In July the FCA opened its MiFID II ancillary exemption notification portal. Commodity firms that are confident they can rely on the ancillary exemption are now able to make a declaration to that effect. Those firms which are yet to determine whether the ancillary exemption applies to them will be mindful of the fast approaching 3 January 2018 deadline. This article aims to provide guidance by setting out the relevant tests and giving examples of the ways commodity firms can ensure they are able to evidence compliance.
What is the ancillary exemption?
The ancillary exemption is designed to cover commercial users and producers of commodities whose speculative trading in commodity derivatives and emissions allowancesis ancillary to their main business.
In order to rely on the ancillary exemption, firms must pass both stages of a two-stage test set out in delegated regulation EU 2017/592 (known as RTS 20):
1. The market share test; and
2. The main business test.
The Market Share Test
The market share test considers whether a firm’s1 speculative trading in an asset class in the EU accounts for a large proportion of the total trading in that asset class in the EU. ESMA has divided the commodities sector into eight different asset classes each with their own threshold, based on factors such as the total size and number of active participants in the market, as set out below:
Those firms whose speculative trading equal or exceed the relevant threshold are unable to benefit from the ancillary exemption. Thus, a metal trader whose speculative trading accounts for 5% of the total EU trading in metals will fall outside the scope of the exemption.
ESMA has published estimates of the overall size of the market in each asset class but is yet to publish final data. Therefore, ESMA has advised firms who have reasonable grounds for considering that they will be able to benefit from the exemption, to make a notification. If subsequent market data indicates that the firm cannot make use of the exemption, it will be expected to apply for authorisation as soon as reasonably practicable. This could cause difficulty in the market as the status of counterparties who have failed to obtain an authorisation could be unclear.
Main Business Test
The main business test aims to establish whether a firm’s speculative trading makes up a minority of the group’s overall business activity. There are two ways in which firms can pass the main business test: through the "proxy test" or the "capital employed test". A firm need only pass one of these sub-tests in order to pass the main business test.
The proxy test
The proxy test uses a group’s total trading in all asset classes in the EU as a proxy for the total business activity of the group. Under the proxy test, only a set proportion of a firm’s total trades in the EU as against the total commodity derivative trading of the group in the EU, may be speculative.
The proxy test contains three thresholds and which one applies depends on how a firm scores on the market share test. For firms whose total trading accounts for 50% or more of the threshold permitted under the market share, only 10% of their total trades may be speculative. For firms whose total trading accounts for less 50% of the market share threshold, up to 50% of their trading may be speculative and for firms whose total trading accounts for less than 20% of the market share threshold, all of their trading may be speculative. This is perhaps best illustrated in the below table.
The proxy test is not split by asset class but rather one threshold applies to all asset classes. Thus a fi rm whose speculative trading in metal derivatives accounts for just 0.5% of total EU metals derivative trading, but whose trade in coal derivatives accounts for 9%, must apply the 10% threshold under the proxy test.
The capital employed test
The capital employed test considers whether the capital employed by a firm in speculative trading in the EU is large compared to the total worldwide assets of the group, as recorded in its consolidated financial statements.
The capital employed in speculative trading is determined by adding (i) 15% of each net position (long or short) multiplied by price for each derivative (ii) to 3% of the gross position (long plus short) multiplied by the price for each derivative. If this fi gure is equal to or less than 10% of the group’s total worldwide capital, the firm may rely on the capital employed test to pass the main business test.
Firms relying on the ancillary exemption must make a declaration to that effect on the FCA’s notifi cation portal. Whilst fi rms are not obliged to provide evidence when making this declaration, they are advised to have appropriate internal procedures in places to enable them to evidence compliance, should the need arise later.
One of the key capabilities fi rms will need is the ability to identify why a transaction should be classed as a genuine hedge as opposed to a speculative trade. To this end, a fi rm’s internal policies should identify the types of derivatives it uses and clearly outline the link between its derivative portfolio and the commercial and treasury risks the portfolio is mitigating. Firms will also need to have measures in place to clearly identify speculative trades so that these are not omitted from any calculations.
We understand that the FCA has already received a number of notifi cations. As the 3 January deadline looms ever closer, fi rms that have not yet done so are advised to gather the relevant data to enable them to decide and evidence whether they come within the scope of the ancillary exemption and are therefore able to avoid the burdens of MiFID II compliance.