https://orcid.org/0000-0001-6155-3192
Abstract
This article is the first to discuss one of the main regulatory responses to the excessive volatility in the gas derivatives market during the period 2021–2023, namely the usage of circuit breakers. As a consequence of elevated and highly volatile energy futures prices, European policymakers decided to impose additional intra-day volatility mechanisms on trading venues. After providing an extensive literature review on circuit breakers, this article is the first to discuss the pros and cons that legislators considered when opting for government intervention by introducing this legal requirement for trading venues. By examining the rationale for legislative changes, this article contributes to the academic work on the regulation of energy derivatives. This article concludes that the benefits of the decision of European legislators to go beyond the existing financial requirements foreseen in the Markets in Financial Instruments Directive (MiFID) II and ask for additional intraday volatility mechanisms to be implemented are not completely supported by academic evidence. Yet, regulators left some flexibility to the market, as they were of the view that a one-size-fits-all approach would not be the way forward, and circuit breaker mechanisms had to take into account the diversity of instruments in energy derivatives markets as well as the peculiarities of the trading venues where these instruments are traded.
Introduction
In August 2022, gas prices were 300 per cent higher compared to February 2022 (ie a record of EUR 236 per megawatt, equivalent to $410 per barrel of oil) and 1000 per cent higher than the average prices previously seen in the European Union, combined with much higher volatility. As a result of the Russia-Ukraine conflict, financial markets also experienced significant declines: the S&P 500 fell by over 10 per cent, the Euro Stoxx 600 index reached its lowest point in nearly a year, and the MSCI All-Country World Index dropped by approximately 6 per cent.1 The Russia–Ukraine war has also driven a significant increase in the VIX index, reflecting heightened volatility in major benchmarks.2 Beyond the adverse effects on financial markets, the invasion has taken a toll on Europe’s real economy. ECB President Christine Lagarde stated, ‘The Russian-Ukraine war will have a material impact on economic activity and inflation through higher energy and commodity prices, the disruption of international commerce, and weaker confidence.’3 Companies are grappling with rising input costs, which have led to higher prices for end products, as evidenced by the Euro area’s annual inflation rate climbing to 9.2 per cent.4
The changing gas prices, attributed to the Russia–Ukraine conflict, further led to stress in gas futures markets as well as electricity markets (ie prices were 10 times higher than in 2021), given that both are highly correlated through marginal pricing in the electricity market.5 The higher futures prices were also due to many parallel uncertainties, such as the shortfall of nuclear energy in certain countries,6 the scarcity of European hydropower generation, and drought-driven low river flows, which negatively affected coal transport.
One solution typically used by trading venues to reduce extensive volatility in the market is the application of so-called ‘circuit breakers’. A circuit breaker is an umbrella term for regulatory levers employed to temper volatility, prevent cash scenarios emanating from inordinate investor overreactions or malfunctioning algorithms, or protect market integrity.7 Circuit breakers, in the general sense, refer to mechanisms that halt trading for a short period of time, such as 60 s, once a specified threshold is reached (ie trading halts) in terms of prices of volatility, and mechanisms that allow for the rejection of all orders with a price outside the set limit (ie price collars). Examples of circuit breakers, such as trading halts and price limits, are therefore often used as synonyms.8
Circuit breakers are typically used to reduce or constrain price volatility when it is considered that prices are not reflective of true market conditions anymore but are instead caused by factors such as traders overreacting to new information, flash crashes, or simply fat finger errors. Although they cannot lower high price levels, which are mainly determined by supply and demand, regulators believe that circuit breakers allow for a cooling-off period for market participants to respond to bona fide evolutions in market demand and supply fundamentals, and provide additional time for the collection of margins (ie, collateral traders deposit before or during clearing) during times of large price movements. Volatility cannot be regulated away with the usage of circuit breakers but could be better managed in situations of ‘yo-yo’ price moments. Even more, if a temporary half of trading could reduce or reverse unfavorable price moments, then the effect might be that the risk of unexpected large margin calls and liquidity problems is alleviated.
Even on a global scale, there is no one-size-fits-all approach by trading venues, and many different types of circuit breakers and calibrations are applied. Halts may, for instance, be discretionary or automatically executed based on pre-defined rules. In case of discretionary halts, the market operator exercises its discretion to halt trading of a security to allow investors the same opportunity to appraise news and make better-informed decisions. Rule-based halts are then activated when predefined parameters are matched. An example is an automatic halt of a stock once a price limit is reached. These halts are more temporary and, in case they are made transparent beforehand, they are easier to anticipate compared to discretionary halts. As a consequence, they allow participants in their trading strategies to keep the potential stopping of trading in mind. Alternatively, mechanisms exist to suspend continuous trading and switch to a call auction if the next potential price falls beyond a predefined range based on a reference price. These actions could then interfere with traders’ pre-existing trading strategies. Some volatility interruption mechanisms are not enforceable market-wise but are enacted on individual securities. This entails that a volatility interruption when triggered only impacts that specific volatile instrument and not the whole market. The price discovery during a trigger auction occurs via publishing auction prices and volumes.
Because of the high volatility in the gas derivatives market, severely impacting margin requirements, the European Securities and Markets Authority (ESMA) was asked by the European Commission to examine why current circuit breakers did not sufficiently work, as well as whether the rules on circuit breakers need to be aligned over the European Union. One reason put forward for why current circuit breakers worked insufficiently is because they are often based on dynamic thresholds (ie thresholds to trigger a trading halt that is automatically adjusted at regular intervals during the trading session)9 and did not take intraday volatility shifts sufficiently into account.
After receiving input from ESMA, the European Commission proposed to the European Council a measure to manage excess volatility in gas and electricity derivatives markets while preserving the price formation process. The intra-day price spike collar (ie, the predefined price range above or below a price is accepted) aims to avoid excessive price volatility and prevent extreme price spikes in energy derivative markets. On 30 December 2022, Council Regulation (EU) 2022/2576 of 19 December 2022, enhancing solidarity through better coordination of gas purchases, reliable price benchmarks, and exchanges of gas across borders,10 entered into force, considering the advice of ESMA. Also in October 2023, ESMA published a supervisory briefing on circuit breakers to provide a comprehensive overview of supervisory expectations regarding the calibration of circuit breakers implemented by trading venues. The measures in Council Regulation (EU) 2022/2576 were further extended on 31 December 2023 and applied until 31 December 2024.
This article is the first to discuss the regulatory measures that were put in place to reduce excessive volatility in the gas derivatives market, specifically by installing an additional requirement for trading venues to have intraday volatility mechanisms. Based on an extensive literature review and analysis of public policy documents, this article details all the pros and cons that were taken into account as the European Commission’s final decision to install these measures, with the view that introducing intraday volatility limits could help the issue of excessive volatility. In this way, this article contributes to existing literature examining the impact of the 2021–2023 energy crisis on updated trading and clearing regulations, discussing the temporary relaxation of collateral requirements for central counterparties (ie, financial institutions that act as intermediaries between buyers and sellers in a transaction, thereby reducing counterparty risk).11 In addition, this study complements the discussion on whether financial regulation for energy firms active in the commodity derivatives markets should be more stringent12 and on the Market Correction Mechanism Regulation that was introduced to further reduce excessive gas prices.13
Although this article primarily focuses on the EEA region, its insights are highly relevant to non-EU market participants, as they account for 46 per cent of all positions held in the EU, including investors and clearing members. Furthermore, TTF derivatives are also traded in the USA on the Chicago Mercantile Exchange (CME), meaning regulatory changes in Europe’s derivatives markets could potentially influence markets in the USA due to these cross-border linkages.
By examining the rationale for legislative changes, this article further contributes to the academic work on the financial regulation of commodity derivatives, and more specifically energy derivatives markets.14 Previous empirical work in this area debates the role of speculation and financialization in commodity markets.15 In this literature, evidence is documented on the increased participation of institutional (ie hedge funds and high-frequency traders) and individual investors (eg through exchange-traded funds) in commodity markets, mostly because of the benefits in terms of portfolio diversification from considering commodities as an asset class.16 Researchers also documented that futures markets dictate the spot market prices, as they include fresh data faster than spot markets because of their innate power, lack of short sale restrictions, and lower transaction costs.17 Futures markets thus perform a fundamental price discovery function across the term structure because commodity cash markets are rather professional markets with only a few actors having qualitative information, while futures prices convey actual and expected supply, demand, and inventory to a larger audience.18 As a consequence, futures markets enable the open-market discovery of commodity prices that are used as a benchmark for physical transactions. Concerning legal analyses applicable to financial energy products, Daiz-Rainey and others19 is one of the rare studies that discusses the various European pieces of financial legislation applicable to energy products but their study has become outdated as many European laws, like the European Market Infrastructures Regulation (EMIR),20 have been introduced or reformed in the meantime, along with the establishment of the Agency for the Cooperation of Energy Regulators (ACER) and the European Securities and Markets Authority (ESMA).
This article concludes that the benefits of the decision of European legislators to go beyond the existing financial requirements foreseen in 2014 and ask for additional intraday volatility mechanisms to be implemented are not completely supported by academic evidence. Yet, unintended negative consequences might be minor because regulators have left some flexibility to the market as they were of the view that a one-size-fits-all approach would not be the way forward and circuit breaker mechanisms had to take into account the diversity of instruments in energy derivatives markets, as well as the peculiarities of the trading venues where these instruments are traded. Hence, there is no calibration foreseen at the EU level entailing a one-size-fits-all approach but it is left at the discretion of trading venues given that they have—by default—the necessary knowledge and expertise to calibrate those mechanisms effectively. Trading venues have to implement the intraday volatility management mechanisms either by integrating it into their existing circuit breakers already established per the Markets in Financial Instruments Directive (MiFID) II or as an additional mechanism.
The remainder of this paper is organized as follows. The following section provides an overview of the energy derivatives market in Europe for readers less familiar with the background, based on Priem (2024).21 Further, a literature overview of circuit breakers is provided. Next, the introduction of an intraday volatility mechanism is discussed considering the literature, while the last section concludes.
The energy derivatives market
The commodity derivative financial ecosystem is displayed in Fig. 1.22
The commodity derivatives financial ecosystem. Source: Priem (2024).
In the energy market, companies can—via their brokers/dealers—buy gas directly on gas exchanges,23 such as the Title Transfer Facility (TTF), a virtual trading point located in the Netherlands operated by Gasunie Transport Services (GTS)24; the Vienna-based virtual trading point (VTP)25 operated by the Central European Gas Hub26; the UK National Balancing Point exchange; the NetConnect German gas exchange; or the Hungarian Gas Exchange NFKP. In addition, companies typically use futures27 as the primary instruments to trade oil, gas, and electricity.28 Most of them are traded on trading venues29 like ICE Endex located in the Netherlands, EEX domiciled in Germany, Nasdaq Oslo domiciled in Norway, and ICE Futures Europe located in the UK (ie 85 per cent of energy derivatives are exchange-traded derivatives, while only 15 per cent of them are traded over the counter).30 The ICE Endex TTF future is the most liquid energy contract in the EU, with an open interest of approximately 920,000 lots as of December 2022, while open interest on EEX TTF derivatives was around 300,000 lots. TTF derivatives are only traded to a very limited extent on Nasdaq Oslo. As of January 2023, gross notional exposures of EEA30 counterparties amounted to EUR 411 billion.31
A significant portion of energy futures are centrally32 cleared, typically through key clearing houses like ICE Clear Europe in the UK for ICE Endex, ECC (owned by Deutsche Börse) for EEX, and Nasdaq Clearing in Sweden for Nasdaq Oslo. Most energy companies access central counterparties (CCPs) through clearing members, which are generally credit institutions. However, certain CCPs, such as Nasdaq Clearing, also permit direct participation by energy companies. When market participants open a futures position, they are required to post initial margin with a clearing member of the CCP. If the price moves adversely, they need to post variation margins and sometimes more initial margins.33 These margin methodologies typically consider the volatility of the prices meaning that the more volatile prices become, the more margins need to be posted. In case a clearing member is no longer able to meet its margin obligations, the CCP has the right to put this firm into default.
Literature review on circuit breakers
The literature on circuit breakers focuses mainly on whether these market intervention tools mitigate volatility or rather postpone it, thereby yielding contrasting results.34 Proponents claim that circuit breakers can be used to reduce or constrain price volatility when prices are not reflective of true market conditions anymore but are caused by traders overreacting to new information, flash crashes, or simply fat finger errors. Circuit breaker mechanisms are then considered to be particularly effective when they lead to a reduction of transitory volatility (ie the tendency of prices to fluctuate around their fundamental values being unexpected by market participants) caused by uninformed traders (ie participants whose trades are not based on new information and whose trades are driven by market sentiment or private liquidity shocks).35 Although circuit breakers cannot lower high price levels, which are mainly determined by supply and demand, they can allow for a cooling-off period for market participants to respond to bona fide evolutions in market demand and supply fundamentals and provide additional time for the collection of margins in times of large price movements. Volatility cannot be regulated away with the use of circuit breakers, but it can be better managed in situations of ‘yo-yo’ price movements.36 Furthermore, if a temporary half of trading could reduce or reverse unfavorable price movements, then it might help alleviate the risk of unexpected large margin calls and liquidity problems.
On the other hand, interruptions to trading and the normal price formation process can have disadvantages or unintended consequences given that there is a loss of price transparency, which is needed for valuation, settlement, and risk management. In addition, there is temporarily an inability for market participants to exit positions, thereby negatively impacting market liquidity. Whether circuit breakers are truly effective depends on the source of price volatility. Academic literature documents that if the source is newly available fundamental information, the circuit breaker is only delaying the inevitable.37 Some studies indicate that volatility can be even greater when trading resumes.38 If large price movements are induced by heavy one-sided order flows (ie order imbalances), informed traders will be forced during the halt to temporize partial or full trading strategies and the volatility that was due to take place will be splattered over subsequent trading sessions, typically with reduced liquidity.39 Also, if investors fear that a halt will occur before they can submit their orders, they might have incentives to submit them earlier to increase the probability that they execute, thereby intensifying price movements and increasing volatility.40 Circuit breakers can thus also have a magnet effect, meaning that they can create a self-filling prophecy.41 If investors fear that a circuit breaker could be triggered, meaning they will not be able to trade, they may try to trade beforehand, thereby creating large volumes that trigger the circuit breaker in the first place. Some scholars are also of the view that circuit breakers exacerbate price disequilibrium and encourage price distortion rather than reducing price uncertainty.42
Certain scholars claim that circuit breakers are effective only when streamlined across markets, as modern (high-frequency) trading enables arbitrage across markets, and suspending trade in the underlying spot market while at the same time allowing the derivative trade might be dangerous. Also, access to alternative trading mechanisms can reduce the effectiveness of circuit breakers if applied only to one market where the instrument is traded while not to the other(s).43 Furthermore, it has been documented that during stressful periods, an impending circuit breaker trigger in a leading market (ie a more liquid, halted, or halt-imminent market) is likely to spur volatility in lagging venue(s) (ie less liquid, continuous trading alive) due to a higher demand for liquidity.44 The latter finding, however, is not formally accepted, as counterevidence is provided showing no intermarket volume migration or volatility spillover in more recent studies using European data.45 One caveat of many studies examining whether circuit breakers reduce volatility, however, is that no information is available about the counterfactual: how would volatility behave in the absence of the circuit breaker?
Intra-day volatility management mechanisms
Article 48 of MiFID II,46 introduced in 2014 and modified in 202447, states that Member States shall require a regulated market, as defined in Article 4(1) point (21),48 to have in place effective systems, procedures, and arrangements to ensure that its trading systems are resilient, have sufficient capacity to deal with peak orders and message volumes, maintain orderly trading under severe market stress, are fully tested to meet these conditions, and are subject to effective business continuity arrangements to ensure continuity of its services if there is any failure of its trading systems. A regulated market must also have in place (a) written agreements with all investment firms pursuing a market-making strategy on the regulated market and (b) schemes to ensure that a sufficient number of investment firms participate in such agreements which require them to post firm quotes at competitive prices to provide liquidity to the market on a regular and predictable basis, where such a requirement is appropriate to the nature and scale of trading on that regulated market. These written arrangements have to specify at least (a) the obligation of the investment firm concerning the provision of liquidity and, where applicable, any other obligations arising from participation in the scheme and (b) any incentives in terms of rebates or otherwise offered by the regulated market to an investment firm to provide liquidity to the market on a regular and predictable basis and, where applicable, any other rights accruing to the investment firm as a result of participation in that scheme. The regulated market has to monitor and enforce compliance by investment firms with the requirements of such binding written agreements and has to inform the competent authority about the content of the binding written agreements and, upon request, provide all further information to the competent authority necessary for the latter to ensure compliance by the regulated market.
Regarding excessive prices or volatility, Article 48(4) of MiFID II states that Member States shall require a regulated market to have in place effective systems, procedures, and arrangements to reject others that exceed pre-determined volume and price thresholds or are clearly erroneous. Member States also have to require a regulated market to be able to temporarily halt or constrain trading if there is a significant price moment in a financial instrument on that market or related market during a short period and, in exceptional cases, to be able to cancel, vary, or correct any transactions. Member States have to require a regulated market to ensure that the parameters for halting trading are appropriately calibrated in a way that takes into account the liquidity of different asset classes and sub-classes, the nature of their market model, and the types of users.
Note that there is thus no one-size-fits-all approach imposed on each regulated market, but the regulated market can calibrate the circuit breakers depending on its specific circumstances. As a consequence, there is strong heterogeneity in the existing mechanisms applied by EU trading venues, and the duration of, for example, a trading halt is independently set by each trading venue. At a global level, the World Federation of Exchanges (WFE) detected that there are about 56 different types of circuit breaker mechanisms, of which 47 are implemented in cash markets and 9 in derivatives markets.49 Some EU circuit breaker mechanisms are industry-specific, while others are market-wide.
Article 48(5) of MiFID II further requests that Member States ensure a regulated market reports the parameters for halting trading and any material changes to those parameters to the competent authority consistently and comparably, and that the competent authority, in turn, reports them to ESMA. Member States must also require that a regulated market, being material in terms of liquidity in that financial instrument in any Member State, has the necessary systems and procedures in place to ensure that it will notify competent authorities in the event of a trading halt. Competent authorities can then coordinate a market-wide response and determine whether it is appropriate to halt trading on other venues where the financial instrument is traded until trading resumes on the original market. Note that the IOSCO Principles for the Regulation and Supervision of Commodity Derivative Markets50 also refer to the suspension or cancellation of trades due to disorderly markets, as well as to the implementation of maximum price fluctuations and position limits to mitigate excessive price volatility and provide time for market participants to arrange necessary finding and fully understand the price movements.
Furthermore, Member States must require regulated markets to publicly disclose on their website information about the circumstances leading to the halting or constraining of trading and on the principles for establishing the main technical parameters to do so. Member States must also ensure that if a regulated market does not halt or constrain trading despite a significant price movement in a financial instrument or related financial instrument causing disorderly trading conditions on one or several markets, competent authorities can take appropriate measures to re-establish the normal functioning of markets. Under MiFID II, competent authorities have the power to require the suspension of trading in a financial instrument, require the removal of a financial instrument from trading, request any person to take steps to reduce the size of their position or exposure, and/or limit the ability of any person from entering into a commodity derivative, including by introducing limits on the size of a position that any person can hold at all times.
Article 18 of Commission Delegated Regulation (EU) 2017/85451 states that trading venues must have at least the following arrangements in place to prevent disorderly trading and breaches of capacity limits: (a) limits per member of the number of orders sent per second, (b) mechanisms to manage volatility, and (c) pre-trade controls. Trading venues must be able to request information from any member or user of sponsored access52 on their organizational requirements and trading controls. In addition, trading venues must have the ability to suspend a member’s or a trader’s access to the trading system either at the initiative of the trading venue or at the request of the member, a clearing member, the central counterparty where provided for in the CCP’s governing rules, or the competent authority. Trading venues must also be able to operate a kill functionality to cancel unexecuted orders submitted by a member or a sponsored access client. This kill functionality must be activatable (a) upon request of a member or a sponsored access client when they are technically unable to delete their orders, (b) in cases where the order book contains erroneous duplicated orders, and (c) following a suspension initiated either by the market operator or the competent authority.
Trading venues must also be able to cancel or revoke transactions in the event of a malfunction in their volatility management mechanisms or in the operational function of the trading system, as well as balance the entrance of orders among their different gateways in case the trading venue uses more than one gateway to avoid collapses. Trading venues must have policies and arrangements regarding their volatility management mechanisms, their pre-trade and post-trade controls and their market access for financial institutions. There also have to be policies and arrangements of the trading venue concerning members’ obligation to operate their own kill functionality, information requirements for members, suspension of access, a cancellation policy for orders and transactions, and order throttling arrangements.53 Trading venues must make public all these policies and arrangements, although this is not necessary for the specific number of orders per second on pre-defined time intervals and the specific parameters of their mechanisms to manage volatility.
Article 19 of Commission Delegated Regulation (EU) 2017/854 then focuses volatility management mechanisms and imposes on trading venues the obligation to ensure that appropriate mechanisms are operational at all times during trading hours to automatically halt or constraint trading. These mechanisms must be tested before implementation and periodically thereafter when the capacity and performance of trading systems are reviewed. IT and human resources must be allocated to deal with the design, maintenance, and monitoring of these mechanisms implemented to halt or constrain trading, and the mechanisms to manage market volatility have to be continuously monitored.
Furthermore, Article 19 requests that trading venues maintain records of the rules and parameters of the mechanisms to manage volatility and any changes thereof, as well as records of their operations, management, and upgrading. They also need to ensure that their rules of the mechanisms to manage volatility include procedures to manage situations where parameters must be manually overridden to ensure orderly trading.
Article 20 of Commission Delegated Regulation (EU) 2017/854 then focuses on pre-trade and post-trade controls and stresses that the following pre-trade controls have to be adapted for each financial instrument traded on the trading venues: (a) price collars, which automatically block orders that do not meet pre-set price parameters on an order-by-order basis, (b) maximum order values, which automatically prevent orders with uncommonly large order values from entering the order book by reference to notional values per financial instrument, and (c) maximum order volumes, which automatically prevent orders with an uncommonly large order size from entering the order book. The pre-trade controls have to be designed to ensure that their automated application can readjust a limit during the trading session and in all its phases. The monitoring also can have a delay of a maximum of 5 s, and an order has to be rejected once a limit is breached. In addition, the trading venues must have procedures and arrangements in place to authorize orders above the limits upon request from the member concerned. Such procedures and arrangements must apply to a specific order or set of orders temporarily in exceptional circumstances. In terms of post-trade controls, trading venues may establish those they deem appropriate based on a risk assessment of their members’ activity.
In April 2017, ESMA decided to publish guidelines regarding the calibration of circuit breakers and the publication of trading halts under MiFID II. The guidelines apply to trading venues that allow or enable algorithmic trading (ie usage of computer algorithms to execute financial trades often based on a predefined set of rules for playing, modifying, and closing orders) on their systems and to their competent authorities. These guidelines stress that circuit breakers put in place by trading venues must use reference prices that reflect the volatility behavior of the concerned instrument reliably and consistently and, where appropriate, should have the ability to refer to external references. Trading venues need to calibrate their circuit breakers according to a pre-defined, statistically supported methodology, taking several elements into account, where appropriate. These elements are, for instance, the nature/asset class of the financial instrument, the liquidity profile and the quotation level of the financial instrument—with tighter parameters for more liquid instruments—the volatility profile (ie overnight volatility, the absolute maximum intraday deviation, and the expected frequency of activation of the circuit breaker) of the financial instrument, the order imbalance (ie the necessity to manually re-calibrate the parameters following a pre-defined procedure with the objective of minimizing the duration of trading interruptions), trading venue mode and rules (ie tighter circuit breaker parameters for continuous auction and quote driven systems), internal references (ie usage of static and dynamic reference prices), external references (ie parameters have to be based on the statistical correlation between instruments in cross-asset (e.g. cash and future instrument) and cross-market (e.g. multi-listed instrument) situations), duration of the halts, and whether instruments are newly issued or not. The ESMA guidelines further stress that trading venues should immediately make public, through the means regularly used for pre- and post-trade information, the activation of a trading halt, its type, the trading phase in which it was triggered, the extension of the halt, and the end of the halt.
ESMA was asked by the European Commission to examine why the current circuit breakers foreseen in Article 48 of MiFID II, specified in Article 20 of Commission Delegated Regulation (EU) 2017/854, and further clarified in ESMA’s guidelines, have (not) sufficiently worked, as well as whether the rules on circuit breakers need to be aligned across the European Union. One reason put forward for why current circuit breakers worked insufficiently is that they are based on dynamic thresholds (ie thresholds automatically adjusted at regular intervals during the trading session) and did not take intraday volatility shifts sufficiently into account. Dynamic thresholds are intended more to prevent erroneous orders and not rapid price swings reflecting market uncertainty. Introducing intraday volatility limits could help address this issue, as a pause in trading would support a more orderly price discovery process as it is intended to provide more time for market participants to process the flow of information during extreme market scenarios.
ESMA proposed on 22 September 2022 the idea—for energy derivatives only—to trigger halts for a limited period and in exceptional circumstances.54 That is, when intermediate price levels are reached, a pause in trading (ie 15 min) could be triggered, or a price collar could be implemented. This duration would be long enough to allow human intervention and, where necessary, ad hoc adjustments to market participants’ strategies but it would still allow price discovery and price moments over longer time intervals and ensure a smooth and orderly resumption of trading. The initial level would be used as a reference price for the closing price of the last trading session. The percentage change required to reach a trigger could be based on the contract level and, thus, no single percentage threshold would be applied to all energy contracts given that all contracts trade at substantially different prices.55
It can be argued that in instances where prices have changed substantially, triggering the mechanisms only based on a percentage variation might not be sufficient or fully effective.56 In such instances, a threshold based on price variations measured in absolute terms (e.g. in EUR/MWh) could also be needed as a complementing measure. The price limit would then be triggered when either of the two thresholds are breached: the price cannot decrease or increase more than a certain percentage and the price cannot increase or decrease by more than a certain EUR amount.
Some industry participants opposed the proposal of ESMA. For instance, according to the Futures Industry Association (FIA), circuit breakers should not be used as a tool to control or cap prices and that, if improperly implemented and calibrated, they could even damage the market and the wider financial system.57 That is, FIA is of the view that each market and product (eg Dutch TTF, German Gas Futures, etc) is unique, and exchanges should therefore take the decision on calibrating circuit breaker parameters (ie triggers, duration of market halts, etc) based on fundamentals and the liquidity of the products they list. Because markets are also evolving, parameterization should be dynamic and the appropriateness of parameters should be reviewed regularly. When developing circuit breaker parameterizations, it is of course also useful to consider further possible drawbacks. That is, prices received from exchanges and trading platforms are crucial inputs for CCP risk management. This means that when a circuit breaker is applied, the CCP will continue to calculate margins based on the latest positions, but either no new price information will be received, or the CCP will need to derive it from other sources. This could lead to risk exposures for the CCP being uncovered. Also, restarting the regular margin call process can be challenging in the absence of (end-of-day) pricing.
Many discussions were also held regarding whether a one-size-fits-all approach should be adopted. Such an approach could have the advantage of preventing sudden capital movements between exchanges and liquidity dry-ups. In the case of correlated instruments, it could also avoid pricing issues on derivatives markets when a cash market is absent. In addition, it would ensure a level playing field for all trading venues when consistently applied and enforced by regulators. In case of a market-wide event, it could even contribute to market stabilization. On the other hand, technical issues may arise in coordinating the reopening of markets after the trading halt between the satellite and reference issues. A one-size-fits-all approach would also not be parametrized to the market where the instrument is traded.
On 30 December 2022, Council Regulation (EU) 2022/2576 of 19 December 2022 enhancing solidarity through better coordination of gas purchases, reliable price benchmarks, and exchanges of gas across borders58 entered into force. This regulation fits within the REPowerEU plan, where an EU Energy Purchase Platform is set up together with the Member States for the common purchase of gas, liquid natural gas (LNG), and hydrogen. European legislators are namely of the view that stronger coordination with and among Member States vis-à-vis third countries would ensure that the European Union’s collective weight is more effective. This would ensure lower gas prices than might otherwise have applied to those purchasing the gas through the service provider individually.
This regulation took ESMA’s advice on board and thus includes requirements for trading venues where energy-related commodity derivatives are traded to set up temporary intra-day volatility management mechanisms to apprehend excessive price movements. The intra-day volatility management mechanisms must be based on an upper and lower price boundary that defines the prices above and below which orders may not be executed. These mechanisms have to prevent excessive movements of prices within a trading day for energy-related commodity derivatives. When setting up the mechanism, trading venues must ensure that the implementation of those measures does not prevent the formation of reliable end-of-day closing prices.
Regarding the upper and lower price boundary, trading venues must establish the applicable calculation method to determine them relative to a reference price. The first reference price of the day shall be the price determined upon the opening of the relevant trading session. The subsequent reference price has to be the last market price observed at regular intervals. Trading venues can express the price boundaries either in absolute value or in relative terms in the form of a percentage variation relative to the reference price. The methodology has to be adjusted to the specificities of each energy-related commodity derivative, the liquidity profile of the market, and its volatility profile. The price boundaries must also be renewed at regular intervals during trading hours based on the reference price.
They apply to energy-related derivatives whose maturity does not exceed 12 months because these are the most liquid contracts and have to be based on the observed market price at regular intervals. Following the advice of ESMA, the regulation is also of the view that intra-day volatility management mechanisms must take into account the diversity of instruments in energy derivatives markets as well as the peculiarities of the trading venues where these instruments are traded. Hence, no calibration is foreseen at the EU level entailing a one-size-fits-all approach, but it is left at the discretion of trading venues, given that they have—by default—the necessary knowledge and expertise to calibrate those mechanisms effectively. Trading venues must implement the intra-day volatility management mechanisms either by integrating them into their existing circuit breakers already established under MiFID II or as an additional mechanism. The trading venue must make public a description of its general features whenever it applies a modification, but it does not need to publish all the technical parameters of the mechanism that it puts in place.
Conclusions and future research
This article analyses and discusses the impact of the energy crisis as a consequence of the Russian–Ukrainian conflict on commodity derivatives trading law in Europe. More specifically, as a consequence of elevated and highly volatile futures prices, regulators imposed on trading venues intra-day volatility mechanisms in addition to the circuit breaker requirements currently requested by MiFID II. This article is the first to discuss the pros and cons that legislators took into consideration when introducing the requirement for trading venues to implement intra-day volatility mechanisms to mitigate excessive volatility in the gas derivatives markets, thereby reducing margin requirements for clearing members and market participants.
Although the academic literature did not find conclusive evidence of the benefits of circuit breakers, MiFID II already entails various circuit breaker measures for trading venues to mitigate excessive volatility. With the increased volatility in the gas derivatives markets, European legislators decided to go even further and ask for additional intraday volatility mechanisms to be implemented. Regulators were, however, still of the view that a one-size-fits-all approach would not be the way forward and one has to take into account the diversity of instruments in energy derivatives markets, as well as the peculiarities of the trading venues where these instruments are traded. Hence, there is no calibration foreseen at the EU level entailing a one-size-fits-all approach but it is left at the discretion of trading venues given that they have—by default—the necessary knowledge and expertise to calibrate those mechanisms effectively. Trading venues have to implement the intra-day volatility management mechanisms either by integrating it into their existing circuit breakers already established under MiFID II or as an additional mechanism.
As energy prices have not been excessively high since, no empirical data are available to see whether the activation of the circuit breakers would have had a beneficial impact. In case the situation would indeed occur, further empirical research could examine whether specific regulation on volatility in times of, for example, war would be effective. Also, further research could examine whether a one-size-fits-all approach is the right way forward. Based on empirical data of circuit breakers, combined with simulation analyses given that not many trading venues currently coordinate the circuit breaker mechanisms, it might be useful to obtain a clear-cut view on this issue.
Nevertheless, an empirical outcome will be relevant given that recital 49 of Council Regulation (EU) 2022/2576 mentions that when the information collected by ESMA shows that higher consistency of implementation of the mechanisms is needed to ensure more efficient management of excessive price volatility across the European Union, the European Commission can specify uniform conditions of implementation of the intra-day volatility management mechanisms, such as the frequency at which the price boundaries are renewed or the measures to be taken if trading moves outside those price boundaries. As a policy implication, it is thus necessary that further research is conducted on the usefulness of the introduced intra-day volatility mechanisms so that policymakers can have lessons learned in case of potential future volatility spikes.
The information contained in this article is the personal view of the author solely and not of the FSMA. This article also does not bind the FSMA in any way. The author is responsible for any errors or omissions. This research did not receive any specific grant from funding agencies in the public, commercial, or not-for-profit sectors. Declaration of interest: none.
Notes
See <https://time.com/nextadvisor/investing/stock-market-rattled-by-russia-ukraine/> (accessed 10 May 2023) and <https://www.ft.com/content/4c4c4c04-151c-467c-b011-136d56546da9> (accessed 10 May 2023)
See <https://lplresearch.com/2022/02/25/what-is-the-vix-index-and-how-has-it-responded-to-russia-ukraine-conflict/> (accessed 10 May 2023) and see <https://time.com/nextadvisor/investing/stock-market-rattled-by-russia-ukraine/> (accessed 10 May 2023)
See <https://www.ecb.europa.eu/press/pressconf/2022/html/ecb.is220310∼1bc8c1b1ca.en.html> (accessed 10 May 2023)
European gas and power markets are integrated as gas is used to generate electricity and therefore, these markets display high correlation around 0.60.
Regarding the electricity market, nuclear power plants in France, as alternative sources of power, suffered from maintenance problems, reducing their capacity when they were needed the most. At the end of August 2022, more than half of France’s nuclear generation capacity was offline.
See Imtiaz M Sifat and Azhar Mohamad, ‘Circuit breakers as market stability levers: A survey of research, praxis, and challenges’ (2018) 24 International Journal of Financial Economics 1130.
For instance, the ICE Endex BV trading venue has interval price limit functionalities that act as a temporary circuit breaker feature on the electronic platform. For eg, financial power futures, the interval price limit threshold is 30 USD, while the threshold is eg 0.20 USD for financial LNG contracts. See <https://www.ice.com/publicdocs/futures_us/Futures_US_IPL_Levels.pdf> (accessed 20 November 2024). The German EEX market then has, with regards natural gas spot contracts, no automatic volatility interruptions mechanisms but has implemented a price deviation control mechanisms. More specifically, EEX determines dynamic ranges within prices of orders may go up or down within a certain timeframe in a specific contract. Orders outside these rangers do not trigger an automatic volatility interruption but are rejected. See <https://www.eex.com/en/markets/mifid-ii-mifir> (accessed 20 November 2024).
Price limits can be daily (interday, static) or intraday (dynamic). In case of static circuit breakers, the upper and lower limits are set once a day (typically according to the settlement price of the previous trading day) and these limits are then the same throughout the trading day. Dynamic circuit breakers have limits that move with the market throughout the day. Within a specific time interval, dynamic circuit breakers define an upper and lower limit of how far an instrument is allowed to move. Hence, the calculation of the upper and lower limits is constantly updated.
Council Regulation (EU) 2022/2576 of 19 December 2022 enhancing solidarity through better coordination of gas purchases, reliable price benchmarks and exchanges of gas across borders, See <https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=uriserv:OJ.L_.2022.335.01.0001.01.ENG> (accessed 9 September 2024).
Randy Priem, ‘A relaxation of European derivatives clearing legislation as a consequence of the 2021-2023 energy crisis’ (2024) 17 Journal of World Energy Law & Business 277.
Randy Priem, ‘Increased financial regulation in the European Union for energy firms extensively active in energy derivatives markets’ (2023) 42 Journal of Energy and Natural Resources Law 211.
Randy Priem, ‘A market correction mechanism regulation as a consequence of the 2021-2023 energy crisis’ (2024) Journal of World Energy Law & Business, forthcoming.
See Ivan Daiz-Rainey, Mathias Simes and John K Ashton, ‘The financial regulation of energy and environmental markets’ (2011) 19 Journal of Financial Regulation and Compliance 355.
See Bernardina Algieri, ‘Conditional price volatility, speculation, and excessive speculation in commodity markets: sheep or shepherd behavior?’ (2016) 30 International Review of Applied Economics 210; Matthias Kalkuhl, Joachim von Braun and Maximo Torero, Food Price Volatility and Its Implications for Food Security and Policy (Springer Netherlands 2016); Dwight R Sanders, Scott H Irwin and Robert P Merrin, ‘The adequacy of speculation in Agricultural futures markets: Too much of a good thing?’ (2010) 32 Applied Economic Perspectives and Policy 77.
See Bahattin Büyüksahin and Jeffrey H. Harris, ‘Do speculators drive crude oil futures prices?’ (2011) 32 The Energy Journal 167; Adair Turner, Jon Farrimond and Jonathan Hill, The Oil Trading Markets, 2003-2010: Analysis of Market Behavior and Possible Policy Responses (Oxford Institute for Energy Studies 2011); Bhabani Sankar Rout, Nupur Moni Das and K. Chandrasekhara Rao, ‘Does commodity derivatives function effectively? A lengthy discussion’ (2021) 13 IIM Kozhikode Society & Management Review 154.
See Charles M Oellermann, Wade B Brorsen and Paul L Farris, ‘Price discovery for feeder cattle’ (1989) 9 Journal of Futures Markets 113; Isha Chhajed and Sameer Mehta, ‘Market behavior and price discovery in Indian agriculture commodity markets’ (2013) 3 International Journal of Scientific and Research Publications 1; S Sehgal, Namita Rajput and Rajeev K Dua, ‘Futures trading and spot market volatility: Evidence from Indian commodity markets’ (2012) 4 Asian Journal of Finance and Accounting 199; Stephen R Koontz, Philip Garcia and Michael A Hudson, ‘Dominant-satellite relationships between live cattle cash and futures markets’ (1990) 10 Journal of Futures Markets 123.
See Ing-Haw Cheng and Wei Xiong, ‘Financialisation of commodity markets’ (2014) 6 Annual Review of Financial Economics 419; Thomas V Schwarz and Andrew C Szakmary, ‘Price discovery in petroleum markets: Arbitrage, cointegration and the time interval of analysis’ (1994) 14 Journal of Futures Markets 147; Stelios D Bekiros and Cees GH Diks, ‘The relationship between crude oil spot and futures prices: Cointegration, linear and nonlinear causality’ (2008) 30 Energy Economics 2673; Keshab Shrestha, ‘Price discovery in energy markets’ (2014) 45 Energy Economics 229.
See Daiz-Rainey, Simes and Ashton (n 14).
Regulation (EU) No 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties and trade repositories. See <https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=celex%3A32012R0648> accessed 5 September 2024
Priem (n 13).
This figure does not display the role of commodity funds or hedge funds that are also active in the market. For more information, see <https://www.fsb.org/2023/02/the-financial-stability-aspects-of-commodities-markets/> accessed 10 May 2024.
In the gas market, a gas exchange allows a shipper or trader to buy or sell gas without the other party to the gas transfer being known to the shipper or trader. The gas exchange operator is responsible for bringing together the volumes of gas offered and the volumes of gas requested.
The TTF is a virtual market place where gas that is already present in the Dutch gas system (‘entry-paid’ gas) is traded (ie after import, regasification, and injection in the EU pipeline system).
In the gas market, a virtual trading point is a non-physical commercial point for trading in natural gas markets representing all entry and exit points in that market area. Gas is exchanged between sellers and buyers without the need to book transmission or distribution capacity.
In the gas market, a hub is a central pricing point for the infrastructure network’s natural gas.
The ICE TTF futures contracts, for instance, are for physical delivery through the transfer of rights in respect of TTF. Trading will cease at the close of business, two business days prior to the first calendar day of the delivery month, quarter, season, or calendar. Delivery is made equally each hour throughout the delivery period. Around 50 per cent of all TTF-gas future contracts are held until maturity, which results in physical gas delivery.
In this article, we focus mainly on gas but given the high correlation between gas, oil and electricity, most arguments also apply to eg electricity futures.
A trading venue means a regulated market, as defined in art 4(1), point (21) of Directive 2014/65/EU (MiFID II), a multilateral trading facility as defined in art 4(1), point (22) of MiFID II, and an organized trading facility as defined in art 4(1), point (23) of Directive 2014/65/EU.
European gas futures are also traded outside of the Europe at eg the NYMEX/CME.
See <https://www.esma.europa.eu/sites/default/files/library/esma70-446-775_preliminary_data_report_on_mcm.pdf> (accessed 10 May 2024).
In case of central clearing, a central counterparty (CCP) will act as a counterparty to both sellers and buyers (novation). In this way, counterparty risk is reduced.
Variation margins are mark-to-market and initial margins often increase because margin models used by CCPs require higher levels of collateral to compensate for heightened volatility of derivatives.
See Sifat and Mohamad (n 7); Lawrence R Glosten and Paul R Milgrom, ‘Bid, ask and transaction prices in a specialist market with heterogeneously informed traders’ (1985) 14 Journal of Financial Economics 71; Kenneth A Kim and S Ghon Rhee, ‘Price limit performance: Evidence from the Tokyo Stock Exchange (1997) 52 The Journal of Finance 885; Harlad Henke and Svitlana Voronkova, ‘Price limits on a call auction market: Evidence from the Warsaw Stock Exchange’ (2005) 14 International Review of Economics and Finance 439; Cyrille Guillaume and others, ‘Market impacts from circuit breakers—evidence from EU trading venues’ (2020) ESMA Working Paper. <https://www.esma.europa.eu/sites/default/files/library/esmawp-2020-1_market_impacts_of_circuit_breakers.pdf> (accessed 10 May 2024); Lawrence Kryzanowski and Howard Nemiroff, ‘Market quote and spread component cost behavior around trading halts for stocks interlisted on the Montreal and Toronto Stock Exchanges’ (2005) 36 The Financial Review 115
See Lucy F Ackert, Bryan K Church and Narayanan Jayarman, ‘Circuit breakers with uncertainty about the presence of informed agents: I know what you know… I think’ (2005) 14 Financial markets, Institutions & Instruments 135.
See Sifat and Mohamad (n 7).
See Glosten and Milgron (n 34); Kim and Rhee (n 34); Henke and Voronkova (n 34); Kryzanowksi and Nemiroff (n 34); Sifat and Mohama (n 7).
See William G Christie, Shane A Corwin and Jeffrey H Harris, ‘Nasdaq trading halts: The impact of market mechanisms on prices, trading activity, and execution costs’ (2002) 57 Journal of Finance 1443.
See Tarun Chordia, Richard Roll and Avanidhar Subrahmanyam, ‘Order imbalance, liquidity, and market returns’ (2002) 65 Journal of Financial Economics 111; Mark S Seasholes and Guojun Wu, ‘Predictable behavior, profits, and attention’ (2007) 14 Journal of Empirical Finance 590.
See Avanidhar Subrahmanyam, ‘Circuit breakers and market volatility: A theoretical perspective’ (1994) 49 Journal of Finance 237.
See Avanidhar Subrahmanyam, ‘The ex-ante effects of trade halting rules on informed trading strategies and market liquidity’ (1997) 6 Review of Financial Economics 1.
See Charles MC Lee, Marj J Ready and Paul J Seguin, ‘Volume, volatility, and New York Stock Exchange trading halts’ (1994) 49 The Journal of Finance 186; Shane A Corwin and Marc L Lipson, ‘Order flow and liquidity around. NYSE trading halts’ (2000) 55 Journal of Finance 1771; David D Cho and others, ‘The magnet effect of price limits: Evidence from high-frequency data on Taiwan Stock Exchange’ (2003) 10 Journal of Empirical Finance 133; see also Henke and Voronkova (n 34); Recep Bildik and Güzhan Gülay, ‘Are price limits effective? Evidence from the Istanbul Stock Exchange’ (2006) 29 Journal of Financial Research 383.
See Martin Martens and Onno W Steenbeek, ‘Intraday trading halts in the Nikkei futures market’ (2001) 9 Pacific Basin Finance Journal 535.
See Subrahmanyam (n 40).
See Peter Gomber and others, ‘The effect of single-stock circuit breakers on the quality of fragmented markets’ (2013) Enterprise Applications and Services in the Finance Industry Conference Paper 71.
Directive 2014/65/EU of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments and amending Directive 2022/92/EC and Directive 2011/61/EU. <https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=celex%3A32014L0065> (accessed 10 May 2024).
Directive 2024/790 of the European Parliament and of the Council of 28 February 2024 amending Directive 2014/65/EU on markets in financial instruments. <https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=OJ:L_202400790> (accessed 20 November 2024).
A regulated market means a multilateral system operated and/or managed by a market operator, which brings together or facilitates the bringing together of multiple third-party buying and selling interests in financial instruments—in the system and in accordance with its non-discretionary rules—in a way that results in a contract, in respect of the financial instruments admitted to trading under its rules and/or systems, and which is authorized and functions regularly and in accordance with Title III of MiFID II.
See WFE, ‘Circuit breakers: A survey among international trading venues’ (2016) <https://www.world-exchanges.org/home/index.php/files/18/Studies%20-20Reports/356/WFE%20Survey%20on%20Circuit%20Breakers.pdf> accessed 10 May 2024.
<https://www.iosco.org/library/pubdocs/pdf/IOSCOPD726.pdf> accessed 10 May 2024.
Commission Delegated Regulation (EU) 2017/584 supplementing Directive 2014/65/EU of the European Parliament and of the Council with regards to regulatory technical standards specifying organisational requirements for trading venues. <https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32017R0584&from=EN> (accessed 10 May 2024).
Sponsored access means a member of an exchange providing other market participants access to that market.
This includes the number of orders per second on pre-defined time intervals, an equal-treatment policy among members unless the throttle is directed to individual members, and the measures to be adopted following a throttling event.
See <https://www.esma.europa.eu/sites/default/files/library/esma24-436-1414_-_response_to_ec_commodity_markets.pdf> accessed 10 May 2024.
The Chicago Mercantile Exchange (CME) implemented these price limits already for e.g. agricultural commodity derivatives’, which are recalibrated twice a year and define the maximum price range permitted for a futures contract in each trading session being anchored to the previous day settlement price; See <https://www.cmegroup.com/education/brochures-and-handbooks/grain-oilseed-and-lumber-price-limit-faq.html> accessed 10 May 2024.
Suppose that a 25% variation is allowed based on a reference price of 50 EUR, then the maximum intraday possible price increase would be 12.5 EUR. If instead the reference price was to soar to 150 EUR, the same 25% variation would lead to a 37.5 EUR intraday increase, which is also considerable.
See <https://www.fia.org/sites/default/files/2022-11/FIA%20letter%20to%20EC%20and%20ESMA%20-%20Exchange%20Risk%20Controls.pdf> (accessed 10 May 2024).
<https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=uriserv:OJ.L_.2022.335.01.0001.01.ENG> (accessed 10 May 2024).
