The European Securities and Markets Authority issued the equivalent of final rules (known as “technical standards”) to implement three cornerstones of the European response to the 2007-2008 financial crisis: the Markets in Financial Instruments Directive II, the Market Abuse Regulation, and the Central Securities Depositories Regulation.
The final technical standards implementing MiFID II are intended to impose regulatory oversight over the majority of non-equity products traded in Europe, and move a significant portion of over-the-counter trading in Europe onto regulated trading venues.
The MiFID II rules will, among other things, establish a methodology for calculating and applying position limits for commodity derivatives, as well as determine when a non-financial firm might be subject to capital requirements; impose organizational requirements on investment firms; regulate high-frequency trading; and require non-discriminatory access to clearing houses, trading venues and benchmarks.
The MiFID II rules will also establish criteria when ESMA should determine whether an over-the-counter product should be required to be traded on a regulated venue and obligations of market-makers.
MAR is aimed at increasing market integrity and investor protection while CSDR’s purpose is to harmonize the functioning of central securities depositories in Europe.
MiFID II's final technical standards are now being considered for approval by the European Commission for up to three months. Countries of the European Union must adopt relevant provisions into national law by July 3, 2016. MiFID II is scheduled to be fully effective on January 3, 2017.
Trading Commodity Derivatives
Under MiFID II’s final technical standards, there will be position limits on commodity derivatives. It is proposed that spot month position limits will be based on deliverable supply while other months (including all months) limits will be a function of total open interest.
In general, the initial threshold for position limits will be 25 percent of the relevant referent with local national regulators overseeing a relevant trading venue having the flexibility to impose limits 10 percent more or 20 percent less than the base threshold. Economically equivalent commodity derivatives traded on different EU trading venues as well as over-the-counter derivatives might be considered the same commodity derivative for position limit analysis.
Hedging positions will be exempt from position limits. Under the final technical standards, firms must be able to show some linkage between transactions and hedging positions to qualify for an exemption. Firms must apply for hedge exemptions to the relevant national regulator; the regulator will have 21 days to accept or reject the application.
Firms may be required to aggregate positions with subsidiaries if the “parent can control the use of positions.” It appears that both the top company and subsidiaries within holding structures may be required to aggregate positions of companies below them. Parent companies are not required to aggregate positions with “collective investment undertakings” that hold positions for investors, where the parent cannot control the use of the positions for its own benefit.
In order to avoid capital and other requirements, the final technical standards require non-financial firms to be below the thresholds of two tests in connection with their speculative trading activity: a market share test and a main business test.
To meet the market share test, a non-financial firm’s speculative trading (based on gross notional value) must be below certain levels compared to overall trading in the relevant EU market. The range is from 3 percent for natural gas, oils and oil products, 4 percent for metals and agricultural, 6 percent for power and 10 percent for coal. Ordinarily the analysis of market share will be based on a rolling annual average of the preceding three years.
To meet the main business test, a non-financial firm’s speculative trading must be less than 10 percent of its overall trading, including hedging activities.
However, if a firm’s speculative trading is 10-50 percent of its overall trading, it may still be MiFID II exempt if its market share is less than 50 percent of each market share threshold (e.g., 1.5 percent for natural gas, oil and oil products, and 2 percent for metals and agriculture). If a firm’s speculative trading is greater than 50 percent of its overall trading, it still may be MiFID II exempt if its market share is less than 20 percent of each market share threshold (.6 percent for natural gas, oils and oil products, and .8 percent for metals and agriculture).
ESMA contemplates publishing draft rules on position reporting later this year.
Investment firms utilizing algorithmic trading, providing direct electronic access or acting as general clearing members must segregate tasks and functions at various levels to reduce the dependency on single persons or units. The specific organizational structure should be determined after a “robust self-assessment.” However, there should be segregation at least of functions and responsibilities between trading desks and support functions including risk control and compliance “ensuring that unauthorized trading activity cannot be concealed.”
(Investment firms include "any legal person whose regular occupation or business is the provision of one or more investment services to third parties and/or the performance of one or more investment activities on a professional basis.")
Among other requirements, investment firms must have kill functionality that enables them to withdraw all or part of orders. For this to be effective, investment banks must know which algorithms, traders or clients are responsible for each order.
Investment firms engaging in algorithmic trading must monitor their trading to ensure it is not operated contrary to any law or trading venue rule. Suspicious transactions must be reported to the relevant national regulator.
Compliance staff at investment firms must have “at least a general understanding of the way in which the algorithmic trading systems and algorithms of the investment firm operate.” Compliance staff must have access to the firm’s kill functionality or direct contact with persons who have access to it.
Other requirements related to investment firms under the final technical standards to MiFID II address stress testing of algorithmic trading systems, management of material changes, prevention and identification of potential market abuse or law or rule breaches, business continuity, pre-trade controls, real-time trade monitoring, post-trade controls, security, due diligence of prospective direct electronic access clients and periodic review afterwards, due diligence on clearing customers generally, and monitoring of client position limits “as close to real-time basis as possible.”
(Click here for a different overview on MiFID II in the article “ESMA Publishes Final Report and Draft Regulatory and Implementing Technical Standards on MiFID II and MiFIR” in the October 2, 2015 edition of Corporate & Financial Weekly Digest by Katten Muchin Rosenman LLP and here for an overview of MAR in the article “ESMA Publishes Final Report and Draft Technical Standards on New EU Market Abuse Rules” in the same publication.)