New European regulations place new burdens on market participants

Contributor: Claudio Capozzi

The global energy and commodity markets saw unprecedented price increases and volatility in the period starting early 2007 and increasing unabated until the third week of July 2008, at which time a financial crisis spawned by the collapse of key financial institutions initiated a free fall in that spread from the US to Europe.  The impacts of these events have been far reaching and significant, bringing about increased public and regulatory scrutiny into markets and market participants around the globe, including new political pressures on governments to rein-in the actions of traders that were perceived to be taking unfair advantage of, and potentially manipulating, the financial and commodities markets.

While most of the emerging market regulation in the United States is concentrated in a singular legislative initiative, the Dodd-Frank Act, European regulators have devised a number of new regulations covering various aspects of market oversight including Markets in Financial Instruments Directive (MiFID) and MiFID II, the Market Abuse Directive (MAD), the Regulation on Energy Market Integrity and Transparency (REMIT) and the European Market Infrastructure Regulation (EMIR).  While MiFID II and MAD are focused to a large extent on financial derivatives markets, asset-centric commodity trading companies, such as utilities, will be most affected by REMIT and EMIR.

REMIT was adopted by the EU specifically to prohibit insider trading and market manipulation in the wholesale energy spot markets, and it became effective on December 28, 2011. Under REMIT, market participants are barred from using inside information when buying or selling energy commodities – meaning that any operational information held exclusively by a trader or company must be disclosed before trading on that information.  Additionally, the rule prohibits the dissemination of any false information that could impact supply or demand and the resultant prices for any energy commodity.  For example, should a generator know that their unit will go off line at a specific time or date in the future, they must disclose and publish that information publically, “in an effective and timely manner”, prior to undertaking any trades related to that outage (such as buying power to meet shortfalls or selling un-needed fuel supplies).  In addition to the reporting requirement, trading companies must also establish intra-company information barriers between the operations and trading components of their business – ensuring that the trading arm does not receive any advantage via having knowledge of operational changes in advance of other market participants.  The legislation also mandates that trading organizations monitor internal communications and notify the regulators in the case of a breach.

While REMIT focuses on market manipulation, EMIR, the European Market Infrastructure Regulation, was passed with the explicit goal of forcing all over the counter (OTC) trades to be cleared through a central counterparty (CCP); or if not cleared through such a facility, imposes new trade repository reporting requirements and mandates improved procedures for risk management, valuation and collateralization of those bi-lateral trades. Much like Dodd-Frank, the aim is to reduce the probability of systemic defaults and to ensure all covered trades are reported to the regulatory authorities so as to facilitate market monitoring and oversight.  While many of the details of the new rules are still to be fully elaborated, clearly for market participants, moving effected OTC trades through central clearing will impose higher margin requirements and result in higher costs.

While the legislative goals of the newly enacted and emerging regulation in the European energy and commodity trading markets are to ensure a level playing field for market participants and reduce the risks of systemic failures, for companies such as utilities and energy commodity trading firms, these new rules create additional compliance burdens and impose increased costs that must be recognized and accounted for.

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