COLUMN-U.S. cracks apart London's commodity market omerta: Kemp
(John Kemp is a Reuters market analyst. The views expressed are his own)
By John Kemp
LONDON Aug 8 (Reuters) - "See no evil, hear no evil, speak no evil" might well have been the motto for Britain's commodity market regulators in recent years.
In too many instances, light-touch self-regulation by the exchanges, overseen by the Financial Services Authority (FSA), now reincarnated as the Financial Conduct Authority (FCA), has degenerated into ineffective or no regulation.
But the cosy relationship among brokers, exchanges and official regulators in London is being blown apart by more aggressive oversight from the United States.
On July 23, the Senate Banking Committee put a spotlight on the physical trading operations of the major commodity-dealing banks with a hearing on whether they should be allowed to control power plants, warehouses and oil refineries.
Prodded by the committee and U.S. banking regulators, JPMorgan has indicated it will reduce its presence in physical trading.
Under attack from U.S. lawmakers and aluminium customers about the lengthy queues at its London Metal Exchange (LME)-registered warehousing operations in Detroit, Michigan, Goldman Sachs has offered to swap any aluminium in the queue for immediately available aluminium, though only for end-users.
The U.S. Commodity Futures Trading Commission (CFTC) last month ordered Wall Street banks and other traders to retain documents, emails and instant messages related to incentives or premiums given to metal producers in exchange for storing metal, as well as load out rates and delivery procedures.
Do-not-destroy notices such as this probably presage a wide-ranging probe into how the warehousing system operates and whether it has artificially inflated location premiums.
On July 31, Reuters reported Britain's FCA has not ruled out its own investigation. "The FCA has been, and continues to be, closely engaged on warehousing issues with the exchange and the various initiatives it has put in place over recent years," an FCA spokesman said on July 29.
The U.S. Department of Justice has also launched a preliminary investigation into aspects of warehousing and metals markets, sources familiar with the matter said.
Now Goldman and the LME have been named co-defendants in a class action lawsuit filed in the U.S. District Court for the Eastern District of Michigan, which covers Detroit. The lawsuit, brought by Superior Extrusion, an end-user, alleges "anticompetitive and monopolistic behaviour in the warehousing market in connection with aluminium prices".
The LME and Goldman Sachs have responded by saying the lawsuit is "without merit" and promised to contest it vigorously.
More follow-on lawsuits have subsequently been filed in Florida and Louisiana.
Criticism is not restricted to metals. Persistent concerns have been expressed about the construction and accuracy of oil-pricing benchmarks such as Brent, which is also based in London, though traded worldwide.
Much of the adverse comment has stemmed from concerns about the methods used by price-reporting agencies (PRAs) to calculate daily benchmarks. Concerns have been expressed that Brent and other oil-price benchmarks are open to the same sort of manipulation as Libor and interbank lending rates.
But behind the arguments about calculation methodology are deeper concerns about the composition and competitiveness of the benchmarks themselves. Falling output of crudes deliverable against the Brent contract has left it looking increasingly unrepresentative and vulnerable to squeezes.
PRAs and regulators have drawn up a voluntary code of conduct and formal principles respectively to deal with some of the methodological issues. And the physical basis for Brent prices is being reformulated to address concerns about declining liquidity. Nonetheless, change has been slow.
Not all these criticisms are valid. Market participants could be forgiven, however, for wondering why reforms are being driven from the United States when so many of the physical commodity markets are headquartered and supposed to be regulated in Britain.
The London commodity community - traders, lobbyists, exchanges and regulators - has bristled at even gentle criticism.
The system has been largely deaf to questions from outside, treating any and all criticism as hostile, even when it has been offered in the spirit of trying to make markets work more effectively.
The result is silence. Few prosecutions and disciplinary actions. Limited disclosure of relevant physical and futures market data. No disclosure about routine or exceptional regulatory and supervisory activity.
The silence is hard to interpret. Either London's commodity markets are among the cleanest and best-behaved in the world of finance, or regulation is not very effective at preventing, detecting and punishing misbehaviour.
Regulators insist the system works well, but they insisted the same about banking before 2008, and there is no way for outsiders to tell.
For dealers, exchanges and regulators, confidentiality is the cardinal principle. Attempts to obtain more information, including freedom-of-information requests, even at a highly aggregated level that preserves confidentiality, routinely run into a wall of silence.
Brokers, exchanges and their academic supporters resist attempts at more transparency. They stress the private and voluntary nature of transactions. No one is forced to buy or sell either the physical commodity or derivatives. Market participants are sophisticated professionals. Caveat emptor.
But this ignores the public functions, particularly in establishing benchmarks, that private commodity markets perform for a much wider range of participants. Benchmarks confer strong elements of pricing power on all those involved.
Traders, exchanges and regulators must expect to be subject to the heightened scrutiny that comes with benchmark status.
Some of London's commodity brokers have already lashed out at U.S. and EU regulators and lawmakers as ill-informed, populist-pandering Know-Nothings.
Britain's international development minister, a former oil trader, in an interview published in the Financial Times on Monday hit out at the European Commission's probe into alleged price manipulation in the oil markets ("Alan Duncan attacks EU oil price probe", Aug. 4).
"The very fact (the Commission) is even considering an inquiry suggests they don't understand what they are dealing with," he said. The comments reflect wider unease among oil companies and traders, who fear the oil market has been unfairly targeted by regulators, according to the newspaper.
But the real question is why none of these issues was tackled in a timely and effective manner in Britain.
London's approach to regulation is being discredited, as U.S. senators and regulators pick over the markets with hearings, raids and subpoenas.
There must be more transparency. Policy formulation should no longer happen behind closed doors at the exchanges, or among them, the regulator and Britain's finance ministry. 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.
No one expects the exchanges and regulators to publish the details of every investigation and intervention in detail. But 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 FCA is at the forefront of developments in commodity market policy," a spokesman told Reuters. "Our regulatory regime in the UK is consistent with international standards and in a number of important respects goes beyond them.
"We have successfully taken to enforcement a number of commodity-related actions, and our feedback statement on transparency published earlier this week clearly outlines our commitment with respect to the transparency we will provide going forward," he added.
The FCA has a "close and continuous" dialogue with commodity exchanges in London and is satisfied they are regulating their markets effectively.
But it is hard to judge the effectiveness of exchange regulation and the FCA's supervision when there are no metrics, either internal or published.
The 2012 Financial Services Act introduced a requirement for the FCA to exercise its functions as transparently as possible.
"Being a transparent regulator is at the heart of our approach," the FCA wrote in a discussion paper on transparency issued in March.
"Explaining to the public, firms and parliament our thinking, the way we work, how we manage our costs and that we are open to scrutiny is important to our legitimacy as an effective regulator," the authority added.
There was recognition it can do more to be transparent, including in the supervisory area: "Disclosing more about supervisory activity should help inform our stakeholders about the trade-offs that we often have to make."
The transparency push is primarily aimed at other parts of the FCA's work. Commodity market supervision is only a small part of the authority's portfolio, which focuses on equities, consumer protection, banking and insurance. Nonetheless, the need for more transparency is essential in this field too.
To rebuild trust and confidence in the system, regulation must not only be effective, but be seen to be effective. If Britain's regulators do not rise to the challenge, supervision will shift to the United States by default. (Editing by Dale Hudson)