Too Poor to Protest?

10^th November 2016

As oil prices continue to languish in the mid $40s, producers who sanctioned exploration and development plans and refiners who hedged their crude oil supply at price levels higher than today and ship owners suffering low freight rates and rising costs from environmental legislation are all feeling the pinch. So the last thing any company in this position needs is to find itself involved in a dispute that it cannot afford to fight.

As an independent expert witness, by definition, I do not concern myself with who ultimately pays the cost of litigation, including my bill, so long as I am comfortable that I will be paid. Any doubt about that and my ability to prove my neutrality to the outcome of the case is compromised.

So I have only just become aware, thanks to the judgement in the Essar versus Norscot arbitration, of the growing number of third parties whose business model is to fund disputes in which they otherwise have no interest. The arbitrators in the case referred to above made the loser cough up for the winner’s bill from its third party funder. This is old news for lawyers, but the idea of “champerty” is new to me.

Champerty, as I understand it, means sharing the damages awarded by the court or panel between the successful litigant and the third party funder (TPF). If the TPF backs the losing side then it picks up the costs for both, if the arbitration panel or judge decides that the loser is liable for the other side’s costs. However the TPF may take out “After the Event” insurance to cover the opponents costs, i.e. insurance taken out after the case has arisen but obviously not after the case has settled.

But beware: there are jurisdictions that have a “no champerty” rule. I understand that Eire is one such state. As with most legal concepts there are bells and whistles attached to the TPF idea that need to be explored by lawyers on a case by case basis.

Coming from a risk management background I am intrigued by the TPF business model. I have to wonder how TPFs calculate risk and whether typical value-at-risk (VaR) models apply to these activities. This question will be brought sharply into focus when TPFs have an IPO and encourage others to invest in their business model.

Is it possible to measure the risk involved in bringing a case to court or is the risk of winning or losing an entirely subjective matter? Forecasting the outcome of a case is likely to be every bit as difficult as forecasting the next move in oil prices, yet we rely on models to assess oil price risk. In the case of litigation we have the body of case law and the track record of particular barristers, judges and arbitrators to potentially populate a risk model with data.

If you can measure risk you can trade it and hedge it. From there it is a short step to commoditising legal risk as a new asset class and having TPF market makers quoting a bid-offer spread on the risk of funding a case.

TPFs are not regulated, although they have a trade association, the Association of Litigation Funders, and are self-regulated on a voluntary basis, i.e. they are not really regulated at all. If legal risk is commoditised it too could be subject to the new financial regulation that the rest of the commodity trading community is now hiring lawyers to implement.

But these developments are years in the future if the legal profession allow them to happen at all. The real point for right now is this: there will always be corporate bullies who ride roughshod over the little guys, safe in the knowledge that their resources will buy them more and better champions of their case. Right now, with oil prices at low levels, the chances of a small company having the cash to put up a fight are pretty low. But the little guys who don’t have the funds to stand up for themselves can potentially bring in a TPF, if their case has merit. If it doesn’t have merit then running it by a TPF first will at least save them money and management time to deal with the real problem of low oil prices.

From my perspective as an expert witness, if litigants are forced to get their act together and consult experts at an earlier stage because they have to convince a TPF to bankroll the proceedings, that can only be a good thing. There is nothing worse than having to advise a litigant that, in your opinion, their case fell at the first fence when they have already galloped half way round the track.

Next Moves in the freight market will determine if SGX got a Baltic bargain

Please click the link below to read Liz Bossley's full article in Tradewinds

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The Regulation of Commodity Markets: Part Five

This is the fifth and final article in a series that takes a critical look at the application of financial regulation to the commodity market. We foresee a problem down the road when the regulators begin to assimilate the hecatombs of new data that will be reported to them by Dodd Frank Swap Data Repositories ('SDRs') and EMIR Trade Repositories ('TRs').

The first article in this series provided an overview of the policy objectives of the G20 group of Finance Ministers and their aim to restore global growth, strengthen the international financial system and reform international financial institutions following the 2007/2009 banking crisis and subsequent recession.

The second article considered the Dodd Frank Act, which is the US approach to meeting America's G20 obligations.

The third article looked at the equivalent European response to the G20's demand for tighter financial regulation, the European Market Infrastructure Regulation ('EMIR').

The fourth article examined two other pieces of European legislation of relevance to commodity markets: the Market in Financial instruments Directive ('MiFID') and the Regulation on Energy Market Integrity and Transparency ('REMIT').

This article focuses on the consequences of new US and European regulation for hedging price risk in the commodity market. Companies that avail themselves of end user or hedging get out clauses to avoid the more draconian clearing and risk mitigation aspects of the new regulations are likely to be put to proof that their hedge transactions are not in fact speculative and therefore are not subject to more intensive regulation or lower dealing limits than apply to hedge transactions.

Dodd Frank: Volcker

Dodd Frank does not target hedging instruments specifically. But it is in the realm of commodity hedging that it is felt most acutely through the Volcker Rule, which was adopted in December 2013. This is because Volcker caused some of the most creative and competitive commodity market makers, the US banks, to exit the business. US banks were adept at trading in physical commodity markets to construct their own risk management scaffolding around the less than perfect regulated commodity hedging tools, which were all that was available to the majority of end users and hedgers.

Volcker was based on the premise that banks were speculating with clients' money. To prevent this, the Volcker Rule prohibits banks and financial institutions from proprietary ('prop') trading, or sponsoring or investing in hedge funds or private equity funds by more than 3% of the fund.

The SEC defines proprietary trading as engaging as a principal for the trading account of the bank or non-bank financial company supervised by the Board in any transaction involving any security, any derivative, any contract of sale of a commodity, or any other security or financial instrument that the SEC or the CFTC may determine. In other words prop trading means trading on the bank's own account rather than on behalf of clients.

In the case of commodity markets the adoption of the Volcker Rule was when the baby was thrown out with the bath-water.

In the commodity markets dealers experience substantial basis risk between the myriad of physical contracts and the limited number of financial instruments that can be used to hedge them. To handle this the US banks that provided hedging services to Major Swap Participants ('MSPs') and to commercial end-users, often entered into offsetting physical contracts that were not immediately obviously a component of an unbundled hedging package. This occurred because, for example, the product quality, locational or timing characteristics of the hedges differed from those of the commodity being hedged.

Most US banks chose to exit the imperfect commodity hedging market once Volcker was adopted rather than run the risk of being judged to be conducting illegal prop trading. These risks therefore have either reverted to the principals or been laid off with less diversified third parties in a market less liquid because of the withdrawal of the US banks from market making activities.

This means wider bid-offer spreads and higher costs for the end-user. This is the exact opposite of the stated aims of Dodd Frank to lower transaction costs, improve confidence in the market, encourage participation by a large number of market participants and increase liquidity in the swap based securities market...........

The Regulation of Commodity Markets: Part Four

The first article in this series provided an overview of the regulatory policy objectives of the G20 group of Finance Ministers and their aim to restore global growth, strengthen the international financial system and reform international financial institutions following the 2007/2009 banking crisis and subsequent recession. The second article considered the Dodd Frank Act, which is the US approach to meeting its G20 obligations. The third article looked at the equivalent European response to the G20's demand for tighter financial regulation, the European Market Infrastructure Regulation ('EMIR').

This fourth article examines two other pieces of European legislation of relevance to commodity markets: the Market in Financial instruments Directive ('MiFID'); and, the Regulation on Energy Market Integrity and Transparency ('REMIT').

MiFID I/ MiFID II

The Market in Financial instruments Regulation ('MiFIR') and MiFID both address market efficiency, safety and transparency and the prevention of market abuse. MiFIR additionally addresses the definition, prevention and criminalization of market abuse with the Market Abuse Regulation ('MAR') and the Market Abuse Directive ('MAD II').

MiFID I, which was adopted in 2004 and which took effect in 2007, aims to create a common internal European market and to promote competition amongst trading platforms. Unlike Dodd Frank MiFID I did not oblige OTC trades to migrate to regulated markets ('RMs').

Instead it recognized the concept of multilateral trading facilities ('MTFs') that are not exchanges, but were allowed to operate alongside RMs in the OTC market. Operators of MTFs were permitted to offer a wider range of more customized instruments than those that are offered on RMs. MTF transactions were subject to less onerous reporting provisions and consequently positions and exposures were more difficult to track.MiFID II / MiFIR, which repealed MiFID I and were adopted in 2014, recognizes an additional trading venue: the Organized Trading Facility ('OTF') in attempt to catch any other trading venues that are not unequivocally OTC. For example, broker crossing systems or inter-dealer broker systems may be regarded as OTFs. Running an OTF is an investment service and the operator must be licensed as an Investment Firm in the same way as an RM or MTF.

Unlike operators of RMs and MTFs, OTF operators have discretion in placing bids and offers and in matching orders, in accordance with clients' instructions. For example, a client of an OTF may specify that it does not want its orders matched with a particular counterparty with whom, for example, it may already have reached an internal dealing limit.

RM, MTF and OTF operators cannot trade using their own proprietary capital, except in the case of OTFs dealing in illiquid sovereign debt instruments. The exclusion of the use of proprietary capital distinguishes these venues from the activities of Systematic Internalizes ('SIs'). Such SIs include, for example, the centralized trading function of major oil company or utility or commodity trading house acting as a central dealer for its asset teams or its overseas affiliates. The SI may deal in the market with third parties or match orders from different affiliates within its own greater corporate book. SIs can use proprietary capital and do not have to be licensed to carry out this activity.

Algorithmic trading is regarded as a particular threat to market stability by prolonging and accentuating price movements. Algorithmic traders are required to install control systems to ensure their procedures are robust and have sufficient capacity, are subject to appropriate trading thresholds and ceilings and can prevent mistaken orders from triggering inappropriate market movements.