The European Commission’s December 2010 consultation paper on wholesale revisions to MiFID has focused on commodities derivatives as an area for regulatory intervention and oversite. The proposals, outlined below, are likely to lead to significant infrastructure changes for firms that trade commodities derivatives, particularly those firms that now rely on exemptions for own account and “ancillary” trading. The proposals place unregulated and non-financial firms into a financial regulatory context by requiring trading authorisation and imposing capital requirements, conduct of business and operational requirements.
The truncated consultation period closed on 2 February 2011 and a formal proposal is expected shortly.
- The Deletion of Article 2(1)(k)1: Currently, MiFID exempts own account dealing in commodity derivatives. The Commission is proposing to delete this exemption on the basis of “[r]ecent experience with various commodity firms setting up MiFID-licensed subsidiaries and the political consensus to limit exemptions from financial regulation only to necessary cases.”2
- Narrowing of the Exemption at Article 2(1)(i)3: Currently, MiFID exempts commodity derivatives dealing that is an ancillary activity in support of another (non-financial services) business. The Commission is proposing to narrow this exemption in two ways: (i) by excluding dealing on own account with clients of the main business in order to ensure that the exemption only applies to hedging physical and price risk; and (ii) by applying the notion of “ancillary activity” in a narrow and precise way by using quantative (the percentage of the main activity represented by the ancillary activity and subject to a maximum limit) as well as qualitative tests.
- Transaction Reporting: The MiFID review is looking at transaction reporting requirements for all financial instruments and markets, and it is clear that the Commission (alongside US and other global regulatory bodies) sees the ability of competent authorities to require the production of trading information as a key regulatory tool in a wider package of as yet unarticulated pre-and post-trade transparency enhancements. The Commission is proposing to extend MiFID’s framework transaction reporting requirement to OTC commodity derivatives. This would encompass commodity derivatives that are not traded on a regulated market, multilateral trading facility or “organised trading facility”4 and all financial instruments whose value “correlates” with the value of a financial instrument traded on a regulated market, multilateral trading facility or “organised trading facility”. Commodity derivatives dealers are likely to be required to report the identity and/or regulatory classification of their end customer as well as provide data on their aggregate positions.
- Regulating Physically Settled Forward Contracts: Commodity derivatives that can be physically settled and which have the characteristics of other derivative financial instruments will be regulated. This will mean supervision by financial regulators of what has, up to now, not been a financial product per se, as well as bring into play mandatory clearing and concomitant mandatory margin requirements.
The Commission is also considering regulations requiring trading venues to “design” contracts that are capable of being physically settled so as to ensure convergence between future and spot prices. If this proposal goes ahead, it would mark a real change in the regulatory approach to product design, but, as yet, the Commission has given no detail on how they believe this contractual objective could be achieved.
- Revisions to the Market Abuse Directive (MAD): Proposals to revise MAD will have a direct bearing on transaction reporting requirements for commodity derivatives. These proposals include (i) extending MAD to cover trading financial instruments on multilateral trading facilities and possibly to those traded on “organised trading facilities”, i.e., to instruments currently considered to be trading OTC; (ii) explicitly including in MAD any market manipulation through influence on the price of financial instruments (though this is already the case in some Member States); and (iii) consideration of an extension of MAD’s scope to cover market manipulation of commodities’ markets via commodity derivatives’ markets. MiFID transaction reporting requirements for commodity derivatives will therefore have to be ramped up in order to enable the enforcement of MAD’s wider scope.
- Emissions’ Trading: Emissions’ trading is currently outside the scope of MiFID, though derivatives based on allowances are included. Proposals directly to regulate emissions’ trading are still up for debate, as the Commission has indicated that a more in-depth study of trading practices and their future is to come.
The Dodd-Frank Wall Street Reform and Consumer Protection Act
Like its EU companion piece, the proposed Regulation on OTC derivatives, central counterparties and trade repositories5, Dodd-Frank requires the clearing and reporting of a broadly drawn population of OTC derivatives, including commodity derivatives. Dodd-Frank also requires registration with the Commodity Futures Trading commission (CFTC) or the Securities and Exchange Commission (SEC) or both by not only swaps dealers, but also “major swap participants”. Criteria published by the CFTC in December 2010 to be used when deciding who is a swap dealer and major swap participant6 make it possible that a number of companies that are predominantly commercial end-users of swaps may be categorised as dealers or participants either because they accommodate the demand of third parties for swaps or because of the size of their non-hedge swap positions.
So far, so (broadly) similar; but in one significant area, Dodd-Frank looks to be doing something that the proposed EU Regulation on OTC derivatives (and the proposals for revisions to MiFID) do not contemplate. On January 15, 2011, the CFTC approved for public comment a proposed rule establishing a new regime of speculative position limits for physical commodity derivatives implementing requirements in Dodd-Frank to prevent excessive speculation and manipulation in the derivatives markets. The proposal, which will move forward in two phases, establishes limits in agriculture, energy and metals markets, and includes limits for the spot month and for single-month and all-months combined. To date, European regulatory bodies have not advocated for position limits as a regulatory tool to assist in securing orderly markets, though the issue is by no means off the table.7
Implications For Firms
It looks inevitable that firms that have up to now been exempt from registration requirements because of the nature of their main business are now going to have to seek authorisation. Establishing and maintaining mandated levels and types of regulatory capital will also therefore be a requirement, though the Commission has said it is going to address capital requirements for firms whose main business is investment services in relation to commodity derivatives as a separate matter. In addition to prudential capital requirements, firms will also have to comply with the conduct of business requirements of their home state regulator, and these will include transaction reporting requirements, including the reporting of OTC trades. It is likely that authorised firms will have to increase capital, put in place transaction reporting systems, and proactively train staff and monitor trading to avoid allegations of market manipulation.