— John Kemp is a Reuters columnist. The views expressed are his own —
By John Kemp
LONDON, July 7 (Reuters) – As the Commodity Futures Trading Commission (CFTC) contemplates toughening position limits and oversight of U.S. commodity markets, the spotlight is shifting to the weaker regulatory regime overseen by the Financial Services Authority (FSA) in London [ID:nN07310607].
Until now, criticism of London has centred on the so-called “London loophole”, which allowed U.S.-based commodity traders to amass positions in U.S. commodity contracts on exchanges registered in London rather than at home to avoid position limits and reporting requirements in the United States.
Commodity traders could evade position limits and reporting on the New York Mercantile Exchange (NYMEX) light sweet oil and heating oil contracts by building up additional positions on the London-registered lookalike contracts on the Intercontinental Exchange (ICE).
The loophole has been largely closed following a “voluntary” agreement between the CFTC, FSA and ICE last year. The FSA and ICE agreed to implement position limits on commodity contracts deliverable in the United States on the same basis as limits applied in New York. In return the CFTC agreed not to seek jurisdiction and continue to allow trading from terminals in the United States under existing “no action” letters.
BORROWING FROM EQUITIES
But closing the London loophole is unlikely to be enough to silence criticism about the standards applying in London commodity markets. The problem is not the FSA’s (voluminous) regulations but the growing gap between what’s written on paper and what happens in practice. It has left everyone (regulators, market participants and customers) unsure about what is allowed and what is not.
It stems from competing visions about the appropriate role for regulation in commodity markets. Historically, these markets were assumed to be dominated by knowledgeable “professionals” who could be expected to look after themselves, rather than “retail” investors. So a light touch regime which prevented obvious abuses (such as fraud) was all that was required.
As the level of participation by retail investors and less knowledgeable customers (such as pension funds) has increased, expectations about the level of regulation have risen. Increasingly, rules developed for equity markets have been applied (in slightly modified form) to commodities — with an emphasis on treating customers fairly, preventing insider trading and prohibiting “market abuse”.
In most cases though, the rules contain a carve out allowing behaviour to deviate from published norms as long as it is in line with “accepted market practices”. The clash between historically accepted practices and what the rules now theoretically say has become an enormous source of confusion about what is and is not permitted.
ACCEPTED MARKET PRACTICE?
To take one example: the execution of large orders on or close to the close of the market and the declaration of a settlement or daily valuation. Established equity market practice puts a special onus on clients, brokers and traders to ensure large or unusual orders executed at this time do not cause, or appear to cause, manipulation or price distortions. Trading in the run up to the close is especially sensitive and subject to heightened scrutiny. Actions which appear designed to “support” closing prices are clearly forbidden.
But the situation is far less clear cut in commodity markets. Many clients want to achieve closing prices since these are used to mark positions to market and to settle hedging programmes. So much trading is concentrated in a relatively narrow “window” ahead of the close and declaration of daily valuations. The large amount of liquidity concentrated in this short period attracts further trading from those needing to execute large orders.
With this late trading activity there is a widespread temptation and open market talk about attempts to “support” or “hammer” the close. But does this constitute market abuse? It clearly contravenes the written regulations. But equally clearly it is in line with accepted market practice. So it falls into a grey area. It seems to depend upon the (unobservable) intentions of the market participant.
Equally contentious is the question of how to deal with large long positions which dominate the market nearby or over certain sections of the forward curve also remains contentious. Such positions would clearly be considered abusive in equities, and the U.S. Treasury has warned bond market participants it will hold them to a high standard of behaviour if they do the same in U.S. government securities. But the position in commodities is more equivocal and the source of perennial controversy [ID:nL7149027].
The FSA requires commodity brokers to submit “suspicious transaction reports” (STRs) where they suspect their clients or others are engaging in activity that could amount to market abuse. But in an update sent to regulated firms in September 2008, the FSA noted it had received only a “handful” of STRs related to commodities out of 700 across all markets, and said it would have expected a greater number. Firms have come under pressure to increase the number of STRs.
The lack of STRs highlights industry uncertainty about what constitutes the level of “reasonable suspicion” needed to trigger a report; what are accepted practices; and how to define misuse of information cases compared with other markets.
TWO-TIER REGULATION PROBLEM
Uncertainty is compounded by the FSA’s decision to devolve frontline market regulation to the exchanges themselves, retaining only a supervisory and second-tier function for itself. While exchange operators have tried to separate their business function (which involves maximising volumes) from their regulatory one (policing market behaviour), there is an inevitable tension.
More importantly, it has left the FSA with a dearth of expertise on commodity matters. Commodities are a very small part of the regulator’s remit. The institution has failed to build up the specialist personnel, knowledge and market contacts it needs to be able to take its own independent view and cross-check the information it is receiving from the exchanges and their members.
In an ideal world, the business and regulatory functions would be separated. Exchanges would run themselves as pure commercial enterprises, with regulation transferred to the FSA. The FSA itself would clarify its fundamental approach – either reverting to the traditional light-touch system and abandoning the pretence of equity-like regulation, or making the new regulatory system real by taking a tougher line on previously accepted market practices.
In reality, this sort of change is too ambitious; it runs counter to too many vested interests. But a useful start would be for the FSA to increase its own expertise in this area, strengthen its market contacts and conduct more direct surveillance and supervision, while making clearer what “market practices” remain acceptable and which ones are consigned to history.
(Edited by David Evans)