By Shane Henley, Global Head of Monitoring Solutions at CubeLogic.

September 27, 2022

 

European power and gas markets are in a state of unprecedented turmoil given disruption to supplies of Russian gas and the ongoing outages in France’s nuclear generation fleet. So severe is this turmoil that many are questioning whether the market itself is still viable and its long-term survival is not guaranteed. So far however, European politicians have not seriously contemplated extreme measures such as the wholesale suspension of the market but even the less invasive measures currently being debated are still likely to have a significant impact on the overall market structure and how firms trade power and gas. But what does this mean for compliance, and in particular those who are tasked with monitoring their traders’ activity for market abuse under REMIT and MAR? 

Where do things currently stand? 

Last week the European Commission (EC) proposed a series of emergency measures to help address the significant rise in energy prices across the EU (the statement from the EC can be read here). The proposed policy measures revolve around three pillars i. Targeted demand reduction across EU member states ii. The introduction of a revenue cap for low marginal cost generation (such as wind, solar and nuclear), and iii. Introduction of a temporary “solidarity contribution” to support energy consumers derived from excess profits generated in sectors excluded from ii. such as from oil, gas and coal.  If adopted, these measures would theoretically permit European energy markets to continue functioning but changes in trading behaviours are still likely.  

Extreme price volatility 

Extreme wholesale price volatility continues to create distortions in forward markets, with many firms unable to trade due excessive margining costs. Some have opted to avoid exchange trading and are looking to the Over-the-Counter (OTC) market instead. Many have abandoned forward trading altogether and have opted to trade on short term markets instead. Such rapid changes and their impact on market behaviour can present many challenges for compliance officers, and transaction surveillance officers in particular, who may struggle to stay on top of what “normal behaviour” looks like. Likewise, sudden changes like those currently being observed are likely to impact the effectiveness of surveillance tools, throwing out threshold calibrations and creating a significant, ongoing maintenance effort. A sudden surge in false positive alerts due to underlying market changes might also disguise genuine instances of market abuse as inundated compliance officers struggle under the increased workload. 

Market participants and liquidity 

Fewer market participants in certain markets might also create distorted liquidity pools and conditions where traders might cause significant price movements, intentionally or otherwise, through relatively benign trading activity which might be construed as abusive. Extreme market conditions where dramatic swings in market prices might cause significant losses (or gains) have the potential to induce traders to act in unpredictable ways, even if their intention was not to manipulate the market. The same logic extends to trading algorithms (algos) which might have behaved one way under previously normal market conditions but which now behave erratically as trading signals have shifted by orders of magnitude.  

Trading focus moving from forward markets to intraday and day ahead  

Unable to trade in forward markets due to the excessive cost of margining and collateral combined with low liquidity and exaggerated spreads, many firms have switched their focus to intraday and day ahead power markets such as EPEX Spot and Nord Pool. These markets have many unique features which make them challenging to perform effective surveillance over, even under normal market conditions. For example, the dynamics of the SIDC market (the successor to XBID) and the interplay between the Shared Order Book and the local market in the final hour of trading. Many firms are not equipped with the right tools to perform effective surveillance over these markets. The current situation has undoubtedly exacerbated these already considerable challenges.  

Heightened regulatory sensitivity – caution advised   

The heightened political sensitivity around dramatically increasing consumer energy costs is likely to become far more acute as we move towards 2023.  Energy firms active in European power and gas markets are strongly advised to take every precaution available to ensure that they are not seen to be behaving in the market in a way that might be deemed to be abusive. Perception in this context matters. It does not take much imagination to envisage a scenario where European energy regulators are on the enforcement warpath in an attempt to assuage a wave of public disquiet over hiked energy bills and their severe impact on European living standards. Now is not the time to be seen abusing the market – even if you are not.   

What should you do about it? 

Firms active in European power and gas markets are advised to take every precaution at their disposal and to prepare now for the worst. This includes: 

• Continuously scanning the market to stay abreast of the proposals being made regarding European power and gas markets, and gaming out scenarios as to how these might impact your organisation’s activities and regulatory compliance risk profile (not only your market abuse risk profile). 
• Reviewing and updating your market abuse risk assessment to reflect the radical changes in market structure and the refocus of your organisation’s trading activities. 
• Ensuring regular, ongoing compliance briefings to your traders to ensure they understand the regulatory compliance context in which they are trading, and the potential impact their trading decisions may have on the organisation. In particular developing an awareness of the importance of how their activities might appear to a regulatory stakeholder, even if the strict definitions of abusive behaviour are not entirely evident. 

• Reviewing and updating your compliance monitoring policies and procedures and closing any gaps without delay. A useful test is to ask yourself, as a compliance officer, whether you would feel comfortable handing these documents over to a regulator for review. In reality, this will often play out in practice during an invasive investigation. 
• Re-reviewing previously approved algos and working with front office to reassess which are “safe” to remain approved for trading. Reviewing your algo approval and control framework is also strongly advised. 
• Reviewing your current transaction surveillance capability for coverage and effectiveness. Particularly in areas such as short term power markets which have often been a blind-spot for many firms.

Finally, this is a rapidly evolving picture which must be closely monitored. Compliance functions will be relied upon heavily by senior management over the coming months to make them aware of the significant emerging compliance risks. With many of these organisations under severe financial stress, and with their hands full with serious and complex commercial issues, it is up to compliance to ensure that very real risk of severe market abuse sanctions are brought into their line of site.