Summary. Key business impacts. Key business impacts. Trading venues. Product intervention commodity derivatives

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1 Key business impacts Trading venues Product intervention MiFID 2: commodity derivatives Summary The Markets in Financial Instruments Directive (MiFID) required member state implementation by 1 November While MiFID was always intended to be reviewed after three years, lessons from the 2008 financial crisis have informed the review, which began following the G20 Pittsburgh Summit in The MiFID revision comprises a recast Directive (MiFID 2) and a new Regulation (MiFIR). The texts of MiFID 2 and MiFIR were agreed by the European Commission, Parliament and Council in February However, these level 1 texts will need to be supplemented by delegated and implementing acts and technical standards as required under the Directive and Regulation which will set out the detailed rules in a number of areas. This briefing gives an overview of the principal changes proposed in relation to commodity derivatives and emission allowances and is one in a series of five briefings dealing with (i) scope, (ii) investor protection, (iii) markets, (iv) commodities and (v) third country. Key business impacts The exemptions available for firms trading commodity derivatives will be significantly narrowed. Any firm currently relying on an exemption in MiFID will need to consider whether it will remain exempt under MiFID 2. Spot emissions allowances and all derivatives in them will be brought within scope. Michael Raffan T E michael.raffan@freshfields.com Mark Kalderon T E mark.kalderon@freshfields.com David Rouch T E david.rouch@freshfields.com James Smethurst T E james.smethurst@freshfields.com Alexander Glos T E alexander.glos@freshfields.com Raffaele Lener T E raffaele.lener@freshfields.com Robert ten Have T E robert.tenhave@freshfields.com The regime for establishing position limits will impose significant burdens on investment firms and market operators in terms of monitoring compliance with such limits and on market participants who will have to provide information not only about their own positions, but also about those held by their clients, their clients clients and so on to the ultimate owner of the position. Freshfields Bruckhaus Deringer LLP MiFID 2: commodity derivatives 1

2 Scope Exemptions MiFID 2 will significantly narrow the exemptions currently available to commodity derivatives trading firms to ensure that participants on commodity derivatives markets [are] subject to appropriate regulation and supervision. The current exemption in Article 2(1)(k) for firms whose main business consists of dealing on own account in commodities or commodity derivatives will be deleted. This will be a significant narrowing of the available exemptions. The exemption under Article (2)(1)(d) for firms that do not provide any investment services and activities other than dealing on own account will be narrowed and will not be available in relation to dealing on own account in commodity derivatives, emission allowances or derivatives in emission allowances; instead, in order to remain exempt, commodity derivative and emissions firms will have to come within the exemption in Article 2(1)(i) for firms dealing in commodity derivatives and emissions on an ancillary basis or within the specific new exemptions in: Article 2(1)(da) for operators with obligations under Directive 2003/87/EC establishing the EU Emissions Trading Scheme (the EU ETS Directive); Article 2(1)(n) for transmission system operators; (if adopted by the relevant member state) Article 3(1)(d) for entities that hedge risks for local electricity undertakings and/or natural gas undertakings; or (if adopted by the relevant member state) Article 3(1)(e) for entities that hedge risks for operators under the EU Emissions Trading Scheme. The exemption in Article 2(1)(i) can be used in conjunction with the exemption in Article 2(1) (d). Therefore to ensure that their dealing in financial instruments other than commodity derivatives and emissions also remains exempt, firms will be able to rely on Article 2(1)(d). In general, Article 2(1)(d) will be narrowed so that it will not apply to firms which (i) are market makers; (ii) are members or participants in a regulated market (RM) or multilateral trading facility (MTF) or have direct electronic access to a trading venue; (iii) apply high frequency algorithmic trading techniques; or (iv) deal on own account when executing client orders. It appears that these restrictions will not apply to a commodity firm that is exempt under 2(1)(i), however as discussed below, in order to fall within Article 2(1)(i) a firm is likely to have to meet certain of these restrictions in any event. The exemption under Article 2(1)(i) is currently available to firms dealing on own account in financial instruments, or providing investment services in commodity derivatives to clients of their main business, on an ancillary basis (where the main business of the firm s group is not the provision of banking or investment services). This exemption will be narrowed so that commodity derivative and emissions firms that execute client orders will be excluded, as will any firm that trades commodity derivatives using high frequency algorithmic trading techniques or whose group s main business is market making in relation to commodity derivatives. The use of this exemption will also be on condition that the person seeking to rely on it annually notifies the relevant competent authority of such reliance and reports on request the basis on which they consider that their dealing on own account or providing investment services is ancillary to their main business. Level 2 measures will set out the criteria for determining when an activity is ancillary to the main business of the group. The criteria will take into account (i) the need for ancillary activities to constitute a minority of activities at group level; and (ii) the size of the trading activity compared to the overall market trading activity in that asset class, but will exclude intra-group transactions that serve group-wide liquidity, hedging transactions and transactions in commodity derivatives and emission allowances entered into to fulfil obligations to provide liquidity on a trading venue. 2 MiFID 2: commodity derivatives

3 MiFID 2 will include two specific new exemptions. Article 2(1)(da) will provide an exemption for operators with compliance obligations under the EU ETS Directive, provided such operators do not execute client orders when dealing in emission allowances and engage in no investment services or activities other than dealing on own account in emission allowances. This exemption is not available to persons who apply a high frequency algorithmic trading technique. Article 2(1)(n) will provide an exemption for transmission system operators as defined in Directives 2009/72/EC and 2009/73/EC (the directives dealing with the internal markets in electricity and gas) when performing investment services or activities in commodity derivatives to carry out certain functions, and any operator or administrator of an energy balancing mechanism, pipeline network or system when performing investment services or activities to keep in balance the supplies and uses of energy. Optional exemptions Article 3 of MiFID 2 will also provide new optional exemptions available to commodity and emissions firms if their member states adopt them. Article 3(1)(d) will provide a specific exemption for entities providing hedging transactions for clients that are local electricity undertakings and/or natural gas undertakings (as defined in the directives dealing with the internal markets in electricity and gas), provided these entities are, broadly, owned or controlled by such gas and electricity undertakings and that such gas and electricity undertakings would be exempt under Article 2(1)(i) if they carried out the investment services themselves. Article 3(1)(e) will provide a similar exemption for entities providing hedging transactions for clients that are operators within the EU ETS Directive. However, member states adopting these optional exemptions will be required to impose certain authorisation, supervision, conduct of business and organisational requirements analogous to those under MiFID 2 on firms relying on these exemptions. Financial instruments commodity derivatives MiFID 2 will potentially expand the range of commodity derivatives within its scope. Commodity derivatives that can be physically settled are within the scope of MiFID if they are traded on RMs or MTFs. Under MiFID 2, such derivatives will also be within scope if they are traded on the new category of trading venue being introduced by MiFID 2, the organised trading facility (OTF), unless they are wholesale energy products (as defined in the EU regulation on wholesale energy market integrity and transparency) that must be physically settled (the REMIT carve-out). There will be transitional provisions under which competent authorities will be able to exempt non-financial counterparties oil and coal derivatives which are traded on an OTF and must be physically settled (C6 energy derivatives contracts) from the clearing obligation and risk mitigation techniques under the EU regulation on OTC derivatives, central counterparties and trade repositories (EMIR). C6 energy derivatives contracts will also not count towards the clearing threshold under EMIR during the 42-month transitional period. Level 2 measures will set out further detail on the derivatives which will be subject to the REMIT carve-out and the transitional provisions. In particular, the measures will specify the meaning of must be physically settled taking into account at least the creation of an enforceable and binding obligation to physically deliver, which cannot be unwound and with no right to cash settle or offset transactions except in the case of force majeure, default or other bona fide inability to perform. Freshfields Bruckhaus Deringer LLP MiFID 2: commodity derivatives 3

4 Financial instruments emission allowances MiFID 2 will bring within scope all emission allowances recognised for compliance under the EU ETS Directive. In addition, derivatives relating to emission allowances which are currently within scope if they must or may be settled in cash or, according to the FCA s Perimeter Guidance, they also have the characteristics of other derivative financial instruments (for example, if they are traded on RMs or MTFs) will be financial instruments under MiFID 2 irrespective of settlement method, trading venue or other characteristics. Trading venues One of the objectives of the MiFID review is to prevent abusive trading, promote orderly pricing and address systemic risk in commodities markets. Position limits To this end, MiFID 2 will require that commodity derivatives traded on RMs, MTFs and OTFs, as well as economically equivalent OTC derivatives, be subject to limits, established by each member state competent authority, on the size of a net position in a commodity derivative which any person can hold at all times. The limits will be set on the basis of all positions held by a person and those held on its behalf at an aggregate group level. The limits will not apply to positions held by non-financial counterparties for commercial hedging purposes although such positions will still be subject to position reporting requirements see Position reporting below. Although competent authorities are responsible for setting the limits, these will be subject to level 2 measures produced by ESMA which will set the criteria competent authorities must follow in establishing the limits. Level 2 measures will also set criteria to determine: what qualifies as a hedging position; when positions should be aggregated within a group; whether an OTC derivative is economically equivalent to that traded on a trading venue; and methodology for aggregating and netting OTC and on-venue commodity derivatives to establish net positions for the purposes of compliance with position limits. Where the same commodity derivative is traded in significant volumes on trading venues in more than one jurisdiction, the competent authority of the venue with the largest volume (the central competent authority) will, in consultation with the other competent authorities, set a limit on that commodity derivative to be applied across all venues. Level 2 measures will set criteria for determining the meaning of same commodity derivative and significant volume for these purposes. The competent authorities of the venues where the same commodity derivative is traded and the competent authorities of position holders in that commodity derivative 1 shall put in place co-operation arrangements including exchange of relevant data, to enable monitoring and enforcement of the single position limit. Operators of RMs, MTFs and OTFs on which commodity derivatives are traded will have to apply position management controls. These will include the monitoring of open positions, information access (including information about the underlying owners of positions and assets or liabilities in the underlying market) and the ability to require persons to terminate or reduce their positions or to provide liquidity back to the market to mitigate a dominant position. 1 There may not be one; limits apply to unauthorised persons too. 4 MiFID 2: commodity derivatives

5 Position limits and position management controls should be transparent and nondiscriminatory, specifying the persons to whom they apply and taking into account the nature and composition of market participants and the use they make of the relevant contracts. Competent authorities will be required to communicate the details of any position limits and position management controls established in their member states to ESMA, which will publish summaries of this information on its website. Position reporting Operators of RMs, MTFs and OTFs on which commodity derivatives are traded will be required to publish weekly reports on the aggregate positions held by different categories of position holders and to communicate such reports to competent authorities and ESMA. Operators will also be required to provide more detailed reports to their competent authorities on a daily basis, setting out a complete breakdown of all position holders, including trading venue members, participants and their clients. Members or participants in such trading venues will have to provide information to the operator on their own positions held through contracts traded on that trading venue and the positions of their clients, their clients clients (and so on until the ultimate holder of the position is reached) on a daily basis to enable the operator to monitor compliance with the position limits. Investment firms trading in commodity derivatives and emission allowances or derivatives in them 2 outside a trading venue will need to provide the competent authority of the trading venue where the commodity derivative is traded or the central competent authority with a complete breakdown of their positions in on-venue commodity derivatives and economically equivalent OTC derivatives, as well as those of their clients, their clients clients (and so on until the ultimate holder of the position is reached) on a daily basis. Reports to competent authorities will need to differentiate between positions entered into for commercial hedging purposes and other positions. Powers of authorities Competent authorities will have power to intervene on an ad hoc basis, including by requiring information regarding the size and purpose of a position or exposure entered into through a commodity derivative, requesting any person to reduce the size of a position or exposure or limiting the ability of any person to enter into a commodity derivative. Competent authorities will be able to apply their sanctioning powers under MiFID 2 to (i) persons situated or operating in their territory or abroad for breaches of position limits on trading venues within their territory; or (ii) persons situated or operating in their territory for breaches of limits set by competent authorities in other member states. Under MiFIR ESMA will play a role co-ordinating the exercise by member state competent authorities of their powers. If certain specific conditions are met, ESMA will itself be able to exercise position management powers to request information from any person regarding their position in relation to a derivative contract, request that a position be reduced or (as a last resort) limit the ability of a person to enter into commodity derivatives. 2 Although position reporting obligations are extended to trading venues on which emission allowances and derivatives in them are traded, and investment firms which trade in them, the obligation dealing with position limits appears only to apply to commodity derivatives. Freshfields Bruckhaus Deringer LLP MiFID 2: commodity derivatives 5

6 Product intervention ESMA will have powers under MiFIR to temporarily prohibit or restrict (i) the marketing, distribution or sale of certain financial instruments or financial instruments with certain specified features or (ii) a type of financial activity or practice where there is a threat to the orderly functioning and integrity of financial markets or commodity markets and if other conditions specified in MiFIR are met. Competent authorities will have similar product intervention powers. The orderly functioning and integrity of commodity markets should be included as a criterion for intervention by competent authorities in order to enable action to be taken to counteract possible negative externalities on commodities markets from activities on financial markets. This is true, in particular, for agricultural commodity markets... In these cases, the measures should also be co-ordinated with the authorities competent for the commodity markets concerned. (Recital 24, MiFIR) Level 2 measures will specify criteria and factors to be taken into account by ESMA and competent authorities in determining when there is a threat to the orderly functioning and integrity of financial markets or commodity markets. 6 MiFID 2: commodity derivatives

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