EU Targets Commodities, High-Frequency Trading in Market Law

The European Union is seeking limits on commodities derivatives and curbs on high-frequency trading as part of proposals to overhaul the region’s financial-market rules.

Today’s plans, which also include a crackdown on so-called dark pools, are aimed at reducing market volatility, increasing regulatory oversight and promoting competition. Specific measures include requiring trading venues to either cap the number of commodity-derivative contracts that traders can enter into, or enforce “alternative arrangements” with the same effect.

“The crisis serves as a grim reminder of how complex and opaque some financial activities and products have become,” Michel Barnier, the European commissioner responsible for the proposals, said in an e-mailed statement from Brussels today. The plans “will help lead to better, safer and more open financial markets.”

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. 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 proposals to overhaul the EU’s Markets in Financial Instruments Directive, or Mifid, were adopted by the European Commission in tandem with other plans to toughen sanctions against market abuse.

Outside EU

The Mifid measures would give EU regulators the power to block companies from outside the region from offering financial services to EU investors unless they meet similar standards in their home market.

Governments and lawmakers at the European Parliament must now agree on the final version of the proposals before they can take effect.

The U.K. Treasury said in an e-mailed statement that “a number of practical issues” need further discussion “not least to ensure we respect the commitment made by G-20 leaders to avoid financial protectionism and not raise trade barriers.”

Under today’s plans, the EU would have the power to set position limits for commodity derivatives across the entire region if it decided that curbs put in place by national regulators weren’t working.

Strict Caps

Position management, a process whereby supervisors can ask a trader to reduce orders on a case by case basis, wouldn’t be an acceptable alternative to strict caps on positions, the EU said.

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.

The EU measures include requiring firms that offer high frequency or algorithmic trading services to prove that they have sufficient risk controls in place and to ensure that clients with direct access to the markets are properly qualified.

The safeguards include requiring trading venues to have “robust controls against problems such as disorderly trading, erratic price movements, and capacity overload,” the commission said. “Limits will be placed on how many orders per transaction participants can place, as well as on how far venues may compete in attracting order flow.”

Algorithmic traders should meet “liquidity” rules that will oblige them “to trade on a continuous basis” and limit their ability to pull large orders, the commission said.

Algorithmic Models

The liquidity rules may encourage companies operating algorithmic models to shift their activities out of the 27-nation EU, Laurence Walton, director of regulatory policy at NYSE Liffe said in a conference call with reporters. NYSE Liffe is the derivatives exchange of NYSE Euronext.

Such firms “would be obliged by the proposal to maintain a level of liquidity to the markets at competitive prices” even during periods of volatility, Walton said, while other traders “would be free to withdraw liquidity based on their own risk profile.”

Dark Pools

The EU is also seeking to push some dark-pool trading through a new form of regulated platform known as an “organized trading facility,” or OTF. Dark pools, or private venues that don’t display prices in advance, have been probed by regulators in both the EU and U.S. because of concerns that their lack of transparency increases price volatility.

The “seeming eradication” of dark pools is one reason why investment banks are “one of the clear losers” from the proposals, Harry Eddis, counsel at law firm Linklaters LLP, said in an e-mail. The EU’s plans will also increase such banks’ costs, he said.

OTFs will help to fulfill agreements reached by the G-20 countries to push trading in over-the-counter derivatives through regulated venues, the commission said.

To promote competition, the proposals 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.

“There will be far less scope for market users to decide how and where to execute their business most effectively,” Damian Carolan, a lawyer at Allen & Overy LLP, said in an e-mail.

‘Equivalent’ Standards

Under the Mifid proposals, companies based outside the EU would only be able to offer investment services in the region if rules in their home nation are judged “equivalent to EU standards.” The commission, the EU’s executive arm, would be in charge of making these assessments.

The commission will also demand “reciprocal” access for EU firms to other national markets. Firms will have to at least establish a branch in the EU if they want to provide services to retail investors. Companies that meet the access requirements will be able to operate across the EU.

Investment companies outside the region “are going to have to radically alter their operating structure,” said Ash Saluja, a financial services lawyer at CMS Cameron McKenna LLP in London.

Market Abuse

In the market-abuse proposals, firms that take part in practices such as insider dealing would face maximum penalties of at least ten percent of annual sales, with individuals risking top fines of at least 5 million euros ($6.8 million). Criminal sanctions may also be used against traders, the commission said.

The commission said today it’s also seeking to extend the Mifid and market-abuse rules to cover spot carbon contracts in an effort to better protect the region’s cap and trade system from fraud.