Energy and Power Market Manipulation: Surveillance with a Regulatory Perspective
Data is the lifeblood of market surveillance. Commodities regulators gain insight into activity by analyzing market data from exchanges and swap platforms, and they have some visibility into the number of participants and trading volume in index benchmark-setting processes. Moreover, energy regulators have data on supply that goes through wires and pipelines. But that only tells part of the story. Companies, on the other hand, have a perfect view because they have data on customer orders as well as cash transactions in the physical markets and futures trades.
Producer hedging activity is of particular concern to energy and commodities regulators because it’s hard for them to tell if a company’s derivatives position is benefiting from its physical trading activity. If the CFTC has reason to suspect manipulation, it can issue a “Special Call,” or what some call a Wells Notice, for more data that will explain certain market behavior. Similarly, FERC can issue a “voluntary request.” When a major event occurs, they may open a joint investigation and ask for subpoena authority.
When a company gets a Special Call from the CFTC, it’s expected to promptly provide detailed books and records (trade data, including financial contracts for hedging and speculation purposes, as well as transportation and storage contracts and cash deals). In a case involving power, the CFTC would likely call for data on capacity and retail deals. The regulator’s goal is to understand the portfolio on the same level as the trader and to have data for anything in your books and records that can conceivably impact a position’s exposure to a change in price. Ultimately, they want to identify evidence of incentive for manipulation; and that is most often reflected in a benefitting index position.
Sparking an investigation
The power market is a scarcity-based model, not a utility reliability-based model. Consequently, extreme events can lead to volatility and extreme price excursion. In February 2021, a deep freeze in Texas led to a massive power failure and sent energy prices skyrocketing. In this example, the market design following deregulation had a role to play.
An event that causes extreme volatility would likely be a ripe time for a form of manipulation called momentum ignition, where a participant’s activity causes a price to move outside the normal range of volatility for that instrument and exacerbates the price movement by inducing other participants to follow the ignited price trend. This is usually executed through orders not intended to trade but have the desired effect of triggering participants to join the price run up or down. In fact, it is often algo trading models that are induced and triggered into joining the trend. There were many momentum ignition scenarios that occurred during April 2020 when Cushing Crude went into negative $36/bbl prices. The regulators would investigate whether anyone was trying to give misleading indications of demand so they could profit from the price distortion.
Today, there is much more inter-agency cooperation.1 There would be a study explaining what happened during the period, who was acting in the market at the time, as well as who benefited and who lost out. The investigation would delve into the relationship between the physical and derivatives markets. The follow-up to these studies would be to then identify the outlier participants to become the center of a regulator’s attention.
The problem is the model itself. The U.S. doesn’t have a wholesale price gouging parameter, and no one sets a maximum price on energy commodities. Power reflects the gas price, which can vary significantly, especially during extreme weather events that result in scarcity. Drawing a line between manipulation and market design is complicated because traders execute transactions at prices that generate shareholder value, and they don’t necessarily concern themselves with the impact on consumers.
That’s where compliance comes in. Compliance needs to determine whether a certain price is reasonable rather than merely desirable and then decide whether to act internally.
Compliance is your friend. Really.
Every day, traders put their own reputation and their company’s reputation on the line. Compliance shouldn’t be viewed as an adversary because it’s there to protect both parties. You’re only allowed to be in business because you’re compliant.
Instilling a culture of compliance, where integrity trumps profit, helps to avoid legal action, fines and penalties. The relationship goes two ways. Traders should be able to explain changes in the P&L, and compliance should have a clear understanding of traders’ portfolios and know when someone is enhancing the value of a position.
The first rule of trading is “know thy position.” Traders may be uncertain of a price at certain times because energy prices can be extremely volatile. But not knowing the direction of their position and how much risk they have on the book should cost them their job. When traders are long in the physical market, they shouldn’t be buying index derivatives priced from that physical product and vice versa. Further, the act of injecting a trader’s speculative position into an energy benchmark’s formation interferes with the fundamentals of supply and demand.
An automated surveillance solution is the best tool for creating this understanding because it provides both visualization details of the orderbook and a play-by-play breakdown of what the trader saw on the screen at that point in time. It is essential to reconstruct the order book and base alerts on that level of detail. Most of the more sophisticated and clever manipulation occurs with a bad actor leaving fingerprints behind in both orders and trades, not by trades alone. Furthermore, regulators aren’t just going to ask for yesterday’s trades or last week’s trades. They may ask to review activity from up to two years ago, and they’re going to look for patterns that indicate benchmark manipulation, such as trading during a settlement period or spoofing to send false price signals to the market.
Robust compliance processes, procedures and automated controls can prove to be very valuable should there ever be an unfortunate instance of market manipulation within a company’s trading operation. It’s a necessary form of insurance to help prevent irreparable damage. Importantly, the regulators are unlikely to go light on a company that fails to have these controls in place.
1. This level of US government agency cooperation between FERC and CFTC has become standard practice ever since the Brian Hunter/Amaranth NatGas case of 2009. (Reuters, 2014. Timeline – Amaranth’s Brian Hunter settles with U.S. CFTC). The prosecution against Hunter was partially hobbled because the two agencies were not coordinating their prosecutions. It resulted in very modest fines against both the trader Hunter and the Amaranth firm. Since then, FERC and CFTC investigations and collaboration on data are much more closely aligned with the goal to achieve more successful prosecutions.
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