Financial Services and Markets Bill

Baroness Worthington Excerpts

Committee stage
Wednesday 25th January 2023 Grand Committee

Moved by

[Baroness Worthington]

21: Schedule 2, page 124, line 12, leave out paragraph 45
Member’s explanatory statement
These amendments maintain the duty for FCA to set position limits on commodity derivatives and over the counter equivalents, and the associated powers to request information and intervene, whilst onshoring the power to set limits which are appropriate for the UK.

[Baroness Worthington (CB)]

My Lords, I am very pleased to speak to this group of amendments this afternoon, having sadly been unable to make Second Reading. I declare my interest as a co-chair of Peers for the Planet. I also declare my relative ignorance of this topic, as I am not steeped in the details of financial services. I very much approach this issue from a layperson’s perspective, guided by common sense. Much of my efforts here are to apply parliamentary scrutiny to this very complex issue and to seek reassurances from the Minister.

As we debated in the previous group, it is vital that we have proper scrutiny of proposed changes to laws and regulations governing financial markets. Potentially poorly regulated markets could have significant negative real-world consequences, as we have seen in the past. Complexity is now endemic in this sector and can catch regulators, and indeed parliamentarians and Ministers, out. Derivative markets are particularly complex and require especially careful scrutiny.

My Amendments 21 to 25 and 41 concern the proposed future regulation of trading in commodities and their derivatives. Many noble Lords will be aware of this, but to give some background, derivatives are used in the financial markets and the wider economy to hedge exposure to commodity prices in the future. However, this opens up the opportunity to speculate and seek profit from volatility. Roughly two-thirds of commodity trading relates to commodities in the energy and food markets. Therefore, unchecked speculation and poor regulation in these markets can have very real-world consequences. Some types of commodity derivative investment are of course socially desirable. For example, soft commodity or energy producers seeking to insure themselves against future risks arising from such things as weather and an unstable climate are making a necessary hedge to keep products economic. However, there are dangerous aspects of this as they relate to food and energy, which affect people’s lives and the affordability of living.

Momentum-based trading strategies can exacerbate steep price rises and the cornering of markets, by which I mean taking large positions that are disproportionate to your genuine participation in the market, which could force unnatural or artificial scarcity into the market and raise prices. More generally, increasing volumes of capital being tied up in future derivatives removes money from the real economy today, where it could be delivering much greater real-world impacts.

There is overwhelming evidence that unchecked speculation produces price bubbles. I do not intend to go into this in detail, but in relation to oil, a 2021 piece in Resources Policy looked back at a whole host of research dating back to 2009 in highly cited journals. So firm is the consensus that there is now a whole body of techniques dedicated to measuring and modelling bubbles. We are well past the point of discussion of whether there is a risk; it is now about how we manage it and its impacts.

The co-author of last October’s UN Conference on Trade and Development—UNCTAD—trade review said that a ratio of around 70% real hedging and 30% speculation might be seen as “healthy”. However, he added that what we see in the market today indicates that the ratio has been reversed: 70% speculation and 30% real hedging. The same report warned of a policy-induced global recession. The report said that insufficient attention has been paid to the “betting frenzies” on future markets in the current crisis and called on Governments to tighten rules on speculation. However, with this legislation we seem to be doing the opposite.

EU legislation on commodity derivatives was introduced, and it was not simply pointless bureaucracy. There was clear evidence in the run-up to and during the financial crash of 2008 that food and energy prices were being driven upwards not by shortages but by fevered speculation, so action was taken. Investment banks were seen to be profiting by around $16 billion a year from commodity trading. Thanks to these new approaches, we have seen that profit-making fall by around three-quarters, according to analysis from the research firm Coalition. So there was a reason for the EU regulations that we are seeking to modify as we translate to post-Brexit financial regulation.

The general point is that we should be seeking to allow the socially beneficial, but not allowing bubbles to be created in this market. We should not be making it easier to do that but keeping a careful eye and tracking trends, while requiring clear data and better disclosure. You could argue that the EU perhaps overreached or did not get it exactly right, and that we should seek to take our own approach, but I have some questions about the Government’s proposals in the Bill.

It appears to me, and I seek reassurance from the Minister on this, that Schedule 2 is handing the power of setting appropriate position limits and controls—and the maximum position any firm can take on trading on a commodity—to financial exchanges, or certainly taking the power to do so. But are those exchanges not incentivised commercially to maximise liquidity and volumes of trade, so does this not create something of a conflict if they are also setting their own limits?

These new arrangements would see the FCA retaining backstop powers to give directions, but only in certain fairly narrowly defined circumstances. It can request information and intervene, but the drafting suggests that the exchanges would be free to set their own limits. Is this the case and, if so, how does the Minister expect them to handle this potential conflict between their commercial interests and a more cautious approach to the prevention of harmful speculative bubbles?

There is also the question of what will be regulated in future. The current rules cover both over-the-counter trades and exchange trades but, as I understand it, this new approach is about simply deciding not to continue to seek oversight of over-the-counter trades. From what I have been able to read, this seems to be based on the fact that those consulted said it was too difficult to do. That does not seem a good enough reason to remove the oversight of OTC trades and focus simply on exchange trades.

There is also the point about exchanges having less oversight of systemic risks building up in the global market. Whereas the FCA engages via the IOSCO, the International Organization of Securities Commissions, and the FSB—

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[Baroness Worthington (CB)]

I shall seek to remember where I was in my speech. I was talking about international co-ordination and how the FCA currently is part of a global network of regulators, and therefore has a more effective chance of spotting systemic risks building up in the global markets, and that the exchanges would not be plugged in at the same level of international co-operation and co-ordination. The FSB warned, in the aftermath of Russia’s invasion of Ukraine, that

“prices have swung wildly, with liquidity temporarily evaporating in some commodity derivatives market segments and a number of traders coming under strain”.

So I ask the Minister: in these uncertain times, how certain are we that UK exchanges can be patched into that wider market scrutiny and regulatory infrastructure, which the regulator currently has the power to do?

The powers retained by the FCA are limited to intervening on operational objectives and, most relevantly here, consumer protection and integrity, but I am concerned that that definition of consumer may be rather too narrow. It could refer, as it does in Section 1 of the 2000 Act, to the investor, rather than the man or woman on the street. I worry that “integrity” could simply refer to soundness, stability, orderliness and lack of crime. I would welcome the Minister’s view on how this maps on to the existing grounds for regulation that are to be revoked, which are much broader and relate to preventing market abuse and market distortion and try to ensure that there is no artificial inflation of commodity prices.

My concern is that we can have a sound and orderly market which works very well for investors but inflates prices for consumers and businesses and adds extra costs on to essential commodities. I believe the FCA should retain the power to intervene in these cases, and that the definition of grounds for intervention should be as broad as it is currently.

I mentioned the over-the-counter derivatives no longer being covered in regulation. I was rather worried to read in the Treasury’s consultation on wholesale markets that:

“The objective of including them as part of the regime was to prevent market participants from circumventing regulatory requirements that are applicable to exchange traded commodity derivatives by dealing in lookalike OTC contracts. However, in practice, identification of these contracts has proven difficult, and they have only been reported in a very small number of instances.”


Therefore, the Treasury concluded that

“the inclusion of these contracts and uncertainty about the scope of this requirement imposes increased legal risk and potential compliance costs for firms.”

To me, that sounds as though something important is proving difficult and, rather than seeking to solve it, make it easier and provide clearer guidance, we have decided to drop it altogether.

The consultation goes on to say:

“to ensure market integrity, the government proposes that the FCA and trading venues should continue to take account of relevant OTC contracts when monitoring markets.”

But amendments to Regulations 27 and 28 take away the power from the FCA to do this and to request information on these contracts. That is my reading of it, but I look forward to reassurance or clarification from the Minister. If the FCA is not able to monitor these transactions, how can we oversee them? Would it not be more desirable to have the FCA retain the powers it has?

I am grateful for the support of the noble Baroness, Lady Bennett of Manor Castle, for my amendments. Essentially, they seek to unhook the legislation from the EU but continue to require the FCA to maintain the same powers to set position limits and to intervene as widely as possible to ensure proper consumer protection and maintain international co-ordination, which is so essential in these markets.

Amendment 41 requires the FCA to make rules requiring listed companies to publish the revenue and earnings attributable to trading commodity derivatives and economically equivalent over-the-counter contracts. I think this is important because I have personal experience—and there is plenty of anecdotal evidence—of firms that are operating very significant trading activities but hiding their profits in their financial statements and in other parts of their accounts, because to disclose quite how much was being made from trading would bring a lot of questions about the nature of those companies. I am specifically talking about energy companies, which have very significant trading activities and are not, at the moment, required to disclose in their accounts the level of profit they are making from those activities.

This is important because it materially affects the ability of financial services to assess the health of these companies. If we are not seeing the extent to which they are engaged in these derivative-trading activities and we are unable to see where the profits are being made, how can we make fair and open assessments about the nature, success and propriety of their business? It is important that we give ourselves the transparency to see exactly how much of this is happening and the degree to which it is altering the balance sheets of companies in these sectors, which are so essential to maintaining our standard of living and, in the case of energy and food companies, have such a material impact on our environment and global climate.

I am sorry that that was a very long speech, but I look forward to hearing the Minister’s responses and to continuing the debate.

[Baroness Noakes (Con)]

My Lords, I will speak to the amendments from the noble Baroness, Lady Worthington. I do not support them, because I think that what the Government are trying to do in this Bill is moving in the right direction.

We have to remember that derivatives are basically a success story. It is a huge financial activity. The total value of derivative trading is sometimes estimated to be a multiple of global GDP. Of course, commodity trading is only a relatively small part of that, but it is important because the advantages of trading allow effective risk management, price discovery and market efficiency. Those are the sorts of things that actually help consumers, at the end of the day, so we must be very wary of trying to interfere in what is fundamentally a successful part of our financial infrastructure.

Of course, speculation is involved in derivatives, there is risk for some counterparties—and sometimes systemic risk—in derivatives, and sometimes they are extremely complicated as individual instruments, even to understand. But they are part of and underpin something that works well for markets overall. We should intervene in that only if absolutely necessary.

My own view is that the changes in the Bill probably do not go far enough to take the dead hand of EU prescriptive regulation away, but they are a solid move in the right direction. As the noble Baroness, Lady Worthington, pointed out, they replace a mandatory regime with a permissive one that allows the rules to be designed for the particular markets. In particular, the changes in Schedule 2 will allow the FCA to transfer responsibility for setting position limits to trading venues, if indeed position limits are needed. For some time now, the FCA has not been enforcing excesses on position limits in respect of the majority of contracts, and the world has not come to an end.

I think Amendments 21 and 22 are a step backwards in trying to preserve a mandatory EU regime. So too is trying to drag over-the-counter derivatives into that regime, because—as the noble Baroness pointed out—it has been found that they are extremely difficult to identify. Their removal from the regime was almost universally supported in the consultation that the Government carried out on changes to the derivatives regime.

Amendment 41 from the noble Baroness, Lady Worthington, is about putting additional information in annual reports and accounts. There are already obligations on companies to report things that are material to an understanding of the financial position of those companies. They are required to describe their trading model and the operating segments that are relevant to them, but they are not required to identify income streams from particular instruments that they operate. There is a good reason for that. Annual reports are already very long, complicated and difficult to understand, and the noble Baroness is asking for information that in very many cases will be wholly irrelevant to an understanding of the financial position or operations of the companies that involve some trading. For many, it is embedded in their marketing activities for the products they engage in. I do not support any of the amendments put forward by the noble Baroness.

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[Baroness Penn (Con)]

There is no sunset clause on this power, just as there is no sunset clause on the powers in Clauses 3 and 4, so it is consistent with the approach we have taken with those other powers.

I thank the Committee for allowing me to address those points in this group. With that and the further information I shall deliver to the Committee on some of the questions from the noble Baroness, Lady Worthington, I hope that she will withdraw her Amendment 21 at this stage and will not move her other amendments.

[Baroness Worthington (CB)]

My Lords, I am genuinely grateful to the Minister for her response, which was very helpful and contained information about which I was not aware—I thank her for that. I will read Hansard in great detail. In her letter, can she explain a little more about those 18 contracts that will be covered and the retained powers? I would find that very interesting, although I am sure I can also google it.

I will now sum up. I am very grateful to the noble Baronesses, Lady Bowles and Lady Kramer, for their contributions. Returning to the statements by the noble Baroness, Lady Noakes, I am sure it is seen as a great success that we have this $600 trillion market in stuff that exists in the future, which is hugely complex and can crash the global economy. Some people will have benefited hugely from it; I have no doubt that some of those people may be in this Room. The point is that there is someone paying at the other end of that profit, and often it is the people at the very end of the chain who are trying to buy food in supermarkets or heat their homes. If a bubble in that market is definitely benefiting some—even maybe benefiting the Government, if they are receiving revenues from it—it comes at a cost, so we should be very mindful of the need to regulate that market. There is evidence after evidence of these bubbles forming because, quite frankly, the incentives to make cheap money are huge. Compared with the real economy, where you actually have to do things, build things, sell things and employ people, the desire to make money fast is overwhelming, and I do not want the UK to become the home of ever more exotic derivatives that allow us to make money the quick and easy way. Let us make banking and the financial markets boring again by getting them back to basics: using money to further society’s aims. If we cannot do that individually, we should do it collectively. I do not want to get on my soapbox, but the fact that we are exiting Europe makes that more difficult, so even more scrutiny needs to be applied now that we are setting our own rules.

I am grateful for the responses. I will end by saying that I had the pleasure of meeting a gentleman who worked in a bank that was more than 500 years old. I asked him about its ESG policies, and he listed them. They started with, “We will make no profit at all from soft commodities”, then went on to the usual checklist about arms and whatever else. I asked him where that came from, and he said, “Oh, we can’t remember”. Because it was such an old-fashioned concept—that we should take a moral position that we will not engage in profiteering from soft commodities—it sort of lapsed into the history of time.

Banking was moral once. I am not saying it is immoral now, but it is incredibly complicated. The incentives to make money in ever more novel ways are always there. Even the noble Baroness, Lady Noakes, alluded to the fact that systemic risks exist. They have existed in my lifetime and I am sure they will come again.

I am glad that we are here to do this scrutiny and very glad of the Minister’s offer to write. I hope that we will revisit some of these questions, and I will end on Amendment 41. I have personal experience of how energy companies are loath to disclose how much of their profits rest on trading. If that is the case, the markets should care about it and disclosure is the most obvious step to address it. With that, I beg leave to withdraw.

Amendment 21 withdrawn.