LONDON/GENEVA European authorities are close to agreeing on the final draft of markets abuse rules that will make the standard commodities market practice of trading on inside information illegal.
Commodities market players say the draft regulation, which will lay the ground work for jail terms for insider trading, could force them to reveal their trading strategies and undermine their businesses.
For centuries, traders have made money from their knowledge of shortages and surpluses of physical commodities, which they say enables them to play a vital role in balancing global markets.
"Applying insider trading to commodities is mad," said Craig Pirrong, University of Houston academic and commodities expert.
"It may make sense to prosecute the use of information illicitly obtained, (but) 'better information' does not mean 'inside information', and any attempt to apply insider trading concepts to commodities will sow confusion and wreak havoc."
Supporters of the regulation argue that some markets including European power markets have already successfully adapted to disclosure rules for insider trading, even though traders objected vociferously, and that other commodity markets will adapt too.
A source close to the negotiations in parliament said a provisional date for the final meeting on the beefed up draft has been set for next Thursday to address issues such as administrative sanctions, the definition of inside information and the inclusion of spot commodity contracts in the regulation.
If the draft is finalised this month before the end of the Irish presidency, the new rules are expected to become EU law by year-end and enter force at the end of 2015.
While most of the new legal requirements will be known once the agreement is reached, the penalties for offences in different countries will become clear once governments have written criminal sanctions into their national legislation.
RECENT SCANDALS ADD FIREPOWER
Recent financial scandals such as the fixing of LIBOR and Platts oil prices have strengthened the case for strict rules, providing firepower to the European parliament, which advocates a tough regime as opposed to the more reticent Council of Ministers.
"The allegations that oil prices have been fixed by reporting agencies and oil companies alike clearly demonstrates the need for tough EU wide rules to tackle market abuse," said Arlene McCarthy, member of the European parliament and co-ordinator of the reform.
"We live in a different world now. Since 2008 - and particularly since Libor - the public want to see us crack down on manipulation and market abuse."
Robert Finney, a partner at law firm Holman Fenwick Willan, agreed that strict rules were likely. "The mere fact that the Commission decided to investigate (the oil market) will provide grist to the mill of those who want a strong regulation on market abuse," he said.
The Council of Ministers, who represent the EU member states, are reluctant to see harmonised jail terms for market abuse across the bloc. The issue of penalties will fall under the revision of the Market Abuse Directive (MAD II), which sources say is so politically sensitive that it is not even being discussed at present.
The full regime may be implemented when MAD II comes into effect sometime later than 2015 - welcome relief for those battling to see how, in practice, insider trading can be extended to commodity prices that are driven by global changes in supply and demand.
"The insider trading definition they're putting in place under MAR (Market Abuse Regulation) is one that's appropriate for securities, not for commodities," said Rosali Pretorius, a partner at Dentons.
"It potentially opens traders up to big lawsuits."
Under the new rules, authorities would be able to force even non-listed companies to publicly disclose supply changes such as oil refinery outages.
Some big trading companies such as Mercuria and Gunvor have already started preparing for the new measures since last year by hiring compliance officers from Wall Street banks.
Blackrock, the world's largest money manager, said in a recent letter to national securities regulators that commodity futures indexes, like stocks and bonds, are based on objective and verifiable prices and information.
"In contrast, physical commodities markets price benchmarks can involve elements of subjectivity as they often require price submission from physical players," it said, citing the pricing of Brent crude.
POWER AND GAS PRECEDENT
Compliance advisers, meanwhile, already have their hands full in Europe's power and gas markets, which are subject to restrictions on inside information under rules known as REMIT.
REMIT for power and gas was published in December 2011, and power and gas utilities have since then been publishing notices of supply outages on their websites.
Supporters of the regulation argue that power markets have adapted to the disclosure rules and that other commodity markets will adapt too. REMIT will only be fully implemented next year, however, and critics say at that point problems will emerge.
"The insider information aspect is challenging. Diversions of LNG (liquefied natural gas) or crude oil from Europe to Asia, for example, would count as inside knowledge, hence would need to be disclosed," said Jerry Jeske, group chief compliance officer at Mercuria.
According to Jeske, European traders would be at a disadvantage to government-controlled producers in non-EU countries, whose traders in London and Geneva are unlikely to divulge information.
Oil majors, because of their vast array of assets, are expected to be the most affected by the disclosure rules, though lightly regulated private trading houses such as Vitol or Louis Dreyfus will also have to adapt.
In the face of shrinking profit margins, many trading firms have sought to extend their control of supply chains through buying physical assets such as refineries.
If the rules are introduced in their current form, they could force global trading houses to build strict Chinese walls. This would require a considerable change in culture for trading houses that pride themselves on having the best information and guard it jealously.
"MAR may well be aimed at major asset owners, but it will have a long tail that will impact trading houses," said Marko Kraljevic, a partner at law firm Clyde & Co.
"This ... will be a new phenomenon for most physical commodity traders, for whom accessing and trading on high quality information is in their DNA," he added.
(Additional reporting by Oleg Vukmanovic in London; and Barbara Lewis and Charlie Dunmore in Brussels; editing by Dmitry Zhdannikov and Jane Baird)
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