Guest commentary by Jim Falvey.
Jim Falvey, general counsel for Green Key Markets, has been an attorney in the derivatives space for over 15 years. He has served as general counsel of Eurex US and IntercontinentalExchange, as assistant general counsel for CME Group and, more recently, as general counsel and corporate secretary of R.J. O’Brien & Associates, a Chicago-based futures commission merchant. He also sits on the advisory board of CMDirect, a web-based commodity trading platform.
Long ago in the day and age of open outcry (okay, it wasn’t that long ago – and is still going on in some locations), exchanges utilized a variety of mechanisms to settle contracts. For example, in contracts with a lot of volume, settlements were fairly straight forward. Just simply do a little math and voila! You have your number. With lightly traded contracts, issues arose. Certain exchanges had pit committees to address these issues. They would meet after the close and figure out a settlement number.
Some observers of this process viewed it cynically as a “creative” process whereby the members of the pit committee would look at their books of business in order to determine the most beneficial level to settle for the day. That is, most beneficial to the members of the pit committee and their proprietary books of business. Many raised concerns about fairness in this world. So, when electronic systems became the primary mode of trading, creativity in settlements, as such, was supposed to go away. Math would control the process. It would be nearly impossible to manipulate a settlement. But, it hasn’t been that simple.
In many energy contracts, a system has evolved whereby members of a modern day pit committee provide prices to a price reporting agency, such as Platts Energy, a McGraw-Hill subsidiary. Platts decides who can contribute to its process and limits the number of participants who provide prices to it. They then apply a proprietary algorithm (also known as “secret sauce”) to the numbers and come up with a settlement price in various energy products ranging from natural gas to crude oil to biofuels. Unfortunately, this approach has shown that it is susceptible to manipulation – so much so, in fact, that a number of groups have called for significant changes to this “creative” process.
Blackrock, one of the largest asset managers in the world, recently issued a paper calling for best practices for better benchmarks. While the Blackrock paper focused on financial, rather than commodity benchmarks, the comments are nonetheless instructive:
- Enhance transparency and disclosure in the process of developing the benchmark/settlement and apply appropriate sanctions for manipulation;
- Focus reform efforts on those benchmarks/settlements that are subjective and based on survey submissions;
- Use transaction data, where available (in lieu of survey submissions and/or supplement survey submissions with real data); and
- Establish greater regulatory oversight and supervision, including a binding code of conduct for the benchmark/settlement providers and submitters that is subject to an independent audit.
While these suggestions are valuable and should be taken into account in any reform efforts, there is a cautionary tale about the history of similar recommendations. Specifically, on February 27, 2003 (over 10 years ago), the Committee of Chief Risk Officers (“CCRO”) issued its seminal paper: “Best Practices for Energy Price Indices.” The CCRO best practices included many of the same items as Blackrock and others have called for recently, such as using real data from real transactions, adopting a meaningful code of conduct for the submitters and the providers of the benchmarks/settlements, etc.
In light of the recent raid of various oil companies and price reporting agency, Platts, in connection with potential manipulation of crude oil prices, it’s clear that the CCRO best practices either haven’t been meaningfully put in place and/or they don’t have enough “bite” such that problems are still occurring.
It is time to finally put an end to creative settlements. Ten years (or even longer) is long enough to accept less than ideal numbers. The first step in doing so is to rely more on objective real transaction data and less so on subjective surveys. From there, we can build real indices that reflect the actual market and less on someone’s opinion.