Regulating regulators – The UK FCA’s first fine imposed on a Recognised Investment Exchange

In its first enforcement decision relating to a Recognised Investment Exchange, the FCA has published a final notice and imposed a penalty of £9.2 million on the London Metal Exchange (LME). This follows the FCA’s previously announced investigation of price volatility in 3-month nickel (3M Nickel) contracts on 7 and 8 March 2022.

Recognised Investment Exchanges (RIEs) are both regulated by the FCA and regulators of trading on the exchanges they operate. Although RIEs have different regulatory requirements from other authorised firms, the FCA findings on governance and decision-making in this final notice are applicable to a wider range of firms.  

Market events in March 2022

In early March 2022the price of the LME’s 3M Nickel became extremely volatile. This culminated in the price rising by an unprecedented 69% on 7 March 2022 and over 100% in the early morning of 8 March 2022, to over $100,000 per tonne. 

The LME subsequently suspended nickel market trading for 8 days and cancelled 3M Nickel trades entered into on 8 March. This sparked the FCA’s announcement of its investigation and a judicial review challenge of the LME’s decisions to cancel 3M Nickel trades. 

Price control requirements for RIEs

Since 3 January 2018, following the implementation of MiFID II in the UK, it has been mandatory for electronic trading venues to have automatic mechanisms to manage price volatility. These mechanisms can be in the form of:

1. automated trading halts, which can detect excessive price movements and in response halt trading for a specific period of time; and
2. static/dynamic ‘price bands’, which only permit trades to take place within specific thresholds. These thresholds are either fixed or linked to a particular reference point (e.g. the price of the most recent trade).

FCA findings 

The FCA found that the LME’s systems and controls were not adequate, effective and appropriate for the scale and operation of its business and to ensure orderly trading under conditions of severe market stress. In particular, the LME did not have adequate controls or policies relating to the operation of its automatic volatility controls, its ‘price bands’.  In particular, the FCA identified the following failings:

• Although the FCA considered the LME’s price bands to be appropriately calibrated, it found that the LME’s focus when operating the price bands was too narrow, treating them as a protection against error trades, other erroneous orders and rogue algorithms rather than as a protection against extreme volatility resulting from market conditions. The LME failed to articulate to its staff operating the price bands that they formed part of its controls more broadly to ensure orderly trading under conditions of severe market stress. 
• The LME’s electronic trading platform, LMEselect, was open for trading between 1am and 7pm GMT. However, between 1am and 7am GMT, the LME only had junior members of its trading operations staff on duty in Hong Kong, who had limited training in respect of what signs could identify a disorderly market. (The focus of their training was identifying disorderly markets arising from error trades or rogue algorithms rather than from ‘genuine’ (i.e. intentional) trades and unusual market conditions.) Decisions about market orderliness could only be taken by the LME’s senior management in the UK, but the trading operations team was the only team to conduct live monitoring of the LME’s market.
• The junior trading operations staff did not escalate the volatile 3M Nickel contract prices to senior management. Instead, during the early hours of 8 March, they disabled the price bands to accommodate the price rises (something which the trading operations team had done on previous occasions when they felt that the price bands were inhibiting price movements resulting from ‘genuine’ trades), after which the price of 3M Nickel increased to over $100,000 per tonne.
• In addition, the LME failed to have internal written procedures or guidance on the use of its static price bands or on the circumstances in which suspension of those price bands may be appropriate. It also failed to publish to the market policies or arrangements regarding the trading operations team’s practice of (i) suspending price bands during periods of high volatility; or (ii) extending the width of price bands beyond the specified published ranges.
• Post event, the LME had been unable for several months to provide accurate and complete information to the FCA in response to questions about the operation and calibration of the price bands on 7 and 8 March, in part because the LME did not capture an accurate chronological record.

The FCA acknowledged the work done by the LME since March 2022 to improve and strengthen its controls. 

Court challenges to the LME’s decision-making

The FCA decision follows the previous High Court and Court of Appeal decisions in judicial review proceedings brought by two hedge funds, Elliott Associates and Jane Street. The funds argued that the LME acted unlawfully in cancelling the 3M Nickel trades on 8 March and, as such, that their right to peaceful enjoyment of their possessions under the European Convention on Human Rights had been breached, and they sought damages on this basis. The High Court and Court of Appeal dismissed the claims, finding that the LME had acted lawfully. (See our blog post on the Court of Appeal decision here.)

Commentary

At the same time as the FCA was investigating the LME for being too slow to suspend trading in nickel futures, the LME faced a judicial review challenge by hedge fund investors for cancelling the trades. On a superficial level, it may seem difficult to reconcile the outcome in the judicial review process that the LME acted lawfully when intervening to cancel the trades and the FCA’s decision to impose a financial penalty on LME for having inadequate systems and controls to, in effect, intervene in the market.  But the two decisions are based on different tests. 

In a judicial review, the English courts consider whether a public body (the LME in this case) has lawful authority to make a decision and whether the decision-making process is rational and meets other public law requirements. Both the High Court and Court of Appeal considered that the LME had made a lawful decision to cancel 3M Nickel trades.

In contrast, the FCA monitors compliance with regulatory obligations and can make enforcement decisions where it finds that a regulated firm has breached a regulatory obligation. The FCA found that the LME’s systems and controls were inadequate and breached the relevant regulatory requirements.

The LME case shows that a decision-making process can be appropriate to meet the public law test but the wider systems and controls, of which that decision-making process may form a part, may not be sufficient to meet the regulatory standards set by the FCA. It is also an important reminder that a market can be disorderly even if it is the result of ‘genuine’ trading activity and not only as a result of abusive or erroneous trading.

This final notice is published at a time when the FCA is focusing on wholesale markets more broadly, and firms are encouraged to carefully consider the FCA’s findings in the final notice.