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Transaction Surveillance
Monitoring of Market Abuse in the Energy Sector
Transaction Surveillance
Monitoring of Market Abuse in the Energy Sector
In recent years, high profile incidences of market abuse in the wholesale banking and
finance sector have become almost common place. These, in turn, have attracted significant
attention from governments, regulators and the general public, prompting firms to enforce robust
compliance frameworks. In contrast, to date the wholesale energy markets have not received the
same degree of regulatory oversight, although that is now changing. The last two years have seen
the phased introduction of REMIT and EMIR, in addition to extensions of the existing MAD and MiFID
frameworks, all of which result in energy companies facing far greater regulatory compliance obligations.
Furthermore, serious examples of abuse in the energy markets, such as the EU ETS VAT carousel fraud and
more recently, the allegations of price manipulation in the UK wholesale gas market are set to only increase
external scrutiny of the activities of the energy players.
Sarah Benson, of Baringa Partners, explores some of the risks and challenges faced by the Energy Sector.
What
constitutes
market abuse?
At its most simple level, market
abuse is considered to have
occurred where a party has
gained an unfair advantage
through trading off the back of
insider information, exploiting
a dominant market position,
having disseminated false
or misleading information
or through manipulation
of market prices. Different
regulations use slightly
different wording to define
market abuse, but these are
broadly the areas covered.
Within these, there are many
different terms to describe
specific behaviours, such
as spoofing, front running,
parking, ramping, wash trading
etc – all of which are precluded
under regulatory and trading
venue rulings.
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Meeting
regulatory
requirements: Catching up
with Financial Services
It is recognised that there is often a
fine line to be drawn between a firm
taking reasonable commercial actions
to manage a portfolio position, versus
an activity which could be construed
as abusive or manipulative. In addition,
the fact that the regulations are
generally non-prescriptive in precisely
how firms should comply with them,
results in energy companies facing a
great challenge in understanding what
these regulations really mean for them.
There is no doubt that the depth
of oversight and inspection that
regulators exert over energy firms will
increase. However, how can energy
companies themselves keep a closer
view on their own activities, before
it ever comes to the attention of the
regulator?
Viewpoint – Transaction Surveillance: Monitoring of Market Abuse in the Energy Sector
To address this, firms can consider
implementing a Transaction
Surveillance capability. Transaction
surveillance is an operational function
within trading organisations whereby
monitoring is undertaken to identify
unusual patterns in trading or market
behaviour which may be indicative of
market abuse. The function comprises
dedicated resources with the skills,
tools and remit to analyse proprietary
trading and market data in the
detection and prevention of abuse.
The team’s activities are underpinned
by a business process framework
which covers routine monitoring,
investigation and escalation of
potential incidents. Obviously, the
outcomes of their work have high
visibility at Board level within the
organisation.
Figure 1 - Transaction Surveillance Tool
Inputs
Analysis
Alerts
Workflow
Market prices
News items
Scenarios
Transaction
data
Scenario
Thresholds
Order data
Rules Engine
Dashboards
Reporting
Investigation
Notification
Escalation
Reference data
Transaction surveillance functions
have been relatively commonplace in
the financial services sector for many
years. However, with the exception
of some large oil companies, the
capability to perform such surveillance
has to date, been uncommon in the
energy sector.
The approach of compliance teams
varies across firms. At the most basic
level, firms may routinely inspect
simple reports of trading activity
and market prices, or undertake
periodic ‘spot checks’. However, these
approaches are resource intensive and
unreliable due to the high degree of
human interaction and interpretation
required. A more robust approach is
to adopt an automated transaction
surveillance tool, as part of the wider
compliance framework.
Is
Transaction Surveillance
really required?
The challenge faced by energy
companies is that the regulations
give little guidance. So while REMIT
stipulates that firms should not enter
into market abuse, it does not state what
the expectations are in terms of ‘best
practice’ to prevent it, leaving firms with
difficulty as to how they prove that they
are compliant. Ultimately, they need
capabilities which are proportionate
to the risk on their portfolio, but
there is little for energy companies to
benchmark themselves against.
The diagram shows the core functional
components of a transaction surveillance
tool. The tool takes in a series of inputs
relating to market prices, transaction
and order data and applies defined
logic which represents market abuse
scenarios to this data. If an incidence of
suspected market abuse is detected, an
alert is automatically created. This will
feed into a workflow for investigation and
escalation if necessary. Typically, these
tools include the ability to investigate/
drilldown into the incident and ‘market
playback’capabilities.
Nevertheless, there are some areas of
the rulings which are very clear, such
as the fact that firms must not enter
into abusive behaviour (and what
constitutes this is broadly defined) and
that they must submit a Suspicious
Transaction Report (STR) as soon as
they become aware of a potential
incident. If firms are to do this, they
will need to have a robust monitoring
capability in place to identify incidences
of abuse and detect events for STR
reporting, in line with their obligations.
In addition, firms need to consider
the broader implications for their
organisation should there be an
allegation of market abuse made
against them. Reputational damage
can be huge and penalties are
increasingly severe, resulting in large
fines, loss of license to operate or even
imprisonment for senior company
personnel.
Viewpoint – Transaction Surveillance: Monitoring of Market Abuse in the Energy Sector
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Figure 2 - Identification of Unusual Trading Behaviour
Trading activity against time
Number of orders
Average
Transactions
Actual
Transactions
The chart shows how unusual patterns
in trading behaviour can be detected
by comparing against the ‘expected’
trading activity for a given product. In this
example, unusually high trading activity
has been detected. This may indicate an
attempt at market price manipulation,
particularly if it occurs around market
close or a pricing window.
Time
Unusual activity
System
solutions for
Transaction Surveillance
do Transaction
Surveillance tools work?
There are many vendors who provide
packaged solutions for transaction
surveillance. These systems contain
algorithms configured to search for
unusual patterns in trading behaviour.
However, it should be noted that
whilst these vendors and packages
are well-proven in the financial
services sector, vendor knowledge
and exposure to the energy markets
is significantly less. An alternative
to the vendor option is to create a
custom built solution or bespoke
reporting capability. Whichever path
is taken, the transaction surveillance
is complex and challenging to
implement in the energy industry.
Where internal expertise is limited in
this new area, it should be married
with external support. Firms should
look for partners with an extensive
knowledge of the energy regulatory
environment, as well as a solid
understanding of the energy trading
platforms, products and systems.
Automated surveillance solutions
operate by detecting abnormal patterns
in behaviour for a given product,
specifically, by detecting deviations
from the ‘norm’. Trade, order and
market price data is imported into the
application. The tool then runs a series
of algorithms against the data sets
configured with user defined thresholds
and boundaries to identify erroneous
events. If an event is identified
compared to an expected value, an alert
is raised in a workflow management
system for investigation and escalation.
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How
It is essential to have a solid
understanding of the portfolio before
embarking on such an implementation,
to ensure that the most optimal tools are
employed for each product. Surveillance
capabilities often comprise a hybrid
of solutions, tailoring specific types of
monitoring to the characteristics of
different traded products.
Viewpoint – Transaction Surveillance: Monitoring of Market Abuse in the Energy Sector
Challenges
for Transaction
Surveillance in the Energy
Sector
It is likely that many energy firms
will consider adopting some sort of
transaction surveillance capability in
the near to medium term. However,
there are some key challenges that
firms will encounter when applying
these tools to the energy sector:
Low liquidity. Some energy markets,
particularly OTC and contracts
further out on the traded curve,
suffer from low levels of trading
activity. The implication of this is
that it makes it difficult to establish
‘normal’, a meaningful benchmark to
compare data against.
Complexity of energy products.
Trade features specific to the
energy markets, such as overlapping
contract periods, industry
calendars and delivery schedules,
cross-commodity interactions,
spread and structured deals, can
lead to significant effort, and
possibly development work, in the
upfront configuration of the tool.
Under REMIT, there are specific
requirements around the provision
of power and gas scheduling and
nominations data to Agency for the
Cooperation of Energy Regulators
(ACER), which implies they will also
monitor these items.
Cross-market dependencies. In the
energy sector, market abuse can in
principle manifest across multiple
markets due to dependencies on
the availability of the underlying
physical commodity. The Californian
electricity crisis of 2000 was a good
example of this, where traders took
generation assets offline and overbooked capacity during periods
of peak demand, then reaped
the benefits by selling out power
positions on the traded markets.
These scenarios are difficult to
detect because tools are not readily
configured to handle data relating to
physical energy assets.
Availability of resources with
suitable knowledge, both for
implementation projects and
ongoing ‘business as usual’
monitoring activity. This is not just
a challenge for business as usual
Compliance teams, but also for
the IT and vendor implementation
teams who must understand and
implement these solutions.
Changing landscape. Both new
regulations and the market
impact of those currently being
implemented could cause change
in the direction of a project. For
example, it is possible that the
move to centralised clearing of
certain commodity derivatives
through EMIR, could drive a change
in trading behaviour for these
products.
It is also worth noting that these
systems do not currently hold
scenarios or data relating to assetbacked energy positions (i.e. physical
asset and system operating data,
balancing markets, etc), meaning that
detection of market abuse involving
both traded markets and physical
assets simultaneously, cannot be
achieved using these tools as they
stand today.
Viewpoint – Transaction Surveillance: Monitoring of Market Abuse in the Energy Sector
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How
can these challenges
be addressed?
Energy firms shouldn’t be deterred by
the challenges faced when implementing
a surveillance function. There are some
key activities which can be undertaken
to help mitigate these risks.
First, it is necessary to understand the
true compliance risk on the portfolio.
Typically, this would involve upfront
analysis which considers each class of
traded product in the portfolio, and
features of the product which might
make it high risk from a compliance
perspective. This would include the
volume of trading activity, market
dominance, degree of regulation of
the product etc. The types of market
abuse scenario which could realistically
occur on the portfolio should also be
considered at this time. This analysis
phase is a critical step to choosing a
solution which is proportionate to the
needs of the business and should be
undertaken before any system selection
or implementation activities are
commenced.
The findings from the analysis activity
should provide a strong steer regarding
the priority in which to address the
different products, helping to shape
a trade surveillance roadmap. The
roadmap should also take into account
practical delivery considerations. Trade
surveillance is generally going to be
new and furthermore, the complexities
outlined above mean that there is much
benefit in taking a phased approach
to implementation. Typically, this
would begin with a ‘Proof-of-Concept’,
starting with products which are
relatively straightforward to monitor
(e.g. exchange traded vanilla products)
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and on-going tuning until an optimal
configuration is achieved. More complex
products would then be added to the
solution, as processes and know how
become embedded within the business.
Clearly there is a balance to be met
between starting with the simplest
products yet ensuring that areas
with the highest compliance risk
are addressed first. In practice, it
is likely that at least some of these
simple products will have the highest
compliance risk or regulatory oversight
associated with them, reinforcing the
prioritisation of the roadmap.
The phased implementation approach
also gradually builds the knowledge
and skills of the team. In addition, it
gives a degree of flexibility should the
prioritisation change at a later date, be it
due to an evolving regulatory landscape
or a change in internal prioritisation.
There are, of course, other beneficial
reasons to consider transaction
surveillance. The presence of such
a capability within an organisation
demonstrates to regulators and
counterparts, a commitment to the
detection and prevention of market
abuse by the organisation. It also
acts as an internal deterrent – the
knowledge that trading activities
are being monitored will most
certainly make traders more cautious
about their behaviour. Finally, trade
surveillance tools hold a wealth of
data about patterns and trends in the
traded markets. This information can
be exploited for commercial analysis,
empowering an organisation with a
deep source of market intelligence
which can be employed by many
functions within the business, not just
the compliance function.
Viewpoint – Transaction Surveillance: Monitoring of Market Abuse in the Energy Sector
The
outlook for Transaction
Surveillance in Energy
There is no doubt that the increasing
regulatory oversight that the energy
sector is receiving will drive firms to
increase the size and capabilities of their
trading compliance functions. Part of this
strengthening in capability will inevitably
lead firms to consider automated
surveillance as one of the tools in their
compliance operating models.
The challenge will be to know what
solutions are the most appropriate and
pragmatic. A lack of familiarity in using
surveillance in the energy sector, means
that firms may be reluctant to be the
first to lead the way, and will choose to
wait for a critical mass to be established
before embarking down this route. The
depth of capability that they decide to
adopt depends on where they want
to be on the compliance spectrum. At
one end, they may choose to meet just
the minimum regulatory requirements,
such as the trade clearing and reporting
requirements stipulated by EMIR and
REMIT. At the other, there may be a
clear commitment from the firm to
demonstrate best practice to regulators,
customers and counterparties, building
comprehensive capabilities but requiring
deeper investment. In practice, firms
will likely find their corporate appetite
lies somewhere in between these two
extremes, but before they can decide,
they must develop a good understanding
of where specifically the regulatory risk
lies in their portfolio and hence, the
depth of capability they require.
Figure 3 - Surveillance across the Trading Lifecycle
Transaction Surveillance uses data from across the full trading lifecycle to search
for unusual patterns in behaviour, with a view to identifying potential incidences
of market abuse. Furthermore, this data and analytics can be a powerful source of
market intelligence for use by other business functions.
Market
Data
Trade
Execution
Trade
Management
and
Settlement
 Market prices
rder
O
cancellations and
amendments
 T rade
cancellations and
amendments
 Number/ size/
velocity of Orders
 Number/ size/
velocity of Trades
 Market
positions
Logistics
 Nominations
 C apacity
positions
Risk and
Middle
Office
Finance
and
Credit
 Positions and
movements
between books
 Counterparty
data
 PnL movements
and spikes
business data
Transaction Surveillance
Unusual Trading behaviour
for investigation
Equally, the energy sector is unfamiliar
territory to many of the vendors who
offer transaction surveillance tools.
Vendors will need to explore methods
of introducing their products to players
in the energy markets and build
the confidence of potential clients
considering these solutions. Partnerships
are likely to form between transaction
surveillance vendors and vendors of
energy trading and order management
systems, to enhance the capabilities and
offerings of both parties.
Business Monitoring
Market Intelligence to support
business strategy and operations
Baringa Partners’ Energy and Commodities Markets business has a strong
track record working with numerous companies in the international
commodities trading markets. Our capabilities and experience extend
across gas, oil, power, coal, carbon, metals, and soft commodities
markets. Our clients in the trading space comprise energy majors,
oil majors, investment banks, regional utilities and funds.
Viewpoint – Transaction Surveillance: Monitoring of Market Abuse in the Energy Sector
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For more information please contact:
[email protected] or
Sarah Benson, Senior Manager
+44 7905 129 108
About Baringa Partners
Baringa Partners LLP is a management consultancy that specialises in the energy,
financial services and utilities markets in the UK and continental Europe. It partners with
blue chip companies when they are developing and delivering key elements of their
business strategy. Baringa works with organisations either to implement new or optimise
existing business capabilities relating to their people, processes and technology.
In 2012, Baringa was named as the Best Place to Work in the UK for the third
consecutive year, and fifth in Europe, by the Great Place to Work® Institute, as well as
winning The National Business Awards Employer of the Year category, reaffirming its
status as a leading people-centred organisation. Baringa Partners is also Energy Risk’s
Consultancy Firm of the Year for 2012 and won the Commodity Business Award for
Market Policy and Advisory.
Baringa Partners LLP, 3rd Floor, Dominican Court, 17 Hatfields, London SE1 8DJ
T +44 (0)203 327 4220 F +44 (0)203 327 4221 W www.baringa.com E [email protected]