APPENDIX 34
Memorandum by the Financial Services Authority
INTRODUCTION
1. We submit this note as a contribution
to the Committee's current inquiry into the rises in gas and electricity
prices in the UK over the past year. It provides information on:
— Our powers for tackling market
abuse in energy markets.
— The background to our autumn
inquiry into the gas market.
— The outcome of our inquiry.
THE FSA'S
POWERS
2. The Committee may find it useful to have
some general background on the FSA's powers for tackling market
abuse in energy markets. The UK's civil market abuse regime, set
out in the Financial Services and Markets Act 2000 (FSMA), aims
to support market confidence in the UK's major financial markets
and exchanges (including the International Petroleum Exchange).
The regime governs primarily the contracts admitted to trading
on those markets but it also covers products whose price or value
is linked to that of an exchange-traded contract and the underlying
reference products of such contracts (eg the commodity which is
the subject matter of a commodity derivative contract, such as
oil or gas futures). Exchanges, such as the IPE, are regulated
and have their own market surveillance and disciplinary functions.
Exchanges have rules and requirements in respect of price discovery
and the price formation process, and have operating arrangements
with the FSA on market abuse. By contrast, trading in forwards
or on over the counter markets is not regulated to the same degree—only
participants are regulated, whereas for exchange business both
the market and the participating firms are regulated.
3. The FSA has powers to take action on
possible misconduct on over the counter brokers' electronic trading
screens—these facilitate dealings directly between firms
or in the underlying product of a derivative contract, as well
as on the exchanges themselves. However, these powers apply only
where is a clear relationship between the behaviour and an exchange-traded
contract covered by the regime, not in its own right. Hence, for
example, if a market participant was seeking to manipulate an
off-exchange market and had no interest in, or resulting benefit
from, any consequential impact on an exchange-traded contract,
we consider that we would, in practice, not be able to use our
anti-market abuse powers against them.
4. If a regulated firm commits misconduct,
we are able to take a case against it under the FSA Principles
of Conduct for Business. However, many participants in off-exchange
markets, particularly the off-exchange energy markets, do not
have to be authorised by us. Finally, we are also able to bring
a criminal charge of market manipulation under section 397 of
FSMA, which requires a criminal burden of proof.
BACKGROUND TO
2003 REFERRAL FROM
OFGEM
5. In November 2003, Ofgem received a complaint
from a market participant alleging abuse in both the upstream
and the traded over the counter gas markets (ie not on the IPE).
Ofgem referred the matter to the FSA under the Concordat established
between the two regulators the previous year to formalise communication
on matters of common interest. The FSA and Ofgem agreed that the
FSA would look into the element of the allegations relating to
the traded markets and conduct on brokers' electronic screens.
There were two parts to this allegation:
(i) That a market participant (firm X) had
been manipulating forward prices, especially in relation to the
benchmark contract for first quarter 2004 (Q1 04), on broker screens
by posting "all or nothing bids" and offers in volumes
too large to trade. It was alleged that this behaviour by firm
X had been prevalent throughout the summer and autumn and that
this enabled firm X to position forward prices to its liking.
To investigate this allegation, we asked the
brokers, the operators of the OTC electronic trading screens,
for details of all orders and trades on their systems in October
and November in lots of greater than 250,000 therms per day—a
trade size considered unusually large for forward trading where
deals have normally been transacted in lots of 25,000 or 50,000
therms. We also requested from the IPE details of positions held
by firm X for January, February and March 2004, the constituent
months of Q1 04[49]
in the IPE's natural gas contract (although no concerns had been
raised about behaviour on the IPE, this information was relevant
given the scope of the FSA's powers, as explained above).
(ii) That a separate market participant (firm
Y) had manipulated day-ahead prices by bidding up prices on over
the counter broker screens around the close of the day's trading.
Specific days were highlighted and other market participants had
commented to Ofgem on firm Y's behaviour.
To investigate this allegation, we requested
from the brokers full details of all day-ahead gas trades executed
on their systems up to and after the close on 31 October and 24
November.
We received all the information requested from
the market participants and the IPE.
FINDINGS
6. Having obtained and analysed the information
requested from the brokers, we sought an explanation from a number
of market participants, including firms X and Y, of their trading
strategy as relevant to these allegations. We also spoke to a
number of other market participants, whose conduct was not in
question, in order to enhance our understanding of market conditions.
7. We also noted IPE's conclusions that
the positions held by firm X were not large and that there was
nothing in their trading or arising from a general analysis of
outright and spread prices that gave any cause for concern or
warranted further investigation. This is significant in the context
of the scope of our powers.
8. On the basis of these discussions, we
concluded that the conduct fell outside the scope of our market
abuse regime. We considered whether we could pursue the firms
using our powers under section 397 of FSMA, but having regard
to the required high threshold of a criminal burden of proof,
we decided not to pursue the matter. We expressed to firm X our
reservations about the practice of placing curve orders in larger
than usual market size on the broker screens. We believe that
this practice may have had an unsettling effect on the curve and
may have relayed misleading messages to the market, especially
given the illiquidity in the market. Similarly, we sought, and
obtained, assurances from firm X that they would continue to ensure
that their systems and controls in this area were appropriate.
9. These conclusions formed the basis of
the announcement on the FSA's website on 4 October 2004. Our work
in looking into these allegations did not constitute a formal
investigation using our enforcement powers and, as such, was carried
out by our Markets Division as part of its market surveillance
function.
10. In September 2004, Ofgem again drew
to our attention their concerns about price rises in the traded
gas market. These concerns were not supported by specific allegations
about behaviour in the traded market and so we spoke to a range
of market participants to gain a better understanding of prevailing
conditions. The consensus from these discussions was that the
market was driven by fundamentals and not by any inappropriate
behaviour in the traded market. (when we say "fundamentals",
we mean factors relating to underlying supply and demand in the
physical market; we formed no judgement and make no comment on
the structure and conduct in the physical market where this is
outside our remit as outlined above.) On this basis, we decided
not to pursue this matter further.
18 February 2005
49 NB Liquidity on the IPE is in individually traded
months rather than in the contracts for the quarters. Back
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