On 20 October 2011, the European Commission published its legislative proposals1 for revisions to Directive 2004/39/EC on markets in financial instruments (MiFID), collectively referred to as MiFID II. The MiFID II proposals are intended to revise certain aspects of the MiFID framework that the Commission believes require modification and to address specific weaknesses in financial markets that emerged during the financial crisis. In particular, the significant growth in the trading of commodity derivatives has led to a consensus that stricter regulation is required in order to control the operation and transparency of these markets and to reduce commodity price volatility. The increased regulation of commodity derivative markets is, therefore, a key feature of the MiFID II proposals. This article provides an insight into the treatment of the commodity derivatives market under the current MiFID framework, in addition to examining the relevant proposed changes under MiFID II and the implications which those changes are likely to have.
Existing Framework Under MiFID
The current MiFID regime, which came into effect in the UK on 1 November 2007, brought commodity derivatives within the scope of EU regulation for the first time. However, while MiFID broadened the regulatory scope to include commodity derivatives, it also introduced various exemptions on which commodity firms could rely to fall outside the regulatory framework. The "ancillary business exemption" excludes from MiFID a firm that:
provided that the activity is ancillary to its main business (determined on a group, not entity, basis) and that the main business is not the provision of "investment services" within the meaning of MiFID. The Financial Services Authority (FSA) has previously clarified the definition of "ancillary activity" in this context to mean an activity that is "directly related and subordinate to the main business of the firm or group, as appropriate," while "main business" is interpreted taking into account relevant factors such as turnover, profit, capital employed, numbers of employees, and time spent by employees.2 The "commodities dealer exemption" excludes a firm whose main business (determined on an entity, not group, basis) consists of proprietary dealing in commodities and/or commodity derivatives, provided that the firm is not part of a group that has as its main business the provision of other "investment services" within the meaning of MiFID. These exemptions were primarily intended to apply to commercial commodity producers and users relying on derivatives as hedging tools, on the basis that, unlike traditional financial institutions, they do not interact with investors or pose a systemic risk to the market. However, the Commission has taken the view that unsophisticated clients may not be adequately protected when entering into commodity derivative contracts with commercial firms that benefit from the exemptions under MiFID, as these MiFID-exempt firms are not subject to any MiFID provisions, including the conduct of business rules. It is worth noting that there are several other exemptions under MiFID on which commodity derivative firms can rely, such as the "group exemption" under Article 2.1(b) and the "own account dealing exemption" under Article 2.1(d). While it is important to be aware of these exemptions, this article does not focus on them as they do not relate specifically to commodity derivatives.
Proposed Changes Under MiFID II
— MiFID Exemptions
In order to provide greater protection to consumers, the MiFID II proposals seek to narrow the scope of exemptions applicable to commodity firms.
Ancillary Business Exemption
It is proposed that this exemption will be amended in two ways:
Commodities Dealer Exemption
This exemption will be removed entirely. The Commission has justified the removal of this exemption by citing its recent experience of commodity firms establishing MiFID-licensed subsidiaries, in addition to the "political consensus to limit exemptions from financial regulation only to necessary cases."3
— Position Limits, Reporting, & Management
The Commission proposes to oblige Member States to ensure that regulated markets (RMs), operators of multilateral trading facilities (MTFs), and organised trading facilities (OTFs) that admit to trading or trade commodity derivatives apply limits on the number of contracts that market participants can enter into over a specified period of time, or alternative arrangements with equivalent effect (e.g., position management with automatic review thresholds) in order to support liquidity, prevent market abuse, and ensure orderly pricing and settlement conditions. In addition, the commodity derivatives markets, whether traded on recognised exchanges or over-the-counter, are currently subject to limited and varying position-reporting obligations across various jurisdictions. The Commission has therefore proposed the introduction of a harmonised position-reporting obligation for all contracts traded on EU organised trading venues that admit commodity derivatives to trading, including RMs, MTFs, and OTFs. The Commission has also stated that the recent growth in commodity derivatives markets justifies greater oversight of positions in derivatives. It therefore proposes to create harmonised powers for regulators to set position limits to reduce systemic risks and curb financial speculation in commodity derivative markets.
— Design of Commodity Derivatives
The Commission has highlighted the issue of convergence between futures and spot prices in various agricultural derivatives, largely due to deficiencies in the contract specifications drawn up by exchanges. It therefore proposes to require RMs, MTFs, and OTFs to design commodity derivatives that they admit to trade and that can be physically settled in a way which encourages greater efficiency between futures and spot prices.
— Emission Allowances
While emission allowances are not currently classified as financial instruments under MiFID, derivative contracts on emission allowances are classified under the same criteria as commodity derivatives. However, the MiFID II proposals bring emission allowances themselves within the MiFID framework for the first time. The Commission has recognised that reclassifying emission allowances as financial instruments would have a "major regulatory impact" on large industrial players, financial firms operating as intermediaries, and small- and medium-sized enterprises within the carbon market. It has, therefore, recommended that an in-depth study be carried out to assess the suitability and proportionality of classifying emission allowances as financial instruments. Firms active in this market will therefore need to be aware of further developments in this regard.
Impact of Changes on Commodity Firms
— Need for FSA Authorisation
Firms should be aware that the narrowing of the exemptions under MiFID may cause them to fall within the MiFID regime for the first time and therefore to become subject to a requirement for FSA authorisation. In particular, the removal of the commodities dealer exemption will place significant pressure on the agency trading structure used by many commodities groups, which allows a regulated entity to trade as agent on behalf of unregulated group companies.
— Reporting, Supervision, & Ongoing Management
Trading venues that admit to trading or trade commodity derivatives will, where the numbers of traders and their open positions exceed certain thresholds, be obliged to make public a weekly report with the aggregate positions held by the different categories of traders of commodity derivatives traded on their platforms. In addition, trading venues will have to provide the regulator with a complete breakdown of the positions of all market members or participants, including the category and identity of their end-clients. The legislative proposals will also allow regulators to request parties entering into derivative transactions to provide the regulator with a full explanation for the position and provide any necessary relevant documentation, including evidence of the purpose of the position (whether that is the hedging of risks or an alternative purpose). Additionally, regulators would be empowered to intervene to reduce the size of the position in the interests of market integrity, stability, and investor protection.
As a result of the narrowing of the scope of exemptions applicable to firms dealing in commodity derivatives, a greater number of firms will be within the MiFID regime and able to take advantage of the MiFID passporting regime. Relevant firms will, therefore, need to evaluate the value of the passporting regime to their particular business models.
The prevailing view in the market seems to be that the MiFID II proposals relating to commodity derivatives are less severe than expected and are not likely to result in a loss of commodity-related business from the UK to other jurisdictions. However, firms entering into commodity derivative contracts will need to remain alive to the possibility that under the MiFID II proposals their activities may no longer fall outside the MiFID regime.
Adrian Brown is a partner and head of the financial services regulatory practice at Nabarro LLP. He advises investment banks, broker dealers, fund managers and corporate finance houses on all aspects of financial services regulation. Telephone: +44 (0) 20 7524 6400; E-mail: email@example.com.Sam Robinson is a senior associate in the financial services regulatory practice at Nabarro LLP. Sam advises clients including banks, stockbrokers, fund managers and investment advisers on all aspects of financial services regulation. Prior to working in private practice Sam worked for seven years at the FSA, the majority of that time in the FSA's General Counsel's Division. Telephone: +44 (0) 20 7524 6836; E-mail: firstname.lastname@example.org.
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