With the publication of MiFID II and MiFIR in the Official Journal of the European Union the clock has now started ticking for commodities firms to familiarise themselves with the new requirements and prepare themselves for regulatory change. MiFID II and MiFIR introduce important changes particularly in relation to the exemptions that define the regulatory perimeter.
Dealing on own account exemption
The dealing on own account exemption contained in Article 2(1)(d) of MiFID will be amended by MiFID II to the extent that a firm will no longer be able to rely on this exemption in relation to commodity derivatives, emission allowances (EUAs) or derivatives on EUAs. However, the impact of the changes are limited in the sense that if a firm is able to rely on the exemption in Article 2(1)(j) of MiFID II, it will automatically be able to rely on the new Article 2(1)(d) exemption in relation to dealing on own account in all other types of instruments. There is no further discussion on the dealing on own account exemption in the ESMA discussion paper or consultation paper.
The ancillary exemption in Article 2(1)(i) of MiFID becomes Article 2(1)(j) of MiFID II and is amended. The amended exemption is only applicable to activities in relation to commodity derivatives, EUAs or derivatives on EUAs and will only be available to firms which: (i) deal on own account in commodity derivatives, EUAs or derivatives thereof (excluding persons who deal on own account when executing client orders); or (ii) provide investment services, other than dealing on own account, in commodity derivatives or EUAs or derivatives thereof to the customers or suppliers of their main business. In both cases the exemption is subject to certain conditions including that the activity is an ancillary activity to the main business on a group level. In its discussion paper ESMA discusses the procedure and thresholds for determining whether an activity is an ancillary activity and commodities firms should carefully consider this. In particular such firms should note the following points that ESMA makes:
- in order to assess whether ancillary activities constitute a minority of activities at group level it is necessary to exclude physical hedging activities;
- transactions in commodity derivatives and EUAs entered into to fulfil obligations to provide liquidity on a trading venue shall not be taken into account, where such obligations are required by regulatory authorities in accordance with EU or national laws and regulations;
- as the ancillary activity must be ancillary on an individual and on an aggregate basis all three factors – the capital for dealing on own account, the capital for the provision of other investment services to customers and suppliers and the sum of these two factors – must account for less than 50% of the main activity of the group; and
- the size of the firm’s trading activity has to be compared with the size of the overall EU market trading activity. ESMA aims to capture entities that trade to a significant extent in comparison with authorised firms in a specific asset class.
Commodity dealer exemption
The commodity dealer exemption in Article 2(1)(k) of MiFID will be deleted when MiFID II comes into effect.
From the above it can be seen that as a general theme there is significant tightening of the exemptions currently used by commodities firms.
EUAs become financial instruments for the purposes of MIFID II.
Financial instruments definition
The ESMA consultation paper sets out draft technical advice concerning the definition of financial instrument under Section C 6, 7 and 10 of Annex I of MiFID II. It is worth noting that in its commentary of C 6 energy derivatives contracts ESMA makes certain points concerning coal and oil as an underlying. C 6 energy contracts are defined as options, futures, swaps and any other derivatives with coal or oil as an underlying and which are traded on an Organised Trading Facility (OTF) and must be physically settled. While ESMA states that derivative contracts with coal as an underlying appear to be an easily identifiable section of instruments it feels that the same does not hold true for contracts with oil as an underlying. According to ESMA the question is whether only different grades of crude oil would qualify as C 6 energy derivatives contracts or whether also other contracts where the underlying is derived from crude oil are within the scope of the exemption. ESMA makes no decision in the consultation paper and calls for stakeholder input.
Physically settled commodity derivatives and REMIT wholesale energy products
The types of physically settled commodity derivatives covered in Section C 6 of Annex I to MiFID is extended to those traded on an OTF. There is, however, a carve out for wholesale energy products that are traded on an OTF and which must be physically settled. Article 95 of MiFID II also provides for the temporary exemption for C 6 derivatives energy contracts from certain obligations under the European Market Infrastructure Regulation. ESMA’s draft technical advice in the consultation paper focuses on clarifying the notion of “must be physically settled”. It also uses the opportunity to ask stakeholders to provide concrete examples of contracts which they consider to be within the scope of the two exemptions.
Having the characteristics of other derivative financial instruments
In the consultation paper ESMA sets out draft technical advice on which physically settled commodity and exotic derivatives should be considered to have the ‘characteristics of other derivative financial instruments’ in respect of C 7 and 10 of Annex I to MiFID II. In both instances ESMA believes that the list provided for in Article 39 of the MiFID implementing Regulation has worked well in practice and is looking to preserve elements of it in relation to C 7 instruments. In relation to C 10 instruments ESMA goes further and states that the list is as close to comprehensive and proposes to maintain it.
MiFID II introduces new provisions that will allow each Member State to impose limits on the size of the net position which a person can hold in commodity derivatives traded on a trading venue and economically equivalent over-the-counter contracts. The discussion paper contains ESMA’s initial work to develop RTS to determine: (i) certain factors that national competent authorities (NCAs) will use in establishing the position limits; and (ii) the methodology for the calculation that NCAs will apply in establishing the spot month position limits and other months’ position limits for physically settled and cash settled commodity derivatives based on the characteristics of the relevant derivative. It is worth noting that ESMA is not mandated under MiFID II to develop RTS in respect of position management controls operated by trading venues. Therefore the discussion paper does not cover this.
An interesting point is that ESMA is required to specify the criteria for determining whether an OTC contract that is a financial instrument within the scope of MiFID II is an “economically equivalent OTC contract” to a listed contract that is traded on a trading venue, in the form of an RM, MTF or OTF. ESMA consults on two possible approaches with one being based on that used by the US Commodities and Futures Commission.
MiFID II requires investment firms, trading venue members and participants, and trading venues to provide data and to produce and publish position reports for commodity derivatives, EUAs and derivatives of EUAs. In addition, MiFID II requires that this data is provided to enable the monitoring of compliance with the position limits that MiFID II establishes. Both the consultation paper and discussion paper cover position reporting and need to be read together in order to get a sense of ESMA’s thinking on this issue. In the consultation paper ESMA sets out draft technical advice concerning the thresholds as to when position reporting applies. The discussion paper includes an analysis of the basis of position reporting and the format of the position report.
MiFIR grants ESMA comparable position management powers to NCAs and in specific circumstances may, as a last resort, limit the ability of a person from entering into a commodity derivative. The consultation paper sets out draft technical advice specifying the criteria and factors which are to be taken into account when determining whether it is appropriate for ESMA to use its position management powers. ESMA’s position management powers are to be used in exceptional circumstances and only where there exists both an emergency situation and a failure or inability of an NCA to take appropriate action. Interestingly, the Short Selling Regulation already makes reference to scenarios which may constitute a threat to the functioning of the EU financial system and ESMA believes some of these scenarios will be applicable to its position management powers.