REMIT (Regulation on wholesale energy markets integrity and transparency) rules mean that, for the first time, there is a consistent framework for energy markets that covers the whole of the European Union. Since these rules came into effect nearly a decade ago in 2011, they have promoted transparency and fair competition across the wholesale energy markets in Europe.
In this series of articles, we will discuss practices such as wash trades, spoofing, layering, and insider trading — all of which are banned under REMIT regulation designed to stop market manipulation attempts and bar insider trading. By being aware of these problems and ensuring best practice, actors can avoid breaking the rules and, in doing so, ensure a better energy market for everyone.
In this first piece, let’s take a closer look at wash trades. In a wash trade, a security transaction gives the impression that a genuine sale or purchase has been made when, in reality, no bonafide market position has actually been taken. Also referred to as “round trip” contracts, wash trades refer to two parties that agree to both buy and sell a certain quantity of energy simultaneously at the same market value.
Wash trades might be executed by a trader and broker in collusion with one another. Alternatively, they could be carried out by investors who are posing as both ends of a security transaction — meaning both the buyer and the seller. A Wash Trade may be used to manipulate the market by making that market look more liquid and active by artificially increasing the trading volume. It could also earn brokers bonuses in scenarios whereby there are financial incentives for energy traders to trade at frequency and volume and can be used as a vehicle for tax evasion.
This form of insider trading isn’t only a problem in the wholesale energy market — although there have been plenty of historic examples in this area. For example, in 2004, BP America settled wash trading charges and paid a $100,000 civil fine. According to the Commodity Futures Trading Commission (CFTC), a former trader for BP Energy carried out pre-arranged trades for electricity contracts at identical prices. The trader and a counterparty agreed to execute a buy or sell using an electronic trading platform, while also executing an opposite buy or sell over the phone at an identical volume, price, and terms. In all, six illegal wash trades took place over the course of three months. BP was fined for not preventing the sales from taking place.
More than a decade on, similar concerns persist regarding possible price manipulation in European power and gas markets. In 2019, the European Union regulator, the Agency for the Cooperation of Energy Regulators, said that it was investigating potential wash trades across these markets. Transactions were flagged because there was no chance of ownership as a result of transactions.
REMIT rules to scrub wash trades
Under Article 2 of REMIT, market manipulation is prohibited in the strongest terms. One of these definitions of market manipulation refers to the providing of false or misleading signals about the supply of and demand for wholesale energy products, which describes the principle between wash trading.
Even wash trades that take place without the goal of manipulating a market can be classified as a form of market manipulation because they create inaccurate impressions about that market and the demand or price of wholesale energy products. This can create uncertainty in the market, possibly resulting in other players in the marketplace acting more conservatively, thereby reducing overall liquidity. They also breed mistrust in the integrity of the market. Because REMIT rule violations are based on actions or attempted actions, rather than the intent of the actor, it’s not necessary to prove that a market participant knew it was infringing REMIT with its behavior.
Complying with REMIT rules is mandatory. PPATs (Persons Professionally Arranging Transactions) have an obligation and responsibility to closely monitor trading behavior to ensure the smooth running of the European wholesale energy markets. They must be able to prove that trades were executed for genuine reasons and conformed to the agreed-upon wholesale energy market practices.
Best practices for compliance
Two measures considered to be best practice for PPATs include a pre-notification from a market participant to the market with details about trades and the flagging of transactions as potential wash trades.
Because the onus is on companies to monitor trades to ensure compliance (and, as with the BP incident, they are liable for fines even if only for not preventing a sale from taking place), it’s crucial that they take proactive steps to protect themselves. A large part of this should include carrying out risk assessments and compulsory training for traders so that they are fully aware of what behavior might be interpreted as manipulative. This should include clear instructions for traders on how to trade and that they fully document their behavior — especially in situations whereby unusual transactions are made that might appear exceptional given market conditions.
Companies should also invest in comprehensive surveillance systems that can help ensure regulatory compliance and, if needed, quickly make this information available to regulators. When you’re talking about best practices, this is the best way to reduce the risk of market abuse.