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8
Questions Surrounding Regulation
In this final chapter, we examine regulation from the angle of the normal functioning of markets. Thus, our discussion does not consider illegal manipulations, such as corners, squeezes, agreements, the sharing of false information and insider trading. Regulating commodity markets is an important concern given the impact that a deficient functioning of the market may have. Various bodies are involved in this regulation, notably the European Securities and Markets Authority (ESMA) and the U.S. Commodity Futures Trading Commission (CFTC), which cooperate within the framework of the International Organization of Securities Commissions (IOSCO).
8.1. Dilemmas surrounding regulation
The dynamics of derivative markets are, by nature, dependent on the dynamics of the cash market as the value of the derivative instruments is dependent on the value of the support. Reciprocally, derivative markets also have an impact on cash markets as the prices that form on futures markets or options markets may be interpreted as expectations and commonly serve as the basis for decisions taken on the cash market.
In terms of regulation, this reciprocal relationship raises a major question: do derivative markets have a stabilizing or destabilizing role on cash markets? A second structural question poses a recurrent problem for regulators: in order for derivative markets to be sufficiently liquid, “speculators” must benefit from participating. But what are the boundaries within which these speculators can act? The question of index funds, especially, is one that arises here.
8.1.1. Organized financial markets are governed by strict regulations on the judicial level
Organized markets continuously submit accounts to authorities who are in charge of supervising them. In France, the Autorité des marchés financiers (AMF; Financial Markets Authority) has significant supervisory powers, especially with regard to investigative powers. This is the same for their counterparts in large OECD countries. The real limits to this supervisory power are mainly the result of limited means, relative to the complexity and large number of operations carried out on the financial markets.
8.1.2. Physical markets have very little regulation
The world of physical trading is only subject to the contractual rules of common law. There is no authority that is specifically dedicated to the regulation of physical markets. It must be emphasized that the concept of business secrecy allows players on the physical market to not publicize most information relating to their activities.
While this secrecy may be waived in the case of a judicial inquiry, this is an exception rather than the rule. In stark contrast, for organized financial markets, supervisory powers constantly have access to a wide range of information.
8.2. A broad overview of the evolution of regulation
The regulation of derivative markets evolves in accordance with a guiding principle that is easy to summarize: in the regulator’s eyes, organized markets do not pose a major problem; on the other hand, OTC markets present global or even systemic risks. A risk is said to be a global risk when the efficacy of the market is altered; a systemic risk arises when the majority (or totality) of actors face the threat of simultaneous defaulting.
The chief efforts carried out by the regulatory authorities thus aim for a better control of OTC markets. An important remark: there is a gradation between the organized markets and “purely” OTC markets that complicate regulation when it involves finding an equilibrium between the autonomy of the actors and preserving the global stability of markets.
8.2.1. Regulation within the framework of the European Union
8.2.1.1. The MiFID II directive
Some part of a new directive, called the markets in financial instruments directive (MiFID) II, which framed regulations for the financial markets, entered into force on July 3, 2017 and the remaining part came into force on January 3, 2018. This text presented very general mechanisms for protecting investors. Among other elements, the Commission delegated the responsibility of monitoring financial markets within the EU to the ESMA (European Securities and Markets Authority).
Two broad aspects of the regulation of commodity derivative markets are already fixed:
- – the limits on the net positions that a player may hold;
- – the evaluation of the risks taken by non-financial actors.
This very technical directive has been explained in a detailed manner on the AMF website and we invite the reader to refer to this. Let us note, however, that this directive was inspired by the desire for markets to be as transparent as possible, not only for the regulators but for all participants. Among other examples, commodities that are traded OTC must become subjects of centralized compensation from the time that they are considered to be sufficiently liquid.
8.2.1.2. MiFID II and commodities
The directive specifies that the positions must be declared and that position limits will be imposed. This signifies that a single operator cannot hold more than a certain proposition of seller or buyer positions. The purpose of this directive is clear – no operator should be able to singlehandedly influence the market by placing massive purchase or sale orders. More particularly, for agricultural commodities, in 2012 the European Union’s Directorate General for Agriculture and Rural Development put in place an Expert Group on Agricultural Commodity Derivatives and Spot Markets which was charged with studying ways to regulate agricultural commodity derivative markets within the framework of the MiFID 2.
Within this group, there are notable contributions from primary players, that is, traders, transformers and cooperatives that have a primary interest in the physical trading of commodities. The general opinion of these players is that derivative markets are very useful, or even indispensable, for successfully carrying out their commercial activity. This results in their contributing to the definition of institutional conditions for the smooth functioning of these markets. It is difficult to summarize these ongoing discussions and we thus recommend that readers refer to the press releases, reports and other communications available online1.
8.2.2. Regulation in the United States
In the United States, the regulation of derivative markets is entrusted to the CFTC:
“The mission of the Commodity Futures Trading Commission (CFTC) is to foster open, transparent, competitive, and financially sound markets. By working to avoid systemic risk, the Commission aims to protect market users and their funds, consumers, and the public from fraud, manipulation, and abusive practices related to derivatives and other products that are subject to the Commodity Exchange Act (CEA) […] The Commission was established as an independent agency in 1974, assuming responsibilities that had previously belonged to the Department of Agriculture since the 1920s”2.
More precisely, the CFTC leads a market surveillance program that aims to preserve the proper functioning of futures markets and options markets. The CFTC highlights four main axes along which they work:
- – detecting and preventing the manipulation of markets and abusive practices;
- – constantly noting significant changes on the market;
- – enforcing and respecting the position limits decided upon either by the CFTC itself or by the stock market on which these exchanges take place;
- – ensuring that the reporting requirements fixed by the CFTC are respected by all the various players.
8.2.2.1. The scope of the regulation covers commodity swaps
Regulation follows a general direction. It is chiefly carried out by subjecting OTC products to the supervision of the regulatory authority. This general movement is now applicable to swaps, especially commodity swaps. For the purpose of illustration, let us reproduce an extract from a text published on the CFTC website: Sec. 733 of the Dodd-Frank Act adds a new Sec. 5h to the CEA that governs the registration and regulation of swap execution facilities. New CEA Sec. 5h(b)(2) adds that a swap execution facility “may not list for trading or confirm the execution of any swap in an agricultural commodity (as defined by the Commission) except pursuant to a rule or regulation of the Commission allowing the swap under such terms and conditions as the Commission shall prescribe”3.
In terms of regulation, an important point to keep in mind is that a swap is an OTC contract. For a long time, regulation authorities would not have any knowledge about the content of swaps. It is only since 2013 that commodity swaps have been required to be covered by reporting rules.
8.2.3. The role of the IOSCO
As its name suggests, the objective of the IOSCO is to coordinate the actions of regulatory authorities of financial markets. The IOSCO is made up of seven committees, the seventh of which is dedicated to commodities:
“Another important mandate of the G-20, which was entrusted to the 7th comity, was the settling of the principles of regulation and of the supervision of derivatives markets. These principles were published in September 2011. The objective of these principles was to help ensure that the commodity derivatives markets fulfill their fundamental price discovery and risk coverage functions, while operating without manipulation or abusive trading programs”4.
However, to the best of our knowledge, the IOSCO is not currently very active in matters concerning commodity derivative markets. While a risky speculation, we could consider this muted activity to be the result of a lack of international cooperation in the supervision of financial and physical commodity markets.
8.3. High-frequency trading: a burning question
In the previous section, we saw that the transparency and comprehensiveness of information – at least the information available to supervisors – appears to be a necessary condition for well-regulated markets. Another element – high-frequency trading (HFT) – seems to today threaten the proper functioning of markets. Its detractors believe that HFT disrupts the proper formation of prices and generates such a large quantity of operations that the monitoring authorities find it far too great in volume to analyze correctly. To those who support it, HFT generates liquidity, which is an essential condition for markets to function well.
8.3.1. Algorithmic trading
Algorithmic trading is based on the use of computers to automatically take certain decisions. These decisions result in automatic selling or purchase orders trading. The important point to understand here is that these algorithms are programmed:
- – to translate the asset management choices;
- – to execute these choices, once made, without any soul-searching.
Let us highlight the existence of low-frequency algorithmic trading: to avoid behavioral biases in portfolio managers, the composition of certain financial funds is determined by an algorithm. However, the composition of these funds can only be adjusted once a week or, on an even more restricted timeline, once a month.
8.3.2. High-frequency trading
HFT is a particular form of algorithmic trading. It aims, notably, to take advantage of speed in analyzing available information, sending orders and executing them. For example, Figure 8.1 makes it possible to illustrate an elementary strategy that is based on HFT:
Figure 8.1. A technique for high-frequency trading
(source: adapted from Biais B., 2013, Banque de France Conference on Algorithmic and High-frequency Trading)
In this example, the initial situation is as follows: the market price is initially 100.00; in order to buy, an order must be placed at 100.01 and in order to sell, an order must be sold at 99.99. New information emerges and we learn that the asset value has now increased to 100.2. Two traders carry out an operation: the quicker of the two sends in a purchase order at 100.01 as they know that this is advantageous as the asset is now worth 100.02. The slower of the two had placed a sale order at 100.01 when the market value was 100.00. Now that the price has increased, this trader wishes to cancel their order so they can quote a higher selling price, however they are not quick enough and their “earlier” order remains valid for a fraction of a second, which allows a high-frequency trader to buy at an advantageous price.
It is important to remember that the only difference between the traders is the speed with which they execute the order: we cannot exclude the possibility that the slower trader is a better market analyst whose response time is too long.
This introductory example is quite condensed while HFT strategies are often extremely complex. A good overview of these can be found in [MAC 13].
In principle, HFT aims to take advantage of price fluctuations resulting from various causes; in reality, it seems that the many fluctuations are actually caused by high-frequency traders. This raises at least two regulation problems:
- – these operations, in certain cases, may be likened to price manipulations;
- – there is even a fear that the fluctuations that these operation cause pose the risk of destabilizing markets.
There have been many debates around these questions in various circles:
- – among the regulators, even the United States Congress has taken up this issue. We can refer, for example, to the report by the Congressional Research Service, titled High-frequency Trading: Background, Concerns, and Regulatory Developments, published on June 19, 2014 and which is available online;
- – certain traders believe that HFT disrupts the normal functioning of the markets. Among these, Eric Scott Hunsader, the founder of the investment firm Nanex, seems to be the leading detractor of HFT;
- – in academic circles, where a whole body of literature is being developed around these questions. In addition to economics and financial mathematicians, there are physicists, “non-financial” mathematicians, software engineers and specialists in artificial intelligence who have all developed particularly stimulating analyses of HFT.
8.3.3. HFT and the risk of manipulation of the market
Let us conclude by highlighting that certain HFT practices have been the subject of legal proceedings. The case we speak of most often today is that of Michael Coscia, a trader accused of having carried out spoofing on commodity markets. His trial began in November 2015, in a federal court in Chicago. In July 2016, Michael Coscia was convicted and sentenced to 3 years in prison. He was the first trader convicted for the practice of spoofing. Going beyond this anecdote, understanding what spoofing is will make it easier to understand the risks induced by HFT.
Let us take the following example: contracts for Brent oil are quoted at around 64 USD per barrel, with regular fluctuations around this price. A spoofing operation can be carried out in two phases, when the selling price is 64.05 USD:
- 1) the spoofer places a massive selling order at 64.03 USD. Many vendors join the spoofer as they think that the selling price is going down. The spoofer cancels their sale order and places a purchase order, thereby being able to buy at 64.03 USD instead of 64.05 USD;
- 2) the spoofer places a massive purchase order of 64.04 USD. Other operators, who think this is a good price, also place this order. When these orders are displayed, the spoofer cancels their purchase orders and places sale orders at 64.05 USD;
The financial outcome of this operation: on a financial level, we see that the spoofer participated when the market quoted a price of 64.05 USD; their maneuvers allowed them to buy at 64.03 USD and resell at 64.04 USD, thereby realizing a gain of 0.01 USD. This gain is, of course, multiplied by the number of contracts they are dealing in. For information, the fraudulent gains realized by Michael Coscia were several millions of dollars.
Remarks: this example underlines one of the risks inherent to HFT. Normally, HFT reimburses the trader who is fastest at making use of price variations; in doing so, the market liquidity is improved as the number of purchases and sales are increased. In practice, it appears that high-frequency traders are incentivized to provoke price variations, and not only to make use of existing variations.
8.4. Conclusion
As we emphasized in Chapter 1, commodity trading is generally recognized as trading of strategic importance. Thus, the question of regulating markets is one that constantly arises. To go straight to the heart of the matter, the smooth functioning of a market is dependent on:
- – the control exercised on the market by a regulatory authority, which assumes that this authority benefits from excellent information and is able to process this and has adequate means at their disposal to act upon the information;
- – an organization of markets – called a microstructure – such that the market prices are as close as possible to the market fundamentals.
To conclude, let us point out that while there is a certain pressure in favor of regulating markets – as can be seen, for example, with the MiFID II directive – there is still a large movement that is against such a regulation. Consequently, although certain activities are now the responsibility of regulatory authorities, many new activities have come up and escape the notice of these very authorities.
Chapter written by Joël PRIOLON.