MiFID II / MiFIR series

The Markets in Financial Instruments Directive (MiFID) is one of the cornerstones of EU financial services law setting out which investment services and activities should be licensed across the EU and the organisational and conduct standards that those providing such services should comply with.

Following technical advice received from the European Securities and Markets Authority (ESMA) and a public consultation, the European Commission (the Commission) published legislative proposals in 2011 to amend MiFID by recasting it as a new Directive (MiFID II¹) and a new Regulation (MiFIR²). The legislative proposals were the subject of intense political debate between the European Parliament, the Council of the EU, and the Commission. However, informal agreement between the EU institutions was finally reached in February 2014. The final MiFID II and MiFIR texts were published in the Official Journal of the EU on 12 June 2014 and entered into force 20 days later on 2 July 2014. Entry into application will follow 30 months after entry into force on 3 January 2017.

The implementing measures that will supplement MiFID II and MiFIR will take the form of delegated acts and technical standards. On 22 May 2014, ESMA released a consultation paper (the CP) setting out ESMA’s proposed advice to the Commission regarding delegated acts and a discussion paper (the DP) setting out ESMA’s proposals for technical standards. Having considered the responses to the CP and the DP, on 19 December 2014 ESMA published a Final Report setting out its technical advice to the Commission and a second consultation paper (the CP2) containing its draft regulatory and implementing technical stands (RTS and ITS). The deadline for responses to the CP2 has now passed.

The provisions in MiFID II and MiFIR relating to commodity derivatives aim to 'improve oversight and transparency of commodity derivative markets in order to ensure their function for hedging and price discovery, as well as in light of developments in market structures and technology, in order to ensure fair competition and efficient markets'. The changes also reflect the G20 agreement to improve the regulation, functioning and transparency of financial and commodity markets to address excessive commodity price volatility.

Emission allowances

Emission allowances (EUAs) will become financial instruments for the purposes of MiFID II. However, it should be noted that the provisions on position limits and position management controls for derivatives in MiFID II and MiFIR refer to 'commodity derivatives', which does not include derivatives on EUAs. The position reporting obligations do, however, apply to EUAs and derivatives on EUAs.

The definition of derivatives in EMIR³ also refers back to MiFID. Spot EUAs will not be in scope of the various EMIR obligations, but derivatives on EUAs will be, whether settled physically or in cash.

Physically settled commodity derivatives and REMIT wholesale energy products

The types of physically settled commodity derivatives covered in Section C(6) of Annex 1 to MiFID will be extended to those traded on an organised trading facility (OTF). However, there is a carve out for wholesale energy products (as defined in REMIT⁴) that are traded on an OTF and which must be physically settled. Such REMIT contracts will not be derivatives for the purposes of EMIR either.

ESMA has proposed that a wholesale energy product should be considered a contract which must be physically settled when it meets the following criteria:

• the contract contains provisions which ensure that the counterparties have proportionate arrangements in place to be able to make or take delivery of the underlying commodity;
• the contract establishes unconditional, unrestricted and enforceable obligations of the parties to the contract to deliver and take delivery of the underlying commodity;
• it is not possible for either party to replace physical delivery with cash settlement; and
• the obligations under the contract cannot be offset against obligations under other contracts between the two counterparties (without prejudice to the rights of the counterparties to net their cash payment obligations).

ESMA has stated that the inclusion of a force majeure clause or other clauses covering a bona fide inability to physically settle the wholesale energy contract or the existence of operational netting arrangements in power and gas markets will not prevent a contract from benefiting from the REMIT carve out. ESMA also clarifies that the existence of default clauses providing that a party is entitled to financial compensation will not prevent a contract from benefiting from this carve out.

MiFID II also contains a transitional provision in relation to the applicability of the EMIR clearing and collateralisation obligations for derivatives relating to coal or oil that are traded on an OTF and which must be physically settled (the criteria in relation to the “must be physically settled” requirement are currently proposed to be the same as those detailed above). Provided the relevant Member State competent authority permits the exemption, non-financial counterparties exceeding the clearing threshold or those entities which become authorised as a result of MiFID II, will not have to clear or collateralise trades in such derivatives until 3 July 2020. In addition, for the duration of the transitional period, non-financial counterparties will not have to include such contracts in their clearing threshold calculations. All other EMIR obligations, including the other risk mitigation obligations and the reporting obligation, will not be subject to the transitional period.

Commodity and exotic derivatives 'having the characteristics of other derivative financial instruments'

ESMA has published its proposals for what “having the characteristics of other derivative financial instruments” means in relation to each of the C(7) (OTC physically settled commodity derivatives which do not benefit from the REMIT carve out) and C(10) (exotic derivatives) financial instrument classes.

In relation to C(7) instruments this will be determined by:

• the level of standardisation of the contract, which will be determined by reference to parameters such as price, lot size, delivery date and other terms that are determined principally by reference to regularly published prices, standard lots or standard delivery dates; and
• whether the contract is either (i) traded on a third country trading venue that performs a similar function to any of the MiFID II trading venues, (ii) is expressly stated to be traded on or subject to the rules of any of the MiFID II trading venues or a third country trading venue or (iii) is equivalent to a contract traded on a MiFID II trading venue or a third country trading venue with regard to the price, the lot size, the delivery date or other terms.

Each of these conditions must be satisfied in order for the contract to be a C(7) instrument. There will be no requirements that the contract be cleared through a CCP or subject to regular margin calls.

“Spot” contracts under which delivery of the underlying commodity is scheduled to take place within the longer of either two trading days from execution of contract or the period generally accepted in the market for that commodity as the standard delivery period are specifically exempted from the C(7) category. Contracts which are entered into for commercial purposes will also be exempt from this category. Currently only contracts entered into with or by an operator or administrator of an energy transmission grid, energy balancing mechanism or pipeline network and which are necessary to keep in balance the supplies and uses of energy at a given time are considered to be for a commercial purpose, although ESMA remains open to adding other specific types of contract to this list.

For C(10) instruments, financial characteristics will be determined by:

• whether the contract is or may be settled in cash at the option of one or more of the parties to the contract other than by reason of default or other termination event;
• whether it is traded on a MiFID II trading venue or a third country trading venue that performs a similar function to a MiFID II trading venue; or
• whether the criteria in relation to C(7) instruments (as set out above) are satisfied.

A contract will only need to satisfy one of the above criteria to be considered a C(10) instrument.

Under MiFID, many entities trading commodity derivatives are able to rely on exemptions to avoid the need for authorisation as an investment firm. MiFID II will severely restrict those exemptions and will have a significant impact on firms that currently rely on them.

Dealing on own account exemption

MiFID II amends the exemption on dealing on own account in Article 2(1)(d) of MiFID. A firm will no longer be able to rely on this exemption in relation to commodity derivatives, EUAs or derivatives on EUAs.

Ancillary activity exemption

MiFID II significantly amends the ancillary activity exemption. It will only be applicable to activities in relation to commodity derivatives, EUAs or derivatives on EUAs and will only be available to firms which:

• deal on own account other than by executing client orders in commodity derivatives (although note that a recital suggests that the execution of orders as an ancillary activity between two persons whose main business on a group basis is not investment or banking services should not be considered to be dealing on own account by executing client orders); and/or
• provide investment services other than dealing on own account to the customers or suppliers of their main business.

In addition, those seeking to rely on the exemption will have to satisfy the following criteria:

• each of the two permitted activities, individually and on an aggregate basis, must be ancillary to their main business when considered on a group basis;
• that main business must not be the provision of investment services under MiFID, banking services under the Banking Consolidation Directive nor acting as a market maker in relation to commodity derivatives; and
• they must not apply a high frequency algorithmic trading technique.

Those relying on this exemption must notify the relevant Member State competent authority on an annual basis that they make use of this exemption, and the relevant Member State competent authority may request details of the basis on which they consider they have met these conditions.

The draft RTS in relation to the criteria for establishing when an activity is to be considered ancillary state that this determination must at least take into account the need for ancillary activities to constitute a minority of a firm’s activities at group level and the size of a firm’s trading activity compared to the overall market trading activity in the relevant asset class. In the CP2, ESMA proposes the following tests:

• the capital employed for all ancillary activity at group level in the EU must be less than 5% of the capital employed for the business globally at group level; and
• the size of trading activity at group level in each of eight asset classes (metals, oil and oil products, coal, gas, power, agricultural products, other commodities (including freight and the C(10) commodities) and EUAs and derivatives on them) in the EU must be less than 0.5% of the size of the overall market trading activity in that asset class in the EU.

There will however be carve outs available in relation to certain intra-group trades, derivatives entered into for hedging purposes and derivative and EUA trades entered into as part of a liquidity provision obligation. Trades entered into as principal by an entity in the group that is authorised in accordance with MiFID II can also be excluded.

The sum of all ancillary activity carried out in the EU must be below both of these thresholds for the exemption to be relied upon. ESMA also proposes to establish a de-minimis threshold whereby a person whose trading activity constitutes less than 0.25% of the overall market trading activity in each asset class can benefit from the exemption without needing to meet the first test.

ESMA has proposed a three year rolling average test with firms to start collecting data from 2016 onwards.

Commodity dealer exemption

The exemption in Article 2(1)(k) in MiFID that was specifically designed for persons trading in commodity derivatives is not included in MiFID II.

Specialist exemptions

MiFID II also contains a new exemption for operators with compliance obligations under the Emissions Trading Directive⁵ where, when dealing in EUAs, such persons do not execute client orders or provide any investment services or perform any investment activities other than dealing on own account, provided they do not apply a high frequency algorithmic trading technique. There are also exemptions for electricity and gas transmission system operators.

Each Member State will have the option to permit an exemption in relation to joint ventures set up by local electricity and/or natural gas undertakings and operators under the Emissions Trading Directive.

Practical consequences arising from revisions to the exemptions

Those commodity firms that currently rely on any of the exemptions in MiFID would be well advised to revisit and update their previous analysis. In particular, the new ancillary exemption will make it difficult for a regulated group to have an unregulated commodity derivative trading subsidiary and the removal of the commodity dealer exemption will put significant pressure on the agency trading structure that is used by many commodities groups and which allows a regulated entity to trade as agent on behalf of unregulated group companies. Where a firm is no longer able to rely on a MiFID II exemption as a result of the changes, it will need to become authorised to carry out the relevant MiFID II business and comply with the applicable rules relating to organisation, conduct and capital. For more information on these requirements please see our other briefings.

Even if an entity is able to continue to rely on an exemption, there are several important provisions in MiFID II and MiFIR that have a broader scope of application than just investment firms and the trading venues on which derivatives and EUAs are traded. These include the new obligation to trade certain derivatives on a regulated market (RM), multilateral trading facility (MTF) or OTF or certain equivalent third country venues, as discussed in our briefing note on trading venues and market infrastructure.

MiFID II and MIFIR impose a number of key changes aimed at reducing systemic risk, combating disorderly trading and reducing speculative activity in commodity derivatives markets through the imposition of new position limit and management powers by trading venues and national regulators and the grant of additional intervention powers to ESMA.

Position limits

The competent authority of each Member State will impose limits on the size of the net position which a person can hold in commodity derivatives traded on an EU trading venue and economically equivalent OTC contracts. They will apply to all positions held both by a person and on its behalf at an aggregate group level. Where the same commodity derivative is traded in significant volumes on trading venues in more than one jurisdiction, a single position limit may be set by the competent authority of the jurisdiction where the largest volume of trading takes place.

Position limits will not apply to positions held by or on behalf of a non-financial entity and which are objectively measurable as reducing risks directly related to the commercial activity of that non-financial entity.

ESMA has produced two draft RTS in relation to position limits. These cover areas including the methodology which the Member State competent authorities should use to set position limits, the type of contracts which position limits will apply to and permissible aggregation and netting for the purposes of calculating a position. Position limits will be set for the spot month and all other months and will apply to both cash settled and physically settled commodity derivatives. ESMA’s proposal is for position limits to be based on the deliverable supply in the underlying commodity with adjustments for specified factors (maturity of the commodity derivative contract, deliverable supply in the underlying commodity, overall open interest, volatility of the relevant markets, number and size of market participants, characteristics of the underlying commodity market and development of new contracts).

The operator of a trading venue for commodity derivatives will also have to apply position management controls. These will include powers to monitor open interest positions; access information about the size and purpose of a position or exposure entered into, the beneficial or underlying owners, any concert arrangements and any related assets or liabilities in the underlying market; require a person to terminate or reduce a position on a temporary or permanent basis; and, where appropriate, require a person to provide liquidity back into the market.

The imposition of position limits and management controls will be a Member State responsibility and will be handled by the relevant competent authorities, although ESMA will be responsible for facilitating and coordinating national measures, including by publishing summaries of the position limits and management controls applied by competent authorities and trading venues on its website. The relevant Member State competent authority and ESMA will publish a list of commodity derivative contracts traded on an EU trading venue and OTC contracts that are economically equivalent to them for the purposes of position limits.

Position reporting

MiFID II introduces position reporting for commodity derivatives, EUAs and derivatives thereof such that each trading venue is required to make public a weekly report of the aggregated positions held by the different categories of position holders (investment firms or credit institutions, investment funds, other financial institutions, commercial undertakings or, in the case of EUAs or derivatives thereof, operators with compliance obligations under the Emissions Trading Directive) for the different contracts traded on that trading venue. These will specify the number of long and short positions held by such categories, changes since the previous report, the percentage of total open interest represented by each category and the number of position holders in each category, when both the number of position holders and their open positions exceed minimum thresholds. The format to be used in respect of each commodity derivative is set out in the draft ITS. There is also a separate obligation on the trading venue to provide its Member State competent authority on at least a daily basis with a breakdown of the positions of all position holders, including the members or participants and their clients on that trading venue.

Investment firms trading in commodity derivatives, EUAs and derivatives thereof outside a trading venue must, on a daily basis, provide the relevant Member State competent authority with a breakdown of their positions in commodity derivatives traded on a trading venue and economically equivalent OTC contracts, as well as those of their clients and the clients of those clients until the end client is reached. The format is set out in the draft ITS.

In order to monitor compliance with position limits, members or participants of RMs, MTFs and clients of OTFs will have to report to the operator of the trading venue details of their positions held through contracts traded on that trading venue, as well as those of their clients and the clients of those clients until the end client is reached.

Position management powers of ESMA

MiFIR provides ESMA with position management powers allowing it to request all relevant information from any person regarding the size and purpose of a position or exposure entered into via a derivative. Having analysed this information, ESMA may require such persons to reduce the size of or to eliminate their position or exposure or, as a last resort, to limit the ability of a person from entering into a commodity derivative. ESMA can only take these steps if two conditions are satisfied: (i) there is a threat to the orderly functioning and integrity of the financial markets, including commodity derivative markets and including in relation to delivery arrangements for physical commodities, or to the stability of the whole or part of the EU financial system; and (ii) a Member State competent authority has not taken measures, or the measures taken are inadequate, to address such threat.

ESMA must ensure that any measure it takes neither creates a risk of regulatory arbitrage nor has a disproportionate detrimental effect on the efficiency of financial markets. As part of this, ESMA must consult the Member State competent authorities and certain other bodies responsible for the physical markets. Any measures must be published on ESMA's website and be reviewed at least every three months.

In addition, ESMA will have powers of supervision and intervention in relation to the marketing, distribution and sale of financial instruments or types of financial activity or practice.