The CFTC Consults on the Use of Artificial Intelligence
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What Is It About
The EU energy and financial regulators simultaneously released reports examining whether the EU gas price cap or Market Correction Mechanism (MCM) has had any “pre-impact” on traded markets despite not having been actively triggered.
Why It's Important
Market interventions of this nature carry potentially significant ramifications firms trading in these markets. This can include price distortions, changes in liquidity and the introduction of perverse incentives, all of which should be of significant interest to Compliance professionals with oversight responsibility of these markets.
Key Takeaways
Although both reports indicate that there were no direct impacts on TTF gas prices attributable to the MCM, ESMA specifically includes an Appendix that outlines seven observations on ambiguities and clarifications around implementation of the MCM. Firms must begin preparing, and where possible simulate, the impact on positions and liquidation of those positions should the MCM be activated.
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Introduction
The Importance of Clarity in the EU Market Correction Mechanism (MCM) Regulation
ACER and ESMA published their respective preliminary data reports (click here and here) assessing the market effects on the introduction of the TTF gas price cap or "Market Correction Mechanism" (MCM). In addition, ESMA also published an Annex outlining seven clarification topics associated with implementing the MCM (click here).
As a reminder, the MCM is a price intervention mechanism targeting financial derivatives traded at EU exchanges with an expiration date of between a month to twelve months maturity on triggering of the cap. According to Article 4 of the Regulation, the mechanism is activated if the following two conditions are met:
the front-month TTF (i.e. Title Transfer Facility) derivative settlement price is above 180 EUR/MWh for three consecutive trading days; and
it is 35 EUR/MWh higher than the EU LNG reference price published by ACER.
Based on the preliminary data reports published by both, it was concluded that no significant impacts could be attributed to the adoption of the Market Correction Mechanism (MCM) so far.
ACER Preliminary Report
The ACER preliminary data report focuses on assessing the current energy market developments, including EU hubs and liquefied natural gas (‘LNG’) price developments, demand and supply developments and infrastructure utilisation and bottlenecks, security of supply, as well as observations on traded volumes in selected EU hubs and for selected products.
ACER noted that prices have fallen significantly since September 2022 after the peak prices in August above the 180 EUR/MWh MCM threshold. It notes that between 20 December 2022 and 18 January 2023 front-month TTF prices further dropped by circa 40% to levels of 65 EUR/MWh in mid-January 2023.
Although there is no preliminary evidence that the MCM has impacted TTF prices, ACER proposes that going forward it will use eleven market indicators to assess potential MCM effects, categorised into three areas as follows:
- Gas Price Developments. The first section looks at gas price aspects, assessing the development of selected gas price indexes and the evolution of price spreads between gas hubs.
- Gas Flow Developments. The second section reviews gas demand and supply dynamics, gas flows and infrastructure use evolution.
- Gas Trading Developments. The third section looks at gas trading activity developments at both exchanges and OTC gas markets.
For those interested in understanding TTF trading dynamics since the MTM was announced, we recommend reading the ACER document in its entirety.
ESMA Preliminary Data Report
The ESMA preliminary data report focuses on market indicators aimed at assessing the potential effects of the adoption of the Regulation on energy derivative markets, including the evolution of volumes and open interests and the potential shift of activity from trading venues to over-the-counter (‘OTC’) trading and to non-EU exchanges. The ESMA report also includes a more qualitative analysis of the risks to Central Clearing Counterparties (‘CCPs’) risk management and the potential impact on the clearing of energy derivatives arising from the introduction of the MCM.
ESMA’s preliminary report is broken into three main sections. In addition, ESMA includes in Annex II seven points of clarification regarding the application of the MCM which it believes would be of benefit to ensure a common understanding and convergent implementation of the Regulation if/when the MCM is activated.
The three sections of the ESMA report are as follows:
[1] Structure and main participants in the EU natural gas derivates market. ESMA observed that derivatives on natural gas (futures and options) were mainly exchange-traded derivatives traded on ICE Endex in the Netherlands, EEX in Germany, and Nasdaq Oslo in Norway (although in far smaller volumes than ICE and EEX) while Energy firms and proprietary trading firms, including algorithmic traders, are the main participants in the EU natural gas derivatives market.
[2] Market Indicators. The report focused on market indicators, including prices, volumes, and open interest, to assess the potential effects of the MCM on energy derivative markets. ESMA noted that so far, no market changes have been identified that could be directly attributed to the regulation. The report also outlined the possible impacts and risks of the new regulatory environment created by the MCM, including a preliminary assessment of how market participants could continue trading TTF derivatives via alternative means.
[3] Potential Impact of the MCM on central counterparties and the clearing ecosystem. The analysis includes a review of CCP margin calls and subsequent liquidity needs for clearing members and their clients. It also outlines the indicators for potential changes in CCP risk management and margin increases that ESMA will be monitoring and analysing as from the entry into force of the MCM, as well as the applicable data limitations.
We review ESMA's Annex II and it's seven clarification observations in further detail below as these accurately represent the more opaque aspects of the legislation.
Compliance Considerations
Although ESMA broadly reached the same conclusions as ACER that there were no preliminary data indicating direct impacts of the MCM on TTF gas prices thus far, it acknowledged that some of the potential effects may only emerge when the activation of the MCM is imminent, and that a rational behaviour by market participants to avoid the activation of the MCM could lead to significant and abrupt changes in the market environment and ultimately affect financial stability.
In addition, it raises seven points of clarification in terms of implementing the MCM as outlined below.
ESMA Annex - Points of Clarification
The seven clarification points which identify both ambiguity and uncertainties in the operation of the MCM are as follows:
- Supervision and enforcement of the Regulation
- Exemptions for contracts prior to 1 February 2023
- Application to default management process
- Scope of the MCM – application to “block-trading facilities”
- Scope of the MCM – meaning of front-year TTF derivative
- Application to options
- Conditions of activation and deactivation
We review and summarise each in detail below however we recommend reading the ESMA report and Annex in its entirety for additional information.
ESMA considers it crucial for the EU Commission to provide clarification on the areas identified below to ensure a common understanding and convergent implementation of the MCM regulation. ESMA notes that it stands ready to provide technical assistance to the Commission in this regard.
1. Supervision and enforcement of the Regulation
The regulation is clear that in the event of an activation of the MCM, market operators and participants are obliged to adhere to the dynamic bidding limit. However, ESMA could not find any express provision in the regulation specifying the responsible competent authority for its supervision and enforcement.
It is ESMA's view that ideally, supervisory responsibilities should be clarified in the regulation.
2. Exemptions for contracts prior to 1 February 2023
The regulation exempts the buying and selling of TTF derivatives concluded before 1 February 2023 from the MCM. The intention of this exemption is to allow parties holding open positions to offset or reduce positions in an orderly manner without the restrictions of the dynamic bidding limit. However, there are some practical questions regarding how this exemption would operate.
- Legal Certainty over Protected Positions. It would appear that any market participant trying to close such a “protected position” from before 1 February 2023 can only do that by “finding” another market participant holding an opposing “protected position” equally wanting to offset or reduce the position. For market participants to submit orders and conclude trades outside the dynamic bidding limit it would be essential to have legal certainty that the positions are indeed “protected” and can be offset based on prices outside of the dynamic bidding limit. Consequently, it would be essential for market participants to have legal certainty that positions are indeed “protected” and can be offset based on prices outside of the dynamic bidding limit.
- Trading Venues role in ‘Protected Positions’. ESMA also notes that it would appear that for orders to offset “protected positions” trading venues would need to establish a separate order book or to technically limit the counterparties that can interact with certain orders in the ordinary order book (implementing such changes would likely take a significant amount of time). A pre-arranged trading facility already offered by commodity derivatives trading venues could be an alternative but raises the same legal certainty issue as the one mentioned above.
ESMA considers it useful if guidance could be provided to ensure a convergent application in full compliance with the regulation given initial feedback from market participants indicates that there are also questions in the market about the correct application of this exemption.
RegTrail Insight
As noted earlier in the newsletter regarding the guidance provided by EEX, for firms to make use of an exemption the trader must enter the relevant information in the respective text field upon order entry and both sides to the trade must meet this requirement else the order will be treated as a “normal” trade and will be deleted. This does not however address the legality question - it is not impossible that both counterparties might not meet the legal threshold for exemption, whatever that might be.
Legal certainty over 'protected positions' will become a very important position should the MCM be activated. Therefore, it is important that market participants work with trading counterparties and exchanges to ensure there are static data/text fields available that provide the ability to tag trades that fall under the 'protected' status on both sides of a trade.
3. Application to default management process
The regulation exempts the Central Counterparty (CCP) from registering OTC transactions in a regulated market to liquidate a defaulter's portfolio that are not subject to the MCM. The exact implementation of these rules is unclear, and there are questions about how trades concluded with auction counterparties will be treated during and after the default management process. ESMA considers it useful if clarification could be provided on this aspect of the regulation.
4. Scope of the MCM – application to “block-trading facilities”
The scope of the MCM and its application to "block-trading facilities" is not specified in the regulation.
Block trades are negotiated bilaterally and fall outside the order book of the Regulated Market while the Regulation currently only applies to orders submitted to the Regulated Market.
ESMA considers it useful if clarification could be provided as to whether such block trades formalised on a Regulated Market outside the order book are within the scope of the MCM.
5. Scope of the MCM – meaning of front-year TTF derivative
The regulation does not define the meaning of a front-year TTF derivative, which is crucial for determining the scope of the MCM.
The dynamic bidding limit under Article 4(5) of the Regulation applies to TTF derivatives that are due to expire in the period from the expiry date of the front-month TTF derivative to the expiry date of the front-year TTF derivative. Stakeholders reported difficulties in determining the contract maturities in scope of the MCM.
ESMA provides a specific example of its interpretation of the front year TTF derivative definition and requests confirmation of its understanding or additional clarification if it is incorrect.
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“According to the definitions under Article 2(4) and 2(5) of the Regulation, the front-month contract is the contract whose expiration date is the nearest among the derivatives with a one-month maturity, and the front-year contract is the contract whose expiration date is the nearest among the derivatives with a twelve-month maturity.
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Although the definition refers to “twelve-month maturity” rather than to a maturity of one calendar year, ESMA notes that in accordance with market practice, only yearly contracts based on a full calendar year are available on trading venues and would meet the definition of having a “twelve-month maturity”.
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Consequently, as of 13 January 2023, the front-month contract is the Feb23 contract (which expires on 30 January 2023) and the front-year contract is the Cal24 contract (which expires on 27 December 2023).
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As a result, as of 13 January 2023, any contract with an expiry date between 30 January 2023 and 27 December 2023 is in the scope of the MCM, irrespective of it being a monthly, quarterly, season or yearly contract.
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Throughout 2023, the front-year contract remains the Cal24 contract, while the front-month contract changes every month. Consequently, each month, there would be one less monthly contract caught by the MCM.
RegTrail Insight
It is important to review current positions in TTF derivatives and qualify how those positions are reported. In addition, firms should perform a portfolio stress exercise to simulate the impact on positions and liquidation of those positions should the MCM be activated.
6. Application to options
The application of the MCM to options is not specified in the regulation. The EEX also noted this in their guidance paper discussed above.
ESMA acknowledges that options will add additional complexities in terms of valuing such instruments in case of an activation of the MCM and asks for further clarification on how the bidding limit should be applied as the option prices are quoted in premium (e.g. depending on the strike / maturity, etc.) and not in nominal gas price, as is the reference price.
ESMA considers it useful if clarification could be provided on this aspect of the regulation.
7. Conditions of activation and deactivation
The conditions for activation and deactivation of the MCM are not specified in the regulation.
According to the Regulation, the MCM activation threshold is linked to the level of the front-month TTF derivative settlement price on ICE Endex and its spread with the reference price under Article 4(1) (i.e. when the Settlement Price is > EUR 180 for three working days and Settlement Price > 35 EUR + Reference Price during the same period), while the MCM deactivation threshold is linked to the level of the reference price alone under Article 5(1) (i.e. if, within 20 working days from the occurrence of the MCM or afterwards, reference price is lower than EUR 145 for three consecutive working days).
ESMA therefore notes that, in theory, there could be a situation where the activation and the deactivation conditions are true at the same time, e.g. where the settlement price (based on TTF contracts not subject to the MCM and/or traded OTC) remains higher than EUR 180 / MWh and at the same time the reference price is lower than EUR 145 / MWh.
ESMA considers it useful if clarification could be provided on this aspect of the regulation.
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