EU May Impose Limits on Commodity Swaps, High-Frequency Trading

The European Union may impose position limits for commodities derivatives and curbs on high- frequency trading as part of plans to overhaul the region’s financial-market rules.

The European Commission, the 27-nation EU’s executive arm, is seeking limits on the number of commodity derivative contracts “any given market members or participants can enter into over a specified period of time, or alternative arrangements” with the same impact, according to copies of proposals set for release on Oct. 20 that were obtained by Bloomberg News.

French President Nicolas Sarkozy has demanded steps to curb commodity derivatives speculation, which he blames for driving up world food prices. He has made the issue a priority of France’s presidency this year of the Group of 20 nations.

While it is “arguably necessary” to take drastic. preventative measures in certain extreme market conditions, this “must be balanced against the adverse consequences that will be caused,” Etay Katz, a regulatory partner at law firm Allen & Overy LLP in London, said in an e-mail.

“Such interference can be highly disruptive, costly and a crude measure to crack down on potential actions of a small minority of market participants,” Katz said.

High-frequency trading firms would be forced to better manage their risk and will be banned from some practices under next-week’s proposals, that will also include draft laws toughening market-abuse sanctions.

High-frequency traders came under increased regulatory scrutiny following the so-called flash crash in May of last year, during which the Dow Jones Industrial Average briefly lost almost 1,000 points.

Flash Crash

The flash crash “alerted regulators to the potential for some trading behavior to seriously disrupt markets,” Richard Reid, the International Centre for Financial Regulation’s director of research, said in an e-mail.

Mary Schapiro, the chairwoman of the U.S. Securities and Exchange Commission, and regulators from the U.S., Europe and Asia discussed high-frequency trading practices at a London meeting on Oct. 14.

Under the plans for commodity derivatives, the EU would have the power to set the same position limits across the entire region if it felt that curbs put in place by national regulators were not working. The rules would help tackle “excessive” price volatility for commodities, according to the EU documents.

‘Little Convincing Evidence’

While Sarkozy has pressed for greater regulation of commodities, the Institute of International Finance, an association representing global lenders, said last month that there was “little convincing evidence linking financial investment with trends in commodity prices and volatility.”

The influence that commodity derivatives have over “energy and food” prices mean that “clear quantitative thresholds” are needed for trading, according to the draft EU rules.

The EU proposals would empower national regulators to set position limits for other kinds of derivatives. The European Securities and Markets Authority would give opinions on whether national measures are justified.

The draft rules are part of a broader overhaul of the EU’s Markets in Financial Instruments Directive, or Mifid, and tougher legislation on EU-wide sanctions against market abuse, scheduled to be published the same day.

Abusive Behavior

Algorithmic and high-frequency trading can give rise to risks such as systems “overreacting” to market events and causing “volatility” according to the draft EU measures. These types of trading can also lend themselves to “certain forms of abusive behavior if misused.”

Planned measures include requiring high-frequency trading firms to prove that they have sufficient risk controls in place and to ensure that clients with direct access to the markets are “properly qualified.”

“Detailed organizational requirements regarding these new forms of trading” will be set out in subsequent EU laws, according to the documents. The EU also plans to list specific examples of trading strategies that should be banned and punished by regulators as market manipulation.

On market abuse, the EU proposals include ensuring that firms found guilty of illegal practices can be fined up to ten percent of annual sales, and that criminal sanctions can be used against traders.

‘Harder for Criminals’

“With minimum EU-wide rules against market abuse, the commission will make it much harder for criminals to get away with insider trading and market manipulation,” Viviane Reding, EU justice commissioner, said in an e-mailed statement.

The documents also include measures to push trading in so- called over-the-counter derivatives onto exchanges and other regulated venues, in line with agreements reached by the G-20, as well as rules designed to increase competition in trading and clearing services.

The draft laws would require exchanges to provide rival clearinghouses with the data they need to process trades. They would also mandate “non-discriminatory” access for clearers and trading venues to “indices and other benchmarks” used to determine the value of financial instruments.

Chantal Hughes, a spokeswoman for EU Financial Services Commissioner Michel Barnier, declined to immediately comment.

To contact the reporters on this story: Jim Brunsden in Brussels at bmoshinsky@bloomberg.net.

To contact the editor responsible for this story: Anthony Aarons at aaarons@bloomberg.net

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Nicolas Sarkozy

Michele Tantussi/Bloomberg

Nicolas Sarkozy, France's president, speaks during a news conference at the Federal Chancellery in Berlin on Oct. 9, 2011.

Nicolas Sarkozy, France's president, speaks during a news conference at the Federal Chancellery in Berlin on Oct. 9, 2011. Photographer: Michele Tantussi/Bloomberg

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