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What Is It About
IOSCO published an update to their 2011 “Principles for the Regulation and Supervision of Commodity Derivatives Markets”. The 24 revised Principles aim to support the physical commodity derivatives markets in providing their fundamental price discovery and hedging functions, while operating free from manipulation and abusive trading schemes.
Why It's Important
The original initiative functioned as a roadmap for many regulators within the G20 when shaping their regulatory regimes for commodity derivatives. The revised principles will undoubtedly fulfill the same role with regulators such as the CFTC in the US throwing their full support behind the adoption of the revised principles.
Key Takeaways
Six new principles were added by IOSCO touching on areas such as the increased role of data and information, and high frequency trading. Specific to compliance, the need for automated surveillance and a focus on multi-market manipulation are highlighted.
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Introduction
IOSCO revises its 2011 Principles for the Regulation and Supervision of Commodity Derivatives Markets to ensure market integrity
This week the International Organization of Securities Commissions (IOSCO) published an update to their 2011 “Principles for the Regulation and Supervision of Commodity Derivatives Markets”. The original initiative was born out of the aftermath of the global financial crisis in the late 2000’s and has functioned as a roadmap for many regulators within the G20 when shaping their regulatory regimes for commodity derivatives.
As these markets have continued to evolve since 2011, several drivers for the refresh were noted including:
- Emergence of additional types of trading venues;
- Adoption of Principles for Oil Price Reporting Agencies;
- Use of direct electronic access by end-users;
- Reliance on electronic data;
- Increasing importance of sustainability factors in investment decisions;
- Increasing role of exchange traded products; and
- Potential impact of novel and unexpected disruptions.
The 24 revised Principles “seek to support the physical commodity derivatives markets in providing their fundamental price discovery and hedging functions, while operating free from manipulation and abusive trading schemes”. The revisions focus mainly on:
- Market surveillance;
- Transparency;
- Price discovery;
- The correlation with physical markets;
- Addressing disorderly markets; responding to market abuse; and
- Strengthening the enforcement powers of trading venues against end-user behaviours.
At 103 pages long (with appendices) the report is relatively long and mostly a rehash of the original report.
Below we highlight several of the new and amended principles which are of potential significance for energy and commodity trading Compliance professionals.
Compliance Considerations
IOSCO have included six new principles as follows:
- Principle 6: Role of Price Reporting Agencies in Price Assessments
- Principle 7: Increased Role of Data and Information
- Principle 16: Unexpected Disruptions in the Market
- Principle 22: Direct Access
- Principle 23: Role of High Frequency Trading and Algorithmic Trading in Commodity Derivatives Markets
- Principle 24: Promotion of Investor Education in Commodity Derivatives Markets
Of particular interest in the updated principles overview section is IOSCO’s acknowledgements regarding market abuse, surveillance, and potential changes in regulatory scope for energy players.
- Need for automated surveillance systems. IOSCO notes that “effective surveillance cannot be accomplished without appropriate technology, including sophisticated programs that are capable of detecting patterns within these large volumes of data. Automated surveillance systems that can monitor and analyse order flow as well as intra-day transactions that can take place in a matter of microseconds along with information on end-of-day positions are critical to an effective surveillance program.”
- Multi-market trade manipulation. IOSCO acknowledges that “regulators have encountered abusive trading practices that involve trading not only in the futures market but also involve OTC physical commodity derivatives markets and/or the underlying physical commodity. Such practices require an appropriate Market Authority to put into place a robust surveillance and enforcement structure that is designed not only to have the powers and techniques to address abusive conditions affecting individual markets, but also to actively detect and respond to abusive trading practices that might involve interaction between multiple markets.”
- Ensuring an appropriate regulation of market participants – potential inclusion of electricity and natural gas producers. IOSCO notes that as markets evolve, it is “critical to keep the scope of financial regulation regularly under review as markets develop to ensure that participants in derivatives markets are appropriately regulated and a further review may be appropriate.” This follows recommendations presented by ESMA to the European Commission in September 2022 to consider including wholesale energy products that must be physically settled into scope for MiFID II and EMIR (click here).
- Challenges designing regulatory regimes to monitor for commodity derivatives. IOSCO acknowledges however that “it continues to be challenging to design a regulatory regime for commodity derivatives markets that appropriately considers the difference in structure and practices of the underlying spot market, the diversity of market participants and the different purposes for their participation in these markets.”
The revised principles focus on physical commodity derivatives in particular and help to ensure that the physical commodity derivatives markets serve their fundamental price discovery and hedging functions, while operating free from manipulation and abusive trading schemes.
RegTrail Insight
How attuned are market regulators to these principles? Almost as soon as the revised principles were released, CFTC commissioner Johnson made this public statement:
“I fully support the adoption of the 2023 Principles, which are consistent with our statute and regulations, to the fullest extent possible.“ She also noted that “Experience has taught us that misconduct and abusive trading often takes place across commodity futures, OTC derivatives, and physical markets, requiring increased coordination and resources to adequately detect and prevent such schemes.”, with a clear allusion to cross-market / cross-product manipulation, an ongoing area of focus for many regulators although still proving a challenge for regulators to effectively detect.
As the "regulator of regulators", IOSCO expects relevant regulators to review their policies and regulations to ensure that the refreshed Principles are put into effect. Elements of a number of the refreshed Principles extend beyond the jurisdictional perimeter of financial regulators. While cooperation between energy and competition regulators is generally functional, some aspects of these principles might not be fully met despite the best intentions of the relevant "securities regulator".
While these principles might not be a direct mandate on energy and commodity firms, regulators are likely to respond to them over time in part or in full. Consequently, Compliance professionals in these firms are advised to consider the relevance of these principles and consider where alignment might be necessary over the medium term should any gaps exist with particular attention paid to the new principles introduced.
Below is a summary of New Principles and Changes to Existing Principles with RegTrail insights where there are potential Compliance considerations.
We recommend reviewing the principles in their entirety with a focus on the newly added principles and where appropriate, benchmark against your current Compliance programmes.
New Principles
Principle 6: Role of Price Reporting Agencies in Price Assessments - Relevant Market Authorities should consider whether the third-party price or index provider that performs a price assessment function, including a Price Reporting Agency (PRA), considers the Principles for Oil Price Reporting Agencies (PRA Principles).
- Specifically, IOSCO recommends that the relevant Market Authority should consider taking appropriate steps to determine whether the third-party price or index provider that performs a price assessment function or PRA has suitable controls, policies and procedures in place in its assessment of the price of a commodity derivative contract.
RegTrail Insight
Those energy and commodity firms who submit end of day prices to Price Reporting Agencies should take note of IOSCO’s recommendation to Market Authorities. Specifically, IOSCO acknowledges that the PRA Principles is intended to enhance the reliability of price assessments and are designed to “facilitate a relevant Market Authority’s ability to detect, deter and if necessary, take enforcement action with respect to manipulation or other abusive conduct.”
Benchmark manipulation continues to be a very important risk to monitor in energy and commodity trading and involves the monitoring of both physical and financial trading activity. This is an affirmation of a regulatory monitoring trend that will continue to evolve as technology surveillance systems provide data and surveillance capabilities to identify potential instances of market abuse.
Principle 7: Increased Role of Data and Information – Relevant Market Authorities should consider establishing a “Code of Conduct” for entities who are either independently or jointly involved in collection, dissemination/publication of data and information relating to the underlying commodity and which plays an important role in the price discovery process and timely hedging decisions by non-financial firms.
- IOSCO notes that with the increasing dependence on data provided by these entities, it becomes essential to establish some basic principles in the form of a code of conduct for these entities.
- It recommends that PRAs should consider undertaking measures to ensure the authenticity of the reported data, such as periodically documenting and disclosing the following information to the public:
- The source and method of collecting initial data (i.e., primary or secondary source);
- Statistical techniques or methodology used for processing of initial data to develop valuable assessments;
- Rationale for adopting the methodology;
- Procedure of review and approval of the selected methodology; and
- Change in the methodology and rationale behind the same.
- It recommends that PRAs should also engage in routine examination of their methodologies to ensure that the data accurately reflects the economic activity under examination while implementing policies and procedures for the identification, disclosure and avoidance of conflicts of interest arising from its function as a data reporting agency.
Principle 16: Unexpected Disruptions in the Market - Relevant Market Authorities should have a process to respond to unexpected disruptions in commodity derivatives markets and the power to intervene, as necessary, in order to restore orderly markets in the event of an unexpected disruption and ensure market participants have a process and adequate plans to address unexpected disruptions.
Unexpected disruptions may occur in the commodity derivatives markets and can have unexpected and unforeseen impact on the proper functioning of the commodity derivatives markets. Such events may include various internal and external disruptions, such as IT, trading or communication system failures; cyber-attacks and system breaches
The Principle recommends implementing maximum price fluctuations and position limits to help mitigate excessive price volatility and provide time for market participants to arrange necessary financing, in addition to allowing time for price movements to be fully understood by all market participants.
RegTrail Insight
IOSCO notes that to mitigate potential risks associated with unexpected disruptions, the relevant Market Authority should ensure that market participants have appropriate business continuity plans (BCPs) in place to address these risks.
IOSCO published a report in 2015 (click here) entitled “Mechanisms for Trading Venues to Effectively Manage Electronic Trading Risks and Plans for Business Continuity”. The report provides guidance on BCP considerations and notes that relevant Market Authority should have an understanding of how the market participants may respond to unexpected events and ensure that they have adequate BCP arrangements in place.
It further notes that, where possible, the relevant Market Authority should identify any potential gaps or risks that may not have been considered or contemplated by market participants in their BCP.
Given market volatility over the past 12 months, firms should review their current BCP policy and where appropriate benchmark against IOSCO principles.
Further, IOSCO notes the need for position limits to help maintain orderly markets. This seems to contradict the actions of both the EU and UK financial regulators who have significantly scaled back their respective position limit regimes (the EU currently mandates position limits for a single "critical" contract). It remains to be seen whether this state of affairs will endure.
Principle 22: Direct Access - Where direct access to commodity derivative markets is offered or permitted, relevant Market Authorities should ensure that a clear framework, including appropriate policies and controls, is in place to facilitate such direct access by market participants, including non-financial firms.
IOSCO references its final report “Principles for Direct Electronic Access to Markets” published in 2015 (click here) and notes that the market or the market intermediary should not offer DEA unless adequate pre-trade information is provided, and both regulatory and financial controls. It further notes that Regulators should retain the power to allow or prohibit any form of DEA as well as to establish requirements in the DEA area, including pre-trade controls and risk limits, and should also exercise regulatory oversight over the decisions made by clients, intermediaries, and exchanges.
RegTrail Insight
The use of DEA access continues to become more prevalent amongst energy and commodity trading firms. Where firms permit DEA trading, it is critical to review your governance over this trading activity to ensure that traders have adequate systems and controls, specifically the ability to monitor orders and trades on a real time basis.
For firms who offer DEA as intermediaries (a service widely offered by many energy and commodity trading firms), it is critical to have a sound vetting process of customer risk profiles of the potential DEA Customer, particularly with regard to sponsored access. The client’s internal systems of monitoring their own risk should be closely reviewed by the intermediary, including whether the client has adequate systems and controls to monitor orders and trades on a real-time basis.
Factors to be considered by firms before granting DEA to their clients include:
- Familiarity with market rules;
- Degree of financial experience;
- Prior sanctions for improper trading activity;
- Proven track record of responsible trading and supervisory oversight;
- Ability to meet appropriate credit and risk guidelines; and
- Proposed trading strategy and associated volumes.
Firms who offer DEA and firms who use DEA to trade commodity derivatives should review the IOSCO report and, where appropriate, benchmark their current governance and controls.
It seems inevitable that regulators will increasingly focus their monitoring and enforcement resources on markets with high levels of algorithmic trading penetration. Firms continue to struggle with the calibration of their surveillance tools to distinguish between human and machine trading. While tags used to identify algorithmic trading are generally available on financially regulated platforms making this task more manageable, this is not always the case for physical energy platforms. Firms with active algorithmic trading activity are advised to seek ways to effectively distinguish and monitor this activity if not already doing so.
Principle 23: Role of High Frequency Trading and Algorithmic Trading in Commodity Derivatives Markets – Relevant Market Authorities and regulated trading venues should have in place a clear framework of policies and controls to analyse the impact of high frequency and algorithmic trading in commodity derivative markets.
- Algorithmic trading, like all electronic trading, results in the need for changes to the way regulators monitor trading. Increased algorithmic trading has increased the complexity of surveillance for competent authorities. Having sophisticated systems or algorithms that monitor trading and detect patterns is a necessity in this environment of high speed and complex trading in order to maintain market integrity and confidence.
Principle 24: Promotion of Investor Education in Commodity Derivatives Markets - Relevant Market Authorities should put in place an appropriate mechanism for promoting investor education amongst market participants and the general public about the potential benefits of the commodity derivatives markets. Relevant Market Authorities should also inform the public and retail investors, about the unique risks associated with investing in commodity derivatives particularly during times of market stress and extreme volatility.
Materially Amended Principles
[Amendments to the original principle are shown in [red] below]
Principle 13: Collection of Transaction Information on Commodity Derivatives Transactions and Positions for Market Surveillance – In respect of commodity derivatives transactions and positions, a relevant Market Authority should consider what information it should collect on a routine basis and what it should collect on an “as needed” basis. A relevant Market Authority that has access to a relevant Trade Repository’s (TR) data should take such broader access into account, as well as its statutory obligations with respect to the TR, in constructing its data collection policies.
- IOSCO notes that with respect to a market participant’s positions on over-the-counter (OTC) commodity derivatives and the underlying physical commodity markets, Relevant Market Authorities should obtain information in specific instances, when demanded under a particular investigation.
- It further notes that, where appropriate, relevant Market Authorities should obtain information on warehouse stocks or other deliverable supply.
Principle 19: Framework for Addressing Multi-Market Abusive Trading and Powers and Capacity to Respond to Market Abuse - Relevant Market Authorities should ensure that the regulatory framework for market surveillance and enforcement within a jurisdiction is structured to provide for active and coordinated detection and enforcement action against manipulative or abusive schemes that might affect trading on multiple trading venues and OTC markets, as well as the underlying physical commodity markets. Relevant Market Authorities should have adequate powers and capacity to investigate and prosecute actual or suspected market abuse, including attempted manipulation.
Principle 20: Disciplinary Actions Against Market and Non-Market Members - Relevant Market Authorities should have and use effective powers to discipline its members or other authorised market participants if an abusive practice has occurred in the market. There should be clarity as to the types of disciplinary actions which can be taken.
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