When ESMA published the draft Regulatory Technical Standards (RTS) on the application of position limits to commodity derivatives on 28 September 2015 it initially hoped that publication would be followed by a period of fine-tuning. Instead the draft RTS provoked fierce debate amongst politicians, traders and market commentators.
The outcome of this debate resulted in a letter from the European Commission to ESMA on 14 March 2016 in which the Commission indicated that ESMA’s proposals would only be recommended once changes had been made to take account of concerns raised by the European Parliament.
Position limits under MiFID II
Despite the market controversy, it is clear that the fundamentals of position limits for commodity traders – by which we mean, the maximum net position which a person can hold at all times in commodity derivatives traded on trading venues or economically-equivalent over-the-counter (OTC) contracts (EEOTC) – will be implemented in some form.
In their Final Report, ESMA state that the purpose of the position limits is to “prevent market abuse, support orderly pricing and settlement conditions (including preventing market distorting positions) and ensure, in particular, the convergence between prices of derivatives in the delivery month and spot prices for the underlying commodity.”
The requirement that National Competent Authorities (NCAs) establish and apply position limits is set out in Article 57 of MiFID II. In other words, neither ESMA nor the NCAs have the authority to prevent imposition of a position limits regime.
The draft regulatory technical standards
In September 2015, ESMA set out the specifics of how the position limits regime would work in practice.
Position limits will apply on a group basis
Importantly, the limits will apply not only to individual entities, but at a group level and parent companies will be required to determine the group’s overall net position by aggregating their own net position with that of all of their subsidiary undertakings. As the MiFID II regime requires continual, up-to-the-moment compliance, groups with multiple trading arms will be required to ensure that their computer systems are capable of calculating the group’s net exposure at all times.
Position limits will apply to both derivatives traded on trading venues and to EEOTC contracts
According to ESMA’s draft RTS, an “economically-equivalent” OTC contract is one which has “identical contractual specifications, terms and conditions, excluding post trade risk management arrangements [for example, clearing], to those of that commodity derivative traded on a trading venue.”
The Commission has concluded that ESMA’s narrow definition of what is an EEOTC which requires the OTC contract to be “identical” to an exchange traded contract could easily result in circumvention because traders could simply change a minor parameter to avoid being subject to the regime. The critical issue is whether variations to lot size, delivery dates or locations really change the economic exposure of a position.
Trades by non-financials to hedge risk are not subject to position limits
Under the level 1 text, “position limits shall not apply to positions held by or on behalf of a non-financial entity and which are objectively measurable as reducing risks directly relating to the commercial activity of that non-financial entity.” In other words where companies are exempt from MiFID II their trades to hedge risk do not fall under the position limits regime provided they:
- Reduce risks arising from potential changes in the value of assets, services, inputs, products, commodities or liabilities which the entity, or its group, owns, produces, manufactures, processes, provides, purchases, merchandises, leases, sells or incurs in the normal course of business
- Qualify as a hedging contract in accordance with the International Financial Reporting Standards
Importantly, however, companies that wish to take advantage of this exemption are required to apply to the NCA which sets the position limit relating to that commodity derivative. This is not necessarily the NCA where the company is registered and does business as the NCA of the largest EU trading venue in the relevant commodity derivative has jurisdiction. In practice, this means that companies that trade a variety of commodity derivatives for hedging purposes may be required to make multiple applications to different authorities in order to acquire exemption. This could be an expensive process involving applications with regulatory bodies in multiple jurisdictions. The good news is that each authority only has a period of 21 days from the date of application to make a decision.
NCAs are required to calculate position limits for each individual derivative
To ensure uniformity of treatment across EU markets, where a commodity derivative is traded in multiple different countries, the NCA located in the jurisdiction with the trading venue with the largest average daily open interest in the relevant commodity derivative over the previous year is required to determine the position limit for the commodity derivative.
The most contentious element of the RTS remains the methodology which ESMA has proposed NCAs should use to formulate position limits.
This is another area where the European Commission has indicated that ESMA needs to rethink its proposal. The Commission concluded, reflecting the strength of political feeling, that the RTS needs to show more sensitivity to different types of commodity, in particular to agricultural commodities which it believes should attract lower limits for both spot and other months’ limits because of their high volatility.
ESMA is asked to reconsider whether contracts with few market participants or low levels of liquidity should benefit from higher maximum limit ranges. The Commission also recommends that the RTS should adjust the other months’ limits where there is a significant discrepancy between open interest and deliverable supply. When open interest is significantly higher than deliverable supply the limits should be set lower and, when open interest is much smaller than deliverable supply, a higher limit should apply.
The challenge NCAs face in calculating and adjusting position limits has caused concern in the market. The NCAs do not have access to the market data that is required to adjust the baseline position limit and determine deliverable supply taking into account the particulars of each individual contract. They are regulatory bodies – not market participants – and are being asked to analyse market conditions for each individual commodity contract and set position limitswhich are economic rather than regulatory decisions. The FCA has expressed concern over its ability to set individual position limits for between 1,500 and 1,900 commodity contracts.
According to ICE, ESMA’s original proposals would have had an adverse impact on front month liquidity in major benchmark contracts like the Brent futures contract. When an exchange which has access to market information concludes that ESMA’s methodology would see a large number of market participants breach position limits, significant changes are clearly necessary.
Position limits moving forward
One thing is clear: a miscalculation when setting the position limit for a particular commodity contract could have an adverse effect on trading. Ironically should position limits be set at the wrong level this could disrupt trading and distort the market. Clearly this is not the intention of the regulators or the European Parliament and the stakes are high, particularly with essential, politically sensitive commodities such as agricultural and energy.
MiFID II is a very political piece of legislation. During an ECON meeting in November 2015, it was even suggested that ESMA was subverting the will of the European legislature for the benefit of the financial services industry. The European Commission has sought to address some of these political concerns in its recent letters to ESMA’s Chairman, Steven Maijoor. These difficulties are exacerbated by disagreements within the financial services industry itself as different market participants will benefit at the expense of others, depending upon the breadth of the definition of “economically equivalent”. Traders will want to see a narrow definition of EEOTC while bankers will want to see it capture a wide range of trades.
In reality, the market’s concerns over the position limits regime are valid. With regulators being asked to set position limits for derivative contracts, based upon economic calculations of market conditions, there is a very real risk that incorrect position limits could be set. All things considered, it would be surprising if the NCAs did not get a position limit wrong and impact on liquidity. The consequences of this could be serious in a commodity bear market which is already subject to economic turbulence.
It remains to be seen whether the position limits regime will achieve its objective of supporting orderly pricing and preventing market distortion.