Markets View - March 2022

Before getting to this month’s Markets View, we want to acknowledge the Russian invasion of Ukraine. As the war escalates, our thoughts are with all those suffering and their loved ones.

In this month’s Markets View, we look at the disruption to the LME Nickel Market following Russia’s invasion of Ukraine, early experiences of the EU CSDR cash penalties regime, clarifications from ESMA on the trading venue perimeter, proposals for a revamp of the EU EMIR clearing obligation regime, and an early exercise in standard setting for digital climate markets.

Disruption to the LME Nickel Market

Following unprecedented price rises as the world processes the implications of Russia’s invasion of Ukraine, the London Metal Exchange (LME) decided to suspend Nickel trading from 8 March through to 15 March 2022, and retrospectively to cancel a number of trades. The key events unfolded as follows.

On 7 March, in response to price volatility across a range of commodities, the LME sought to maintain market orderliness by introducing backwardation limits and a deferred delivery mechanism for certain contracts.

On 8 March, specifically with regard to Nickel, following unprecedent overnight increases in prices during Asian trading hours, the LME decided to:

• suspend the Nickel market on all of its venues as of 08:15;
• retrospectively cancel all trades executed on or after 00:00 UK time on 08 March in the inter-office market and on LMEselect; and
• temporarily cease publishing Official Prices and Closing Prices for Nickel contracts.

These developments have had a considerable impact on numerous members of the LME and their clients, as well as parties to transactions that use LME’s Official Price or Closing Price for Nickel as a reference price. We have been assisting multiple clients in addressing the implications and continuing fallout. We have prepared a summary note which sets out more detail of the LME’s powers and potential liability for having taken the above-mentioned actions. Please contact Stephen Lock if you would like a copy.

It is taking time for the Nickel market to resume normal functioning, despite the LME’s efforts to manage matters through price limits, delivery deferrals and enhanced position disclosure requirements. The market reopened on 16 March, but trading on LMEselect had to be suspended again for several hours due to an IT system error, which also led to the cancellation of certain trades. Furthermore, because trading hit the pre-set price limits, the LME did not recommence publication of Official Prices and Closing Prices until 22 March. We continue to monitor the situation and offer advice as the course of events evolves.

The EU CSDR cash penalties regime: the view from one month in

It has now been just over a month since the cash penalties regime under the EU CSDR came into force. The cash penalties regime aims to improve settlement efficiency by incentivising participants to reduce the volume of settlement fails. Under the regime, central securities depositories (CSDs) must apply a penalty mechanism for collecting penalties from failing participants and redistribute these to receiving participants. Although the penalties only range from between 0.15 to 1 basis point depending on instrument type, ESMA’s latest market data shows, eg, that settlement failure rates in equities have remained unusually high since March 2020 and so penalties could add up for CSD participants and their clients.

In line with the coming into force of the regime, several industry bodies have updated their guidance for participants on implementing and administering the cash penalty regime. ISLA updated its CSDR Penalties Best Practice Guidelines for the cash penalty regime to reflect comments from its members and to align it with guidance from other trade associations and ICMA has updated its FAQs and Best Practice Recommendations to reflect initial experiences of the regime. These updates reflect that many aspects of the cash penalties regime remain unclear, eg, the regulatory status of cash penalties and whether primary issues are subject to the regime. In summary, market views on such aspects are still developing and so firms should watch out closely for any updates to regulator or trade association-issued guidance.

Given the operational burden of administering such a system, CSD participants and their clients may be considering solutions that avoid or simplify the process of passing the credits and debits arising from cash penalties further down settlement and trading chains, eg, by waiving or netting payments. Firms considering such solutions should pay particular attention to compatibility with applicable inducements or client money rules.

Casting the net wider: ESMA consults on the definition of multilateral systems and the trading venue perimeter

ESMA has published a consultation on its plans to clarify the definition of a multilateral system and the trading venue perimeter under MiFID. While clarification is welcome in this area, it is expected that the proposals would result in a lot more firms being required to seek authorisation. ESMA’s proposals should, therefore, be reviewed carefully by investment firms and market operators currently subject to the MiFID regime as well as by firms that currently consider themselves out of scope.

The main adjustments that expand the scope of the perimeter, and to which firms should give most attention, are:

• Communication tools—Outside of the definition of multilateral systems are general-purpose communication systems that are not governed by rules that facilitate the interaction of trading interests, eg, platforms that just provide pricing data or the general advertising and/or aggregation of trading interests. ESMA considers that systems will facilitate the interaction of trading interests where members can react to those interests. It should be possible to act upon those trading interests and match, arrange and/or negotiate on essential terms (being price, quantity), eg, by including a button, or by providing the ability to communicate. Significantly, ESMA says interaction does not require the conclusion of a contract.
• Pre-arranged transactions—As a transaction cannot be concluded on more than one trading venue at the same time, ESMA considers that systems that pre-arrange transactions which are negotiated as multilateral should be considered as an extension of the trading venue where the transaction is ultimately formalised. In such cases, pre-arranging transactions in a multilateral way is only possible without authorisation as a trading venue when (a) all transactions must be formalised on a trading venue and (b) transactions benefit from a pre-trade transparency waiver. The trading venue must ensure through contractual arrangements that all relevant MiFID requirements are complied with.
• Single-dealer third-party operated RFQ systems—Bilateral trading relationships in FICC markets have become increasingly popular with sell-side counterparties and liquidity providers. However, a single-dealer platform operated by a third party that brings together trading interests, even if it were only to provide clients access to a single counterparty and does not trade on own account, should be regarded as a multilateral system and must seek authorisation as a trading venue.
• OMSs and EMSs—A significant number of market participants are making use of proprietary or third-party systems that support the internal management of orders (OMSs) or their execution (EMSs). OMSs and EMSs that send orders for execution directly to specific counterparties instead of trading venues might be considered multilateral in nature and so in scope of trading venue authorisation, eg, an EMS that allows firms to send RFQs to multiple parties and for interactions of interests in the system.

If firms have any comments on ESMA’s proposals, and we expect many will, then these must be submitted using the form provided on the consultation page by 29 April. Alternatively contact us as we are preparing a response on behalf of a trade association. ESMA will consider the feedback received and publish a final report in Q3 2022. Firms should watch out carefully for this publication as ESMA expects national regulators to require firms to assess their systems against the report and reflect on whether they are operating under the appropriate authorisation capacity.

An EMIR targeted review scopes out the way forward for central clearing in the EU

The European Commission (EC) has published a consultation on measures to improve the competitiveness of EU CCPs and clearing activities as part of a package announced by EU Commissioner Mairead McGuiness to address over-reliance on third-country (read UK) infrastructures. The measures are based around two pillars: (1) growing EU domestic clearing capacity and (2) strengthening the EU supervisory framework.

The consultation asks all interested stakeholders for their views on what the future measures should look like. The measures proposed are sweeping, aimed at widening the scope of participants and products caught by clearing obligations, limiting the use of third-country CCPs, improving the competitiveness of EU CCPs, and giving EU-level supervision a stronger role. The most significant of these measures for clearing participants and their clients are:

• Limiting the use of systemically important third-country CCPs (Tier 2 CCPs)—To reduce the importance of Tier 2 CCPs, the EC proposes measures including a higher risk weight for excessive exposures to Tier 2 CCPs, setting exposure reduction targets, or requiring EU participants to fulfil the clearing obligation only at EU CCPs or non-systemically important third-country CCPs.
• Broadening the product scope of the clearing obligation—To broaden the range of clearing services of EU CCPs, the EC proposes extending to the clearing obligation to existing and additional products.
• Modifying the scope of the clearing framework—In relation to the clearing obligation, the EC proposes introducing incentives (regulatory and otherwise) to encourage more clearing by private entities that do not access CCPs directly, noting that firms such as insurance companies and investment funds access the services of CCPs through a clearing member.
• Empowering EU-level supervision—Supervision of EU CCPs’ compliance with EMIR currently sits with national regulators, to better address risks from increased cross-border clearing, simplify procedures, and remove uncertainties, the EC proposes a stronger role for EU-level supervision, which could involve the allocation of responsibility to a single EU regulator.

Reducing over-reliance on third-country CCPs is clearly a priority for the European Commission as it set a tight deadline of 22 March for responses to the consultation and indicated that it plans to adopt any legislative proposals as soon as Q3 2022.

IETA to map out credibility of digital climate markets as crypto moves mainstream

The International Emissions Trading Association (IETA) has announced the formation of a Task Group to examine trends in digital carbon markets and make recommendations for principles of best practice in the development and use of digital markets and assets for market operators and service providers. The Task Group has been formed in response to the emergence of a wide range of digital assets that have begun trading in voluntary markets and demand from the industry for high integrity principles and practices.

The Task Group will focus its review on the potential of digital tools in monitoring, reporting and verification and providing highly secure, transparent and globally accessible registry infrastructure. It will also focus on digital innovations in asset formation, such as issuing carbon credits in the form of digital credits or native tokens secured on a public blockchain.

From its review, the Task Group will develop a set of recommendations aimed at ensuring broad public and market confidence and high environmental integrity to support the goals of the Paris Agreement. In formulating its recommendations, it will consider:

• the opportunities for digital tools and assets to improve market efficiency and broaden market access to new and developing parties;
• consumer and other risks addressed by digital offerings in providing new market services;
• how digital offerings in the carbon market relate to the international carbon markets envisaged in the Paris Agreement and, more broadly, help deliver the goals it sets out; and
• what market integrity principles and regulatory recommendations should be proposed for digital market participants and service providers.

The consultations of the Task Group are ongoing and it will present its findings and recommendations at a public webinar. The public webinar has been delayed and so interested market participants and service providers should monitor the IETA’s website for further announcements.