, the FCA (Financial Conduct commercial fi rms may respond to this requirements for fi rms that trade Authority), has required exchanges challenge. For banks in the EU, they exclusively in commodity derivatives. to employ a ‘position management’ will need to assess how OTC There has even been talk in the industry regime under which positions taken in commercial client business that is that the expiry of the two key CRR their markets are scrutinized and, to the presently hedged with on-exchange exemptions might be pushed back extent such positions have the potential derivatives could be affected. to 2020. Until this happens though, to lead to disorderly settlement or be The challenges in transitioning to affected fi rms will be looking on used to effect an abusive strategy, are this new regime are magnifi ed by the nervously. appropriately managed. For instance, in certain cases positions could be scope and ambition shown by MiFID’s EU trading venues will also be capped or reduced at the direction of co-legislators. Position limits will apply impacted by changes brought about an exchange and in accordance with to all commodity derivative contracts by MiFID II/MiFIR. Whilst these venues the authority set out in its own rulebook. traded on a trading venue – whether will still continue to provide the market that be, in European jargon, regulated with a compelling offering – a central ‘IT IS REGULATORS … THAT WILL markets (in other words, exchanges), place to manage risk in a transparent multilateral trading facilities (MTFs), or DETERMINE THE MAXIMUM ACCEPTABLE and, where relevant, cleared manner the as yet unknown pool of participants “SPECULATIVE” POSITION IN ANY GIVEN – there will also be changes to the to be classed as organized trading COMMODITY DERIVATIVE …’ current model, a new environment to facilities (OTFs) – as well as derivative adapt to. The most notable of these contracts trading in the OTC market The new MiFID framework will changes is with respect to position deemed to be economically equivalent change the emphasis of this current limits, which is a new concept for to any of those on-venue contracts. arrangement. Whilst the new European commodity markets. This regulations will require exchanges Implementation risk is therefore high. will be the focus for the remainder of and other trading venues in the EU To move from a regulatory framework the article. that list commodity derivatives to which has largely excluded the use For the USA, position limits are not a operate effective position management of position limits (barring a few recent new concept. The CFTC (Commodity controls, this will be overlaid with introductions of exchange-administered Futures Trading Commission) has for an all-encompassing position limit delivery and expiry limits), to a place decades directly imposed limits on a regime. This is a signifi cant change. where position limits apply to the vast core set of agricultural contracts, and It is regulators across the EU that will majority of commodity derivatives in the also effectively required exchanges determine the maximum acceptable EU, is a bold move. Regulators face a to set limits across a broad swathe ‘speculative’ position in any given gargantuan task in accurately setting of other commodity and fi nancial commodity derivative, not the trading appropriate limits for the potentially contracts. The origin of position limits in venues. These maximum levels will be thousands of affected contracts the USA dates back as far as 1936 with hard limits, applying to both the spot simultaneously, and must therefore

OXFORD ENERGY FORUM 25 ENERGY TRADING AT THE CROSSROADS

remain open to amending these initial potentially thousands of contracts in contracts approach expiry, by capping limits in light of practical experience as real time, discounting hedging activity spot month derivative positions to a the case may require. where relevant and aggregating proportion of overall physical market positions across contracts and supply (except for contracts where The scope of the regime will group entities in appropriate cases. this isn’t a relevant concept, such as presumably also result in a Position reporting capabilities will also weather, where position will be prosecutorial shift, with national have to be enhanced. Whilst many capped as a proportion of open regulators in the EU likely to take participants already report positions interest). However, the usefulness of an a leading role in prosecuting limit to certain exchanges, the MiFID ‘all other months’ limit is less obvious, breaches. In the normal course of position reporting regime is far more as the risk of an abusive squeeze events, generally speaking it is the extensive, requiring reports to be sent occurring outside the spot month is far exchanges that enforce against minor to all venues where open commodity less likely to occur. Nonetheless, such rule infractions, whereas enforcement derivative positions are held, and for limits are required by the legislation. action taken by national regulators is some fi rms reports must also be sent ESMA’s proposal to cap the ‘all other usually reserved for more high profi le directly to national regulators. Clearing months’ positions to a proportion of and egregious misconduct, such as fi rms that operate on a pan-European overall market liquidity, subject to a serious market abuse cases. level are likely to have to bear de minimis threshold to ensure limits Yet this will surely have to change, at signifi cant extra costs and investment. do not artifi cially stymie the growth of least in certain cases. This is because It is not clear whether such costs could new and illiquid contracts, is therefore position limits will apply to on-venue be easily passed onto each client in an probably the best way of calibrating the contracts and economically equivalent environment where the cost of clearing framework given the constraints of the OTC contracts. Trading venues will is already rising signifi cantly. Trading legislation. venues and regulators must also have simply not have sight of positions in There is also fl exibility built into the adequate systems enabling them to OTC contracts, and in such cases methodology – a sensible step when receive and make use of position data compliance with limits will have to limits will apply to so many and so in MiFID-compliant formats. be assessed by national regulators varied a set of contracts. Having fi rst with appropriate access to position In addition to the overarching calculated a baseline limit of 25 per data, potentially across different EU requirements set out directly in the cent of either deliverable supply or jurisdictions. The picture could be MiFID II/MiFIR legislation, ESMA (the open interest, regulators will have further complicated if one position limit European Securities and Markets the power to amend that limit, either was to be applied to more than one Authority) has recently published upwards to a maximum of 35 per cent on-venue contract, as the legislation the detailed rules required for or downwards to a minimum of seems to envisage in certain cases. implementation in the form of draft 5 per cent, after assessing a range The quality of information fl ows Regulatory Technical Standards of factors relevant to that specifi c between the exchanges and national (RTS). Whilst the RTS remain subject contract. regulators, and between national to the review and approval of the EU Yet the benefi ts afforded by this regulators themselves, is therefore Commission, Council, and Parliament, fl exibility come with a caveat: going to be critical if policing and they do give a very good indication regulatory discretion in the setting of enforcement of position limits is to be as to how some of the mechanics of the limits needs to be wielded with completely effective. the regime will work in practice. There due skill, care, and caution. Setting are a number of features to ESMA’s limits too low could unnecessarily ‘CLEARING FIRMS THAT OPERATE ON proposed regime that are worthy of constrain legitimate trading activity – A PAN-EUROPEAN LEVEL ARE LIKELY comment. clearly a negative outcome. Yet even TO HAVE TO BEAR SIGNIFICANT EXTRA First, ESMA’s methodology which where higher limits are established, COSTS AND INVESTMENT.’ national regulators will use to calculate circumspection will still be needed to position limit levels on commodity ensure markets remain orderly and There are also system build derivative contracts in their jurisdiction free from abusive practices; position implications and cost outlays to is, broadly speaking, a sensible limits should never negate continual consider. For market participants, their framework. ESMA’s methodology and effective use of position systems must be sophisticated enough addresses the risk of abusive management powers by exchanges to assess compliance with limits across squeezes occurring as derivative and other similar venues.

26 OXFORD ENERGY FORUM DECEMBER 2015: ISSUE 103

Second, parts of ESMA’s commentary longer-dated expiry structures, such as contracts. Subject to assessment and on the factors that could drive the quarterly expiries that are common to approval by regulators, these contracts position limit upwards or downwards certain agricultural contracts, the spot would then be added to a public list. from the baseline level are data month limit would apply to the same This would be a partial solution, but driven, and trading venues should ‘spot month’ contract for three months. other complexities also need clarifying, therefore be braced for multiple data such as whether an OTC contract could Fourth, ESMA has drawn the defi nition and information requests. This would of economically equivalent OTC be economically equivalent to more be particularly welcome in respect (EEOTC) contracts narrowly. OTC than one on-venue contract, and how of assessing the level of deliverable contracts will be caught by limits if they OTC contracts with pricing structures supply relevant to a contract, with have ‘identical contract specifi cations that don’t neatly map to on-venue certain trading venues holding and terms and conditions’ to on- expiry and pricing structures should be signifi cant expertise in this area. venue contracts (though the defi nition treated. Such questions may be moot, Whilst the draft RTS do not appear to specifi cally excludes ‘post-trade risk however, if the currently proposed oblige national regulators to consult management arrangements’ as a narrow EEOTC defi nition is retained trading venues for deliverable supply necessary factor). A related recital and passed into European law. estimates, ESMA’s Final Report on also requires an OTC contract to have the draft RTS indicates this is certainly the ‘same underlying commodity that ‘ESMA’S NARROW DEFINITION OF THE contemplated and it is something is deliverable at the same location’ “SAME” COMMODITY DERIVATIVE therefore we believe is likely to happen as an on-venue contract. ESMA’s MEANS THAT IN MOST CASES EACH in practice. However, in the interests intention appears to be to reduce the CONTRACT … WILL BE GOVERNED BY of transparency and integrity, any complexity of applying position limits to deliverable supply estimates a diverse and somewhat unknown set A SEPARATE LIMIT.’ provided by trading venues to of contracts in the OTC market. Yet it regulators should be as a general remains to be seen as to whether this Fifth, ESMA’s narrow defi nition of the principle a matter of public record, will be the case in practice, and much ‘same’ commodity derivative means as is the case in the USA, except will hang on how regulators and the that in most cases each contract in perhaps in cases where proprietary market will interpret the term ‘identical’. the EU will be governed by a separate data of a third party is used. For example, OTC contracts are limit. MiFID II requires that where the ‘same’ commodity derivative is traded Third, it would appear that spot month typically governed by agreements that in signifi cant volumes on trading position limits will apply to a contract contain terms and conditions that do venues in more than one EU Member for as long as it is deemed to be ‘the not appear in the terms and conditions State, those contracts should share spot month’. This is different to how for trading in on-venue contracts – will the regime has typically worked in that difference mean that ESMA’s OTC the same limit. However, ESMA’s US markets, where the spot month defi nition effectively becomes an defi nition of ‘same’ in this context is limit only applies for a certain period, empty set? very narrow – based on the EEOTC defi nition previously referenced and such as the last three business Assuming at least some OTC contracts a requirement that the two contracts days prior to expiry. Under the EU could be found to be equivalent to ‘form a single fungible pool of open regime though, ESMA has defi ned on-venue contracts, the question then the spot month contract as ‘the next arises as to whether the market could interest’. The latter clause appears to contract in that commodity derivative establish with certainty what an mean that one contract may be closed to mature’. Absent any clarifi cation EEOTC contract is – a fundamental out by trading a second contract. Very it would appear the spot month limit prerequisite for participants to adhere few, if any, contracts traded across will apply the moment a contract to position limit levels and for multiple venues are, in our view, likely to becomes designated as ‘the spot regulators to validate fi rms are meet this requirement. The net effect is month’ and will remain in force until compliant. It would appear that a that under the current market structure the contract expires. Depending on defi nitive public list would be the it is highly unlikely contracts traded where specifi c position limit levels are optimum way of achieving this on different venues will be governed set by national regulators this could necessary certainty. Participants could by the same limit. There is therefore prove to be signifi cant and it becomes be asked to notify regulators of the an apparent disconnect between the more notable for contracts with less OTC contracts they deem to be policy intent of the co-legislators and frequent listings – for contracts with economically equivalent to on-venue ESMA’s proposal on this point.

OXFORD ENERGY FORUM 27 ENERGY TRADING AT THE CROSSROADS

But what of cases where two or more of an overall limit, such as 2.5 per cent compliance with a given limit? It is also of the ‘same’ contracts are traded of deliverable supply shared equally not clear whether aggregation merely across multiple venues in a single EU amongst ten venues? Neither scenario occurs from the topmost position Member State? Whilst the MiFID II provides an optimal outcome. holder downwards (as seems to have legislation is silent on this point, it been ESMA’s intention from previous Sixth, the proposals on aggregating would appear ESMA’s proposed consultations) or whether aggregation positions across a group are not clear. rules would require positions in such is also meant to occur ‘upwards’ Barring a carve-out for qualifying contracts to be aggregated too. through a corporate structure. Further investment managers, the regime However, again, the narrowness of guidance from ESMA will be needed requires a ‘parent undertaking’ to the defi nition of ‘same’ would seem to to ensure a clear and consistent aggregate its own positions with each preclude that as a realistic possibility. interpretation on the standards for of its ‘subsidiary undertaking’ fi rms. The It would also appear that where similar aggregation. defi nition as to what constitutes parent (but not the same) contracts are traded and subsidiary undertakings is found Seventh, the workability of the process on the same venue, such as options in the Consolidated Accounts Directive for obtaining a hedge exemption and related futures, or ‘mini-sized’ (2013/34/EU) – the relationship being regime is questionable. Leaving aside and related ‘main’ contracts, there is triggered in scenarios where a parent the implications of banks and other arguably no requirement to aggregate holds a majority of the voting rights fi nancial institutions being ineligible for positions in such contracts (although of a subsidiary, or breaches one of hedge exemptions (a MiFID legislative trading venues could still aggregate a number of tests related to control issue that ESMA cannot fi x), ESMA positions in such contracts for their own over the governance framework of a has proposed that national regulators monitoring and surveillance purposes). subsidiary (such as powers to appoint be permitted 21 days to consider The narrowness of the defi nition of or remove Board members and each hedge exemption request – an ‘same’ commodity derivative could management). impossible wait if business risks require pose headaches for regulators when hedging immediately – with no ability to determining appropriate limit sizes. ‘… THE AGGREGATION STANDARD fi le exemptions ex post, even in limited This resonates most in markets that SHOULD ADDRESS BOTH THE CORPORATE necessary cases. Commercial fi rms are fragmented, and European power RELATIONSHIP BETWEEN ENTITIES AND could therefore face diffi cult decisions and gas markets are a good case in as to how to manage specifi c price risk TRADING CONTROL.’ point. There are multiple exchanges of a physical commodity when faced and broker platforms active in these with immediate hedging requirements, ESMA specifi cally states in its Final markets in Europe with substantially which could include seeking access Report that the aggregation standard similar contracts offerings, all of which to markets without such constraints or should address both the corporate will be caught by the EU-wide position where hedge exemptions may be more relationship between entities and limits regime. Whilst market participants easily obtained. trading control. However, the may see many of these gas and power Accounting Directive tests are not It also appears ESMA’s proposals contracts as substantially similar in designed to measure, and therefore could require fi rms to apply to national economic terms, or even identical in completely ignore, whether or not one regulators on a position-by-position certain cases, they are unlikely to be group entity exercises trading control basis, as the draft RTS seems to classed as the ‘same’ for position limit over the derivative positions of another require relevant fi rms to demonstrate purposes. group entity. Consequently, it could be how a position reduces risk directly A potential problem could therefore possible in certain cases that an entity relating to their commercial activity in arise as to how limits will be set for is required to aggregate its derivative order to obtain a hedge exemption. each of these similar contracts. Let’s positions with those of another entity Such an approach could see assume that national regulators within the same group over which it regulators swamped with requests determine the appropriate spot month has no direct knowledge or control. and aggravate the ineffi ciency of the limit in a European gas contract should This could obviously be problematic strict 21 calendar day process. A more be set at 25 per cent of deliverable from a compliance standpoint, as how workable approach would be to allow supply. Will each contract on separate would two sister companies that are national regulators to grant hedge venues be allocated a limit of 25 per deliberately separated by location and exemptions based on the likely or cent of deliverable supply? Or will each fi rewalls, for example, know whether possible commercial activity of a fi rm of those venues proportionally share their combined positions were in over a certain forward looking duration,

28 OXFORD ENERGY FORUM DECEMBER 2015: ISSUE 103

such as a year, rather than requiring scoping perspective at least. However, in this paper, and fi rms and trading exemption requests to be fi led on a per a comprehensive comparison between venues should remain fully engaged in position basis. Although this approach the details of the proposed EU and these issues. may ultimately be adopted, it does not US regimes is at this stage diffi cult, appear to be expressly contemplated in not least because a number of factors ‘THE PLETHORA OF REGULATIONS … the draft RTS. It would also make sense relevant to the proposed US regime COULD HAVE A PROFOUND IMPACT ON to permit the ability for fi rms to be able are in fl ux, and the actual position THOSE MARKETS.’ to fi le for positions limits on an ex post limits levels for EU markets will not be basis in cases where circumstances proposed by national regulators until Yet position limits are just one aspect require risks to be hedged immediately. some point in 2016. of the wider changes affecting EU commodity derivative markets. The Eighth, and lastly, MiFID II does However, unlike in the USA, where apparent aims of the new regulations not explicitly provide for a phased an established position limit regime are unquestionably noble – to uphold implementation. The attendant risk already exists, a mindset change in market integrity and to safeguard the is obvious – the market may not Europe will be required to adapt to the effi cient functioning of those markets. have enough time to adapt to the new order. Changes on this scale will But the plethora of regulations, either new regime or to trade out of larger likely affect most fi rms, and certainly recently implemented or those soon positions in an orderly manner those that typically carry positions of to come into effect, could have a if required. Short of a legislative any reasonable size. Traders will likely profound impact on those markets. amendment that would provide an have to carefully manage positions Impending MiFID authorization and adequate phase-in, it will be incumbent to remain in compliance with limits, attendant capital requirements will upon the national regulators to publish and fi rms’ systems and monitoring surely infl uence, and in some case capabilities will have to be advanced their proposed and approved position drive, affected fi rms’ strategic business enough to ensure that remains the limits as expeditiously as possible so decisions. Other fundamental changes case. The picture could be further as to provide maximum notice to the to market conventions are afoot, such complicated where a fi rm is part of a market of the forthcoming changes. as those brought about by the new large group. Certain fi rms must also MiFID transparency regime. Firms of Setting aside the specifi c details become familiar with new processes, every ilk will be affected and market of the EU regime, there is also the such as applying for hedge exemptions structures could change. The fi nal international aspect to consider or aggregating group positions, and shape of these regulations and how and in particular it will be important build those requirements into trading the industry responds will defi ne the to understand how the EU position and hedging strategies. Firms must commodity trading landscape in the limits framework will dovetail with the begin to prepare for these changes EU for the next 5 to 10 years. proposed limits regime in the USA. now, but there remains a high degree It is the stated intention of ESMA of uncertainty on points of interpretation The views expressed herein are not to apply limits to third country and exactly how the regime will work solely those of the authors and do not venue contracts, which will prevent in practice. Regulators would do well necessarily represent the views of any jurisdictional overlap from an EU to bring clarity to the points we raise CME Group.

Risks to the proven effi cacy of energy markets Ian Taylor

We are entering uncharted territory for energy markets and the companies do this remarkably effectively, driven the energy markets. The scope and which use them. by the underlying forces of demand depth of regulation which has recently and supply. As the recent halving in been, or is in the process of being, Every day the world’s commodity the price of oil has shown, the markets implemented, across both the USA and markets cause the raw materials, on can deal with signifi cant shifts in price, the EU is unprecedented and questions which the global economy depends, to with no impact on market orderliness or remain regarding its impact on both move to where they are needed. They liquidity. Thus their primary purpose is

OXFORD ENERGY FORUM 29 ENERGY TRADING AT THE CROSSROADS

to act as a price discovery mechanism Sea Oil, market openness, the rise been the case to date. That is, one for materials that are the building of the price-reporting agencies, and which takes account of the unique blocks of economic activity, unlike the establishment of the International characteristics of the energy markets. many other traded markets whose Petroleum Exchange (today’s To consider our concerns more primary purpose is to raise or increase Intercontinental Exchange or ICE) in specifi cally, at present two areas come capital. the 1980s, all contributed to European to mind; the implementation of Markets benchmarks and pricing being those in Financial Instruments Directive ‘THE FACT THAT SOME INSTITUTIONS used in contracts globally today. (MiFID II) and the issue of ‘systemic WHICH ARE ACTIVE IN THE CAPITAL But there has been a signifi cant shift, risk’. MARKETS ARE ALSO ACTIVE IN both in terms of production and, more importantly, consumption. At its peak, COMMODITY MARKETS, DOES NOT Concerns relating to implementation of the North Sea accounted for just under MAKE THE MARKETS ALIKE.’ MiFID II 9 per cent of production globally, today it is 3 per cent and, in the current The capital markets are also With regard to MiFID II – which price environment, this is likely to fundamental to economic activity but we should not forget is legislation fall further. Similarly, in 1980 Europe they are different; they serve a different originally conceived for the protection accounted for 24 per cent of global purpose, function in a different way, of investors, not to facilitate an orderly consumption, compared with 15 per market in commodities – ESMA (the and pose different risks. The fact that cent today (the USA has always been European Securities Market Authority) some institutions which are active in the largest consumer with 28 per cent has recently published its proposed the capital markets are also active in in the 1980s and 20 per cent today). In Regulatory Technical Standards (RTS). commodity markets, does not make contrast, as you would expect, Asia’s Whilst we appreciate that ESMA has the markets alike. Hence the need for increase in both absolute terms and sought an open and active dialogue policy makers and regulators to ensure share of global consumption is marked: with market participants throughout the that their proposed regulations do from 10.5 million barrels a day to 30.4 process, areas of concern remain. not have unintended consequences, million barrels a day (17 per cent to particularly for the end consumer. 33 per cent) over the same period. ESMA has recognized that companies which are not investment businesses The focus of both policy makers and Today, China’s consumption alone are nonetheless at risk of being regulators on improving markets is is equivalent to the whole of Asia’s captured by the regulation – which understandable in the wake of the consumption in 1980. If India’s and could result in say, a utility company fi nancial crisis, the call on taxpayer China’s consumption patterns evolve to being regulated as if it were an funds, and subsequent investigations emulate Europe’s relatively low levels of investment fi rm. To try and address into market manipulation. The concern consumption, they will account for 18 this, current proposals seek to match is that by treating commodity markets per cent by 2020. hedging activity through fi nancial from an investment market perspective, In this context, it is unsurprising instruments with physical activity. with respect to regulation, the risk that challengers to Europe’s energy Unfortunately this is a poor proxy exists that their effi cacy is eroded, to derivative markets and pricing and, as industry bodies have already the cost of both the real economy and mechanisms are already arising. proposed, it would be both simpler and the end consumer. Policies and regulations which more effective to look at the allocation diminish the competitiveness of This will result in two unfortunate of accounting capital to determine the Europe’s markets will only strengthen outcomes. The fi rst is that the market company’s core business. the position of competitors and drive will become less effi cient and more pricing activity to other regions. volatile, with the consequence that ‘INVESTMENT FIRMS INVEST TO The losers will not only be Europe’s costs to end consumers will rise. The GENERATE A RETURN, COMMODITY consumers and industries, who are second is that activity, and in some likely to experience relatively higher TRADERS MOVE PHYSICAL cases entire markets, will migrate to prices, but the markets themselves. COMMODITIES …’ other jurisdictions, most notably the All participants have benefi ted from fast growing markets in Asia. markets which function effi ciently within Having spent my entire career in the Europe’s place at the heart of world a stable, respected, and appropriate physical markets, the differences oil markets is largely accidental. North regulatory framework, as has generally between our business and that of an

30 OXFORD ENERGY FORUM DECEMBER 2015: ISSUE 103

160 Volume Price 500,000 140 450,000 400,000 120 350,000 100 300,000 80 250,000 lots 200,000

USD/barrel 60 150,000 40 100,000 20 50,000 0 0

Oil price and the volume of contracts traded

investment fi rm seem clear. Investment with no impact on liquidity, as the chart after 2008, meaning that short-term fi rms invest to generate a return, ‘Oil price and volumes of contracts uncollateralized exposure is very commodity traders move physical traded’ shows. It has also served to limited and the likelihood of large, commodities – hence our obsession demonstrate how conservatively unfunded exposures forcing a sudden with logistical details and real commodity trade operations manage collapse and systemic failure is highly consumer demand, country by country their risk exposure – without careful unlikely. This is not to say that trading and fuel by fuel. Some of the tools we hedging, many market participants would houses will not fail. They will, and the use may be the same, but that does have suffered signifi cant losses. consequences for employees and not make the businesses the same; equity holders could be tragic, but their if hydrocarbons became obsolete unfunded exposures to other market Commodity traders don’t pose a ‘systemic overnight, most energy trading participants will not be suffi cient to risk’ operations would no longer exist, engender a domino effect. whereas investment fi rms would simply In this context, the resurgence This begs the question of whether fi nd another asset class to invest in. of questions from some quarters commodity markets can experience regarding the issue of whether physical Similarly, position limit rules must ‘systemic failure’ in the same way trading operations should be regarded be set in such a way as to refl ect that credit markets seized up in 2008. as a ‘systemic risk’ (akin to that created the practicalities of each market – There are multiple participants in by the banking sector) is clearly practicalities which will differ from energy markets – most of which are not misguided. market to market, depending as much signifi cantly interlinked and all of which on the constraints of the underlying The rationale as to why commodity respond to the underlying economic physical market as the fi nancial traders do not pose a systemic risk drivers of physical demand and supply. markets. Here also there is a real risk has been comprehensively articulated So long as there is confi dence in the that rules intended to promote market by Professor Pirrong of Houston demand for the underlying commodity, integrity result instead in a distorted, University on a number of occasions. and the funds to facilitate trade, the illiquid market, which is of limited use to The funding model of commodity market will continue to trade; the end-users. trading businesses – with long- process of transferring ownership of The recent collapse in the price of oil term funding and short-term, readily a commodity is well established and has demonstrated how effectively marketable liabilities – is the reverse relatively simple, certainly much simpler commodity markets have responded to of that of the banks and some other than with fi nancial instruments. Hence the underlying realities of demand and fi nancial institutions. The position has the demise of any participant will supply, as well as how capably they been further strengthened since the simply be seen by its competitors as a can handle signifi cant price volatility, introduction of mandatory clearing commercial opportunity.

OXFORD ENERGY FORUM 31 ENERGY TRADING AT THE CROSSROADS

Importance of maintaining robust prices are as much a part of ‘IT IS IMPERATIVE THAT RULES AND commodity markets commodity markets as ‘irrational exuberance’ is a human weakness, REGULATIONS ARE DESIGNED TO The world’s major commodity but eventually, as recent months have PROTECT THE INTERESTS OF THE REAL markets are well established and shown, the fundamentals of supply ECONOMY AND CONSUMERS.’ robust. They have continued to and demand take over. As I began by function effectively even in the face of saying, commodity markets exist to regulations are designed to protect swings in price and huge shifts in continuously facilitate the movement the interests of the real economy and demand from the OECD to the of goods around the world. This is consumers by enhancing this function, developing world, most notably Asia. their primary and essential purpose and above all others. Otherwise Europe will Bubbles and temporarily infl ated it is imperative that rules and be the poorer.

Are regulators right to worry about the oil benchmarks? Peter Stewart

The three most widely used crude hear the price of oil on the television. forward Brent price is itself derived oil benchmarks are North Sea Brent, They are baffl ed and often astonished from the Brent futures price and the West Texas Intermediate (WTI) from when they fi nd out the reality. Exchange for Physical differential). the USA, and Oman crude from the Moreover the values are not the result Middle East. As is well known, the ‘ASSESSING THE VALUE OF BRENT CRUDE of a survey or an average of deals; bulk of the 92 million barrels of crude OIL IS ANYTHING BUT SIMPLE.’ buyers and sellers meet and transact oil sold each day is priced based their deals on the Platts screens – in on published assessments or daily The scientist Isaac Newton said: ‘Truth what has become known as the Platts averages of deals done in these three is ever to be found in simplicity, and ‘window’ – bids and offers are posted grades of oil, known as benchmarks. not in the multiplicity and confusion of and may or may not result in actual The assessed value of physical or things.’ Assessing the value of Brent transactions, and only the market price ‘dated’ Brent published by Platts, a crude oil is anything but simple. Brent at a particular moment in time (4:30 leading price-reporting agency (PRA), crude oil is currently most frequently London time) is refl ected in the daily is the most widely used benchmark. sold based on a value that Platts will assessment. These assessments and Billions of dollars worth of oil and in the future publish for the lowest in the real-time fl ow of bids and offers signifi cant volumes of gas and LNG price of four not very similar grades can be seen by anyone who wants change hands each day based on of crude oils (Brent, Forties, Oseberg, to pay a hefty subscription fee. Platts’ dated Brent assessment. Other Although Brent is generally regarded and Ekofi sk, also referred to as BFOE) benchmarks published by companies as the market with the most complex on the days around or shortly after the such as Petroleum Argus and ICIS are structure, similar mechanisms of cargo is loaded. That is usually 2–4 also used by the industry. varying degrees of complexity are weeks after the deal between a seller used in assessing the value of other The Brent market has evolved over and a buyer is concluded. The value benchmarks. the years and it is now one of the that Platts publishes on the bill of most complex of commodity markets. lading date is itself not based on a Platts’ methodology and those of its From experience, it takes one full transaction that is concluded at a competitors – Petroleum Argus, ICIS, day on a training course to explain fi xed price. The calculation that Platts and others – have evolved over time, comprehensively from scratch how makes each day of the fi xed price value and the assessment systems have Platts makes its daily assessment for each of the four grades is usually been adapted as the market itself of dated Brent. It is usually the most derived from at least two, and arguably has changed. So the fact that the diffi cult day of such a course. People three, separate fi nancial instruments: assessment methodologies used are from outside the oil industry generally the Brent forward price and the sometimes convoluted cannot be laid expect that oil is sold at a fi xed price Contract for Difference between the solely at the doors of the PRAs (Platts in dollars per barrel, which is how they physical cargo and forward Brent. (The took a more active role in defi ning the

32 OXFORD ENERGY FORUM DECEMBER 2015: ISSUE 103

standards for trades that it will consider expressing the value of the several and so mathematical systems that in its assessment when it set up the hundred different grades of oil that are give predictable results, such as taking BFOE system, and with the subsequent actively traded as a differential to it, averages of large numbers of trades, introduction of quality escalators allows market participants to discern give them a sense of comfort. As for and alternative delivery procedures). quality trends more readily, as well as transparency, the lack of a reliable fi xed Nevertheless, it seems evident that the time structure of the market. There price number that represents the ‘real’ there has been a growing lack of trust is more ‘information’ in the prices value of physical oil is a huge concern. between the regulatory community, and spreads than if everything traded Regulators may look askance at the the price-reporting agencies, and the at a fi xed price, like electrical goods pea soup of spreads and ratios that trading community in recent years, in a department store. Traders can allows traders to trade so creatively particularly in Europe. The IOSCO make more money in a system that and which makes the market so (International Organization of Securities is non-transparent, so their heyday effi cient. They may well ask, is all of Commissions) principles were was arguably in the highly secretive this just smoke and mirrors, a way developed to ensure best practices early days of oil trading when the of obfuscating the fi xed price of the in assessments were followed; but likes of Marc Rich dominated the commodity? some groups within the European image of an oil trader in the public’s Union now want to go far beyond these imagination. But as the market became ‘FOR THE PRICE-REPORTING AGENCY, principles, in a way that many in the more transparent, traders needed THE AGENDA IS TO REPORT THE TRUTH industry believe would add to the cost liquidity more than anything else; as AS ACCURATELY AND TRANSPARENTLY of transactions and would ultimately arbitrage becomes more effi cient, AS POSSIBLE.’ hurt the consumer. Whether that will margins become increasingly thin, so happen depends on decisions that the frequency and size of transaction For the price-reporting agency, will be taken in the coming weeks and – the liquidity of the market – speeds the agenda is to report the truth months. up. Traders see a valuable role for as accurately and transparently as their trading activities in ironing out Rather than take sides in this debate, possible. The PRA has to make an temporary imbalances of supply and this analysis seeks to characterize assessment each day, whether or not demand. This involves risk, so it is the agendas that motivate the three the market is transparent or liquid. natural that they should seek to make groups (traders, regulators, and PRAs); The badge of honour of the PRA is to money from these activities. it then examines the evolution of the publish more accurate information. benchmarks; and then tentatively From my experience, the PRAs do ‘WHAT [THE PUBLIC AND THE REGULATOR] suggests some ways that regulators, not care much about liquidity. Platts the industry, and the PRAs might WANT IS A CLEAR EXPLANATION OF THE was certainly suspicious of replicable fi nd common ground in which trade FIXED PRICE OF THE COMMODITY.’ systems, such as averages based on continues, while not being perceived as large numbers of deals, as these are a threat by regulators. The public and the regulator have zero easier to game. But the PRAs care a interest in the minutiae of details that lot about transparency and the The benchmark system, transparency and are the lifeblood of traders; they do not accuracy of their assessments. For liquidity care about small or even big changes example, Platts took a decision in in grade spreads, backwardation and the early 2000s to start publishing For a trader, the virtue of the contango, arbitrage openings, location the names of companies involved in benchmark system is that it allows spreads etc. What they want is a clear physical oil transactions; it was a very market participants to easily see the explanation of the fi xed price of the unpopular decision with the industry relative value of different grades of oil. commodity, because business and the who for decades had reported deals Using a single reference grade, and public are exposed to the retail price of to Platts on the assumption of the fuels derived from crude oil, and it anonymity along the lines of: ‘Brent ‘FOR A TRADER, THE VIRTUE OF THE is their interests that regulators typically reported sold at Sep minus 20 cts, BENCHMARK SYSTEM IS THAT IT ALLOWS seek to protect. High liquidity may in ARA trader to US major’. Likewise, the MARKET PARTICIPANTS TO EASILY SEE itself be suspicious; the gut feeling ‘window’ system was unpopular when THE RELATIVE VALUE OF DIFFERENT is that if traders are trading so much, it was fi rst put in place in the European GRADES OF OIL.’ they must be making pots of money. products market; traders were Despite that, regulators like replicability vociferous in denouncing it.

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Ironically, while Platts put more and focused liquidity on the key benchmark the Brent weekly CFDs allowed the more effort into opening up Pandora’s grades. Forward contracts for Dubai gap between the forward 15-day (or Box by making the physical market and Brent became more liquid, later 21-day and 25-day) market and fully transparent, regulators received frequently with 60–80 full cargoes of the physical price. These instruments mixed messages – even from some Brent changing hands in so-called allowed traders over time to sell of the large oil companies – about ‘daisy chains’ in what at the time was physical cargoes of oil on a Dated whether the assessment system could the 15-day Brent market. The liquidity Brent-related price plus a differential. be trusted. on futures markets, although initially Using risk management instruments, lagging that of the 15-day market, traders could lock in a fi xed price saw an even more impressive growth on the day a trade was concluded, Historical evolution of benchmarks trajectory. The NYMEX light sweet despite the deal being invoiced based When the benchmark system was crude contract was set up in 1983 and on the Platts average Dated Brent set up in the mid 1980s, the futures the IPE’s Brent contract followed in price on/around bill of lading plus the markets were still in their infancy, 1988; both became dominant markers differential. there was no developed swaps for the outright market value by the Indeed, there was no reason at all why market, and the physical market was end of the decade. The New York Dated Brent should not itself trade at shrouded in secrecy. The evolution of Mercantile Exchange (NYMEX) is now a differential to its own value in this the benchmarks, including Brent, is part of Chicago Mercantile Exchange system. Rather than physical Brent described in Bassam Fattouh’s study (CME); and the International Petroleum trading at a fi xed price, it traded against ‘An Anatomy of the Crude Oil Pricing Exchange (IPE) is now owned by the Platts dated Brent, which itself was System’ (Oxford Institute for Energy Intercontinental Exchange (ICE). set by the Brent future, plus an EFP Studies, WPM40, January 2011). The This evolution resulted in a dichotomy (exchange for physical) differential, price-reporting agencies at the time that characterizes the benchmarks plus a CFD (contract for difference) were among the only sources of price today, and still troubles regulators. differential. The Brent future, while very discovery, so it made sense to use their While pricing remains tied to the liquid, did not result in physical delivery, daily assessments of the key marker assessments published by the except by the bilateral mechanism crude grades as a barometer of overall reporting agencies, the outright price of the EFP. So the value of the most market value. transparency through the day is from infl uential physical benchmark moved Platts’ daily assessments for individual the futures screen. Because the from being a negotiated fi xed price, crude oils were already widely used market’s trading structures evolved to an assessed number determined in term contracts and in settlement of before the futures markets took off, the by the value of a suite of fi nancial spot transactions, particularly in the legacy pricing mechanisms did not instruments which did not involve USA. Although a relative latecomer adjust to the new reality. Even in the physical delivery, plus a negotiated to international crude oil assessment, early 1990s, many crude oil traders differential. For oil traders, the system Platts’ forward assessments of Oman (fantastical as it may now seem) worked well. It was highly fl exible, it and Dubai, Brent, ANS (Alaskan believed that the futures markets were allowed the price to be set when the North Slope), and WTI were quickly a passing fad. cargo loaded, and it preserved the incorporated in term contracts with time gradient of the market and the Physical Brent deals at this time were OPEC members. quality differentials between crude oils. often concluded at differentials to the But to regulators, it was ‘anything but Platts published daily assessments of 15-day price, so a dated cargo would transparent’. the fi xed price value of the oil, which change hands at (for example) ‘January didn’t involve any complex sums 15-day Brent less 20 cts/barrel’. As A series of changes followed which because, at the time, crude oil was more pricing converged on the Platts established Platts as a determiner of generally traded at a fi xed price. As the physical Brent assessment, so risk market structure, rather than simply an market evolved, and risk management management instruments evolved that observer of the market. The evolution structures became more sophisticated, bridged the gap between the futures of Dated Brent into dated BFO and the market structures also became and the physical, and the forward and then dated BFOE is well known; more complex. Whereas in the past the physical. The Dated to Frontline subsequently, the Forties assessment traders had tended to tie contracts to Swap allowed traders to fi x the spread was subject to a quality penalty based Platts’ assessments of individual crude between the fi rst month future and on its sulphur; and more recently prices oil grades, the benchmark system Platts dated Brent assessment, while were adjusted to avoid an options

34 OXFORD ENERGY FORUM DECEMBER 2015: ISSUE 103

value for grades such as Oseberg and and fi nally the fi xed price assessment systems that were used in fi nancial Ekofi sk from affecting the Brent price. cannot be seen through the day in markets. Regulators should resist No doubt further changes will be made real time, but only after the window is the urge to teleport fi nancial market as markets evolve. A reporting agency closed and the price assessors have solutions to a commodity market that is such as Platts probably sees this as done their arcane and sometimes fundamentally different in its operation. sensible due diligence in the quest for complex calculations. The market structure is not something an ever more precise assessment, a To those who have grown up in the that can be decided by a committee. fi ne tuning of the basic steps put in quotes-related system, it often seems It is the job of each member of place through the BFOE mechanism to inconceivable that things could be the trading community to decide avoid the manipulation of assessments. done differently. The reality is that individually. A regulator cannot make To a regulator, the mechanism may there are many ways in which the such decisions; nor can a price- well look like an evolutionary accident, market could restructure itself to give reporting agency. But it is important similar to those birds whose tail gets more robust price discovery, as well that there is a forum for discussion so long that they become incapable of as being simpler and more intuitive to among the three groups, because movement; a case of the survival of the comprehend. better decisions will result from a weird, rather than the survival of the fi t. fuller understanding of the priorities of A switch to fi xed price trading is one each. The current situation in which possibility; it happened in the US Moving forward (apparently) the regulators trust neither market in the days after 9/11 when the the trading community nor price- The irony of the benchmark system NYMEX was shut. Other oil markets reporting agencies is undesirable. and the use of published assessments trade at fi xed prices; hedging is still European regulators appear intent on is that it was supposed to simplify possible through swaps that are rushing through new rules no matter and clarify the market by making its settled against values published by what they are told by professionals with structure more transparent. In fact it the PRAs. Deals could also be done years of experience in the business. has resulted in a system in which the at Brent futures-related prices in much value of ‘real oil’ is discovered through the same way as in the good old days, Unfortunately, this provokes what a set of spreads. The fi xed price is that when physical Brent was traded at is often a lightly concealed disdain on the futures exchange, a contract a differential to the 15-day forward. among the industry for the regulatory which converges on settlement with There is also no reason why market effort, because the regulator is the second forward ‘cash’ BFOE participants should put all their eggs in perceived to be anti-market and to month. Although cash BFOE trades the Brent basket price; a trend towards not understand how markets work. in the ‘window’ at a fi xed price, this is more diverse regional benchmarks is Even when the three groups – traders, for relatively brief periods during the arguably already underway. regulators, and PRAs –use the same assessment process. Trading volumes words, they do not necessarily have a have anyway declined as the swaps ‘REGULATORS SHOULD RESIST THE common language, because the words market has grown. URGE TO TELEPORT FINANCIAL MARKET have different meanings for each of them. Words such as ‘transparency’ The futures price is clearly not the SOLUTIONS TO A COMMODITY are brandished – like light sabres in physical price; but because it can be MARKET …’ a Star Wars battle – by all three of the seen on a screen through the day, is groups trying to claim the moral high readily available without a subscription Meanwhile, regulators should listen to ground, but with no attempt to sit down fee, and is a fi xed price rather than the market. Financial market regulators and really understand what the concept a price set through a differential, it is were alarmed at the manipulation of of transparency means for each of the widely quoted in the media as the ‘real’ the LIBOR benchmark. Even before individual entities. price of oil. Conversely, knowledge of that hot potato exploded, the PRAs the physical price is only available for a knew of the weaknesses of such What is needed is not just a three- hefty subscription fee; it is increasingly subjective mechanisms, and had way discussion between the industry, an abstraction that is dependent on developed systems to make their regulators, and PRAs, but a genuine a methodology, and is usually set as own oil price assessments more attempt to mutually understand the a differential to another instrument; objective and robust than the weak others’ language.

OXFORD ENERGY FORUM 35 ENERGY TRADING AT THE CROSSROADS

Regulation and the price-reporters Neil Fleming

The history of the relationship ‘can be subject to confl icts of interest’ 2013 launched a much-publicized between regulators and commodities does not make it so in all cases. probe into oil pricing, with raids on markets has been characterized by the offi ces of Shell, BP, Statoil, and Nevertheless, governments and the three questionable assumptions: Platts. general media, in particular in Europe, that a problem exists at all with the have spent the past several years In 2012–13 Ofgem and the UK measurement of value in energy whipping themselves into a froth of Financial Conduct Authority (FCA) and commodities; that automated suspicion over the state of price- meanwhile conducted an investigation measurement systems are less reporting in commodities markets. into alleged manipulation of natural gas vulnerable to manipulation than people; Governments have also spent a fair bit prices after ICIS reported apparently and that a static measurement system of money, rightly so, trying to get to the anomalous trades to them. can guard against potential future bottom of their suspicions. manipulation. ‘ENERGY TRADERS FOR THEIR PART Traumatized by the example of LIBOR IOSCO Principles ARE FOND OF BLAMING MARKET and some forex markets, regulators MANIPULATION FOR THEIR OWN began four years with the additional Beginning in 2011, the International MISTAKES.’ ‘Medieval Witchcraft Trial’ assumption Organization of Securities that all benchmarks are alike. To quote Commissions (IOSCO), as the Politicians are fond of saying there is from the EU Parliament’s draft text from body representing the majority of no smoke without a fi re. Energy earlier in 2015 for regulating markets: international fi nancial regulatory traders for their part are fond of authorities, conducted an in-depth ‘Serious cases of manipulation blaming market manipulation for their review of price-reporting in the crude of interest rate benchmarks such own mistakes. oil market, in collaboration with the IEA as LIBOR, EURIBOR, as well as and IEF, and made recommendations The world has rather short memories, foreign exchange benchmarks, designed to help prevent however. Who remembers, for example, causing considerable losses to manipulation of oil price indices. the EEC’s 1980s investigation of consumers and investors and Known as the ‘IOSCO Principles’, the alleged price-fi xing in European oil further shattering the confi dence recommendations largely codifi ed markets? Or the 1936–7 US anti-trust of citizens in the fi nancial pre-existing methodology and lawsuit against Platts and 23 US oil sector, as well as allegations transparency practices, but added companies, still the largest criminal that energy, oil and foreign a layer of transparency through the prosecution ever brought in the USA. exchange benchmarks recommendation that price-reporting These pieces of history seem nowhere have been manipulated, agencies (PRAs) submit to external to be found in regulatory memory. demonstrate that benchmarks auditing of their price-reporting Indeed, they are nowhere to be found can be subject to confl icts of methodologies and standards. on the Internet, either. Platts’ PR interest and have discretionary department appears to have expunged and weak governance The Principles have been embraced the 1930s investigation from the regimes that are vulnerable to and implemented by all large-scale company’s offi cial history, despite the manipulation.’ (bolding added) price-reporting agencies, including fact that it exonerated the company Platts, Argus, ICIS, OPIS, and RIM. It takes only a moment’s thought to fully; and the EU appears to have lost All have applied the principles to all appreciate that an allegation cannot all records of its 1980s probe into the commodities markets they cover, demonstrate anything, unless it is suspected oil market malpractice. including those for natural gas, metals, proven. And to say that a benchmark petrochemicals, and fertilizers. For the record, however, let’s just repeat that neither of these historical ‘TO SAY THAT A BENCHMARK “CAN BE investigations found any evidence Investigations of oil market behaviour SUBJECT TO CONFLICTS OF INTEREST” of wrong-doing. Likewise, Ofgem’s DOES NOT MAKE IT SO IN ALL CASES. Not to be outdone by IOSCO, however, recent gas market investigation, which the EU’s competition authorities in focused on a particular pattern of

36 OXFORD ENERGY FORUM DECEMBER 2015: ISSUE 103

trading in 2012, concluded that no ‘Marathon Petroleum Company seriously attempting to sell a cargo of price manipulation had taken place. LLC (MPC) settled charges oil at the highest available market Markets await the outcome of the for attempting to manipulate a price. EU’s Shell–BP–Statoil–Platts probe price of spot cash West Texas The second thing to note about the with interest. To date, nothing has Intermediate (WTI) crude oil cited example is that it is written emerged, aside from UK government delivered at Cushing, Oklahoma entirely conditionally: criticisms of the probe as ‘political on November 26, 2003, by ‘If its conduct was successful, posturing.’ attempting to infl uence downward MPC would have benefi ted the Platts market assessment for Part of the reality is that governments, from lower Platts spot cash WTI spot cash WTI for that day. As a which are after all elected by assessment.’ net purchaser of foreign crude oil energy consumers, tend to priced off of the Platts spot cash The reality is that the oil company launch investigations into market WTI assessment if its conduct did not benefi t from lower prices, manipulation when prices go up. was (sic) successful, MPC would because the price-reporting agency’s There is no traceable history of similar have benefi ted from lower Platts methodology ensured that no investigations into falling prices, spot cash WTI assessment. The misconduct of the kind cited was despite the fact that most oil market order fi nds that, on November 26, possible. participants in the so-called developed 2003, MPC purchased NYMEX world ought primarily to be motivated Thirdly, activity of this kind is already WTI contracts with the intention to push oil prices down rather than up, proscribed under existing law and of selling physical WTI during the since on balance they are buyers rather market abuse regulation in both the Platts window at prices intended than sellers. USA and Europe. to infl uence the Platts WTI spot In recent years, however, as the EU cash assessment downward. The question is therefore: why is this text above shows, the simple existence Further, during the Platts window, case being cited as evidence of the of investigations into possible market MPC knowingly offered WTI need for additional regulation? The manipulation has increasingly been through the prevailing bid at a Marathon case, which is now 12 years cited in media reports, opinion pieces price level calculated to infl uence old, appears to be the only oil market by self-styled ‘market experts’, and downward the Platts WTI case IOSCO was able to cite. And it is even regulatory documents, as assessment.’ arguably evidence not of the need for evidence that the manipulation exists. regulation, but of the success of PRA There are three things to say about methodologies in deterring attempted It’s interesting to note that in two years this. manipulation. of research into crude oil markets, First, the fi nal assertion, namely that IOSCO’s work in drafting its ‘Principles Marathon ‘knowingly offered WTI for Oil Price Reporting Agencies’ Investigation of natural gas market through the prevailing bid’ appears to (produced in October 2012), cites behaviour be incorrect. Platts insiders indicate only three examples of attempted This leaves IOSCO’s two cases from that, at the time IOSCO’s report fi rst manipulation of price-reporting the US natural gas market. One appeared, they checked their records agencies over the course of the relates to trading behaviour. That is, in and found that Marathon had not in previous 20 years. Of these examples, 2008, the CFTC fi ned Energy Transfer fact ‘offered through the bid’ at any two relate not to oil price-reporting but Partners of Dallas Texas USD 10 point. Indeed, Platts price-reporting to natural gas markets in the USA. million for selling ‘massive quantities’ methodologies – and those of its of natural gas on the Intercontinental The remaining case, which is an oil competitors – make it impossible for Exchange – a futures exchange – in market case and relates to an incident nonsense offers of this kind to be order to drive prices down and benefi t in 2003, is an account of an alleged taken into account by price reporters. the company’s swaps position. attempt by Marathon Petroleum to The methodologies prescribe that infl uence Platts crude oil prices. Note anomalous offers (or bids) are There is no suggestion that the sale the word ‘attempt’. To quote IOSCO automatically ignored on the basis of of the massive quantities did not take directly, itself quoting a CFTC the simple and logical premise that place. But since it is incumbent on (Commodity Futures Trading no one in their right mind would offer price-reporting agencies to base the Commission) order: below an existing bid if they were prices they report on real transactions,

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it is hard to see how such behaviour market. This is the now-infamous case a tradable price exists at the posted could be represented as manipulation of how, early in the 2000s, a number of level, and then rapidly withdrawing of price-reporting agencies. natural gas traders in the USA supplied the bid or offer before a counterparty fabricated deals data to Platts for can ‘hit’ the price. Since the rules built This is a key point, and one that is often inclusion in its natural gas indices. into exchanges permit the withdrawal overlooked or misunderstood. There is of bids and offers, this practice is a difference between pushing a market This may be the only established ‘permitted’ by electronic systems, and around, and pushing a price-reporting case in history of market participants is diffi cult to guard against. agency around. successfully manipulating the number published by an energy price By contrast, most PRAs have long ‘Manipulation’, in other words, is a publication – rather than manipulating since built into their methodologies a slippery word with many defi nitions. the market itself. Those gas traders principle that spoofi ng a bid or offer In the eyes of a regulator, a market who participated in this exercise did by reporting it to the PRA and then is manipulated if a player or group of so by straightforward fraud: inventing ‘fl aking’ on the price level indicated in players causes prices to do something trades that had never happened, and effect constitutes a lie. To be fair to the they would otherwise not ‘normally’ exploiting a submission mechanism regulators, over time fi rst IOSCO, and have done. This includes using a that lacked a means to check their latterly perhaps the EU’s legislators leveraged position to profi t in one veracity. too, have come to appreciate that market area from activity in another. such methodological safeguards are There are two things to note about this It also includes use of a privileged not accidental; and that the initial position to infl uence underlying supply case. assumption that all benchmarks were (or less obviously, demand). First, it was the price-reporting somehow as compromised as LIBOR agency itself, Platts in this case, was not, in fact, correct. ‘A PRICE-REPORTING AGENCY CANNOT that detected the fraud in 2003 and Indeed it seems likely that the EU’s REPORT WHAT PRICES “OUGHT” TO BE, blew the whistle on it, without the fi nal regulatory text will back away from ONLY WHAT THEY CAN BE SHOWN TO BE.’ presence of any regulatory lumping PRA methodologies into the framework. same basket as those that were shown In the eyes of a price-reporting agency, Second, that even though this is the to be founded in fundamental confl ict however, such ‘manipulation’ can only apparent case of demonstrated of interest. The proposed ‘compromise only be reported on. The price of oil is price manipulation in history, some text’ of the EU’s regulatory draft for whatever the price of oil is, provided regulators have gone on to suggest fi nancial benchmarks states, quite that it results from market behaviour. that this very practice – the mildly, only that: That is to say, it is not, nor can it ever submission of unchecked deals be, the role of a price-reporting agency ‘All benchmark administrators information into a mechanized to somehow counteract genuine market are potentially subject to confl icts process – is the best way to behaviour. A price-reporting agency of interest, exercise discretion safeguard against future cannot report what prices ‘ought’ to be, and may have inadequate manipulation of price publications. only what they can be shown to be. So governance and control systems IOSCO’s second example appears to That makes little sense. Safeguarding in place.’ be irrelevant as well. markets against manipulative And the latest draft of the EU behaviour cannot be achieved by There are essentially only two types of Parliament’s text notes that: mechanization. activity against which price-reporting ‘Accordingly, certain provisions of agencies should arm themselves. this Regulation are not appropriate These are: Spoofi ng to apply to commodity activities which create the Indeed, concerns voiced by regulators benchmarks. Principles developed appearance of market activity – as recently as October 2015 about for commodity benchmarks by wash-trading and its analogues, and ‘spoofi ng’ in electronic trading systems IOSCO in collaboration with the for energy highlight the problem. International Energy Agency and outright fraud or lying. Spoofi ng is the practice of posting bids the International Energy Forum, This brings us to the fi nal case cited or offers in a trading system with the among others, are specifi cally by IOSCO, again from the natural gas purpose of creating the impression that designed to apply to all commodity

38 OXFORD ENERGY FORUM DECEMBER 2015: ISSUE 103

This makes an average a plausible of the market complex. Those spreads ‘NEVERTHELESS, THE CONVICTION mechanism for agreeing on a typical can be qualitative: the difference in REMAINS AMONG MANY REGULATORS value in a market with very high liquidity. value between Brent crude oil and THAT A SINGLE APPROACH “OUGHT TO” And indeed price-reporting agencies Oman/Dubai, for instance. They can WORK FOR ALL MARKETS.’ make extensive use of averaging, be differentials in forward time: July under appropriate circumstances – for BFOE (Brent, Forties, Oseberg, Ekofi sk) example in natural gas markets, where versus August BFOE. Or they can be benchmarks and therefore this there are large numbers of deals. differentials in the processing chain: the Regulation provides that certain spread between the price of crude oil requirements will not apply to Clearly, if we average foreign exchange and the price of gasoline. commodity benchmarks.’ transactions over the course of a day, we will get a number that is broadly Nevertheless, the conviction remains ‘TRADING EFFICIENCY ENSURES IT IS representative of that day’s activity. among many regulators that a single RARELY POSSIBLE FOR A SIGNIFICANT Ironically, however, no one cares what approach ‘ought to’ work for all GAP TO OPEN OR CLOSE IN A SPREAD markets. the broadly representative number is. MARKET.’ You cannot trade foreign exchange at a broadly representative number: only Automation and averaging Typically these relationships are far less at the latest number. Similarly for stock This brings us to the second issue that exchanges and other very high liquidity volatile than the outright price itself. has dogged the relationship between markets. The average for the day is Trading effi ciency ensures it is rarely regulators and commodities markets: a statistical accident, based on the possible for a signifi cant gap to open automation. And with automation: distribution of trading volume, which is or close in a spread market. If crude oil averaging. a random event. When people choose tracks higher, so does gasoline. to trade will have an impact on the An average is a very interesting thing, So far so good. However, in the real resulting average. In terms of the value from an abstract point of view. As world, the traded volume of physical represented, the average therefore a statistical tool, averaging can be oil is actually very low. There are not equates to the price at a random time invaluable in providing information thousands of trades per day, as there somewhere between the open and about everything from the behaviour of are in futures markets, but literally only the close. subatomic particles to the behaviour a handful, at best. This means that as of teenagers. Averages are the If we look closer, we discover that the market complex moves higher or cornerstone of the insurance industry. it should also be the case that the lower, the time at which a trade takes However, as any insurance broker will random time represented is, to some place has a disproportionate infl uence ruefully concede, averages are not extent, determined by volatility. The on the resulting average price. much use when it comes to predicting more volatile the period of the day, the Consider the example in the chart fl oods, let alone dealing with them. The higher the traded volume is likely to ‘Averaging in thin markets’, shown on average height of the tide in the coastal be, as buyers and sellers slug it out the next page. The two markets Netherlands tells us nothing about over market direction. That means in (indicated by the two lines) have an whether or not a specifi c high tide will turn that a weighted average for the intimately linked spread relationship: fl ood half the country. day will probably over-represent the as one moves higher, so does the other. most volatile period of trading for the Averages have some obvious And vice versa. However, the markets day. In the worst case interpretation, characteristics. They are most useful – in question are in the habit of trading the average is determined, or at least they provide most information – when actively at different times of the day. unduly infl uenced, by periods of they involve a very large sample, or a The market represented by the lower atypical market activity. sample over a long period of time. They line trades mostly in the morning (the are least useful – that is to say, least The conundrum of averages gets more square points on the line), while activity likely to deliver meaningful information complicated when we start to examine in the market represented by the upper – when they involve a small sample or the impact of averaging on markets line is concentrated in the afternoon a short period of time. And, obviously, such as those for oil, where the (the diamonds on the line). This is not they wink out of existence altogether market’s economics depend primarily hypothetical. There are real markets when the sample size hits one, or not on the outright price of oil, but on which exhibit this behaviour: for worse, zero. the spreads between different pieces example where the market represented

OXFORD ENERGY FORUM 39 ENERGY TRADING AT THE CROSSROADS

120

116 Real spread throughout: USD 5 112

108

104 Upper line trades average USD 108.4

100 Lower line trades average USD 106

96 Apparent spread: USD 2.40 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Averaging in thin markets

by the upper line has a close and is used by PRAs where appropriate. relationship with another geographical But it is clearly inappropriate in thinner ‘… THE TERM “JUDGEMENT” HAS market that is not open at a time when markets, and positively misleading in BECOME PEJORATIVE IN SOME it is morning for the market represented markets where inter-product spread QUARTERS, IN THE CONTEXT OF by the upper line – as happens with relationships are important. DETERMINING MARKET VALUE.’ European and US markets, obviously. There is also a school of thought which In the example, a succession of lower says that more reliable benchmarking In the idealized world of the politician line trades occurs during the rising may be obtained by averaging not just seeking to protect consumers market of the morning. The afternoon the transactions for the day, but also from market manipulation, price sees markets fall somewhat and fi ve the prices published by a range of determination should be taken out upper line trades yield an average of price-reporting agencies. of the hands of those who might fall prey to such manipulation and be USD 108.40. This compares with the However, if agencies B and C have entrusted to mechanized systems, lower line trades averaging USD 106. better methodologies than agency robots in effect, that do not use things There is an apparent spread between A, then surely including agency A’s like ‘judgement’ as tools in price lower and upper of USD 2.40. But this number in the mix simply dilutes the determination. It’s interesting that spread is entirely inaccurate. The real gap quality of the supposed benchmark? the term ‘judgement’ has become between the lower and upper markets You don’t get better wine by mixing the is more than twice the spread indicated output of the top Bordeaux vineyards pejorative in some quarters, in the context of determining market value. by the average: it is USD 5/barrel. with the output of wineries in Scotland. In fact, averaging the prices published It’s as if the term implies that wide-eyed Clearly, under these circumstances, any by multiple pricing agencies is almost price reporters are making arbitrary price determination system that produces guaranteed to result in a ‘muddy’ decisions about what prices should such an anomalous outcome is not to number – representative of neither one be, without regard to what is actually be trusted. Yet indexation based on methodology nor another. happening in the market-place. That weighted averaging is the picture is quite false. recommendation for all price Static model vs evolutionary and use of ‘Judgement’ at price-reporting agencies determination methodology that we see ‘judgement’ enters the picture in two ways: coming from many regulators the world over. This is not to say that weighted This brings us to the third major theme: First: in determining what parameters averaging does not have a place. As the difference between a static model, should be used in the creation of a noted it works well in some markets and an evolutionary one. market-measurement methodology;

40 OXFORD ENERGY FORUM DECEMBER 2015: ISSUE 103

and when it is appropriate (with market from ‘borderline’. And, it must be range. It is impossible to design a consultation and input) to change those remembered, eliminating the borderline mechanistic price determination parameters. is 95 per cent of the job of the price- system that will not fail under reporting agency. It may be that PRAs exceptional circumstances, and which Second: in the application of the discount large numbers of perfectly is not susceptible to evolving market methodology itself, judgement can be genuine trades in the process of sophistication or deliberate attempts to used, under exceptional circumstances arriving at their market prices. Indeed, ‘game the system’. (accompanied by an explanation this is probably one of the reasons as to why) to deviate from a strict why market participants are given application of the rules (which a robot Price settlement methodologies to complaining about PRAs: they would always enforce) to ensure that are inherently conservative, and will If we look at the methodologies the objective of the methodology is discount a transaction if there is a for price settlement of all futures achieved in the face of anomalous reasonable possibility that it is non- exchanges the world over, the problem data. This can happen, for example, repeatable – the product of fl uke or becomes apparent. Typically, these in relation to a transaction that deliberate manipulative intent. methodologies will state that settlement appears to conform to the rules of the prices will be determined by averaging methodology, but violates its spirit. Rationale for IOSCO recommendations the fi nal x minutes of trading in the No regulatory regime, and no course of the day. The assumption methodology can ever fully deter a Ultimately, IOSCO showed in-depth is that the fi nal x minutes will always single rogue trader from attempting understanding of this state of affairs in contain enough trades to make this to manipulate a market. The purpose producing its fi nal recommendations for possible. This is fi ne – usually – in of the application of judgement in the crude oil market, in acknowledging successful, active, liquid markets. methodology design and its application that there are markets in which However, for newly launched futures is to forestall such attempts. seemingly concluded transactions contracts the assumption that trading alone cannot determine value. IOSCO The objective of price-reporting volume will be suffi cient at the close for was criticized in some quarters for agencies is in general to report prices this rule to work is distinctly unproven. taking this position. But it was correct at which transactions are typically to do so. Therefore the exchange includes a possible. For this reason, they usually second provision in its rules: in the express price assessments in terms It also showed substantial restraint in event that there are fewer than y trades of a range – the meaning of that range the matter of the disclosure of process. in the closing period, the settlement is usually: ‘a typical deal is possible in There is a school of thought which price will be determined by taking this market at a number between price would demand that all methodological trades over period z. Furthermore, in A and price B’. Judgement enters the process be laid bare in the interests the event that there are no trades in picture because of that term ‘typical’. of benchmark transparency. The period z either, the settlement price In theory a transaction is possible at counter-argument, which has prevailed shall be determined by a ‘panel of under IOSCO for now, is that full any price. But the PRA must determine experts’. Who sits on this panel is methodological disclosure is analogous if the price is a one-off ‘unrepeatable’ frequently a mystery. fl uke, an attempt at manipulation, or to requiring banks to publish details of genuinely representative of market their security systems. If a price-reporting agency were to value. This requires investigation publish such a methodology it would of the circumstances surrounding ‘IT IS IMPOSSIBLE TO DESIGN A lose all credibility in the marketplaces it the transaction, and, especially, MECHANISTIC PRICE DETERMINATION serves. The fundamental problem with the rules the exchanges outline is that consideration of data that is not SYSTEM THAT WILL NOT FAIL UNDER transactional – in particular the the basis of measurement is arbitrarily EXCEPTIONAL CIRCUMSTANCES …’ prevailing levels of bids and offers at changed by the rule itself. ‘The price the time of the transaction. is derived from fi ve minutes of trading, If we hand determination of market except on slow days, when it is derived All these things inevitably involve value to the robot, the robot will from an hour’s trades.’ the thing called ‘judgement’. No typically include fl ukes and anomalies conceivable automated rule on in its price assessments. Worse, it may There are two problems here. The earth can perform as well as human also include deals that are manipulative fi rst is obvious. We are not comparing intelligence in sorting ‘representative’ in intent or fall outside the bid/offer like with like. The second is more

OXFORD ENERGY FORUM 41 ENERGY TRADING AT THE CROSSROADS

insidious. It is that the existence of the Transparency and evolution of regulators to prefer statistical methods rule provides an exploitable trading methodologies over time-specifi c ones, or to assume opportunity. exchange-trading will eliminate the The assumption on the part of potential for market manipulation. It This has important implications for how politicians that exchange-based trading is the tendency to believe that once a best to manage price determination is somehow safer from manipulation problem is solved, it is solved. in markets where volume is not is thus arguably one of the bigger guaranteed – that is to say, physical errors in this whole debate. There is In short, the temptation to impose static commodities markets. The creation of no market on earth, we might assert, rules on price-reporting organizations rules also creates trading opportunities. that is more transparent than the North has more potential to damage the good This is true whether a robot is in charge Sea physical crude oil market. Every functioning of energy and commodities or not. trade is reported, by multiple PRAs, markets than any other step. and indeed by brokers. The names of If I declare that markets will be So what does success look like? the parties to every trade are reported. measured at 4.30 p.m. each day, The individual bids and offers leading Unless we can change human nature traders interested in the outcome up to their trades are also reported, we need to accept that from time to of that measurement will tend to try time someone will attempt to break to execute a trade at 4.30 p.m. If I and commentated on. The news that the rules and try to infl uence a market declare that markets will be measured drives the price is reported in real unfairly. The politician’s dream of by averaging all trades over an eight time by at least four independent legislating attempted manipulation hour period, traders interested in the global news-reporting organizations. out of existence is just that: a dream. outcome of that measurement will try The physical prices themselves are The efforts of EU regulators to impose to execute as many trades as possible invariably constrained, indeed virtually additional governance constraints on at a price which favours their position. dictated, by one of the most liquid PRAs emerges in this light as just that: There is nothing to stop a trader from futures markets on the planet. Deriving a desire for control, rather than a desire buying and selling at the same price. the physical price of BFOE from market to reduce manipulation, and one that Indeed, it’s a commonplace. The fact activity is arguably the easiest market- could have dangerous consequences that if I buy at USD 100 and sell at reporting exercise on the planet. for proper market function if the control USD 100 I have created two verifi able Why then was this market the focus sought impedes free competition transactions, both at USD 100, without of so much scrutiny four years ago? among PRAs or prevents them from spending any money at all and this Answer: at heart, because the price of doing their jobs. does not seem to worry the fi ercer the commodity was fi ve times higher advocates of averaging. In a thin than it was a decade ago. Indeed, if ‘THE MARKET NEEDS A CERTAIN LEVEL OF market, however, we can argue that it the EU backs away from some of its TRANSPARENCY TO ENSURE ATTEMPTS should. Even, indeed, in a not-so-thin more draconian ideas for regulating market. TO MANIPULATE ARE EXPOSED.’ commodities markets today, it may One of the great disadvantages, well be in part because the political The market needs a certain level of indeed, of electronic trading is that it pressure to act has evaporated with transparency to ensure attempts to is typically anonymous. It is hard to the fall in energy market prices since manipulate are exposed. This means it determine whether 500 transactions at mid-2014. needs independent parties observing USD 100 are the result of 250 buyers However that may be, the ability of markets – price-reporting agencies in buying from 250 sellers, or two people PRAs to report this and other markets other words – who are in a position selling and buying from each other successfully is critically dependent on to spot the behaviour, and have the by pre-arrangement at an identical one thing – the freedom to evolve and freedom to evolve their methodologies price. One of the great and overlooked adjust market reporting methodologies as markets themselves evolve; and advantages of price-reporting agencies as markets themselves evolve. A then we need regulators to address is that they are typically aware of methodology that works today may not the behaviour. the identities of who sold to whom, work tomorrow. even if they agree not to disclose this This describes exactly the situation information, and repeated to-and- The greatest danger inherent in the we see today in commodities markets. fro de facto wash trading of the kind attempted regulation of commodities We tamper with this situation at our suggested is easy to detect. markets is therefore not the tendency of peril.

42 OXFORD ENERGY FORUM DECEMBER 2015: ISSUE 103

Will MiFID II hurt industrial players in Europe? Andreas Walstad

Much of the criticism of Europe’s Whereas energy and energy-intensive But these arguments – however regulation of trading has focused companies were largely exempted valid – seem to fall on deaf ears in on its potential impact on large from the obligations under MiFID I, the Brussels. Few seem to believe that companies with substantial physical revised directive cast the net much industrial players will now secure and derivatives market exposures. wider. Brussels wants deep, liquid, last-minute exemptions to the capital There has been much less focus and transparent derivatives markets requirements under MiFID II. If the on the potential fallout from the new and to achieve this it believes investor battle is lost on MiFID II exemptions, regulations on industrial players for protection and counterparty risk are key lobbying for amendments to the CRR, whom energy trading is a sideshow. challenges that need to be addressed, and designing a capital regime which But stakeholders in the European also in energy markets. is appropriate for fi rms with substantial power and gas industry have physical assets, may be a better idea. However, the question arises as to highlighted the risk that the EU’s Although amending the CRR may be whether Brussels is burdening non- revised Markets in Financial diffi cult to achieve in practice, Brussels fi nancial companies with a directive Instruments Directive (MiFID II) could will listen to the industry’s concerns that is too stringent relative to their seriously damage industrial players and if the arguments come across as market share and the fi nancial risk consequently hurt liquidity in European suffi ciently compelling. they pose. power and gas markets. One key issue is that companies that Potential adverse effects from MiFID II do not secure exemptions from MiFID Concern over extension of regulation to licensing would be subject to capital The open letter said that the new rules non-fi nancial companies requirements under the EU’s Capital could force industrial players out of An open letter – published on 15 Requirement Regulation (CRR). That European energy markets, and that the October – called for caution. It was means energy companies and energy- direct cost to energy markets would signed by the energy trade groups intensive industries would have to amount to at least EUR 15–20 billion Eurogas (an association representing prove they have enough cash to cover per year. Although it is hard to put a the European gas wholesale, retail, and trading losses, depending on their risk precise fi gure on the cost of market distribution sectors) and Eurelectric profi le and fi nancial structure. Energy participants leaving or reducing their (an association representing European producers will basically be treated like activity in European gas and power electricity producers, suppliers, investment fi rms and will be subject to markets, there is no doubt that traders, and distributors), as well as the capital requirements under the CRR. reduced liquidity will eventually harm European Federation of Energy Traders consumers in terms of higher energy (EFET), and a number of energy- ‘ENERGY PRODUCERS WILL BASICALLY prices. After all, energy-intensive intensive industries. BE TREATED LIKE INVESTMENT FIRMS industries such as aluminium, steel, and chemical production are key The letter said in part: ‘We note with AND WILL BE SUBJECT TO CAPITAL players in wholesale energy markets. concern that the European Securities REQUIREMENTS UNDER THE CRR.’ The energy bill for some aluminium and Markets Authority’s (ESMA’s) producers is around 40 per cent of fi nal proposal for level 2 measures Energy companies and industrial production costs. Hence the need to is designed in such a way that many players have argued vigorously that hedge their exposure to energy price non-fi nancial companies trading in they do not pose systemic risk and volatility is self-evident. commodity derivatives on an ancillary should therefore not be regulated basis to their main commercial as banks. Another argument is that It appears reasonable to argue that the group business would risk capture industrial players are rich in assets – proposed rules drawn up by ESMA do in the scope of MiFID II, facing as a not in cash – hence it is unreasonable not go far enough in exempting consequence disproportionate capital, that regulators expose them to stringent non-fi nancial companies from trading prudential and liquidity requirements capital requirements. Additionally, they commodities derivatives on an ancillary normally applicable only to investment lack the staff and experience to deal basis. For instance, ESMA’s banks.’ with fi nancial regulation of this scope. methodology, for use by non-fi nancial

OXFORD ENERGY FORUM 43 ENERGY TRADING AT THE CROSSROADS

companies when applying for an fi nancial and banking crisis. Taking the who do not want to be regulated on an exemption from MiFID licensing, takes necessary steps to strengthen investor equal footing with investment banks. no account of the company’s asset protection and minimize counterparty A legitimate concern is that binding base and primary commercial risk is key to achieving trust and capital requirements under the CRR business. stability in derivatives markets. It is also could force these fi rms to sell off understandable that the EU does not Instead, ESMA has set out thresholds assets to downsize or, alternatively, want to give outright exemptions to based on the total trading activity for try to attract more equity capital from companies trading energy derivatives. non-fi nancial fi rms. That means a non- owners. Reducing counterparty and default risk fi nancial fi rm may be exempted from should ultimately benefi t these markets MiFID II is one of several legislative MiFID II if its trading in gas derivatives in the longer term. instruments drawn up by Brussels constitutes less than 3 per cent of in response to the fi nancial crisis. its total trading activity. For power Let’s not forget that many European The Market Abuse Regulation/ derivatives, the proposed benchmark is energy markets are still seeing low 6 per cent. levels of liquidity and competition. In Directive and the Regulation on wholesale gas, the trading hubs TTF Energy Market Integrity and It would make sense to include a (the Dutch Title Transfer Facility) and Transparency – as well as the European ‘capital employed test’ to be added NBP (Britain’s National Balancing Point) Market Infrastructure Regulation as an additional option for non- are the only gas hubs in Europe with – are also in the process of being fi nancial fi rms. This is also what many more than 100 registered participants implemented. Moreover, the obligation stakeholders seem to want. A capital each and churn ratios above 10, to report trades under the Regulation employment test was proposed by according to a market monitoring on Wholesale Energy Markets Integrity ESMA in December last year, but has report released by the Agency for the and Transparency (REMIT) came into since been abandoned. Such a test Cooperation of Energy Regulators would allow comparison of the capital force on 7 October. (ACER). A liquid market typically has invested in commodity derivative multiple buyers and sellers, allowing The European Commission has until transactions with the capital employed trades to move quickly in and out of the end of December to decide whether in assets and commercial activities at positions. to adopt the technical standards group level. proposed by ESMA. The directive is Several banks and other fi nancial In addition to capital requirements, expected to enter into force in institutions have left or downscaled MiFID II will also impose position limits January 2017. energy trading in order to focus on on energy trading. The position limits their core markets such as equities and will range from 10 per cent to 40 per fi xed income instead. Whether a tighter ‘… THE INDUSTRY’S CALL FOR MORE cent of deliverable supply. Again, the regulatory regime for energy derivatives FLEXIBILITY SHOULD BE TAKEN SERIOUSLY.’ main concern is that players will leave will actually make banks return to these markets or reduce trading activity markets remains to be seen. Banks Although a tighter regulatory framework substantially, due to perceived over- have vast experience in dealing with on energy trading will likely deliver long- regulation. Players leaving could also fi nancial regulation; it is not unthinkable term gains, the industry’s call for more affect security of supply. that they will see a tighter regulatory fl exibility should be taken seriously. A framework as at least one of several longer phase-in period for non-fi nancial Industrial players should be treated reasons to return to energy trading in fi rms is one option. A grace period of, differently the longer term. say, three years would give industrial Brussels is of course right to revise its All things considered, it is not hard players breathing space to adapt to the market rules in the wake of the 2008 to sympathize with industrial players new requirements under MiFID II.

44 OXFORD ENERGY FORUM DECEMBER 2015: ISSUE 103

The impact of fi nancial regulation on energy markets Andrew Tuson

Since the fi nancial crisis, we have seen regulatory regimes and focus relating The main problem with the European governments and regulators seek to to the equities markets should be Commission’s current proposals for introduce regulatory change to prevent extended to cover the commodity the Benchmark Regulation is that the manipulation of fi nancial markets markets. As a result, the Review found they do not suffi ciently address the and to protect consumers. Whilst the that products traded within the fi xed difference between rate markets regulatory changes proposed may income, currency, and commodity and physical markets. In the rate work well for fi nancial markets, their energy markets should fall within the markets, such as foreign exchange, application to energy markets in fact scope of the market abuse regime in the benchmark price is derived from poses risks to the orderly operation the UK and that authorized fi rms should the details of trades conducted on of those markets. It appears that ensure that adequate surveillance is exchange. In other words, there is no governments and regulators have conducted across these markets in requirement on those who conduct failed properly to consider how their order to identify the risks of potential the trades to decide whether their proposals will impact the energy manipulation. Arising out of the Review, trading data should be used for the markets in particular and how the price one key area in which regulation is purpose of setting the FX benchmark rate. However, in the physical markets, of physical commodities is generated. developing in the UK, and also across such as the oil market, the benchmark the European Union, is in relation to ‘… GOVERNMENTS AND REGULATORS price is set by price-reporting agencies the way in which benchmark prices are who assess the volume and prices HAVE FAILED PROPERLY TO CONSIDER produced. of transactions conducted in a HOW THEIR PROPOSALS WILL IMPACT In the UK, as a result of the Review, particular window. Given that such THE ENERGY MARKETS …’ the crude oil futures market’s principal transactions are conducted ‘over-the- fi nancial benchmark, the ICE Brent counter’, rather than on exchange, In the UK, commodity markets have Index, has become a regulated in the physical markets there is no come more sharply into focus since benchmark. This benchmark, central repository of trading data. This the fi nancial crisis. Press reports have along with seven others, has been means that price-reporting agencies suggested that the oil market may have determined as being of such in the physical markets are reliant on been manipulated just as the LIBOR importance to the UK fi nancial system market participants speaking to them, rate was manipulated. In the UK, HM that the way it is produced is now providing market information, and Treasury, the Bank of England, and subject to FCA rules which govern how voluntarily disclosing details of the the Financial Conduct Authority (FCA) the benchmark price is calculated. The transactions conducted. Unless this have conducted a year-long review other seven benchmarks now regulated happens, price-reporting agencies will into the fi xed income, currency, and not have access to data enabling them commodity markets through the ‘Fair in the UK as a result of the Review to set their benchmark price. and Effective Markets Review’ (the include fi nancial rate benchmarks such Review). The Review has published as the LIBOR and the WM/Reuters detailed recommendations on how London 4pm Closing Spot Rate. Market participants markets, including the energy market, At European level, the European Through the proposed Benchmark should be adapted in order to avoid the Commission is proposing to introduce Regulation, those who contribute risk of market manipulation. a regulation, referred to as the data to price-reporting agencies would The Review found that prior to the Benchmark Regulation, which will be subject to stringent regulatory fi nancial crisis, regulatory focus centred govern the way in which all benchmarks criteria. These criteria include on the operation of the equity markets are used within the European Union. requirements that contributors should and on ensuring that prices of equities Benchmarks include indices used to not provide any data where there is a and other products were not distorted. set the price of fi nancial instruments confl ict of interest and that they sign The Review identifi ed that regulation of or certain fi nancial products within up to a code of conduct set by the fi xed income, currency, and commodity the European Union. Negotiations price-reporting agency. The code of markets should be brought into line regarding the terms of the Benchmark conduct would prescribe the issues with that of equity markets, and that Regulation are on-going. which market participants would be

OXFORD ENERGY FORUM 45 ENERGY TRADING AT THE CROSSROADS

required to take into account in order to of unreliable market data, this would provide details of their trades to the ‘CURRENTLY, PRICE-REPORTING be likely to damage the accuracy of price-reporting agency. If these criteria AGENCIES USE THEIR EXPERT MARKET benchmark pricings. are not met, sanctions could follow, KNOWLEDGE FREELY, TO ADJUST FOR A further concern for price-reporting including the right for authorities such ABNORMAL MARKET CONDITIONS.’ agencies in the energy market is as the FCA to seize documents and that those who act as price-reporting information and to issue fi nes. participants disclosing details of agencies are not generally set up As a result of these proposed their transactions to price-reporting specifi cally for that purpose, but regulatory changes, market participants agencies. Price-reporting agencies rather act as journalists reporting on may become concerned about the risks themselves are also facing additional market developments in the industries of breaching the requirements of the regulatory burdens. Two concerns arise they cover. Often, the benchmark Benchmark Regulation. Market in particular, discussed below. price they produce is a by-product of participants may therefore decide that The fi rst concern is that the approach their principal activity. However, as a they should cease to speak to price- taken by the proposed Benchmark result of the requirements currently reporting agencies and give details of Regulation is that price-reporting in the Benchmark Regulation, price- their trades, in order to avoid potentially agencies should produce their reporting agencies will need to become breaching the Benchmark Regulation. benchmark price based on an average authorized fi rms and be regulated Uncertainty over how regulators are price of the trades conducted on any by their local regulators, such as the likely to interpret the proposed one day, or in any particular trading FCA in the UK. As a result of this regulation and impose sanctions could window. If price-reporting agencies regulatory scrutiny and the potential again make it less likely that market derogate from this approach and sanctions where regulators may seize participants would be willing to apply their own analysis to trades documents and information belonging continue to provide details of their conducted, they are taking the risk that to a price-reporting agency in the transactions to price-reporting regulators may determine that they are event of a suspected breach of the agencies. If fewer market participants not using an appropriate methodology. Benchmark Regulation, there is a risk speak to price-reporting agencies and This risk does not apply in the rate that some price-reporting agencies disclose details of their transactions, markets, where an average price of may consider that their ability to this in turn would reduce the amount of trades conducted on any one day conduct their primary function – acting data available which price-reporting may be applied in order to create an as journalists – is constrained. Under agencies could use in order to set the accurate benchmark price. However, the proposals, journalists would not be benchmark price of energy in the physical energy markets, simply able to refuse to disclose the source of commodities. taking an average of transaction prices their data and would have to hand over These diffi culties do not apply in the conducted on any one day could in their source data if required. If some same way in the rate markets. For fact lead to distorted and unreliable price-reporting agencies determine example, a market participant who pricings. Given the vagaries of supply that they do not wish to be regulated in enters into a transaction in the FX and demand in the physical markets, the way proposed by the Benchmark market will not have a choice over the number of transactions conducted Regulation, this could adversely impact whether the details of that transaction on any one particular day may be the market, as there would be fewer are taken into account for the purpose unusually low, or traded at an unusually price-reporting agencies competing of WM / Reuters calculating their high price. Where this happens, simply with each other to produce the most London 4 p.m. Closing Spot Rate. taking an average of the transaction accurate and reliable benchmark price Such data will automatically be prices made on any one particular in the market. provided by the exchange to the day could lead to benchmark prices becoming dislocated and volatile. price-reporting agency when the daily Reform of energy markets benchmark price is calculated. Currently, price-reporting agencies are able to use their expert market Whilst the European Commission knowledge freely, in order to adjust for has acknowledged that there are Price-reporting agencies abnormal market conditions. If price- some differences between the rate Concerns over the effect of the reporting agencies felt constrained markets and the physical commodity proposed Benchmark Regulation from applying their expertise to adjust markets, and whilst they have sought extend beyond the issue of market transaction prices to take account to draft some derogations from their

46 OXFORD ENERGY FORUM DECEMBER 2015: ISSUE 103

same way as fi nancial markets were. deterrent to market manipulation will ‘… THE DEROGATIONS DO NOT GO Governments and regulators would have been introduced from July 2016 FAR ENOUGH IN ADDRESSING THE control these markets more effectively when the Market Abuse Regulation is FUNDAMENTAL DIFFERENCES BETWEEN through gaining an understanding of implemented. Through this regulation, RATE AND ENERGY MARKETS.’ how the markets operate in practice it will become a market abuse offence and by working to achieve reforms to manipulate benchmark rates if these were considered necessary. requirements in relation to rate markets, (including in relation to commodities). In this regard, it is notable that the the derogations do not go far enough in The UK civil market abuse regime will International Organization of Securities addressing the fundamental differences also be extended to cover products Commissions (IOSCO) produced between rate and energy markets. traded on Multilateral Trading Facilities guidelines for the creation of fi nancial and Organized Trading Facilities. Given the risk of damage to the energy benchmarks, and the energy markets These reforms should, in turn, provide markets which could be caused have responded well to these regulators with suffi cient additional through proposed regulatory reform in guidelines, which are considered to tools in order to tackle market abuse this area, it is perhaps surprising that have introduced sensible and realistic and market manipulation in the energy regulators have not fully considered the standards. Given the work of IOSCO, markets. The Market Abuse Regulation it seems unfortunate that the European implications of their proposals. Whilst in itself may therefore provide a more Commission does not simply leave the there is an understandable political effective tool for managing the risk markets to work with these guidelines. driver to introduce regulatory reform of manipulation than the current which addresses the causes of the Whether the European Commission’s proposals for a Benchmark Regulation, fi nancial crisis, the energy markets current proposals in relation to the which could in fact result in the energy cannot be said to have been involved in Benchmark Regulation are brought into markets being damaged by creating the causes of the fi nancial crisis in the effect in due course or not, a signifi cant distorted and unreliable prices.

OXFORD ENERGY FORUM 47 ENERGY TRADING AT THE CROSSROADS

NEW OIES PUBLICATIONS

Recent Research Papers US Shale Oil Dynamics in a Low Price Trade-off: Saudi Arabia’s Oil Policy in Natural Gas in China – A Regional Environment the 2014–2015 Price Fall Analysis by Trisha Curtis by Bassam Fattouh, Rahmat Poudineh, by Xin Li November 2015 and Anupama Sen October 2015 November 2015 Oil in Uganda – Hard Bargaining and Complex Politics in East Africa Recent Energy Comments A Holistic Framework for the Study of by Luke Patey Interdependence Between Electricity The New Economics of Oil October 2015 and Gas Sectors by Spencer Dale by Donna Peng and Rahmat Poudineh The Dynamics of the Revenue October 2015 November 2015 Maximization – Market Share

CONTRIBUTORS TO THIS ISSUE

Liz Bossley is CEO of the Consilience Jonathan Hill is a regulatory He worked as Director of markets Energy Advisory Group Ltd compliance specialist at BP and pricing at Platts until 2007.

Peter Caddy is Head of Global Orçun Kaya is Economist at the Ian Taylor is President & CEO of Vitol Development at Argus Media Ltd Banking, Financial Markets, and Bert Tieben is head of Competition and Regulation team of Deutsche Bank Jonathan Farrimond is Senior Regulation Policy at SEO Amsterdam Research. Deutsche Bank AG Compliance Offi cer at the CME Group Economics, an independent Marco Kerste is head of Financial Neil Fleming is an independent research organization affi liated with Markets and Finance at SEO energy and commodities market the University of Amsterdam Amsterdam Economics, an consultant. The former Global independent research organization Andrew Tuson is Senior Associate at Editorial Vice-President of Platts, affi liated with the University of Berwin Leighton Paisner LLP and former Head of Content for Amsterdam ICIS, he currently works as Strategic Andreas Walstad is EU Policy & Advisor to ICIS and as an associate Ben Pott is Head of European Affairs, Regulation Editor for Interfax Global consultant for African energy market ICAP Energy, the publisher of Natural Gas specialists CITAC Daily and Global Gas Analytics Peter Stewart is the owner of Pricing Graham Francis is Managing Director Energy Ltd, a consulting and training Paul Wightman is Director, Research of ICAP’s Commodities business in company focused on the pricing of and Product Development, at the EMEA oil, gas and other sources of energy. CME Group

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48 OXFORD ENERGY FORUM