Last week saw the FCA fining 5 banks £1.1bn for the manipulation of indices covering the FX market. Once again, regulators are showing that they will not tolerate market abuse, and are making well known the fact that they mean business in their efforts to clean up the market.
The energy and commodities industry is experiencing its own journey into this world. REMIT is specifically intended to address the issue of market abuse in the gas and power markets, and the new Market Abuse Regulation will strengthen this. So the question comes up once again: Should we panic? Should we go and spend a lot of money on projects in order to make sure that we are “covered”? Will all of this make it even more expensive to remain in the market?
The Rules: REMIT
Two sets of rules are in play when it comes to market abuse in the energy market: REMIT covers all trading activity related to gas, power and LNG, whether physical or financial. Under REMIT, attempted and actual market manipulation breach the rules. The various texts give examples of the types of activity that comprise manipulation, although there is a wider net than the specific examples.
In terms of enforcement, each National Regulatory Authority was to be given powers to impose sanctions upon breach. Not all EU countries have done this yet, and the sanctions differ across jurisdictions. In most cases, the sanctions are “civil” i.e. they lead to fines. In some, there are criminal sanctions that can lead to jail sentences. In the UK, criminal sanctions are targeted to come in early next year.
Having said all of this, only “Professional Person Arranging Transactions”, and venues are obliged to monitor their own activities for breaches. Looking at the ACER guidance on Article 15 of the Level 1 REMIT text makes this clear (reference). This means that you cannot get fined for simply not monitoring your activity, although it is clearly something worth thinking about.
The Rules: MAR
Targeted at financial instruments the Market Abuse Regulation together with the second Market Abuse Directive is also set to come in over the next two years with the Regulatory Technical Standards in the process of being written. The rules extend the original MAR to cover far more instruments in addition to other extensions.
Among the provisions proposed is the requirement to have an “automatic trade monitoring system”. If this is enacted it will be mandatory to have some sort of electronic monitoring system, unlike REMIT.
It is also the case that fines and sanctions are likely to be much higher.
While MAR applies to financial trades only, it does cover all commodities, unlike REMIT.
Which rules apply?
The question of which rules apply depend on several factors. A key one is whether a trade is a financial instrument. The outcome of the current ESMA consultation on whether physical forwards are derivatives will in part determine in a trade is covered by MAR. Other factors that apply when a trade is covered by both REMIT and AMR will also need to be taken into consideration.
Looking at the FCA fines
Turning back to the FCA fines last week, is it worth examining the notices issued for each of the 5 banks involved. There is an interesting trend that emerges: that of “culture”. While the fines are clearly for the acts of manipulation themselves, the banks are castigated because of the take on what is referred to as a “compliance culture” in their organisations. Taking the RBS notice as an example, the summary in section 2 talks of “failing to take reasonable care to organise and control its affairs responsibly and effectively with adequate risk management systems”. In paragraph 2.2 it explicitly states “The Authority also expects firms to promote a culture which requires their staff to have regard to the impact of their behaviour on clients, other participants in those markets and the financial markets as a whole.”
Paragraph 2.7 states: “These failings occurred in circumstances where certain of those responsible for managing front office matters were aware of and/or at times involved in behaviours described above.”
Section 4 of the document has a part entitled “The failures of systems and controls at RBS”. The section talks about the fact that “There are no detailed requirements for systems and controls concerning spot FX trading in the Authority’s Handbook” but does continue to stress how important the topic is. Later it states “The right values and culture were not sufficiently embedded in RBS’s G10 spot FX trading”. The section continues to talk about controls. But very little mention is made of surveillance systems. In fact the only mention of any type of surveillance system is one to monitor activities in chat rooms.
However, the theme that we do see across the document is a general requirement to assess and monitor activity. Much reference is made to the “three line” model, the lack of detailed monitoring and guidance, and the failure to introduce a true “compliance culture”
What can we learn from the fines?
There are many learnings that one can infer from the fines, but what one can note is that the regulators are not looking for a formulaic answer to abuse prevention. Rather a pragmatic approach that looks across the options is what is required.
There are many facets to a policy to prevent abuse. This encompasses training, culture and systems. The message from the FCA is clearly that a blend is required.
Training, is an important aspect of the defence against abuse. If the correct people in the organisation such as traders and the back office are not aware of the rules, then they are more likely to be broken.
Systems are also important. But it is worth noting that the introduction of an automated surveillance system can be a large undertaking. This article on the CTRM Center by Yasmine Li of Baringa gives a comprehensive overview of the work involved in the roll out of a surveillance system. The article also notes how hard it is to make such a system effective and the work that this could entail. It is worth noting that such systems are not fool proof, and at the end of the day are only one of the tools at the disposal of the compliance department to reduce abuse.
In the end systems are only one way in which compliance can understand what is happening in the organisation. Other forms of monitoring and communication, such as simply speaking to traders, can be just as valuable.
But it is culture that makes the difference. Ultimately the larger fines will only result if you abuse the market or use inside information, at least under REMIT (although you will need to report the data too). A company that puts effort into creating a culture of compliance will likely significantly reduce the chances of abuse within their organisation. An enterprise where compliance is at the heart of everything they do is less likely to err.
The message of the fines is that defence is a balance. It is important to understand what is going on in your organisation, and there are many ways of doing this. But it is just as important to have the right organisation.
Pragmatism is best – Don’t panic.
The current focus on compliance is feared by many to be introducing many costs into the activity of trading that were not there before. This is undoubtedly true, but who wants to be fined for a lack of compliance?
What is also undoubtedly true is that it is possible to spend limitless amounts of money on solutions. Before doing so, it is important to ask yourself whether that spend is going to really help you to comply. It is in the interests of the market participant to make best use of their funds in order to reduce the chances of abuse in their organisation. However there are many competing interests at play. Do not let yourself get panicked into large projects which may not achieve the required objective.
In the FCA press release, it is announced that they will be undertaking a “remediation programme [which] will require firms to review their systems and controls and policies and procedures” in the FX market. However they go on to say that any remedial action will depend on various factors within the firm, and about the firm. We can expect this type of supervision in energy and commodities as well.
In the end, compliance will be achieved by adopting a balanced programme of controls, activities and projects. Taking a holistic view of the tools available, and doing so in good time, will ensure that you are not panicked into high spending projects unless they suit your organisation, but still remain on the correct side of the law.