The MiFID II regime will come into force throughout the EU on 3 January 2018. Many of the new rules will directly impact commodity market participants both inside and outside the EU. Two key areas are the new commodity derivatives position limits and reporting regimes.
What are the new regimes?
MiFID II arguably enacts the most extensive position limits regime anywhere in the world. The regime requires regulators in member states, or national competent authorities (NCAs), to determine limits on the size of positions (long or short) that any market participant (regardless of their location or regulatory status) can take in any commodity derivative contract executed on an EU trading venue. This includes regulated markets, multilateral trading facilities (MTFs), and organised trading facilities (OTFs)), along with “economically equivalent OTC contracts” (EEOTCs).
The position limits regime will be reinforced by a position reporting regime. This will require members/participants of trading venues to report their positions in commodity derivatives to the trading venue on a daily basis, as well as the positions of their clients, their client’s clients, and so on, down to the ‘end client’. In addition, investment firms trading in commodity derivatives outside a trading venue must report to the relevant NCA on a daily basis their positions in all commodity derivatives as well as those of their clients down to the ‘end client’. Trading venues are also required to make daily and weekly reports to their NCA concerning positions held by their members and the aggregate positions held by different categories of persons in different commodity derivatives respectively.
Recent Guidance and Remaining Areas of Ambiguity
Below, we have summarised some of the key areas where recent guidance has been provided or further clarification is required to remove ambiguities relating to the position limits and position reporting regimes.
Article 5 of the Position Limits Delegated Regulation states that EEOTC contracts must have “identical contractual specifications, terms and conditions” to contracts executed on trading venues. Certain minor deviations such as lot size, delivery dates deviating by less than one calendar day and post-trade risk management, are permitted. In practice, given that the requirement is for all terms and conditions, and not just contract specifications, to be identical, it is possible that very few, if any, contracts will be EEOTC. ESMA has now confirmed that it will not be publishing a list of EEOTC contracts, so it will be for market participants to decide whether or not any particular contract they enter into will be EEOTC.
The definition of commodity derivatives” includes certain “exotic derivatives” which do not have a commodity underlying, such as those based on “indices and measures”, and “inflation rates”. There has been industry feedback querying what, if any, limits should apply to these contracts, as well as whether they should be reportable under the position reporting regime.
The European Securities and Markets Association’s (ESMA) updated Q&As on commodity derivatives clarify that position limits should only be applied to derivative contracts relating to indices if the underlying index is “materially” based on commodity underlyings (commodities have a weighting of more than 50% in the composition of the underlying index), and that inflation derivatives are outside the scope of the regime.
There is an expectation that ESMA may soon be issuing guidance that financial instruments outside the scope of the position limits regime will not be subject to position reporting because the purpose of position reporting is to monitor position limits.
Non-financial counterparties (NFCs), firms which are not authorised under EU financial services regulation, and third country firms that would not need to be authorised if established in the EU, are able to apply for an exemption from a position limit for a contract where it can be demonstrated that the contract is being entered into to hedge risk directly relating to their commercial activity - the so-called “hedging exemption”.
Regulators are starting to inform market participants how they intend to apply the hedging exemption, and their approaches are not always consistent. The UK NCA, the Financial Conduct Authority (the FCA), has indicated that firms should apply for the exemption when they consider they may be close to exceeding the limit in a particular contract. By contrast, the German NCA, BaFin, has suggested that position limits should only apply to speculative trading and that once an exemption has been obtained, a firm may disregard all its hedging trades. ESMA has indicated that there will be no further Q&As on this and it appears that there may end up being some regulatory arbitrage as to how this exemption is applied throughout the EU.
The term “end client” (used in the context of position reporting) is not defined in MiFID II. This has led to some concerns among market participants as to how the term will work in practice. ESMA has recently updated its Q&As on commodity derivatives to clarify that all positions in commodity derivatives must be included in such reports. This means that where an investment firm is reporting the positions of an end client that is not an investment firm and does not therefore have reporting obligations of its own under MIFID II, its report should cover both the end client’s own account positions and any positions that the end client holds on behalf of third parties. ESMA encourages that such third party reporting should be disaggregated on a person by person basis, although it notes that there is no legal obligation to do this and that it may be impractical in certain circumstances. ESMA has also stated that the requirement to identify clients and clients of clients until the end client in position reports cannot be waived - even where to identify a position holder would breach legal, regulatory, or contractual impediments, such as non-EU data protection laws. The FCA, which is responsible for monitoring compliance with the position reporting regime, has not yet commented on the practical consequences of failing to identify a position holder in light of this latest guidance from ESMA.
The publication of further guidance by ESMA and the FCA is necessary, given that firms may require a substantial lead-in time to get the IT infrastructure in place to monitor, capture, and report the required information under the position limits and reporting regimes, to ensure they can be compliant on day one. We anticipate that further guidance, and the position limits themselves, will be published in the coming months. In order to manage the evolving regulatory landscape, firms should monitor future publications by ESMA and the FCA and seek legal advice if they are unclear as to how they will be impacted.