Expanded range of in-scope commodity derivatives
Removal and narrowing of key exemptions
Position limits and position management controls
Expanded powers of ESMA
The EU Markets in Financial Instruments Directive (2014/65/EU) (MiFID II) will introduce the following changes:
- An expanded range of commodity derivatives(1) will be brought within the scope of regulation;
- Exemptions for firms dealing in commodity derivatives will be narrowed significantly;
- Mandatory position limits on firms dealing in commodity derivatives will be introduced, with an exemption for non-financial firms;
- A mandatory position reporting regime for trading venue operators will be introduced; and
- The European Securities and Markets Authority (ESMA) will have expanded powers of intervention in relation to position management.
The range of financial instruments covered by MiFID II is broader than that covered by the first EU Markets in Financial Instruments Directive (2004/39/EC) (MiFID I). In particular:
- emissions allowances and related derivatives have been included in the list of MiFID II financial instruments;
- the MiFID I category of financial instruments relating to options, futures, swaps and any other commodity derivative contract that can be physically settled – provided that they are traded on a regulated market or multilateral trading facility (MTF) – has been expanded to include such derivatives where they are traded on an organised trading facility (OTF) (although wholesale energy products traded on an OTF that must be physically settled are excluded);(2) and
- the existence of clearing arrangements is no longer an indicator that a derivative is a financial instrument and therefore within the scope of MiFID I.
MiFID I applies to commodity derivatives, but includes a number of exemptions. The exemptions available for firms dealing in commodity derivatives under MiFID II will be significantly narrower than under the current MiFID I regime. In particular, there is currently a significant exemption for firms whose main business is dealing on their own account in commodities or commodity derivatives.(3) This exemption will not be available under MiFID II. Other key exemptions available under MiFID I in relation to commodity derivatives have also been rationalised, narrowing the scope of exempted activities. Firms trading in commodity derivatives which are currently outside the scope of MiFID I because of an exemption will need to review their positions to establish whether they will be within the scope of MiFID II, or whether any alternative exemption is available.
Under MiFID II, a specific 'ancillary activity exemption' will be available where a firm's commodity derivatives activities are ancillary to its main business, provided that it does not use high-frequency algorithmic trading techniques and does not belong to a group which has investment services or banking services as its main business. A firm will be able to avail of this exemption if:(4)
- it deals on its own account in commodity derivatives, but does not deal on its own account when executing client orders;(5) or
- it provides investment services in commodity derivatives (other than dealing on its own account) to the customers or suppliers of its own business.
Firms relying on this exemption must notify their national competent authorities (NCAs) that they are relying on the exemption and, on request, must explain the basis on which they consider that the relevant activities are ancillary to their main business.
To qualify for the ancillary activity exemption, the activities relating to commodity derivatives must, individually and in aggregate, be ancillary to the main business of the firm's group. The final draft regulatory technical standards (RTS) proposed by ESMA, set out in its September 2015 final report, state that a firm cannot consider its activities ancillary to its group's main business if:
- the size of its trading activity exceeds a certain proportion of the overall market activity in the European Union in the relevant commodity classes (the 'market share test'); or
- its speculative activity does not exceed a specified proportion of its main business activities at a group level (the 'main business threshold').(6)
The proposed RTS sets out the relevant thresholds for each test and how these will be calculated. The market share test will be applied at an asset class-specific level, with thresholds ranging from 3% (for derivatives on gas, oil and oil products) to 20% (in relation to emission allowances or derivatives based on them). The main business threshold will be 10% in most cases, but there is also a backstop mechanism to ensure that the tests capture only the larger market participants:
- If a firm's speculative trading activity is 10% to 50% of its total trading, it is still exempt if its market share is less than 50% of the threshold for the market share test (eg, 1.5% for gas and oil derivatives and 10% for emission allowances and derivatives); and
- If a firm's speculative trading activity is above 50% of its total trading, it is still exempt if its market share is less than 20% of each threshold in the market share test (eg, 0.6% for gas and oil derivatives and 4% for emissions derivatives).
Firms trading in commodity derivatives that are not currently authorised under MiFID I will need to assess whether they qualify for the ancillary activity exemption.
This exemption is unavailable for any secondary trading activity.
MiFID II will require NCAs to establish and enforce limits on the size of a net position that a person can hold at any time in commodity derivatives traded on a trading venue or economically equivalent over-the-counter (OTC) contract.(7) Where the same commodity derivative is traded in significant volumes in multiple jurisdictions, the NCA of the trading venue where the largest volume of trading takes place shall set the single position limit to be applied to all trading in the same contract.(8) NCAs must notify ESMA of the position limits they intend to set. ESMA will then publish an opinion and the NCA must either conform to ESMA's view or justify any deviation. ESMA may override an NCA in certain circumstances.
The position limits will not apply to positions held by a non-financial entity (NFC) that are objectively measurable as reducing risks directly relating to the NFC's commercial activity.(9) However, such positions will still be subject to position reporting requirements. ESMA's September 2015 final report contains final draft RTS setting out criteria for determining whether a position qualifies as reducing risks directly relating to commercial activities and the procedure that NFCs should apply to avail of this exemption.
Operators of trading venues on which commodity derivatives are traded will also have to apply transparent and non-discriminatory position management controls. These will include powers for the trading venue to:
- monitor participants' open interests;
- access information and documentation relating to participants' exposures;
- require that positions be reduced or terminated; or
- require participants to provide liquidity back to the market on a temporary basis.
Trading venue operators must provide details of these arrangements to their NCAs. NCAs will in turn notify ESMA, which will publish this information on its website.
ESMA's September 2015 final report contains final draft RTS setting out its proposed methodology for the calculation of position limits. ESMA proposes that NCAs should:
- calculate a baseline spot month position limit of 25% of the deliverable supply for that commodity derivative;(10) and
- adjust the baseline to take into account the particular characteristics of that commodity derivative, the relevant underlying commodity market and the commodity itself.
The final draft RTS elaborate on the factors to be considered when making this adjustment. Generally, NCAs may deviate from the baseline position limit by 10% to 20%, so that the final position limit reached is between 5% and 35% of deliverable supply – although a special regime will apply in respect of new and illiquid contracts.
ESMA has maintained its proposal that position limits in the spot month should be based on deliverable supply, but has decided – based on feedback – that position limits in other months should be based on total open interest. Where there is no underlying deliverable supply, the spot month position will also be based on open interest.
Trading venues will have to make public weekly reports on the aggregate positions held by different categories of trader in relation to the different kinds of commodity derivative. Trading venue participants will have to report to the trading venue on their positions and those of their clients on a daily basis. The trading venue's weekly report will then be sent to the NCA and ESMA and made public. Venues will also have to submit a daily report to the national competent authority with a complete breakdown of the positions held by all persons at the venue. ESMA's December 2015 final report(11) contained revised draft implementing technical standards (ITS) detailing the format and timing of these daily and weekly reports and breakdowns. The most recent draft ITS included some changes since previous drafts – for instance, it is now proposed that the reporting deadline for trading venue operators be 5:30pm (Central European Time) on Wednesday of each week in respect of positions held as at close of trading hours on the previous Friday.(12)
ESMA has recommended that the obligation for trading venues to produce weekly reports should apply only when both of the following thresholds are met:
- There are 30 or more open position holders existing in a given contract on the trading venue; and
- The size of the open position exceeds a level of four times the deliverable supply in the same commodity derivative.(13)
ESMA considers that a 'position' is "the net accumulation of buy and sell transactions in a particular commodity derivative, emission allowance or derivative on an emission allowance at a specific point in time that has yet to be closed out, expired, or exercised, as appropriate to the instrument concerned". ESMA also notes that an alternative definition of this term would be based on the concept of an open interest controlled by a person.(14)
ESMA also has powers under the Markets in Financial Instruments Regulation (600/214) (MiFIR) to request information about the size and purpose of any person's derivative position or exposure. After analysing that information, ESMA may require the person to reduce or eliminate derivative positions (and also, as a last resort, may limit the person's ability to enter into commodity derivatives).
ESMA's position management powers can be used only in emergency situations which the relevant NCA has failed to sufficiently address. In particular, the exercise of ESMA's powers must address a threat to the orderly functioning and integrity of financial markets or to the stability of the whole or part of the EU financial system.
ESMA's December 2014 technical advice:
- sets out non-exhaustive criteria for determining circumstances which would justify the exercise of these powers by ESMA;(15) and
- lists relevant indicators for determining when to use its powers to require that positions be reduced.(16)
MiFID II and MiFIR I came into force on July 3 2014. Most of their provisions were scheduled to come into effect in member states from January 3 2017, with member states having until July 2016 to transpose MiFID II into national law. However, it is now expected that the implementation of MiFID II will be delayed until January 2018. It is not yet clear precisely how the delay will be enacted, but it seems likely that it will have a knock-on effect on the timing of phased implementation arrangements, including those described below.
The European Commission is drafting delegated acts on the basis of ESMA's technical advice.
Once three years of data is available, firms or groups aiming to rely on the ancillary activity exemption will have to calculate a simple average for the three years of figures on a rolling basis to determine whether they fall above or below the thresholds. In the interim:
- notifications made before July 1 2017 should be based on data from July 1 2015 to June 30 2016; and
- notifications made between July 1 2017 and June 20 2018 should be based on data from July 1 2015 to June 30 2017.(17)
For further information on this topic please contact Michael Thomas or Bianca Smith-Moir at Hogan Lovells International LLP by telephone (+44 20 7296 2000) or email (email@example.com or firstname.lastname@example.org). The Hogan Lovells International LLP website can be accessed at www.hoganlovells.com.
(2) The circumstances in which a contract should be considered one which "must be physically settled" are set out in ESMA, Final Report: Technical Advice to the Commission on MiFID II and MiFIR, December 19 2014 (ESMA/2014/1569).
(4) It is possible to use the MiFID II exemptions cumulatively, so a firm in this category may still be exempt where it also conducts other MiFID II activities which fall outside of these categories if another exemption applies in respect of those other activities.
(5) ESMA's view is that the execution of orders in financial instruments between two non-financial entities directly and without any further intermediation by third parties as ancillary activity does not constitute "dealing on own account when executing client orders", and that activities of that nature would not prevent a firm from using this exemption.
(7) ESMA has proposed in its final draft RTS that an OTC commodity derivative contract is considered economically equivalent to a traded commodity derivative where it has identical contractual specifications, terms and conditions, excluding post-trade risk management arrangements. The final draft RTS also defines the circumstances in which a commodity derivative can be said to be the same as another. See draft RTS 21 in ESMA, Final Report: Draft Regulatory and Implementing Technical Standards MiFID II/MiFIR, September 28 2015 (ESMA/2015/1464), Annex 1.
(8) ESMA has set out criteria for determining the trading venue where the largest volume of trading takes place and what is considered to be significant volumes where the same commodity contract is traded on trading venues in more than one jurisdiction.
(9) ESMA's final draft RTS sets out a definition of 'non-financial entity' for these purposes. See draft RTS 21 in ESMA, Final Report: Draft Regulatory and Implementing Technical Standards MiFID II/MiFIR, September 28 2015 (ESMA/2015/1464), Annex 1.
(17) RTS 20 in ESMA, Final Report: Draft Regulatory and Implementing Technical Standards MiFID II/MiFIR, September 28 2015 (ESMA/2015/1464), Annex 1. These dates reflect the current draft RTS, but may be subject to change in light of the overall delays to MiFID II implementation.
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