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Summary of Triland Metals Limited's Response to the Consultation Paper on Commodity Derivatives Regulation

Core Content

Triland Metals Limited, as a broker/dealer on the London Metals Exchange (LME), has provided detailed responses to a consultation paper concerning the regulation of commodity derivatives under MiFID and CESR/CEBS. The responses address key regulatory concerns, including market participation, informational asymmetry, transparency, and prudential requirements.

Main Views and Key Information

1. OTC Commodity Derivatives and Spot Trades

• OTC Transactions: Most OTC transactions involve options and averaging. Averaging deals are entirely OTC, while some options are cleared by LCH Clearnet.
• Spot Trades: The proportion of spot trades is very small.
• Regulatory Definition: Both OTC and exchange-traded commodities fall under the definition of 'financial instruments' in MiFID.

2. Participation by Unsophisticated Investors

• Private Clients: Direct participation by private/retail clients is minimal.
• Reasons for Low Participation:
  • Large minimum contract sizes.
  • Complexity of understanding financial instruments versus physical commodities.
  • Regulatory burden on firms offering services to private clients.
• Corporate Clients: Corporate clients (e.g., miners, smelters, distributors) are the main participants, often with experience in physical markets or through appointed experts.

3. Informational Advantages in Commodity Derivatives Markets

• Brokers/dealers have more detailed knowledge of financial instruments than their clients.
• Clients generally have sufficient understanding of the derivatives they trade.
• No significant 'knowledge gap' exists similar to the pensions mis-selling issue of the 1990s.

4. Informational Asymmetries and Market Abuse

• Two Main Forms:
  1. Creation of false impressions of supply and demand to manipulate prices (e.g., nickel price squeeze in 2007).
  2. Manipulation of closing prices.
• LME Response: Established procedures to detect and investigate abuse, praised by FSA in 2005 for maintaining market integrity.

5. Lending and Trading Exposures

• No lending is involved in LME broker/dealer activities.
• Customers either use credit lines or pay upfront, with exposure managed through Master Netting Agreements (MNA) and ISDA agreements.

6. Risk to the Financial System

• Specialist commodity firms pose limited systemic risk due to:
  • Fewer customers (mostly market professionals).
  • Focus on hedging rather than speculation.
  • Reputational risk being the main concern.

7. Systemic Risk Compared to Banks and ISD Firms

• Systemic risk from commodity firms is lower due to:
  • Deliverable physical assets as the underlying product.
  • Limited cross-market contagion due to narrow market focus.

8. Transparency Concerns

• No Transparency Concerns: Triland has no such concerns in metals derivatives trading.
• Reasons for Strong Transparency:
  • Close cooperation among specialized brokers.
  • Access to quality market data from LME and third-party sources.
  • Customers maintain accounts with multiple LME members for competitive pricing.

9. MiFID Transaction Reporting Requirements

• Limited value in regulating metals derivatives due to:
  • Existing LME position reporting already ensures market integrity.
  • Professional clients give specific instructions, making COBS rules less applicable.
  • Metals markets are less speculative compared to equities.

10. CRD Capital Requirements

• Agree: Full application of CRD capital requirements would impose a misaligned regulatory burden.
• Reasons:
  • Capital requirements are not proportionate to the risk posed by commodity firms.
  • Smaller firms would face significant costs in compliance and risk modeling.
  • Regulatory capital is primarily intended to protect inexperienced clients.

11. CRD Large Exposure Requirements

• Agree: These would also impose an unnecessary regulatory burden.
• Reasons:
  • Most trades are squared hedges, with exposures already locked in.
  • 'Mark to market' practices reduce surprises for clients.
  • Exposures are generally smaller than those of banks and ISD firms.
  • Existing tools (MNA, ISDA, collateral) manage risk effectively.

12. Regulatory Arbitrage

• Not Envisaged: Regulatory arbitrage is not a concern in the metals market due to:
  • LME rules requiring proximity to the City of London for Category 1 members.
  • FSA authorization requiring UK-based head offices.
• Contrast with Energy Markets: Energy firms may have more flexibility in location.

13. MiFID Organisational Requirements

• Adaptable: The SYSC rules are adaptable to a qualitative risk management approach.
• Limited Applicability: Most MiFID organisational rules are not relevant to the metals market due to the professional client base and nature of products.

14. Client Categorisation Regime

• No Problems Identified: The current regime has not caused issues.
• Suggestion for Change: An expanded definition of professional clients and eligible counterparties could be beneficial, particularly for knowledgeable but small clients.

15. Conduct of Business Rules

• Limited Applicability: Most MiFID rules are not applicable to LME broker/dealers.
• Key Concerns:
  • COBS 11.2.26: Requirement for prior consent to best execution policy is problematic, especially for clients outside the EEA.
  • Best Execution: Less relevant in metals markets due to client-driven trading and limited customer base.

16. Appropriate Prudential Regime

• Options 1 and 2 are considered more appropriate.
• These options would avoid imposing an overly burdensome regime on low-risk commodity firms, which could limit their ability to serve market participants.