Away from the contentious debate over Dodd-Frank derivative market reforms that followed the 2008 financial crisis, this new battle takes place in the gray area separating cash markets for commodities like crude oil and power from the swaps or futures contracts that are tied to those prices.

While many companies legitimately trade in both markets, often to hedge their positions, regulators say others are manipulating one market in order to profit in the other.

The Federal Energy Regulatory Commission (FERC), armed in 2005 with expanded powers to tackle manipulation, is leading the charge with advanced enquiries into several big energy firms and banks, its orders show. The Commodity Futures Trading Commission (CFTC), which gained a broader mandate to pursue price fixing in derivative markets in 2010, joined the fray last year.

A broadside last month reverberated across the industry: FERC accepted a record $245 million settlement with Constellation Energy over allegations the utility's traders had scheduled physical flows of electricity at a loss in order to reap a greater profit on derivative positions.

Initially viewed by some analysts as a concession from Constellation to win approval of its merger with Exelon Corp, more signs are starting to emerge of a broader effort to address a type of trading activity that in the past had threatened to slip between financial regulators with differing mandates and a history of battling over regulatory turf.

The FERC declined to discuss its enforcement approach on Wednesday, but FERC Chairman Jon Wellinghoff told Reuters in March that the commission has beefed up market enforcement. The Constellation settlement signals "there is no profit to be made in manipulating the market; it will be a huge net loss for you," he said.

Last week FERC quietly gave notice of "alleged violation" by four former Barclays Capital power traders for deals in California between 2006 and 2008 that were similar to what Constellation did in New York -- making uneconomic trades in physical electricity markets to profit from financial swaps on the IntercontinentalExchange.

A Barclays Capital spokesman said the allegations were "without basis" and that the bank had been fully cooperating with the investigation. All the traders named by the FERC had left the firm and that the bank had ceased trading in the Western power market this year for unrelated reasons.

Within the past 10 months, BP and Deutsche Bank have also been given such notices.

The heightened scrutiny comes just as many of the same banks and trading companies are struggling to adjust to tough new derivative rules, including the need to post more collateral.

Some fear the impact could be the same: Diminished liquidity, greater volatility, higher prices.

"What worries me about the interrelated markets theory is that it's so amorphous," said one senior executive with a large commodity merchant. "Even legitimate activities could be cast in this pejorative light, which tends to have a chilling effect. Maybe the easiest way to stay out of trouble is not trade."

GONE BUT NOT FORGOTTEN

Even after the California power scandal, Enron meltdown and implosion of hedge fund Ameranth fueled an unprecedented level of regulation and scrutiny of power and gas markets, authorities have struggled to bring in cases of loss-leader trading.

Such deals are possible because of the nature of commodity markets, where trading in the futures and derivative markets often dwarfs the opaque, sometimes illiquid cash markets on which they're based. The U.S. crude futures market trades as much one billion barrels of oil a day; global supply is less than a tenth as much.

Once an open secret in many markets across the globe, the most egregious forms of such activity have largely disappeared from U.S. energy markets as regulators clamped down. It persists in less intensely regulated places like Singapore, dealers say.

But with new U.S. cases dating back five years or more, some executives fear a "tail effect" in which old trades could come back to sting; others say the amorphous nature of the charges threatens to entangle even legitimate deals, ultimately chilling trading activity and driving up costs.

"Simultaneous physical-for-financial transactions are widespread in the industry, but the extent to which they cross the line from hedges to manipulative in intent and effect it's hard to judge," says Craig Pirrong, a professor of finance at the University of Houston and authority on energy trading.

The FERC's focus is apparent on its list of "alleged violations". Out of 15 such notices since it commenced the controversial practice of pre-announce advanced investigations in early 2010, at least 11 are related to manipulation. Prior to this year, the agency claimed only a handful of successful settlements, several of those related to Ameranth Advisors.

Among those recently named are oil major BP's U.S. trading arm, the subject of several major fines over the past decade. The FERC says it pursued the strategy in Texas natural gas markets in 2008, according to a notice last July.

Deutsche Bank Energy Trading was also served a notice over manipulation in December, although it related to scheduling and congestion issues rather than loss-leader trading.

A BP spokesman said the firm stands by its initial public response in February 2011: "BP natural gas traders did not engage in any inappropriate or unlawful activity in late 2008 and we disagree with any allegations to the contrary."

Deutsche Bank declined to comment.

Law firm Winston & Strawn LLP, which calls itself one of the largest energy law practices in the country, says regulators are clearly seeking to make in-roads into the gray areas between markets, opening up critical questions in the process.

"The Commission has yet to articulate any guidance on the aspect of the transactions in question that it views as manipulative," its lawyers wrote on its website last week.

"The frequent reference in the Constellation settlement to the unprofitability of the physical trades suggests that lack of profit motive is the critical factor. Yet, some may question such a focus, given that many hedges are not intended to generate a profit."

At the same time, global regulators are taking a harder look at the role of price reporting agencies (PRAs), which are often the ones responsible for establishing the physical prices used to settle billions of dollars of derivatives a day but have no formal oversight responsibilities or authority.

The International Organisation of Securities Commissions said in March that reported prices were at risk of being manipulated by selective or false prices.

THE TWAIN SHALL MEET

FERC is not alone in getting tougher.

Last May, the CFTC -- which primarily oversees derivative markets but has some limited authority in physical trades -- sued independent oil merchant Arcadia Energy and two of its senior traders for allegedly manipulating physical oil supplies at Cushing, Oklahoma, the basis for the New York Mercantile Exchange's contract, in order to profit on futures trades.

Arcadia's motion to dismiss the case -- which has not yet been ruled on -- shows the difficulty in making such cases stick. The CFTC has yet to win a manipulation case, and the Arcadia suit is widely seen as a landmark case.

In a November filing, Arcadia's lawyers sought to reject the CFTC's charges on two grounds: first, the CFTC does not have jurisdiction over the cash crude oil market or oil-price spreads that Arcadia was trading; second, the CFTC failed to prove that its traders intended to manipulate the markets.

Jurisdiction has long been a thorny issue in pursuing cases that cross between cash and derivative markets.

Inter-agency tensions were thrust into the spotlight in 2007 when the CFTC and the FERC pursued enforcement actions against Amaranth Advisors for alleged gas futures market manipulation. The jostling was exacerbated by personality clashes and budgetary squabbles by dueling departments, observers say.

The CFTC asserted "exclusive jurisdiction" over futures market trading, while FERC said that Amaranth's trades impacted physical gas prices. Both agencies pursued parallel enforcement actions and fines against Amaranth and its former head trader, Brian Hunter.

FERC and CFTC also butted heads in the wake of the Dodd-Frank legislation over U.S. energy traders regulation of utility trading of power and electric transmission deals.

But signs of enhanced collaboration are now emerging, which could lead to a more coordinated approach. FERC kept the CFTC informed of the Constellation case as it proceeded, FERC officials say, as investigators increasingly reach beyond physical trades to study their impact on financial exchanges.

"The levels of complexity that these traders engage in is always going to be difficult for regulators to keep up with," said Tyson Slocum of Public Citizen, a consumer advocacy organization. "At a minimum, there needs to be more active coordination and a formal sharing of information."

A third regulator is also in the fray: the Federal Trade Commission, which was granted significant authority to pursue manipulation in the over-the-counter oil market in 2009.

But observers say the FTC has taken a much more conservative approach on the question of "scienter", a legal term for intent or recklessness, which has traditionally been a requisite for proving that a given trader engaged in manipulation. While amended CFTC and FERC measures now set a lower threshold for proving the "intent" behind such deals, the FTC has shown no inclination to pursue a similarly aggressive approach.

"FERC has an ethic that is much more aggressive than we are seeing at some of the other agencies," Michael Greenberger, law professor at University of Maryland and CFTC's former director of trading and markets.

PROSECUTOR PUSHES

Commissioners credited former New Mexico U.S. Attorney Norman Bay, named to lead the FERC enforcement office in 2009, for helping drive the Constellation enquiry. Industry officials say he has brought a prosecutor's zeal to the agency, which until a decade ago did little but set power tariffs.

"He has that prosecutors background but he also has an excellent sense of the energy market and the overall energy field - he's put the two together in a very complimentary way," FERC Chairman Jon Wellinghoff said in an interview last month.

While the Constellation deal has not set a legal precedent, it may embolden the agency to push forward such cases.

"If they took a particular approach and got someone to settle, that sends a strong message to the market that they would do so again and have similar expectations," said one lawyer at a large commodity trading organization.

Former FERC Chairman James Hoecker said that he hopes the additional enforcement activity does not draw resources needed for traditional rate-making activity, or undermine the marketplace by punishing traders without warning.

"The important thing from my perspective is (for FERC) to ensure that the market operates and that you do what you need to do in advance to make sure the market operates rather than coming in afterward with a ‘gotcha'," said Hoecker, senior counsel with Husch Blackwell LLP in DC and outside counsel for WIRES, an electric transmission industry group.

(Reporting By Jonathan Leff, Scott DiSavino, Tim Gardner in Washington and Eileen O'Grady and Christopher Baltimore in Houston; Editing by Bob Burgdorfer)

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