What is new? It has been a very busy period for commodities businesses tracking new regulation aimed at making the commodity markets more transparent and reducing systemic risk.
The EU Regulation (648/2012) on OTC derivatives, central counterparties and trade repositories ("EMIR") has already had a significant impact on trade reporting and the new EU Directive (2014/65/EU) ("MiFID II") and EU Regulation 600/2014 ("MIFIR") on markets in financial instruments which came into force on 2 July 2014 will change the regulatory landscape for commodities firm.
Historically many commodity traders were MiFID exempt, did not require an authorisation to trade in commodity derivatives and so avoided the need to comply with the complex rules that apply to regulated companies. This is changing and we examine why in this note.
ESMA (the European Securities and Markets Authority) has been clear, and nowhere more so than in their Consultation Paper issued in December last year, that the intention behind MiFID II is to capture a range of commodity firms previously excluded from the legislation and address any competitive distortions arising from the current MiFID exemptions.
The extended scope of MiFID II is largely attributable to the removal and tightening of the exemptions previously available to commodity firms.
The old regime - MiFID
Under EU Directive 2004/39/EC ("MiFID"), which has applied since 2007, commodities firms were often able to rely on the exemptions in Articles 2(1)(i) and 2(1)(k). These stated MiFID would not apply to:
- Commodities firms which dealt on own account or provided investment services in commodity derivatives to clients of their main business provided provision of investment services was ancillary to the group's main business and the group's main business was not provision of investment services or banking. (2(1)(i))
- Commodities firms whose main business was dealing on own account in commodities or commodity derivatives as long as the firm did not belong to a group whose main business was provision of investment services or banking. (2(1)(k))
In the past commodity firms were able to rely on these MiFID exemptions for their dealing activity and obtain FCA authorisation for a group company as in-house arranger or agent using the so called "with or through" exemption to conduct some speculative trading which was caught by the UK Financial Services and Markets Act. This option may no longer be available.
The new regime – MiFID II
Under the new regime the old Article 2(1)(k) exemption will be deleted in its entirety and not replaced.
The main exemption likely to apply to commodity firms in the future can now be found in Article 2(1)(j) of MiFID II . MiFID II will not apply to firms carrying on the following activities:
- Dealing on own account, in commodity derivatives or emission allowances or derivatives. Market makers can qualify under this exemption but firms who deal on own account when executing client orders are excluded. The exclusion means that brokers who deal as principal on exchange and have back to back contracts with their clients cannot benefit from the exemption.
- Providing investment services, other than dealing on own account, in commodity derivatives or emission allowances or derivatives to the customers or suppliers of their main business.
In order to qualify for the exemption the following conditions must be met:
- The activity must be ancillary to the firm's main business when considered on a group basis;
- The group's main business cannot be the provision of investment services or banking; and
- The firm must not use any high frequency algorithmic trading technique.
A firm must make an annual notification to the appropriate regulator (in the UK this will be the FCA) to rely on the exemption and give the reasons why it considers its activities ancillary to its main business.
The critical issue in assessing whether these conditions are met is what counts as "ancillary activity". ESMA has been tasked with producing regulatory technical standards to determine the criteria and these were published as part of ESMA's Consultation on MiFID II/MiFIR in December 2014. Two criteria are to be taken into account when assessing whether an activity is "ancillary". These are:
- whether the commodity derivatives trading constitutes a minority of activities at group level; and
- the size of a firm's relevant commodity derivatives activity compared to overall market activity in the relevant asset class in the EU.
If one of these thresholds is breached, the firm will not benefit from the exemption.
When assessing the main business of a group it is necessary to look at the business of the whole group including any subsidiaries domiciled outside the EU. Certain transactions are excluded in applying the tests. These are:
- intra-group transactions for servicing group-wide liquidity or for risk management purposes;
- hedging and treasury financing transactions; and
- transactions entered into to provide liquidity on trading venues - for example where a trading venue requires a market maker to provide liquidity.
One factor to determine whether trading in commodity derivatives represents a minority of a group's business will be the relative amount of capital employed in derivatives trading compared to the capital employed in the main business. But ESMA has made it clear that this is only one factor.
There are real practical difficulties in looking at the size of a company's commodity derivatives activity in relation to overall EU market activity in the relevant asset class. EMSA intends to divide the size of trading activity into the following broad asset classes: (i) metals; (ii) oil and oil products; (iii) coal; (iv) emissions allowances; (v) gas; (vi) power; (vii) agricultural products; and (viii) other commodities including freight. Although trading activity undertaken for hedging purposes is not taken into account ESMA has set a surprisingly low threshold of 0.5% of overall market trading activity in each asset class as the trigger to determine whether the exemption ceases to be available.
Implications for commodity traders
It will be increasingly difficult for commodity firms to retain their exempt status. Much will now turn on whether trading in commodity derivatives can be considered "ancillary" to another main business and the new test is not easy to fulfil. Firms must be MiFID II compliant by 3 January 2017. Firms currently operating under a MiFID exemption will need to check whether they can continue to remain exempt. A number will need to apply for authorisation and there is a long lead time. Although it may be possible to process an application more quickly the FCA has 6 months from receipt of a properly completed application to make its decision. Firms should start their analysis now to meet this timetable.