The FCA’s proposals for commodity derivatives regulatory reform

Introduction

On 4 December 2023, the Financial Conduct Authority (FCA) published its consultation paper CP23/27 on reforming the commodity derivatives regulatory framework. In this briefing note, we look at the background to the consultation, the key areas covered by the FCA’s proposals, and expected next steps.

Background and context to the proposals

Much of the current commodities regulation in the UK derives from G20 commitments that were implemented through the Markets in Financial Instruments Directive 2014/65/EU (MiFID II) in a way that was harmonised across the EU. Post-Brexit, the UK undertook the Wholesale Markets Review, which concluded that the UK could achieve the same results better by making a few changes. Some of those changes were dependent on amendments to legislation, which were made in the Financial Services and Markets Act 2023 (FSMA 2023), and this has enabled the FCA to develop the detailed changes that would need to be made through its rules.

However, in the process of this legislative change taking place, there has also been considerable volatility in the commodities markets (and the markets more generally). Those experiences have highlighted that using derivatives to hedge physical commodity exposures can heighten liquidity risks, which can be transmitted through the wider financial system. There is also insufficient information about over-the-counter (OTC) positions, which makes it difficult to assess some of those risks. CP23/27 therefore also proposes changes that are driven by these experiences.

In addition, the FCA has drawn insight from best practice internationally and from some other jurisdictions’ regimes, as well as taking account of discussions and feedback that it has had with a range of external stakeholders and industry. All these different considerations are reflected in the proposals set out in CP23/27.

The transfer of power to set position limits

One of the FCA's proposals relates to the transfer of the principal power and responsibility for setting position limits from the FCA to trading venues, in line with legislative measures introduced by FSMA 2023. The FCA is of the view that as the venues are much closer to the action, they are better placed to set the position limits and, on an ongoing basis, to monitor and make sure that these are complied with, so that is essentially what the proposed new regime seeks to achieve.

There are a few caveats, however, to the trading venues’ responsibilities and powers:

• Although the power will move from the FCA to the trading venues, there will be a lot of detail in FCA rules that the venues will have to comply with. The FCA will set the broader framework and, within that, the venues will set position limits based on the criteria identified by the FCA.

• There will also be significant reporting and approval requirements set by the FCA (discussed further below). This means that while the trading venues will need to create their own frameworks and run their own assessments, they will still report to the FCA and need FCA approval for some actions.

• Under the provisions introduced by FSMA 2023, the FCA will retain a catch-all power to intervene in certain circumstances. As with several of the other developments we have seen in the financial services regulatory space recently, there is a lot of focus on risk frameworks and ensuring that there is a true assessment of potential risks and exposures.

Trading venues will therefore have a lot to think about when implementing the new regime, as they will need to comply with the FCA requirements and create their trading venue specific requirements on top of those.

Scope of the position limits regime

Territorial scope

An initial point to flag in relation to scope is that the FCA is not proposing to change the territorial scope of the position limits regime, so position limits would continue to apply to participants that trade in relevant contracts irrespective of where they are based (i.e., in the UK or elsewhere).

Critical and related contracts

The application of position limits will be restricted to so-called “critical” commodity derivatives contracts which are identified by the FCA. There is a list of these contracts in CP23/27, and the FCA explains why certain contracts have been included in that list and why others have not. For the most part, the list should reflect the currently applicable scope, although there are some differences along the boundary. For example, the FCA does not propose to categorise as critical certain derivatives that are on the existing list but which have a relatively small market, as well as certain derivatives that it considers likely to be deemed related contracts of another critical derivative. Conversely, a cash-settled energy derivative which does not appear in the existing list in the FCA’s supervisory statement on commodity derivative position limits does appear in the FCA’s proposed list of critical contracts. The FCA has also provided a list of the key principles and criteria that it has used in the proposals and which it also plans to use an ongoing basis, in order to maintain the Critical Contracts Register. The FCA plans to give 45 days’ notice of any changes to the Critical Contracts Register, despite the fact that market participants had asked for a longer consultation period for such changes.

An interesting point to note in the CP is the distinction between critical and “related” contracts. A related contract is defined in the proposals as a commodity derivative contract traded on a UK trading venue which has its settlement price linked to that of a critical contract, which references a critical contract, or which has the same underlying commodity as that of a critical contract. Whilst critical contracts will be identified by the FCA, trading venues will be responsible for identifying related contracts and they will need to have a clear list on their website for participants to consult. The FCA again provides criteria for identifying related contracts, but as a minimum they would have to include minis, balances of the month (Balmos) and mini-Balmos.

Another important point to note is the difference between position limits and accountability thresholds (which we will discuss below). Participants will need to be aware of both and they will effectively act as two layers of checks.

Exemptions

The FCA is proposing to have three exemptions under the new regime. The first is the hedging exemption, which already exists and would be maintained under the proposals. There are then two new exemptions: the pass-through hedging exemption, which is essentially for structures where a financial entity trades with a non-financial entity for hedging purposes; and the liquidity provider exemption.

Under the proposals, trading venues would be responsible for the granting and ongoing monitoring of exemptions, meaning that firms intending to use an exemption will need to make an application to the trading venue and provide the information required by each type of exemption and specified under the trading venue’s rules. Market participants will need to notify the trading venue of any significant change to the information it has provided as part of its exemption application, and the trading venue will reassess whether the exemption should continue to apply or be withdrawn.

The FCA also proposes the introduction of an “exemption ceiling” (i.e., limits on the size of exemptions). Trading venues would be required to consider whether an exemption ceiling should apply and, if so, to ensure that all exemptions granted are subject to that ceiling, as well as being subject to risk assessments and other applicable requirements. Any market participant breaching its exemption ceiling would be required to comply with additional reporting requirements to the trading venue, and the venue may also take further steps following a breach.

Trading venues would also be subject to a series of notification requirements set by the FCA in connection with these exemptions, which apply both per exemption granted and on an annual basis. The FCA would need to be notified by the trading venue of each exemption granted and any exemption ceilings applied, as well as an annual report of all exemptions granted, any breaches of exemption ceilings and the steps taken following those breaches.

Changes to reporting on position limits

New rules for trading venues on position management controls

The FCA is proposing so-called “accountability thresholds” both for spot contracts and for the forward curve contracts that trading venues will need to set. These will apply to critical contracts and the details will be set by the trading venues – following the important theme that runs through these proposals, of powers being delegated to trading venues within a framework set by the FCA. Various criteria are listed for trading venues to use when setting the accountability thresholds, but they will effectively be designed to look at the real risk analysis of factors such as how large the positions are, how much the market could be cornered, and various other considerations.

Accountability thresholds will form part of position management controls and are intended to support the early identification of risks before they crystallise. Participants will be subject to additional reporting requirements where an accountability threshold is exceeded and there will then effectively be obligations on the markets to review.

As well as applying to contracts that are trading on the markets, the accountability thresholds will also apply to referential OTC contracts and referential contracts traded on other trading venues – making the accountability thresholds much broader than the other aspects of the regime. The purpose of this broader application is to ensure that trading venues will, in accordance with their respective methodologies, need to analyse what the implications are when the accountability threshold is exceeded, including whether the historic positions are appropriate, what the impact will be on the market, whether it could create market instability, and whether there has been any kind of market abuse.

Enhanced reporting requirements for firms

The second aspect of the reporting changes relates to position reporting. The FCA is proposing to introduce enhanced reporting from firms to trading venues, which will require additional reporting when certain conditions are met. An important point to note here is that these enhanced position reporting requirements will not only apply to critical contracts – they will also apply in certain circumstances where firms hold positions in related OTC derivatives and derivatives traded on overseas markets. Again, the detailed criteria for when these additional reporting requirements are triggered will be set by the trading venues, based on high-level criteria set by the FCA. Participants will find the detailed requirements on this in the trading venues’ rules.

Guidance on the ancillary activities test

HM Treasury published legislation in May 2023 – the Financial Services and Markets Act 2000 (Commodity Derivatives and Emission Allowances) Order 2023 (the Order) – which is due to take effect in 2025. The Order will remove the transitional ancillary activities exemption, which is currently in Article 72J of the Regulated Activities Order, and the references in that to the UK version of Commission Delegated Regulation 2017/592 (also known as UK RTS 20) which sets out the ancillary activities exemption test and also the requirement to notify the FCA annually if you are relying on the ancillary activities exemption.

These changes have been made to implement the conclusions of the Wholesale Markets Review, with the aim of simplifying the regime and returning to a more principles-based regime in the UK which looks at whether derivatives activity is ancillary to a company or its group’s main business by reference to a qualitative as opposed to a quantitative test. The ancillary activities exemption remains important in the UK post-Brexit because various exclusions in the UK regime refer to MiFID business, such as dealing, being subject to the ancillary activities exemption.

To address this, the FCA is consulting in CP23/27 on guidance which sets out its understanding of “ancillary” as something that is related and subordinate to the main business of the group. The FCA seems to assume that using derivatives to hedge identifiable risks arising from that main business would be ancillary, but it does not rule out the possibility of other business that goes beyond risk management also being ancillary. It also sets out a number of factors that companies must have regard to when making that determination. At the request of industry, one of these factors is the trading and capital employed thresholds which are used in the current EU technical standard, which is different from the test as set out in the current UK RTS 20. They consider a firm’s trading activity against the overall trading activity of the group or the estimated capital that a group would be required to hold against the market risk inherent in their derivatives and emission allowance trading activity.

This test does not appear to be mandatory, and companies may also have regard to other factors such as profits, staff numbers, and the time they spend in relation to their investment services or activities. However, it will be interesting to see how many companies prefer the comfort of the quantitative tests that they are essentially being told they can still have regard to. There is also likely to be some debate about whether being able to rely on this quantitative, essentially EU trading test (as amended to incorporate certain types of UK specificities), will necessarily mean that a firm’s trading activity is ancillary in all cases. For example, a company could be using it to undertake a limited amount of speculative trading that is not related to its main business. We should therefore expect to see further discussion around how exactly this test will work in practice.

Next steps

The consultation closes on 16 February 2024 and the FCA has said that it will then publish its proposals. The exact timing is not yet known but it is likely to be within a reasonable timeframe, as there is considerable policy and political pressure to finalise these rules, which are effectively part of the implementation of FSMA 2023. Firms should watch out for further updates on this from the FCA during the course of 2024.