COLUMN-FSA coffee case heralds commods crackdown: John Kemp
LONDON, June 2 (Reuters) – The Financial Services Authority’s (FSA) decision to fine a London coffee broker 100,000 pounds ($146,400) and ban him from working in the financial services industry marks a significant toughening in the market abuse regime for commodities.
The banning order on Andrew Kerr marks the first successful action for market abuse in commodity markets. Kerr is accused of helping a client execute large orders during a period in which reference prices were set based on a volume-weighted average. It was a deliberate move to influence market prices in the run up to an option expiry.
While Kerr’s behaviour was unusually blatant, and unfortunately for him captured on tape in unguarded language, using large volume trades to support or batter market prices close to daily or option settlements is common practice across commodity markets.
It has been tacitly supported by much of the industry as well as the regulator. So the decision to make an example of Kerr suggests a marked tightening of the rules, or at least the way they are implemented.
LOOPHOLE IN EU REGULATIONS
I have written before that the problem stems from a conflict at the heart of the EU’s Market Abuse Regime.
The main directive (EU Directive 2003/124/EC as transposed into UK law at Section 118 of the Financial Services and Markets Act) warns about potential abuse resulting from trading in substantial volumes affecting the price of a financial instrument; large orders in a concentrated time span causing price movements that are subsequently reversed; and orders around a specific time when reference prices, settlement prices and valuations are calculated that an effect on those prices or valuations.
Unfortunately, the general prohibition has been muddied and undermined by the exemption for “accepted market practices” (EU Directive 2004/72/EC, transposed into UK law at Section 123 (2)). This creates the problem of what happens when behaviour that in other contexts or markets would be considered abusive becomes an “accepted market practice” directly contradicting the general prohibition.
The safe harbour for accepted practices has created a mile-wide loophole for potentially abusive practices that continue to flourish because they are hallowed by ancient practice and custom.
The problem has been worse in commodities because some dealers and clients have successfully argued these markets should receive different treatment from equities and other financial instruments with different rules, particularly on insider trading and some elements of market abuse. There has been a general sense that rules governing other financial markets across the EU do not apply to commodity trading.
“ACCEPTED PRACTICE” NO MORE
But two recent cases, one on each side of the Atlantic, suggest regulators’ attitudes are hardening:
(1) The FSA last year rejected an attempt by two Dresdner Kleinwort traders to claim that trading in credit notes while in possession of inside information about a future issue was an “accepted practice” in credit markets.
The Dresdner case did not change the law. But it did shift the interpretative balance between the general prohibition and the accepted practice defence in favour of the former. The FSA in effect said that even if trading ahead was quite normal in credit markets, it could not justify behaviour which seemed to contravene the general market abuse rules so directly and blatantly.
(2) In April, the U.S. Commodity Futures Trading Commission (CFTC) fined Moore Capital $25 million for attempting to manipulate settlement prices of platinum and palladium on the New York Mercantile Exchange (NYMEX). Moore’s former portfolio manager “entered market-on-close buy orders that were executed in the last ten seconds of the closing period for both contracts in an attempt to exert upward pressure on the settlement prices of the futures contracts”.
The trading practice was sufficiently common to have its own name (“banging the close”). The CFTC nonetheless determined it violated Section 9(a)(2) of the Commodity Exchange Act.
The CFTC noted “trading in both contracts was relatively illiquid, and the [former portfolio manager]‘s trading in the contracts on the close frequently accounted for a significant portion of the volume. The [former portfolio manager]‘s trading strategy took advantage of these key characteristics of these two markets — thinly traded, illiquid and volume-weighted average settlement price calculations — to attempt to manipulate the daily settlement prices”.
This is precisely the same type of behaviour which the FSA has now sanctioned in London.
STANDARDS LOSER THAN EQUITIES
In the more tightly regulated markets such as equities, it has always been clear that trading patterns which influence prices (intentionally or unintentionally) will draw close scrutiny and can constitute market abuse. Participants know their trading will be held to an even stricter standard at sensitive times around the opening and closing of the market, and they are expected to exercise especial care.
In contrast, in commodity markets, efforts to protect, support, bang or depress closing and settlement prices by dealers and clients are the norm and have for the most part been seen as fair game, part of the normal warp and weft of the market.
* In part this reflects the assumption participants in commodity futures markets are professionals rather than retail customers, so they need less protection. Those who choose to participate do so at their own risk.
* It reflects a sense that normal rules applying to other markets are not relevant and do not apply to specialist markets in energy and raw materials.
* Dealers often argue these markets are so large and so global they cannot in any case be manipulated successfully.
* Unusual practices have also flourished as a result of regulatory neglect. Until very recently, commodity markets were too small and obscure to attract much regulatory attention.
CONVERGENCE WITH OTHER MARKETS
It is not clear whether Kerr was simply unlucky to get caught, and incautious about the statements he and his client made on a taped telephone line, or whether it is the start of a broader attempt to tighten behaviour in commodity markets and bring it more into line with standards prevailing in other areas.
This was a fairly open and shut case in which neither broker nor client made any effort to disguise their direct intention to trade in the volume necessary to move the price and achieve a very specific outcome. In its statement, the FSA warned it viewed the behaviour of the unidentified “Client A” as “more egregious”, implying that an even more serious penalty will be imposed if the FSA can bring that case to a conclusion.
The FSA specifically found “the transaction was not effected for legitimate reasons and was not in conformity with accepted market practices” (paragraph 5.2). It created a false and misleading impression (5.1.1) and secured futures prices at an abnormal or artificial level (5.1.2).
Most market abuse cases involving closing prices are unlikely to be so clear cut. But the sanctions against Kerr and Moore, as well as the Dresdner traders, suggest a tougher approach to accepted market practices, including in the previously light-touch area of commodities.
The end of exceptionalism in commodities was to some extent inevitable as commodity markets became much larger, hit the headlines after the record price rises in 2005-2008, and began to draw in a much wider range of retail and institutional investors used to higher standards of enforcement elsewhere.
In sanctioning Kerr, the FSA specifically noted “conduct of this sort undermines confidence in the coffee futures and options markets, and, in extreme cases, in the wider derivatives markets, and has the potential to discourage new participants from entering those markets”.
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