A key feature of the price assessment processes utilised by
price reporting agencies (PRAs), such as Platts, Argus and ICIS in
the oil and gas markets, is the "Market-on-Close" (MOC)
approach. An important part of the MOC process is the role which
the trading "window" plays in the formulation of the
final prices published by the relevant PRA for each oil benchmark.
Although PRAs provide information about their price assessment
processes, an appreciation of what that entails is not universal in
the market. "Trading in the window" can mean different
things depending on the PRA referred to and the reference price in
question; each PRA operates its own methodology and these vary
according to the market.
This client alert seeks to provide an introduction to the role PRAs
play in the oil and gas markets and the broad price assessment
methodologies they employ in determining daily benchmark prices
– including the role of the trading "window". It
also highlights the current regulatory review of PRAs and touches
on a point of interest in connection with the review of the Markets
in Financial Instruments Directive (MiFID).
The Role of PRAs PRAs are information publishers
(typically operating within news organisations) which provide price
data and reference prices (often referred to as "indices"
or "benchmarks") to the markets based on physical and
financial trading activity reported to them.
These prices are then used by traders in physical and financial commodities in a number of ways:
- for spot physical trading activity;
- for hedging of physical trading activity;
- to settle floating price deals;
- under long-term contracts which need to be priced on a regular basis throughout the term; and
- as reference prices for other derivatives contracts, including some futures contracts.
The aim of a PRA is to provide the market with its assessment of
the prevailing market price during the applicable pricing period
for its various benchmarks, achieving a degree of price
transparency which market participants (large and small) can rely
on. Where PRA benchmarks are successful, liquidity in the relevant
market centres on them – and in and around their related
trading windows. For these key benchmarks, market participants rely
on the integrity of the data used and of the assessment processes
and methodologies applied.
Pricing Methodologies – the "Trading
Window" approach The trading "window" is a
constituent part of MOC methodologies, a price assessment process
favoured by some of the larger PRAs. Generally under a MOC
methodology, the PRA assesses prices by reference to data submitted
voluntarily to it by market participants relating to (a)
transactions concluded and (b) where relevant, bids and offers
published on its systems. Submission of this information can take
place via telephone, trader's squawk boxes, instant messenger
services, or directly by subscribers via web-based screens visible
to all other subscribers (e.g. the Platts eWindow, which is an
on-line real-time communication tool used by reporters and traders
in connection with the MOC process).
Under the MOC process, PRAs do use pricing submissions received
throughout the entire day, but the most important period is the
final defined period of time (the "window") within the
trading day over which the PRA monitors market activity to
establish the price. Typically the price established in this way is
the price assessed at the end of the window.
Traders are invited to submit open bids and cargoes for sale in the
lead up to a specified cut-off time, after which no new bids or
offers will be accepted by the PRAs. This can have the effect of
narrowing spreads at or towards that point. During the window, the
PRAs watch the market on or very nearly on a real time basis to
gather data on transactions concluded during this most liquid
period of the trading day. PRAs then use the prices of concluded
trades, and where relevant, of unfilled bids and offers, to
establish the published price for the day. If liquidity is
relatively low, the bid/offer spread information may become more
relevant in that assessment.
One of the arguments in favour of this methodology is that instead
of relying only on the subjective impressions of reporters
telephoning traders for information, there is a formal mechanism
(i.e. the "window") built into the price discovery
process.
However, use of the "window" approach is not universal.
Some PRAs adopt an entirely subjective approach (i.e. telephoning
contacts and making a call on the relevance of the information
gathered based on first-hand extensive trading experience of
reporters); others use a formulaic approach (relying on data
submitted in writing by a panel of traders).
Even where a PRA follows a MOC approach, it will often apply a
subjective judgment to set specific prices so as to smooth what it
may perceive to be the otherwise undue impact of particular
transactions or market features (e.g. variances between crude oil
qualities, cargo sizes, vessels, ports and the relative
creditworthiness of buyers and sellers from transaction to
transaction).
PRAs have wide discretion to exclude bids, offers or transactions
which they believe to have been submitted abusively or in bad
faith. The way in which this and other discretions are exercised in
practice – and the problem of transparency in relation to it
– is the subject of various consultations on the role and
potential oversight of PRAs (which are briefly referred to
below).
A feature of the price assessment process currently common to all
is that market participants have no obligation to submit bids,
offers or trade data to PRAs: this is done voluntarily (and some
market participants may not do so at all). There is also no general
obligation on market participants submitting data to submit all
potential data in their possession. This is also the subject of the
consultations highlighted below.
The Platts "eWindow" Price Discovery
Mechanism The trading "window" can, in some
contexts, refer to more than just the period of time over which an
assessment is primarily based. To take Platts as an example, in
2007 it developed its Editorial Window, or "eWindow",
through which trading companies can submit indicative bids and
offers on a screen visible to other subscribers to that service in
real-time. eWindow bids and offers will have one of three action
tags associated with it – "Hit" or
"Lift", which are orders entered by other participants
(or their authorised brokers) that can be executed by following the
procedure below, or "take", which are non-executable
orders entered by Platts editors which participants may mark
interest on, which may be entered into offline bilaterally.
If a party wishes to execute a transaction which is shown on the
eWindow system, then this is possible, as the eWindow platform is
linked to ICE (the interpretation of these arrangements and their
precise interaction in the contract formation process is a matter
of interpretation of all the circumstances, on which some may have
differing views). In order to execute a transaction in this way, a
trader may do so by clicking through from a single screen on either
the "Hit" button or "Lift" button next to the
desired order, a pre-confirmation window then appears which then
requires the trader to confirm the deal. Once the deal has been
confirmed then a further trade confirmation window will
appear.
Platts views a refusal to enter into a trade in the manner
described above with suspicion, as the bids/offers submitted
through the eWindow should be reflective of the actual price at
which that trader would enter into trades. Parties which do not
stand by a bid or an offer submitted through the eWindow platform
are sanctioned by Platts, first by having their bid/offer
submissions removed from the day's price formation database,
and secondly, by being barred from entering further bids/offers on
the eWindow platform for a period of time specified by
Platts.
Regulatory Review There is an on-going review as
to how far regulators could, or should, go in terms of regulating
PRAs. In part, this debate has been complicated by the different
roles that PRAs play. Up to now, the focus of most of that
discussion and resulting reports and recommendations primarily has
been the price assessment methodologies PRAs employ and the price
reporting element of their role.
Over the past year, there has been a series of consultations
concerning possible regulation of PRAs and, more generally, the
formulation of benchmark prices across the financial and
commodities sectors. This resulted in the publication by IOSCO of
its final report detailing "Principles for Oil
Price Reporting Agencies" in October 2012 (the
IOSCO Principles). This report stopped short of
recommending formal regulation in favour of self-regulation. IOSCO
intended to conduct a review of PRA compliance with the IOSCO
Principles over an 18-month period (up to April 2014). Following
that review, IOSCO suggested that it might recommend that market
authorities would prohibit the use of benchmarks provided by non-
compliant PRAs in commodity derivatives contracts.
Although this may represent a softening of IOSCO's original
position, the issue of formal regulation of PRAs has since been
raised again within the EU (roughly coincident with the
Libor/Euribor review). A recent consultation by the European
Securities Markets Authority (ESMA) and the
European Banking Authority (EBA) on
"Principles for Benchmarks-Setting Processes in
the EU" closed on 15 February 2013. This
consultation followed the IOSCO approach of setting out non-binding
principles, stressing they are intended as a means to provide a
"common framework to work together and provide a glide
path to future obligations that are likely to be
binding".
In neither the IOSCO Principles nor the ESMA/EBA consultation is it
recommended that market participants be compelled to submit data to
PRAs.
IOSCO has just closed another consultation on the wider issue of
"Financial Benchmarks" (on 11 February 2013). A final
report is due in April.
This is an area that is still very much on the move.
Regulatory and Tax Status of Window Trades A key
question for some will be whether transactions conducted in the
"window" would be regarded as "financial
instruments" for regulatory purposes. If so, this would have
multiple consequences (including the application of derivatives
reform regulation under the EU Market Infrastructure Regulation
and, perhaps, the application of the proposed EU Financial
Transaction Tax).
A "financial instrument" for these purposes is defined
under MiFID. MiFID, however, is under review and a new category of
"financial instrument" may be proposed to include some
trades, potentially including physical trades, conducted on an
"organised trading facility" (OTF).
There is some way to go before the draft legislation is settled,
but we now have a reasonably good idea of the likely OTF
definition, which is very broad indeed. A question some have begun
to consider is whether there is a danger of an unintended
legislative consequence: if a PRA's window trading facility
were regarded as an OTF, trades concluded within it could be
characterised as "financial instruments".
This may depend on the outcome of negotiations between the European
Parliament and the European Council, to whom this issue and the
potentially serious and undesirable consequences flowing from it,
have been highlighted by many market participants. But if the
politicians do not address this issue, the analysis will likely
turn on the question whether a PRA's facility is in fact an
OTF.
The key issue here is whether transactions are concluded within a
system operated by the PRA. If transactions are concluded outside
that system, this may be sufficient to avoid an OTF treatment.
This, of course, leaves open the question: how far does a PRA's
"system" extend? That is a matter for analysis in each
given case and will depend on a precise analysis of the relevant
contractual framework.
As we highlighted at the outset, each PRA is different and their
prices, windows and related facilities need to be analysed with
their specific features in mind.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.