First FCA enforcement action and fine against a Recognised Investment Exchange

On the 20th March, the FCA issued a substantial fine to the London Metals Exchange, in relation to market disruption in Nickel futures which occurred in 2022. The fine and associated enforcement action had been widely expected by the market, and a number of legal proceedings relating to the case continue.

While the market conditions which are the reference point of the fine were extreme, the failings which the FCA sets out in the final notice are far more commonplace and mundane. Ultimately the FCA traces the failings back to inadequate policies and procedures for managing extreme market conditions, exacerbated by much of the activity occurring in Asian trading hours, when many of the LMEs senior people were in principle contactable, but in practice were probably asleep (their Asia hours are 1am to 7am after all). The FCAs ire seems also to have been increased by a lack of adequate recordkeeping of key decisions which were made during the management of the market stress (particularly relating to the application of, and changes to, ‘volatility controls’ or ‘price bands’).

All Exchanges and trading venues should read the final notice closely, as many of the failings identified in the LME case are likely risks in other organisations.

Supporting extended trading hours

Exchanges and trading venues are under ongoing pressures from market participants to extend their trading hours. In an environment where cryptocurrency exchanges routinely support 24/7 execution, it is unlikely that this pressure will reduce, and so venues must try and respond to the evolving needs of their users as best they can.

However, the economics of supporting such extended hours can often be bleak. For many contracts, a very significant majority of trading activity occurs within a short window of each trading day, and any extension to the trading day is likely to add only a small incremental amount of volume (and therefore revenue for the venue). On the cost side, supporting extended hours means shift work (i.e. more staff), overtime (more expensive staff) or adopting a follow the sun model (opening new offices and extra staff!).

As a result, many Exchanges and trading venues cover these lower revenue-generating hours with more junior staff, sometimes working in remote locations where it is harder to integrate them effectively into the core operations team. This is not a problem while these hours are quieter as expected, but in the LME Nickel case appear to be the major aggravating factor for the LME receiving a fine.

All Exchanges and trading venues operating shift work or follow the sun models should review these carefully in light of the LME fine.

Policies and procedures for managing market stress and extreme volatility

Although the commodities market is perceived as more exposed to the kind of market stresses seen in the LME Nickel case, every asset class has case studies where extreme stresses of this kind have occurred. Writing policy documents for such scenarios is a thankless task – it is nigh on impossible to anticipate in policy every possible market event, particularly as the next may look nothing like anything that went before.

However, the regulator clearly expects a policy, and MiFID II demands that mechanisms for managing volatility are implemented. As such, Exchanges and trading venues should design frameworks which are clear, transparent and predictable for the normal expected range of market conditions, but also build enough flexibility for Senior Management to take extraordinary action when extraordinary conditions demand it. All staff should be familiar with the policy, or better yet participate in ‘firedrill’ type exercises, which allow them to practice applying the controls in simulated stresses.

Training and Recordkeeping

It is important to remember that the LME did not receive a fine because there was a stress in the Nickel market, market stresses are an expected part of the management of markets. Alongside the perceived inadequacy of the LMEs arrangements for managing such stresses, one of the main drivers for the fine seems to be failings in simple hygiene factors such as training and recordkeeping. Again, these failings seem to have been exacerbated by the operation of remote staff in a follow the sun model.

In light of the LME fine, all Exchanges and trading venues should consider whether training and recordkeeping practices are sufficient, for all relevant staff. Where shift work or follow the sun models are used, further action should be taken to ensure that the operation team form one coherent unit, with a common understanding of the application of policies and procedures, and an equivalent level of training.

You can find the press release here.

Please feel free to get in touch if you have any questions regarding how this may impact your firm.