Markets View – Summer Update 2023

As we enter the summer there's still plenty happening in the regulatory space for markets. This month we look into the detail of a hefty FCA fine for compliance failings, new requirements that are surprising derivatives traders in European energy markets, as well as the most exciting recent developments around the compliance and voluntary carbon markets.

As always, please do reach out to us with any feedback or questions. 

Know Your REMIT

Not all regulatory changes get a clear signposting. Financial services firms who have accessed trading in wholesale energy derivatives on EU exchanges via DEA (without having their own membership) have come in for a surprise at the hands of ACER, the EU's Agency for the Cooperation of Energy Regulators. Previously comfortably outside the reach of REMIT - the EU regulation designed to prevent market abuse in the wholesale energy market - these firms now find themselves dragged into the fold.

So, what's changed? ACER recently made a subtle amendment to its Transaction Reporting User Manual (TRUM), eliminating a carve-out that applied to trades filling the following criteria:

• derivatives based on electricity or natural gas produced, traded, delivered or transported in the EEA;
• conducted on an exchange through another firm's membership, rather than their own; and
• that were either financially or (provided the relevant firm did not have arrangements to make/take delivery) physically settled.

The effect is that firms trading certain derivatives are now 'market participants' within the scope of REMIT, and so under an obligation to register with a relevant EU national authority. ACER expects compliance with the new guidance by (a loosely defined) 'mid-2023', so affected firms should act swiftly to understand their position.

What next? We anticipate that a number of firms will be obliged to register as REMIT participants for the first time following the TRUM update. This which will involve identifying a suitable Member State to register in and making the necessary filing with the relevant local regulator. We have been advising several clients on their REMIT registrations over the past few weeks; please feel free to reach out if you would like further guidance.

Finally, as a heads-up for all firms within REMIT's purview: keep an eye on the Commission's proposal currently making its way through the EU Parliament and Council, that has the potential to make a number of alterations to REMIT off the back of the recent turbulence in European energy markets. We're keeping a close watch on this one as it works through the legislative process, so stay tuned.

CJA Insider Dealing Regime Overhaul - That's MAR Like It

The Insider Dealing (Securities and Regulated Markets) Order 2023, effective since 15 June, brings the scope of the criminal offence of insider dealing under the CJA 1993 in line with the civil regime set out in UK MAR. This change follows the joint HMT / BoE / FCA Fair and Effective Markets Review in 2015 into structural risks in the FICC markets.

How we got here. Both the CJA and MAR list the securities and markets on which the insider dealing offence can be carried out. Historically, the lists under the CJA have been much narrower than the UK MAR equivalents, leading to a gap in respect of securities or markets that the CJA didn't cover, and some markets that 'fell off' the CJA's list over time simply because they'd changed their name.

Overall, following the changes, the CJA regime captures trading:

• in MiFID financial instruments covered by MAR - previously, securities such as currency options, CDSs and units in collective investment undertakings were out of scope;
• on trading venues covered by MAR, i.e. UK, EU and Gibraltar regulated markets, OTFs and MTFs - this replaces the CJA's previous reliance on a list of named venues; and
• on 3 other venues (NASDAQ, SIX Swiss Exchange and NYSE) due to particular trends around UK insiders disclosing information relating to securities traded on them.

Key takeaways. The Treasury has noted that, on the basis firms should already complying with UK MAR, this expansion of scope under the CJA should not impose any additional costs. However, firms should still bear in mind the possible need to update policies and procedures accordingly.

Cum-Ex Raiding - the FCA Issues its Biggest Fine to Date

Attention compliance teams! The Financial Conduct Authority has come down hard on ED&F Man Capital Markets Ltd (MCM) for oversight failures in cum-ex trading, handing the firm a £17 million fine. Cum-ex trading, which exploits value differences between shares with and without dividends, has been under scrutiny in many jurisdictions for potential tax abuses. MCM was found to have collected around £5 million in fees for trading strategies that facilitated illegitimate withholding tax ("WHT") reclaims from Danish authorities. The FCA found that WHT totalling £20 million had been reclaimed despite the fact MCM's clients had not owned or borrowed any shares, received any dividends, or paid any taxes.

This case marks the largest fine meted out by the FCA to date in the cum-ex trading arena, considering the severity of the breaches and the significant revenue involved. It's important to note that the fine includes a 30% settlement discount, which brought it down from around £22.5 million.

What happened? The FCA's account points to various shortcomings. While MCM possessed tax and legal opinions supporting their strategies, they are said to have lacked robust systems and controls to ensure these opinions were available and remained relevant. Compliance also faltered in monitoring and reviewing MCM's trading activities and neglected to consider associated risks. The responsible Board Member was also deemed to have an inadequate grasp of the strategy, meaning they were unable to provide meaningful oversight or challenge. As a result, MCM was found to have breached FCA Principles 2 and 3 (requirements for firms to conduct business with due skill, care and diligence and to take reasonable care to organise and control their affairs, respectively).

Lessons learned. MCM's example serves as a poignant reminder of the vital role played by Compliance functions in ensuring firms have adequate systems and controls in place when relying on legal advice. Firms must ensure that they are capable of:

• checking that any legal advice is both available and up-to-date;
• confirming that it aligns with their trading (and other) strategies; and
• promptly identifying and addressing any questions or concerns.

Importantly, legal advice does not absolve firms of their responsibilities; they should still have a solid understanding of their trading strategies and continually monitor and review any trading undertaken. The FCA's ruling aligns with its approach to combatting financial crime, as outlined in Market Watch 52. Ultimately, tackling financial crime clearly remains a burning topic for the FCA, with it accounting for 14% of their regulatory enforcement cases for the 2021/2022 period. Clearly, this issue is here to stay.

EU ETS - Capping It Off

Recent developments in the EU's Emissions Trading System (EU ETS) are set to have a significant impact on financial services companies involved in trading emission allowances or invested in the growing list of industries that are subject to mandatory emissions caps.

Since 2005 the EU ETS has been a cornerstone of the EU's efforts to reduce greenhouse gas emissions. Under the system, certain energy-intensive companies (Operators) are subject to an annual cap on their greenhouse gas production, which reduces each year. Every year, Operators must surrender enough "emission allowances" to cover the emissions they produced, otherwise they face penalties. Holding of allowances isn't limited to Operators - other firms can and do hold accounts to trade them (and derivatives thereof) as MiFID financial instruments. But it's the Operators who must have them, and who acquire them either through free allocations (where applicable), participation in auctions, or trading with intermediaries or other Operators on applicable exchanges.

What has changed? In response to growing climate concerns and increased government-level commitments, the EU has brought in proposals to beef up its own carbon reduction targets - the "Fit for 55" package, so-called because it targets emissions reductions of at least 55% by 2030). To that end, several instruments that result (or will result) in a profound upgrade to EU ETS have recently been published, including:

• an Amending Directive to the EU ETS itself;
• an Aviation Amending Directive affecting the application of the EU ETS to aviation;
• a Maritime Regulation which tweaks the EU ETS in the context of newly-covered maritime transport activities; and
• a 'CBAM' Regulation, which, in parallel to EU ETS, from 2026 will phase in a "carbon border adjustment mechanism" requiring certain Operators to account for embedded emissions in products imported into the EU.

The new rules make several targeted changes that will alter the shape and feel of EU ETS. For instance, the legislation:

• decreases the total cap on emission allowances available per year through two one-off reductions (in 2024 and 2026),
• accelerates the rate at which the cap decreases year-on-year
• broadens the scope of the ETS to include emissions from the maritime transport sector from 2024,
• sets up a whole new ETS for carbon emissions from road transport and heating fuels from 2027.
• takes important steps towards phasing out free allowances for "hard-to-mitigate" polluting industries. There are various parts to this, including a phasing out (from 2026) of free allowances for certain Operators in tandem with the phasing in of the CBAM Regulation; we're also seeing a transition to full auctioning in the aviation sector from 2026; meanwhile the new maritime, road transport, and buildings sectors will have no free allowances from the get-go.

Just as interestingly, the Amending Directive also flags a number of areas for the Commission's future consideration, indicating that further changes may be just around the corner. Issues include how to account for "negative emissions" (greenhouse gases permanently removed from the atmosphere), whether to lower the thresholds for currently in-scope activities (thereby growing the pool of Operators), and whether to expand EU ETS coverage into yet more sectors.

Immediate Thoughts. The new package of changes is enormous, and some elements will take years to come to fruition. What is already clear, though, is that it represents a real step-change and shows how central EU ETS is to the EU's carbon reduction plans. As the number of Operators grows and the emission caps and free allocations dwindle, many polluters will increasingly feel the pinch, while firms trading allowances will undoubtedly see plenty of new opportunities.

CIX: (Carbon) Credit Where It's Due

One recent snippet that caught our eye in the dizzyingly fast-changing world of voluntary carbon markets was the launch this month of CIX, a new Singapore-based global exchange for two-way spot trading of voluntary carbon credits.

There has been a lot of talk in recent years about 'scaling' the voluntary carbon markets, to unleash perceived demand from individuals and companies who are concerned about climate change and seeking to mitigate their own impact. This is an example of the product being brought, quite literally, to market.

Currently, CIX are only making one standardised contract available for trading (CIX Nature X, or CNX), a curated basket of REDD+ projects registered with Verra. Each available contract lot represents 1,000 metric tonnes of CO2 equivalent, giving an indication of the size of market players they are targeting. We can see there is also a facility for users to register privately negotiated transactions, allowing them to engage in off-exchange trades whilst ensuring compliance with market regulations. It's a complex framework, clearly designed in anticipation of voluntary carbon trading going mainstream.

Even so, these are still early steps down the road of 'scaling up', with plenty of obstacles for stakeholders of all kinds. There continue to be questions around the true environmental value of such credits - with Verra in particular taking a lot of recent flak. We can see this is impacting trading prices and volumes. Meanwhile, the space for market operators like CIX is becoming increasingly congested, as they jostle for position alongside existing players like ACX (also in Singapore) and CBL in the US. But if firms can lay the right foundations, the potential for growth remains staggering. All in all, the number of moving parts makes this a fascinating space to watch, and we'll be keeping a keen eye as the commercial and regulatory dynamics in this nascent industry continue to evolve.

If you are interested in trading voluntary carbon credits (or, for that matter, emission allowances in the compliance markets or any other regulated instruments), then you may be aware we have developed a tool called Trading Venue Reviewer, which is packed full of readily-digestible and cross-comparable information to help you navigate and comply with the contractual and regulatory obligations when using trading venues. If carbon trading is really your thing, then we've even put together a specific package which gives you access to the carbon markets we currently cover on the tool in one place (not including CIX - yet!).

We are also excited to announce a brand new tool we are working on, called Carbon Reviewer, which answers all the big questions (practical, legal and otherwise) around trading in compliance and voluntary carbon instruments across multiple jurisdictions. We already have working demo materials which we'd be delighted to share. Please reach out to Rosali Pretorius if you would like more information.