The last few years have seen many anti-abuse cases brought against traders, spanning LIBOR, insider dealing and others. We have also seen some anti-abuse cases in commodities and energy, for example the case where the CFTC and FERC investigated a North America based oil company in 2015 for gas price index manipulation. However, many cases have not resulted in fines. Examples of this include the alleged NBP price manipulation of 2012 and the “Chocfinger” case in 2010, neither of which resulted in convictions.

The last few years have seen many anti-abuse cases brought against traders, spanning LIBOR, insider dealing and others. We have also seen some anti-abuse cases in commodities and energy, for example the case where the CFTC and FERC investigated a North America based oil company in 2015 for gas price index manipulation. However, many cases have not resulted in fines. Examples of this include the alleged NBP price manipulation of 2012 and the “Chocfinger” case in 2010, neither of which resulted in convictions.

In general, the commodities and energy sector have not traditionally had the same internal monitoring technology in place as financial counterparties, for many reasons, be they historic, cultural or otherwise. Outside of the big companies, a smaller proportion of market participants will, for example, have a dedicated surveillance system. See Figure 1.

The sector is now seeing both an increase in regulation and scrutiny, from regulators and due to two sets of rules:

The Regulation of wholesale Energy Markets Integrity and Transparency (REMIT) came into force in 2011. This outlaws market manipulation and the use of inside information, with sanction legislation being put in place from June 2013 onwards. The final data reporting deadline is on 7th April 2016, after which regulators will be able to monitor the market for possible manipulation.

The Market Abuse Regulation (MAR) will be familiar to most in the financial markets. When it is implemented on 3rd July 2016, it will also include not only on-venue commodity derivatives but also off-venue trades and spot commodities that may influence their prices.

Increased scrutiny

Regulators have recently made it known that the sector will be subject to greater scrutiny than before. Last September, Ofgem published an open letter¹ on the application of REMIT, reminding market participants of the rules, and specifically pointing out that certain activities, such as “layering” are breaches of REMIT and will be treated as such. The letter served as a reminder that breaches of REMIT articles 3 and 5 (inside information and market manipulation) may result in criminal sanctions being applied. Sanctions are also in place for breaches of the rest of REMIT.

The end of the summer also saw the publication of a thematic review of the commodities sector by the FCA². This found that in many (but not all) cases, the controls, technology and culture in the sector lagged the financial markets. The review stated that:

“Firms that did not fully recognise the risks of market abuse were more likely to employ inappropriate surveillance, in terms of the choice of automated or manual systems, calibration of systems and frequency of monitoring. Overall, there was little order level monitoring, making it difficult for firms to demonstrate effective monitoring for market manipulation, and we often found surveillance being done on an inadequate or poorly targeted sample basis.”

Elsewhere in Europe, the end of last year saw the first fines in REMIT. A small fine of 10,000 Euros in Estonia was dwarfed by a 25 million Euro fine handed to Iberdrola for breaches of the REMIT market manipulation rules. The market was sent a clear message that REMIT enforcement had begun.

Now that data is being collected by ACER, monitored and sent to local regulators such as Ofgem and BNetZa, the sector is being subject to ever closer scrutiny.

REMIT – A brief recap

REMIT has been enacted in order to specifically prohibit Market Abuse and the use of Inside Information in the gas and power markets in the EU. It applies to all physical and financial (derivatives) trades, and also includes LNG where the supply is intended for the EU network.  REMIT is enforced by National Regulatory Authorities, who are local energy regulators such as Ofgem The entire effort is coordinated on an EU wide basis by ACER, the Agency for the Cooperation of Energy Regulators. REMIT can be considered to have four pillars:

1. Inside Information
2. Market Manipulation prohibition
3. Market Participant registration
4. Data reporting

It is forbidden to utilise inside information for trading activity except in the case of some narrowly defined exemptions. Inside Information in the context of REMIT includes information related to physical assets. For example a power station outage which has not been published could be considered inside information.

REMIT also prohibits actual and attempted market manipulation, which can involve any activity that is considered “abusive”. The act, and also guidance issued by ACER does list some very specific examples, which include techniques such as “marking the close” and “market cornering”. In many cases the types of abuse are similar to the financial markets, although the physical side can make it more complex to detect.

It is the data reporting element that is currently the focus of the market. On-venue activity, that is activity arising from an Organised Market Place (OMP), usually an exchange or a broker platform, needed to be reported to ACER from 7th October 2015. Off venue OTC data needs to be reported from 7th April. This includes not only “stand alone” trades, but also long term contracts, such as Power Purchase Agreements, and trades such as secondary capacity trades. The second phase of REMIT has proven to be difficult and will in all likelihood require significant “tweaking”, in much the same way that EMIR has. However, the fact that the data is all being sent to the same database means that it will likely become useful a lot sooner into its life than EMIR data.

ACER collect the data and run monitoring software on it, but they also send a copy of each country’s data to local regulators, who run their own processes. We can thus expect cases to be brought against market participants based on the data (as opposed to suspicious transaction reports) within the coming months.

Monitoring requirements under REMIT

The obligations of market participants to monitor their own activity under REMIT are outlined in Article 15 of the Act, where it is stated that “Professional Persons Arranging Transactions “ (PPATs) “shall establish and maintain effective arrangements and procedures to identify breaches of Article 3 or 5”.

There is a great deal of discussion about who exactly a PPAT is. ACER’s guidance on REMIT states that: “These include at least trading venues like energy exchanges and brokers.” In March 2015 ACER issued a document³ specifically examining the concept of a PPAT. There it outlined several scenarios of companies which should have the status. Some were instinctive – for example most OMPs would be considered to be PPATs. Market Participants’ definitions are less straight forward, especially when sleeving⁴ is involved.

A key point however is that not all market participants have an obligation to carry out internal monitoring under REMIT. Some have considered using this as a reason to spare some monitoring. However, many now consider this to be a bad idea, for several reasons including:

• It is best practice to have monitoring in place, whether obligated to or not. Most companies would prefer to have a good grasp on what their traders are up to.
• The existence of effective monitoring is thought of by some to be a good defence in the event that manipulation is taking place in the organisation.
• In the event of a manipulation, most would wish to know about it before a regulator, and take appropriate action.

Now that regulators have most market data, monitoring is likely to take place very soon. We can therefore expect interest in monitoring due to REMIT to increase in the very near future.

When will REMIT data collection be effective and useful?

From April 7th onwards (July 7th for “backloaded” contracts) ACER will be collecting data for the entire set of data covering the European wholesale gas and power market. In theory, this will permit them, and local regulators, to run monitoring processes and software. The question is, how likely will such monitoring be to find possible market abuse?

Those who have been involved in the data collection phases of REMIT will know that it has not been a straightforward exercise. The second phase of off venue data collection has seen a great deal of confusion around how some of the data is to be collected. The breadth of contract types across Europe means that it is unlikely that all data will be sent in a 100% readable format. Some data types, such as for capacity and transportation trades, have a great deal of confusion around them, and this data is even less likely to be useful.

At a public workshop on 16th February ACER talked of a new set of schemas being planned for spring of 2017. This is likely to be more than just a fine tuning and many are now talking of a third phase of reporting. This also may support the argument that full monitoring will be tough.

Despite all of this, it would be unwise to assume that no monitoring will be possible using the data. ACER have made the choice of pulling all sent data into one database, and in the end there is only one set of schemas. This means the data is less subject to incompatibility than say under EMIR, where even now, over two years after go live, there is a struggle to make sense of the data.

The documentation and guidance provided by ACER has also been copious when compared to EMIR. Many public workshops and roundtables have meant that the regulator does have a good idea of what to expect. And ACER have been in the process of getting their surveillance system up and running for quite some time.

In short therefore, while the data will not be perfect, it will certainly be possible for ACER and the other regulators to perform some monitoring. Market participants would therefore be well advised to assume that they are “being watched” to some degree.

MAR – How does it apply to the commodities markets?

The Market Abuse Regulation(MAR) alongside MAD II will apply from the 3rd July 2016, and will cover several aspects of the commodities markets. To summarise, MAR applies to the following activity:

1. Derivatives activity on venues including regulated markets, MTFs and eventually OTFs
2. Derivatives activity that could effect on-venue prices
3. Spot commodity that could effect on-venue prices

There is a great deal of discussion and legislation around which commodity trades are considered to be “derivatives”, which is primarily defined in MiFID Annex I Section C. The original version of MiFID has had guidance issued around its application, in particular paragraphs 6 and 7, which define whether physical forwards are considered to be derivatives. A detailed discussion of this topic is beyond the scope of this article, but the outcome is extremely important as to which activity will be in MAR in the first instance.

In addition to derivatives, the inclusion of spot commodities, will widen the application of MAR to non derivatives in some cases.

Many commodities companies are not currently “Investment Firms”, i.e. financial companies under MiFID. Never the less, the anti-abuse and some other measures of MAR will apply to all executing transactions in the market. And these rules will be enforced by financial regulators, as opposed to energy regulators.

A key difference between MAR and REMIT is the monitoring obligation. Under MAR the requirement to carry out effective monitoring is applied to “Professional Persons Arranging or Executing Transactions” (PPAETs). MAR Article 3(28) defines a PPAET as:

“a person professionally engaged in the reception and transmission of orders for, or in the execution of transactions in, financial instruments”

This definition is far wider than that under REMIT and the market generally is accepting that this is a requirement to monitor. The introduction of MAR will therefore only increase the push to monitoring in the sector.

The MiFID II/ MAR “Underlap”

MAR has always been scheduled to be implemented before MIFID II, which has caused an “underlap” of the rules. Since MAR makes reference to some aspects of MIFID II and MIFIR, there are some parts of MAR which will not apply until MiFID II is implemented. The delay of MiFID II will lengthen this period. The impact on the commodities sector is several fold:

Scope

MiFID II seeks to alter Annex I Section C, in several respects:

• Physical forwards executed on an OTF is added to the list of in scope derivatives (There is a “REMIT carve out” for some gas and power activity)
• EU Emissions Allowances (EUA) will become derivatives under a new paragraph 11 of MiFID II Annex I Section C

Until MIFID II is implemented, these specific activities, i.e. activity on an OTF, and EUAs are not part of MAR.

Financial counterparties

MIFID II is likely to require many of those in commodities and energy to set up a regulated entity, under the “Ancillary Activity” test contained in RTS 20 (which was “sent back” by the commission to ESMA on 17th March). Financial Counterparties have some obligations, which non-financial counterparties do not. Those who are only “in” once MIFID II is here will also be affected by the underlap.

Monitoring and Surveillance in the commodities and energy trading sector

At the start of this article, we briefly stated that the monitoring facilities inside commodity and energy traders are not as mature as financial services in general (with notable exceptions). What we can now see is that things are likely to change.

While the drivers are clearly coming, there is still a fear across the sector that they will be “oversold” surveillance systems, and that “big compliance” in general is not always necessary. We can therefore expect to see an incremental move to better monitoring and surveillance across energy and commodity companies.

Many in the sector do not yet have the ability to “replay” what took place at a particular moment, or why orders or trades were placed. Most companies do not store orders for example. We are likely to see this being remedied as a first step. The availability of order data from REMIT OMPs will make this easier.

We are then likely to see energy and commodity companies moving through different stages of maturity in their monitoring capability. This would be divided into “organisational” and “technological”.

On the organisational side, we can expect both an expansion of personal and possibly a fine tuning of the structure of the compliance organisation, so that a true independent oversight function is formed.

On the technological side, we can expect the “replay” facility to turn into some basic reporting to begin with, later being replaced by rules based surveillance engines and more advanced analytical capabilities. It does need to be borne in mind that the technology which is used in financial markets is often not suited to commodities markets, where not only does the physical element make monitoring quite different, but where legitimate reasons to enter orders and transactions are often driven by different factors.

The possible future state

To summarise, several drivers exist to push the interest in monitoring and surveillance in the sector:

• Scrutiny from regulators
• REMIT data being monitored by regulators
• Monitoring requirements from MAR

These as well as a general desire by the industry to be seen to be “clean” and transparent, as well as following best practice is likely to drive interest in better monitoring over the coming years.

References:

1. See https://www.ofgem.gov.uk/sites/default/files/docs/2015/ 09/20150814_remit_open_letter_september_2015_0.pdf
2. See https://www.fca.org.uk/static/documents/newsletters/market-watch-49.pdf
3. See https://www.acer-remit.eu/portal/document-download? documentId=x158hc794xa
4. A transaction whereby two counterparties that do not have credit with each other, ask a third party that has credit with both to be a middleman to facilitate a trade. This practice achieved some notoriety in 1998, when it emerged that the collapsed US power marketer Power Company of America had been regularly sleeving forward electricity deals. (Risk.Net)

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