The Authors increase competition, transparency and investor protection. MiFID II expands the scope to include commodity derivatives dealing. Romal Almazo MiFID II (legislation) and MiFIR (regulation) impact not only the way firms organise their internal systems and how they manage their controls, but also how they conduct business with their customers. Firms coming into scope of this regulation for the first time will be authorised by their local regulator. This authorisation - MiFID passport - will allow regulated firms to offer services across Europe. Rohan Wilson Commodity dealers are subject to important changes under MiFID II regulation. This has far-reaching implications for both commodity trading market participants and for the market as a whole. Exemptions for commodity derivative dealers are being removed and more firms will be regulated under MiFID II, many for the first time. ESMA 1, the European supervisor and regulator, is empowered to enforce new position limits on market participants (read: forcibly close out positions) in exceptional circumstances. Trading firms will report their positions daily to the market operator, who will report positions daily to ESMA. ESMA will publicly disclose an overview of the positions held on contracts. The 3 rd January 2017 implementation date of MiFID II may seem a long way off, but for the many firms who fall under the expanding scope of MiFID II, there is a great deal of work to do. Necessary plans need to be put in place now and there will be little regulatory sympathy for those who have not prepared 2. Implications of MiFID II MiFID I was established with the aim of harmonising the regulation of fragmented markets across Europe. The intention was to These firms will also be subject to capital requirements under the banking regulatory framework (CRR and CRD IV) 3 and will be classed as financial counterparties under EMIR. CRD IV includes requirements on the type and amount of capital you must hold, risk management, corporate governance and reporting requirements. EMIR 4 entails higher standards of clearing, reporting and OTC trade risk mitigation. MiFID II requires firms to review their business models, as well as invest considerably in both IT and compliance. These firms have had to consider how trading activity is perceived, optimize what is traded and also ensure that trade reporting to repositories is established. Once a firm is categorised as a financial institution (i.e. is MiFID regulated), it no longer qualifies for hedging exemptions. The original MiFID exemption for commodity traders has been removed. As a consequence, many more firms, which deal in commodity derivatives, will become regulated under MiFID II 1 and be treated as a financial institution in the same way as banks, insurance companies or UCITS. An exemption remains for ancillary activity and for some energy derivative contracts, which must be physically settled. 1 ESMA is the European Securities and Markets Authority. 2 Once firms have understood what is expected of them, they must make changes and implement MiFID II failing to prepare will not be considered acceptable. David Lawson, FCA Director of Markets, September 2014. 3 CRR/CRD IV - Capital Requirements Regulation and Directive IV. 4 EMIR - European Market Infrastructure Regulation designed to increase stability of the OTC derivative market. Avantage Reply MiFID II implications for Commodity Derivatives, Page 1
De minimis test: Is your gross trading volume more than 0.25% of any commodity asset class? Take away privileged trades (hedging, intragroup and liquidity obligations) De minimis exemption Ancillary activity exemption tests: is your firm exempt? If your European commodity dealing volume is small enough and it is a small enough part of your business, you may be exempt because it is an ancillary activity. This is provided that you are a non-financial organisation which does not participate in high frequency trading. ESMA has structured the ancillary activity tests to make sure that the commodity dealing is ancillary to the dealer (capital employed test) and that the trading is ancillary to the market (trading activity test). ESMA has also reduced the calculation requirements for smaller dealers (de minimis test). Trading Activity test: Is your net trading volume more than 0.5% of any asset class? MiFID Regulated Firm Capital Employed test: Is your capital employed in EU MiFID activities net of privileged trades more than 5% of your global capital employed? If your firm deals in less than 0.25% of the total EU volume as measured by gross notional value in each commodity asset class 5, then you have a de minimis exemption from MiFID II. This means you do not have to do the capital employed test. However, you will still have to complete an annual notification to your national competent authority and be prepared to explain how you have been exempted. It is intended that firms use a single year of their trading data 6 for this calculation in January 2017 (using 12 months of data from January 2016), scaling up to using three years of their data on a rolling basis by January 2019 (using 36 months of data to cover 2016-2018). Ancillary Activity exemption For the trading activity test, look at the eight asset classes that ESMA have divided the commodity markets into. Calculate how much trading your firm does by volume (gross notional value) in the EU in each of these. Remove the privileged transactions of hedging, intra-group and liquidity obligation trading volumes from this calculation 7. Do not include trading activity conducted by an entity within the firm that is already MiFID regulated. If this represents 0.5% or more of the EU volume for any asset class 8, then your firm will be subject to MiFID II. Please be aware that this 0.5% level is open to revision and may be altered to reflect the conditions in different asset classes. 5 Asset classes currently include Metals, Oil and oil products, Coal, Emission allowances, Gas, Power, Agricultural and an Other commodities asset class, which includes freight. 6 The simple average of monthly input is to be used from January 2016 to December 2016. However, due to the steep operational challenges involved in attempting to calculate this number between the 31 st of December 2016 and the 3 rd of January 2017, ESMA have taken this suggestion back to the drawing board. 7 The EMIR, European Market Infrastructure Regulation (EU) 648/2012 definition of hedging and intra-group transactions is used here. Please note that, wherever possible, ESMA have aimed to use existing measures and tools. 8 ESMA is aware that the total EU volume for each asset class is currently not feasible to calculate and is doing data analysis to ascertain what these numbers are. Avantage Reply MiFID II implications for Commodity Derivatives, Page 2
For the capital employed test, calculate the capital employed by your firm in eligible EU MiFID II activities. These are activities for which your firm would have to be authorised were it not exempt. These do not include hedging, intra-group transactions or liquidity obligations. Do not include trading activity conducted by an entity within the firm that is already MiFID regulated. Divide this number by your firm s global capital employed 9 at group level. If this is 5% or more, then your firm will be subject to MiFID II from the 3 rd January 2017. Position limits are introduced ESMA will set a position limit for every commodity derivative traded on a regulated market, multilateral trading facility or organised trading facility. This is a single limit per contract, which applies to all firms on an individual basis. These position limits will also be set for economically equivalent OTC contracts which mirror non-otc contracts. There will be a spot month position limit and other months position limit 10. Cash and physically delivered derivatives will be included together in these two categories. Under the mandate to provide a framework for these contracts and to allow national competent authorities to have some latitude in calibrating this framework, ESMA has set a range of position limits of 10-40% of deliverable supply 11, with national authorities having some freedom to choose the limit per contract 12. Their decision will be guided by volatility and maturity of the contract, the characteristics of the underlying, the amount of deliverable supply, the number and size of the market participants and the size of the overall open interest. markets or the EU financial system or where the national competent authority has not taken adequate measures. ESMA may request information about the size and purpose of any derivative position. Having analysed this information, ESMA may then require the position to be reduced or closed out. In exceptional circumstances, ESMA may prevent the person from trading. Knowledge that ESMA has this option could alter the market dynamic during extreme commodity price moves. More comprehensive position reporting There are three sets of position reports to consider. These sets are detailed in level 1 rules and ESMA only has a remit to establish the formats of position reports. Investment firms will need to send a daily report of their gross commodity derivative and economically equivalent OTC positions to the competent authority (where the firm is acting as an intermediary, information on the end client is sent 13 ). Market operators will also be required to send daily reports to the competent authority. When there are at least 30 participants in a commodity derivatives market and the open interest, (adding spot and forward months), is more than four times the deliverable supply, then trading venues will have to report weekly aggregate positions to ESMA, via the competent authority. ESMA will publish details on the number of long and short positions, by category (commercial, investment, etc.), the percentage of open interest held by each category and the number of participants holding a position in each category. It is intended that this method gives information on market structure whilst preserving confidentiality. Please be aware that the deliverable supply denominator is not final and that there is currently a debate within ESMA about whether this should be changed to an open interest metric for forward months. Issues remain about the netting of contracts, the definition of hedging (further complicated by the EMIR Q&A s) and the treatment of physical forwards. ESMA now has direct position management powers. ESMA can withdraw or freeze products in your firm if you haven t complied fully. It may exercise powers where there is a threat to the financial Estimating the impact This regulation is not yet finalised. Timings, calibrations and parts of the framework have been recently withdrawn, modified and/or reconsidered. A dynamic approach is therefore required in order to cope with the shifting goalposts of this regulation. In the rule writing process, general Level 1 rules are set in the MiFID II text, after which ESMA proposes draft Level 2 9 Use the accounting definition of capital employed, namely including total equity, current debt and non-current debt. ESMA is aware that not everyone segregates their accounts in this way and are looking into proxies/alternatives. 10 ESMA recommends that the spot limit is lower than the other months limit as it is concentrated in one expiry contract. 11 Deliverable supply information is not yet available for all markets how to achieve this is a work in progress. 12 The national authority which has the most liquidity of a contract in their marketplace sets the limits for the contract. 13 If the client is also acting as an intermediary, then the chain is reported. Clearly this is a challenge. If an investment bank has executed a trade on behalf of another investment bank, who has arranged the trade for a secret client, then there are confidentiality issues. Hence, it is a work in progress. Avantage Reply MiFID II implications for Commodity Derivatives, Page 3
implementation rules. It will then consult with market stakeholders and eventually send a revised set of rules to the European Commission 14 for rubber stamping. ESMA is currently in the consultation process for the Level 2 rules. What is clear from stakeholder s feedback is that many people are concerned with being classified under the new system as a financial institution for the first time. Businesses have already stated that they will be restructuring themselves in response to this regulation. assess whether restructuring your business is an option and fits with your strategic objectives; define and execute specific changes required to meet your new obligations, e.g. position reporting. There is also a lot of feedback from the market about a potential negative impact on liquidity from this new broader casting of the net as well as a possible loss of competitiveness in Europe. Impact estimates vary and are speculative at this stage. The framework and calibration of the level 2 regulation is not yet complete. However, the European Federation of Energy Traders see none of its members as being exempt and the Baltic Exchange see up to 30% of their active members as having to become authorised as MiFID investment firms for the first time under the new system. Ultimately, the review of MiFID ties into the wider slew of regulation linking with the: European Market Infrastructure Regulation (EMIR), Regulation on Energy Market Integrity and Transparency (REMIT) 15 and Market Abuse Directive/Regulation (MAD/MAR) 16. MiFID also derives its basis from the 2009 G20 commitment to improve the functioning and transparency of financial and commodity markets and to address excessive commodity price volatility. It calls for market regulators to have formal position management powers. In achieving this, ESMA will have a great deal more influence. How can we help? We can help you plan and prepare for the new commodity derivatives requirements under MiFID II as follows: determine whether this applies to you - there is a fair amount of work required, including analysis of your trading activity; 14 For example, MiFID in the level 1 text determines that some ancillary dealing is permitted, but ESMA defines what some ancillary dealing is in level 2. For more detail, see the Lamfalussy process. 15 REMIT is the Regulation on wholesale Energy Market Integrity and Transparency. 16 MAD is the Market Abuse Directive and MAR is the Market Abuse Regulation. Avantage Reply MiFID II implications for Commodity Derivatives, Page 4
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