(John Kemp is a Reuters market analyst. The views expressed are
By John Kemp
LONDON Feb 27 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. (here)
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
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
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.
OPEN TO DIALOGUE
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
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"
("U.S. cracks apart London's commodity market omerta" Aug. 8,
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
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
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
The update is frank about the unique challenges of
regulating commodity markets because they "straddle the
Financial regulators such as the FCA have the authority to
regulate derivatives but not to trade in the underlying physical
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
And abusive behaviour in physical markets can have a direct
impact on the price of financial derivatives, the FCA
Financial regulators such as the FCA and the U.S. 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 U.S. Federal Energy Regulatory
The aim is to create a seamless regulatory system, but
important gaps remain.
The nature of commodity market participants is also
"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
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
"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
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
While the FCA has more supervisory authority over them than
the trading houses, it still has "less information on their
financial position than in the case of conventional financial
firms and groups".
The regulator admits changes in the regulatory landscape
have not fallen equally on market participants, effectively
driving business from more highly regulated banks to less
tightly regulated trading houses, oil companies and utilities.
The shift is expected to continue, a classic instance of the
law of unintended consequences. Nonetheless, the FCA is
determined to minimise opportunities for regulatory arbitrage.
"We will be alert to any trend for market standards to
become subject to a 'race to the bottom' as a result of
regulatory and competitive inequalities," the FCA promises.
Preventing regulatory arbitrage is easier said than done.
Given the patchwork of national and international laws that
govern different aspects of the commodity markets and pressure
from politicians to retain business in their own trading hubs,
it is easy for traders to play one regulator off against
But at least the FSA's old, discredited "light touch"
approach is being replaced by something a little more robust,
and it seems more willing to acknowledge and engage with a
broader range of views than in the past.
(Editing by Dale Hudson)