Some of the most fiercely contested provisions of MiFID II (EU Directive 2014/65/EU) are:
- the obligations on Member States to impose position limits on commodity derivatives; and
- the obligation on market participants and market operators to provide regular position reports on their positions in commodity derivatives and emissions allowances.
Position limits are intended to prevent market abuse and to ensure convergence between the price of a commodity derivative in the delivery month and spot prices for the underlying commodity. In December 2014 the European Securities and Markets Authority (“ESMA”) published draft regulatory technical standards (“draft RTS”) on how it proposes to implement these provisions which has reignited the debate.
In this update, we look more closely at what these obligations will mean for commodity firms.
Member States are obliged to ensure that their national authorities establish and apply position limits on the size of a net position which a person can hold in commodity derivatives traded on trading venues and economically equivalent OTC contracts. The limits apply to all “persons” and will be set on all positions a trader holds or are held on its behalf at aggregate group level. There has been a lot of debate about when an OTC commodity derivative contract is to be considered “economically equivalent”. Under the draft RTS ESMA has proposed that an OTC commodity derivative would be “economically equivalent” to a traded contract when it:
- explicitly refers to or is otherwise based upon a commodity derivative traded on an EU trading venue; or
- is valued on the basis of the same or an equivalent commodity of the same or equivalent grade that is deliverable at the same location, or another equivalent location so long as the other delivery location has similar economic characteristics and is deliverable on the same date as that of a commodity derivative that is traded on a trading venue.
Fortunately ESMA is required to publish a list of what these contracts are as it is difficult to apply these tests.
Limits will not apply to non-financial counterparties who use commodity derivatives for hedging purposes. The test for a hedge is the same as that under the European Markets Infrastructure Regulation (“EMIR”). In other words the trade must be objectively measureable as reducing risks directly relating to the commercial activity of the non-financial counterparty. If a non financial counterparty wants to use the hedging exemption it must apply for an exemption.
ESMA is responsible for proposing the methodology to determine position limits for the spot month and other months position limits for physically settled and cash settled derivatives. ESMA acknowledges that there needs to be flexibility in setting the limits particularly for new products and for illiquid markets. It will, for example, be relevant to look at whether a commodity is perishable, how it is transported and delivered, whether there are capacity constraints at delivery points and whether the product is seasonal.
ESMA has proposed that the starting point should be a position limit that imposes a baseline limit of 25% of “deliverable supply”. Under the draft RTS ESMA proposes how the baseline figure for “deliverable supply” in each commodity derivative should be calculated. It is unclear whether “deliverable supply” is to be interpreted narrowly as the supply used for settlement or as a pricing reference for the traded commodity derivative or more widely as the “deliverable supply” in the underlying physical commodity. If this baseline figure is incorrect, there is a real risk that position limits will be set too low.
ESMA has, therefore, proposed that the baseline could be adjusted by +/-15% up to 40% or down to 10% depending on a range of factors. The factors that are relevant to increasing or reducing the limits include:
- the maturity of the commodity derivative contract: the more frequently the derivative expires, the higher the limit should be.
- the deliverable supply in the underlying commodity: the greater the quantity of “deliverable supply”, the higher the position limit.
- the overall open interest in commodity derivatives and in other financial instruments with the same underlying commodity: the greater the volume of overall open interest, the higher the position limit.
- the volatility of the market in the commodity derivatives: the greater the volatility, the lower the overall position limit.
- the number and size of the market participants that hold a position: the greater the number of position holders,the lower the overall position limit. It is odd to set a lower limit where there are a greater number of participants.
- the characteristics of the underlying commodity market: the greater the flexibility of the underlying market, the higher the position limit. There could be a difficulty with this test as it is easy to inadvertently build up a large position in an inflexible market where there are few delivery points.
- whether a new contract is being developed: the position limit should be set at a higher level for new contracts which will be less liquid.
Position limits are set by the national authorities. Where the same commodity derivative is traded in several EU locations, the competent authority of the jurisdiction where the largest volume of trading takes place will set the position limit. National competent authorities are required to review and reset the position limits where there is a significant change in deliverable supply, open interest or any other significant market change.
Position management controls
Trading venues which trade commodity derivatives are required to apply position management controls. These need to include, as a minimum:
- monitoring open interest positions.
- accessing information about the size and purpose of positions as well as the ultimate beneficial owners of positions.
- powers to require a person to terminate or reduce a position or put liquidity back into the market.
Member state regulators will also have similar powers.
Trading venues which trade commodity derivatives or emissions allowances have an obligation to:
- Publish a weekly report of the aggregate positions held by the different categories of person for the different commodity derivatives when the number of persons and their open positions exceed minimum thresholds. These reports must specify the number of long and short positions as well as the percentage of the total open interest held by each category of participant.
- Provide the competent authorities with a complete breakdown on a daily basis of the positions held by everyone on the trading venue, including their members, participants and clients.
Members or participants on regulated markets, multilateral trading facilities and organised trading facilities must report their positions on a daily basis to the trading venue. The report must give details of their own positions and the position of their direct and indirect clients.
Investment firms must provide on a daily basis a complete breakdown of their positions in commodity derivatives traded on EU trading venues and “economically equivalent” OTC derivatives contracts. The report must detail the firm’s position and the position of their direct and indirect clients and distinguish between hedging transactions and other positions.
The trading community has raised serious concerns about the position limits regime and position reporting obligations. Their primary concern is that the position limits could have an adverse effect on liquidity. They will make life difficult for investment firms and banks who have traditionally been liquidity providers to producers and end users who want to hedge price risk which as recent volatility in the oil market has shown, is a real threat to business.
ESMA is required to submit its draft RTS to the EU Commission by 3 July 2015 and so this issue will continue to be hotly debated for some time.