Markets View – November 2022 (part 2)

Welcome to the Part 2 of the November edition of Markets View. Regulators on both sides of the Channel have clearly been busy with markets-based initiatives, which will be more trick than treat for some. In this bumper issue, we look at IOSCO's consultation on developing sound carbon markets, the FCA's consultation on the trading venue perimeter, ESMA's call for evidence on pre-hedging, the FCA's Market Watch 70 on market conduct and transaction reporting issues, ESMA's proposals to address high prices and volatility in energy derivatives markets, the Bank of England's (BoE) proposal to modify the derivatives clearing obligation (DCO) to reflect USD interest rate benchmark reform and ESMA's updates to its Q&As on commodity derivatives and market structures topics.

We hope you enjoyed Part 1, which we published earlier this month. Please now find Part 2 below. The full version of Markets View - November 2022 can be accessed here.

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

IOSCO consults on the development of sound carbon markets

On 09 November 2022, coinciding with the COP27 meeting in Egypt, IOSCO published Consultation Report CR/07/22 with recommendations for establishing sound Compliance Carbon Markets (CCMs) and Discussion Paper CR/06/22 with key considerations for enhancing the resilience and integrity of Voluntary Carbon Markets (VCMs). Comments on each of the papers must be submitted by 10 February 2023. This will be of interest to current and future participants in the carbon markets.

The Compliance Carbon Market Consultation draws on experience with established emissions trading schemes as well as commodities markets, to make 12 recommendations for the smooth functioning of both primary and secondary emissions allowances spot and derivatives markets.

The Consultation helpfully touches on the key features of the main schemes in the EU, UK, California, the Regional Greenhouse Gas Initiative (RGGI) in the US and China. It also discusses past and current weaknesses in the design of these market, including:

• concern that free allocation of emissions allowances can result in those operators having no incentive to participate in the Compliance Credit Market;
• oversupply of emissions allowances - either by local overallocation or through allowing interoperability with offset markets - leading to low carbon prices;
• lack of consistent and accurate calculation of emissions leading to failure of demand and supply dynamics; and
• policy decisions on issuances and allocations impacting on price.

IOSCO's first 7 recommendations focus on the primary market and on ways to improve price formation and transparency. So for instance, the second recommendation is that auctions should be preferred to free allocation and Recommendation 4 calls for predictable market intervention mechanisms.

There has been much recent debate on the participation of financial market participants in the compliance markets. IOSCO presents data showing a marked increase in interest.  It points to several positive features of the secondary market.  For IOSCO, the secondary market:

• provides the ability for non-compliance firms to access emission allowances.
• provides a hedging mechanism for firms and energy generators against future price volatility
• by allowing hedging of risks, aids in the deepening of market liquidity in such products
• signals a price that allows for firms to make more informed investment decisions on their carbon output.

In Recommendation 5, IOSCO proposed that non-compliance firms should participate in primarymarkets to facilitate market making, access to the markets, carbon financing, the provision of liquidity, and price formation mechanisms.

There are 5 further recommendations to strengthen the secondary markets. These cover position management controls, transaction reporting and regulation and supervision of trading venues.

The 8 questions for consultation include questions on whether and how to link compliance carbon frameworks, given the Article 6 negotiations, and on whether certain IOSCO principles for secondary markets and for commodity derivatives markets, such as those on transparency, position limits, market abuse and market surveillance are appropriate for, and should be extended to CCMs. Responses will be used to further refine IOSCO's 12 recommendations for CCMs.

The Voluntary Carbon Markets Discussion Paper is the result of an IOSCO fact-finding exercise on voluntary carbon offsets. It puts forward considerations for the improvement of market integrity while acknowledging that its work is only one part of the overall change needed in voluntary carbon markets to ensure sound and well-functioning markets in which investors can trust. IOSCO also asks for comments on whether it should cooperate with private initiatives such as Integrity Council for the Voluntary Carbon Market (ICVCM) and Voluntary Carbon Credits Integrity Initiative (VCMI).

Having consulted with many different market participants and commentators, IOSCO concludes that there are three obstacles to the scaling of voluntary carbon credit markets:

1) the environmental integrity of the carbon credits at project level;
2) the structure of the market, and certain market participants' behaviour; and
3) The risk of greenwashing

As for environmental integrity, there is general concern about the lack of standardized methodologies to measure additionality of projects, to avoid double counting and leakage of carbon, to ensure the permanence of the reduction or removal of greenhouse gas emissions or manage non-permanent reductions or removals, to assess co-benefits (like community impacts) and generally to ensure adequate verification and transparency.

IOSCO notes that there is no regulatory oversight of voluntary carbon credit markets and no clarity on the legal treatment of carbon offsets as of yet. This, together with the dearth of information on the market and lack of standardisation of carbon credits or documentation, affect market integrity.

IOSCO puts forward the following key considerations:

1) Open access: broad access to a trading market promotes price efficiency and fairness, liquidity and efficiency so access criteria should not be too restrictive
2) Market integrity: To promote market integrity. IOSCO advocates the adoption of several features well known in regulated markets, such as the dissemination of rules, policies and procedures setting out criteria for issuing offsets, market admission criteria and dispute resolution mechanisms; market surveillance and trade monitoring, market participation criteria such as adequate resources and staffing.
3) Publicly available data to promote transparency: IOSCO calls for appropriate levels offundamental market data disclosure to promote price discovery. It also emphasizes accurate disclosure by companies who rely on carbon credits to offset their emissions to achieve net zero emissions.
4) Price discovery. Pre- and post-trade transparency should promote price discovery in the voluntary carbon markets.
5) Product standardization/Environmental integrity. To ensure a robust and liquid market for carbon credits, market participants must be confident that each carbon credit purchased in the VCM accurately represents such emissions reduction or avoidance to meaningfully reduce GHGs.
6) Interoperability. Interoperability of offset registries would be useful. A global registry akin to the Climate Warehouse Initiative under current development, would help address the fragmentation risks stemming from multiple offset issuers maintaining separate registries for their respective programs.
7) Financial integrity of transactions, including settlement and delivery certainty. IOSCO advocatestrade monitoring programmes which include the capacity to detect abnormal price movements, unusual trading volumes and impairments to market liquidity. In addition, it supports the imposition of minimum financial standards on financial intermediaries. It also requests an audit trail helps to detect and deter customer and market abuse.
8) Legal certainty. We agree with IOSCO's call for legal certainty as to the bankruptcy treatment for carbon credits, netting provisions between counterparties, conflicts of laws, and forms of legal documentation, among other aspects of these markets.
9) Governance. The call for appropriate governance of voluntary carbon markets makes perfect sense.
10) Conflicts of interest. IOSCO draws attention to (obvious) conflicts between issuing the carbon credits, operating the trading platform and participating in the market and calls for these to be addressed.
11) Enterprise risk management. And finally, IOSCO turns to the individual company level and calls for the implementation of effective risk management programs.

Excessive volatility and increasing margin levels in EU energy derivatives markets

Following a request from the European Commission, ESMA has set out its proposals for addressing excessive volatility and substantial margin increases in energy derivatives markets, which should be carefully considered by participants of these markets and CCPs who clear related trades.

• Circuit breakers. To contain "excessive volatility" in the energy derivative markets, a new temporary type of trading halt mechanism is proposed that would apply in exceptional circumstances, eg, volatility spikes leading to disorderly trading conditions. The mechanism would be set at EU level and apply to all venues offering trading in energy derivatives. The intention is that pauses in trading would support a more orderly price discovery process during periods of stress. However, there is a risk that such a halt may affect market participants' ability to manage risk exposures, which ESMA is alive to. Given current levels of volatility reflect market fundamentals and lack of information rather than a failure of existing mechanisms, ESMA's desire and ability to intervene is limited.
• Margins and collateral. To help non-financial clearing members (NFCs) secure sufficient liquidity to meet increased margin requirements, but without undermining the stability of CCPs and the financial system, ESMA proposed a cautious easing of margin eligibility requirements, dismissing any significant relaxation of the rules. In its Final Report, ESMA proposes a draft RTS amending EMIR (i) making uncollateralised commercial bank guarantees eligible specifically to help NFCs acting as clearing members and subject to strict conditions, such as time and concentration risk, and (ii) enabling guarantees issued or backed by public entities to qualify as eligible collateral subject to a number of conditions, such as the type of public entity. 
• Regulating commodity traders as investment firms. NFCs trading commodity derivatives currently benefit from the ancillary activities exemption from MiFID2. ESMA suggested revising or replacing this exemption, particularly for the biggest entities, so that such firms would need to be licensed and supervised as investment firms. This change would have a major impact on the largest NFCs trading commodity derivatives, which would need to comply with the increased burdens of MiFID authorisation and satisfying the capital requirements of the EU investment firms' prudential regime under the IFR. Any changes, however, would likely take too long to implement to relieve the market pressures expected this winter.

In addition, ESMA recommended measures to increase transparency in energy markets by improving NCAs' visibility of OTC transactions, so they can better assess exposures and risks, and by subjecting physically-settled wholesale energy products traded on OTFs to transaction and position reporting requirements (to NCAs and ESMA). None of these measures, nor the measures listed above, though, are likely to be a silver bullet for solving the immediate challenges facing European energy markets and their participants.

At a glance...

BoE modifies DCO to reflect USD interest rate benchmark reform

The BoE published a Policy Statement on its proposal to modify the scope of contracts subject to the DCO under UK EMIR, which is relevant to all financial and non-financial counterparties subject to the DCO as well as to CCPs. Implemented through amendments to the onshored BTS 2015/2205, the BoE's final policy added SOFR overnight index swaps with an original maturity between 7 days and 50 years to the DCO from 31 October 2022. In order to align with the date of CCPs' contractual conversions of USD LIBOR contracts, contracts referencing USD LIBOR will be removed from the DCO on 24 April 2023. Several CCPs have already issued details of their plans for these contractual conversions, eg, LCH will convert contracts over 22-23 April and 20-21 May 2023. The specific dates on which each of the modifications to the DCO will come into force are set out in the final UK Technical Standards instrument.

Updates to ESMA's MiFID2 and MiFIR Q&As on commodity derivatives and market structures topics

ESMA published an updated version of its Q&As on MiFID2 and MiFIR commodity derivatives topics mainly to reflect changes to the MiFID2 commodity framework introduced by the Capital Markets Recovery Package. The main changes to the EU commodities derivatives framework, include:

• Position limits - Limiting position limited to agricultural commodity derivatives and to significant or critical contracts and introducing new exemptions to the position limits regime.
• Ancillary activity - Amending the criteria to be met for the ancillary activity exemption and deleting the yearly notification of eligibility by market participants to relevant NCAs.
• Securitised derivatives - Excluding securitised derivatives based on commodities or commodity indices from position reporting and position limits.

ESMA also published an updated version of its Q&As in respect of market structures topics. Adding Q&A 35 to Section 2 on Direct Electronic Access (DEA) and algorithmic trading, ESMA clarifies that a trading venue may set instrument-level trading hours for a specific sub-set of financial instruments (or for a specific financial instrument), provided that details of the specific trading hours are made public and communicated by the venue to market participants.