By publishing a new primer on the changing landscape for commodity markets and emerging issues for regulators, Britain's Financial Conduct Authority (FCA) has taken a welcome first step towards greater transparency. Despite its rather dull title, the FCA's "Commodity Markets Update", released on Thursday, is the best summary of how markets are changing in response to the fading super-cycle and tougher regulation in the wake of the financial crisis.
It describes clearly the choices financial regulators must make in trying to strengthen oversight without reducing liquidity, and how they are dealing with the links between regulated financial derivatives and unregulated physical markets. Updates have been published by the FCA's forerunner, the Financial Services Authority (FSA), since 2008. But like most FSA publications, they were filled with jargon and appeared aimed at a small circle of insider specialists, most of whom would already have been familiar with the contents.
The sporadic publication schedule (just two in five years) suggests communication with a broader audience was not a high priority. So the FCA's decision to resurrect the publication, this time in plain English, marks a welcome signal of its willingness to engage with a much wider range of stakeholders. In a forward to the update, David Lawton, the FCA's director of markets, promises to keep the wider community briefed on the latest developments in policy and supervision as part of an "ongoing dialogue".
The concept of dialogue implies the FCA is willing to explain and listen to alternative viewpoints - an openness that often seemed absent at the FSA. In the past, I have criticised the opaque approach of the FSA and the FCA to regulating commodities, especially the "cosy relationship among brokers, exchanges and official regulators" ("US cracks apart London's commodity market omerta" August 8, 2013). Too many decisions were taken by small groups of regulators, lawyers and lobbyists in private with minimal input from or accountability to the wider public.
I argued there must be more transparency. "Policy formulation should no longer happen behind closed doors ... Far more discussion and justification should be published and shared with the industry, the public and, yes, the media, so the rationale for decisions can be properly scrutinised and tested." "There must also be much more openness about potential problems as they emerge and the actions that regulators and exchanges are taking to deal with them."
"Britain's new Financial Conduct Authority should at least publish aggregated statistics and an informative annual discussion about emerging concerns and its regulatory activities." The new Commodity Markets Update serves that purpose well. Gone is the testy defensiveness that marked FSA publications. Instead the FCA outlines the regulatory issues and options, the legal limits on its powers, and the trade-offs it must make in deciding how aggressively to regulate different markets.
The update summarises the FCA's recent regulatory and supervisory activities, as well as its priorities in negotiations with super-regulators at EU and international level. The update is frank about the unique challenges of regulating commodity markets because they "straddle the regulatory perimeter". Financial regulators such as the FCA have the authority to regulate derivatives but not to trade in the underlying physical commodities.
However, financial and physical markets are tightly coupled so conduct in the (unregulated) physical market can easily spill over into the (regulated) financial marketplace. Delivery and storage mechanisms in the physical market impact on the formation of prices on the financial side. Behaviour by physical market participants who are not regulated by the FCA affects prevailing standards of conduct in all markets. And abusive behaviour in physical markets can have a direct impact on the price of financial derivatives, the FCA acknowledges.
Financial regulators such as the FCA and the US Commodity Futures Trading Commission are supposed to work more closely with physical market regulators like Britain's Office of Gas and Electricity Markets and the US Federal Energy Regulatory Commission. The aim is to create a seamless regulatory system, but important gaps remain. The nature of commodity market participants is also changing.
"There have always been ebbs and flows in prominence of (different types) of market participants," the FCA observes. "Currently the trend is towards a decline in the activity of the banks and a rise in the role played by commodity trading companies." Directionless markets, declining client interest, a rise in compliance costs, and increased pressure from regulators about their physical trading activities, have seen many of the major commodity banks scale back their operations or exit entirely. Non-bank entities, particularly trading houses, have taken an increasingly prominent role at the expense of the banks.
"Trading companies have tended to locate the bulk of their activities in less transparent jurisdictions," the FCA warns. Most disclose much less information than banks. Financial regulators tend to supervise only a small part of their operations. "Operating in plain sight, the trading firms represent a 'known unknown' that quite naturally attracts attention from regulators and central banks," the FCA admits. Britain's regulator is agnostic on whether trading houses pose systemic risks, but says it is developing a dialogue with them where possible and characterises the response as "constructive". Trading houses are not the only commodity market participants that have grown at the expense of the banks. Oil firms and gas and power utilities have also boosted their trading operations.
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