For the first time in the EU, position limits on commodity derivatives have been introduced as a formal regulatory intervention. The primary aim of position limits is to prevent market abuse or distortion, which are balanced against the objectives of the need to support orderly pricing and settlement conditions, the development of new commodity derivatives and the proper functioning and legitimate commercial activities of their underlying market.
MiFID II requires competent authorities of Member States to establish and impose a maximum quantitative threshold on a firm's net position, held individually or on its behalf at an aggregate group level, for each commodity derivative traded on EU trading venues (ETD) as well as their economically equivalent over-the-counter derivatives (EEOTC). Under MiFID II, trading venues now cover not only regulated markets and multilateral trading facilities, but also organised trading facilities.
This regime seeks to align itself with that of the US Dodd-Frank Act, but the broad EU definition of "commodity derivative" means that a much higher number and range of instruments fall within scope. Unlike the US regime, which only covers physical commodity derivatives of sufficient liquidity, the EU regime also covers cash-settled and securitised derivatives that may not have a commodity as its underlying or a tangible underlying at all, and new or illiquid contracts.
All commodity derivative traders need to comply with these limits, even firms exempt from the MiFID II licensing requirement. A non-financial entity which is not a financial counterparty under EMIR can rely on the commercial hedging exemption by making an application to the relevant competent authority in respect of each commodity derivative's position limit. The exemption will not help firms to avoid other associated compliance requirements, such as position reporting obligations.
ESMA, tasked with calibrating the regime, does recognise that a one-size-fits-all approach is not workable. ESMA's final draft regulatory technical standard 21 (RTS 21) sets out the proposed methodology for the calculation of the limits and seeks to provide some flexibility. Overall, the quantitative spread for the limits is made stricter under RTS 21 than the original proposals, but a special regime for new and illiquid contracts has been carved out.
Position limits regime - Overview
Position limits apply to the size of a net position, in respect of each commodity derivative, held by a firm individually and on its behalf as well as at a group level. There is a limit for each commodity derivative. The limits apply at all times and therefore firms must monitor these limits intraday.
For a commodity derivative that is only traded on a single venue established or operating in one single Member State, the competent authority of that Member State is responsible for setting the limit (the "specific position limit").
For the "same" commodity derivative that is traded on more than one Member State venue and subject to certain "significant" thresholds of trading volumes being exceeded, a competent authority of the Member State of the venue with the "largest volume" of trading (the "central competent authority") is responsible for setting the limits (the "generic position limit") in consultation with other competent authorities.
RTS 21 provides competent authorities with a clarification of the core concepts under MiFID II, and the methodology for calculating position limits with reference to the standard baseline for spot month and other months' commodity derivative contracts. It also explains how a firm can calculate its own and its group's net position in order to comply with the position limits regime. The criteria and guidelines of the application of the commercial hedging exemption is also covered.
Separately, under MiFIR, competent authorities may impose more restrictive position limits and position management controls if justified under exceptional circumstances. The effect of these temporary and exceptional measures is limited to a maximum of six months, though extendable for a further six months, provided certain conditions are fulfilled.
Generally speaking, competent authorities bear the primary responsibility to set position limits and exercise position management powers, but ESMA will perform a facilitation and coordination role in relation to measures taken by competent authorities. Under MiFIR, ESMA is given a power to intervene if necessary. To prevent regulatory arbitrage, ESMA will annually monitor the consistent application of position limits by the competent authorities.
Scope of commodity derivatives trading covered
The position limits regime catches physically-settled and cash-settled (including securitised) commodity derivatives, traded on EU trading venues and EEOTC. The relevant competent authority will determine when an OTC commodity derivative is economically equivalent to a derivatives traded on a venue. A list of ETD and EEOTC will be published.
MiFID II and RTS 21 do not contain any reference to the need for the commodity derivatives to have at least one European counterparty. This may imply that it is sufficient for the commodity derivative to be connected to a EU venue, either being traded on it, or as a EEOTC to a ETD in the EU to bring it in scope.
The definition of commodity derivative under MiFID II, which cross-refers to MiFIR, is broad. It covers instruments of different structures (including contracts in securities such as exchange traded products which have commodities as an underlying) and certain types of underlying beyond strictly commodities (e.g. exotics such freight rates and climatic variables).
RTS 21 states that a contract should be deemed EEOTC where it is valued on the same underlying commodity that is deliverable at the same location and with the same contractual specifications, terms and conditions such as date of delivery. It must also have a highly correlated economic outcome to a contract traded on a venue. Differences in post trade risk management arrangements are not relevant.
Scope of commodity derivatives subject to generic position limits
When the "same" commodity derivative is traded in "significant volumes" on trading venues in more than one Member State, the central competent authority of the venue with the "largest volume" will, in consultation with the other competent authorities, set a generic quantitative threshold to be applied across all venues where such a commodity derivative is traded.
The concept of the "same" commodity derivative could refer to a subset of ETD in the context of generic limits or a sub-set of both ETD and EEOTC in the context of specific limits. However, this term is only relevant for the purpose of assessing if a generic limit is required instead of a specific limit.
RTS 21 provides that the commodity derivative is considered the "same" where these contracts:
- Have identical contractual specifications and terms and conditions (i.e. economically equivalent), excluding post-trade risk management arrangements; and
- Form a single fungible pool of open interest. For securitised derivative, the open interest requirement is replaced by having the securities in issue by which the positions held on one venue may be closed out against those held in the other trading venue.
RTS 21 also sets out the thresholds for "significant volume" as the volume that over a consecutive three-month trading period in the commodity derivative on that trading venue:
- Exceeds an average daily open interest of 10,000 lots in the spot and other months' combined; or
- In the case of securitised derivatives, when the number of units traded multiplied by the price exceeds an average daily amount of €1 million.
The trading venue of the "largest volume" is the one which has over one year:
- The largest average daily open interest; or
- In the case of securitised derivatives, the highest average daily amount.
The competent authorities of the venues where the "same" commodity derivative is traded and the competent authorities of position holders in that commodity derivative shall put in place co-operation arrangements including exchange of relevant data, to enable monitoring and enforcement of the single position limit.
Trading venues that list the same commodity derivative contract must also put in place appropriate communication and liaison arrangements to ensure that the volumes of open interest are known at all times to the relevant competent authorities.
RTS 21 sets out the details for the calculation and setting of specific position limits by competent authorities. These limits would be specified in lots, with lots meaning the unit of quantity used by the trading venue on which the commodity derivative contract trades.
RTS 21 provides for a special regime for new and/or illiquid contracts below a certain size. This takes the form of a tiered approach whereby the position limit for the spot month and for other months is set at a fixed level of 2,500 lots or securities in issue until a de minimis threshold of 10,000 lots is exceeded, after which it is calculated under the standard methodology. Such an arrangement could avoid a more stringent standard methodology to apply to new and/or illiquid contracts.
For contracts above the de minimis threshold of 10,000 lots, a standard baseline and quantitative thresholds will be set.
This means that the de minimis regime is not applicable to commodity derivatives subject to a generic position limit, as these derivatives must be above a certain size and trading volume to be subject to those limits.
Standard methodology for contracts above de minimis size
The standard quantitative baselines for the setting of position limits by competent authorities largely differentiate spot month from other months, with the former using a percentage of the deliverable supply and the latter using a percentage of the total open interest (excluding open interest in the spot month).
The relevant baselines for spot month and other month limits largely apply in the same way to both physically settled and cash settled commodity derivatives contracts, with certain exceptions:
- Where there is no underlying deliverable supply for a commodity derivative (such as commodity derivatives listed under Annex I, Section C10 e.g. weather), the spot month position limit should be based on open interest;
- For securitised derivatives which do not have a maturity date or a series of different maturity dates, no difference is made between spot and other months and the limits are calculated based on a percentage of the instruments in issuance.
ESMA has taken a broad approach under RTS 21 that spot month is the time period immediately before delivery at expiry during which the delivery of the physical commodity is to be made and the length of this period is specific to each commodity derivative and may not actually correspond to exactly one month. Spot month contracts refer to the contract that is the next contract in that commodity derivative to mature. Other months contracts cover all other months which are not spot months.
A contract that is EEOTC to an ETD is considered a spot month contract when the commodity derivative traded on a trading venue to which it is equivalent is the spot month. For securitised commodity derivatives which do not have a maturity date or a series of different maturity dates no difference is made between the spot month and other months for the purposes of the position limits regime.
Quantitative thresholds for contracts above the de minimis size
Competent authorities are given the responsibility of setting position limits, as well as reviewing and adjusting the limits as market circumstances change in order to support liquidity and facilitate orderly settlement. In the process, they will also monitor any accumulation of dominant positions and market squeezes.
ESMA anticipates that competent authorities should be able to implement a schedule of decreasing position limits ranging from the point in time when a contract becomes a spot month contract until maturity, in order to enable position limits are more precisely and adequately set.
For the spot month's position limits, RTS 21 provides that the standard baseline should be 25% of deliverable supply. There is flexibility for a competent authority to increase this by a maximum of 10%, or decrease this by a maximum of 20%, if justified by certain factors such as the characteristics of the commodity derivatives contracts and its underlying market. Examples of the relevant considerations are the length of the maturity period, absence of market participants, newly developed or illiquid contracts above the threshold, and the need to support the orderly settlement and functioning of the contract and its underlying market.
For other months' contracts, 25% of the total open interest is the baseline, with flexibility for competent authorities to adjust down to 5% and only up to 35% of open interest. Total open interest is considered more appropriate than an average figure for the other months' position limit, which is applied across all maturities other than the spot month as the distribution of the positions is often concentrated in the months closest to maturity.
ESMA previously requested for views regarding the transitional period for implementing the position limits regime, specifically, the length of period a limit should be fixed for a specific contract (except in exceptional cases) and the notice period for subsequent future adjustments to a limit. ESMA has not provided an indication on their position on these points in RTS 21.
How do firms calculate their net position for each commodity derivative?
RTS 21 provides that a net position for each commodity derivative is established by aggregating and netting off positions held over ETD, the same commodity derivative and EEOTC for spot month and other months' contracts separately. Though the drafting is slightly ambiguous, it appears that a separate netting process is required for each commodity derivative subject to a position limit, whether it is specific or generic limits.
ESMA has provided comments on how these provisions operate:
- The calculation of a net position on physical contracts can be determined by netting off long and short positions and the size of a position held through an option contract should be calculated on a delta equivalent basis.
- Netting calculations should be applied separately to determining the spot and other month's positions based on the characteristics of the relevant derivative.
For the avoidance of doubt, ESMA emphasises that the counting and netting of instruments against physical holding and instruments outside of MiFID II's scope is not required/permitted, i.e. those falling within REMIT. ESMA is of the view that the concept and threshold of the "same" should uphold the robustness of the position limit on the principal commodity derivative contract and prevent firms from inappropriately netting positions across dissimilar contracts.
ESMA also finds it important to ensure a narrower definition of EEOTC to avoid such contracts being subject to multiple position limits, and in order to prevent inappropriate or multiple or selective netting off of potentially dominant trading venue positions through the use of bilateral OTC arrangements. RTS 21 therefore frames EEOTC narrowly to apply to limited circumstances and restrict firms' exercise of discretion in the netting process.
However, ESMA has not accepted the proposal to establish an exhaustive list of EEOTC.
When to aggregate at a group level?
Positions held by others firms on behalf of a firm should be included in the calculation of that firm's position limit and for position limits to be applied at both an entity level and at a group level.
RTS 21 sets out in detail when positions are required to be aggregated on a group basis in order to assess if the position limit is complied with at the group level. It is appropriate to only provide for aggregation at the group level if a parent undertaking (over 10% ownership in the chain) holds the position directly or can control the use of positions. Such aggregation can lead to positions at the level of the parent being higher or lower than the positions at the individual subsidiary level.
Positions held by collective investment undertakings (or their management companies) on behalf of their investors or customers rather than on behalf of their parent undertakings do not need to be aggregated, provided that the parent undertakings cannot control the use of those positions for their own benefit, and do not influence the investment decisions regarding the opening, holding or closing of those positions.
ESMA suggests that only EU group entities are covered, which should mean all group entities established or operating in the EU. This contrasts with the definition of "group" in RTS 20, which includes group entities established outside the EU when deciding on the application of the MiFID II commodities exemption.
How to fall within the hedging exemption?
Article 57(1) of MiFID II states that "position limits shall not apply to positions held by or on behalf of a non-financial entity which are objectively measurable as reducing risks directly related to the commercial activity of that non-financial entity". RTS 21 sets out a two-fold criteria to assess whether the positions held by or on behalf of non-financial counterparties qualify for the exemption.
The risk-reducing characteristic of hedging contracts is recognised by the use of the accounting definition of a hedging contract based on IFRS rules. Even though non-financial entities do not apply IFRS at an entity level, RTS 21 provides that this accounting definition should be available to and be taken into account by non-financial entities for the purpose of assessing if the hedging exemption would apply.
The second criteria requires the position to be "directly related" to risk reduction. RTS 21 recognises that the use of risk management techniques, such as macro- or portfolio-hedging and proxy hedging, by non-financial entities to mitigate their overall risks arising from their own or their groups' commercial activities may result in a position that is not identical, or closely correlated, to be entered into as part of the overall risk-reducing portfolio.
Is the reliance on the hedging exemption safe?
Only commercial hedging is covered but treasury activities are excluded. RTS 21 specifies the need for risk policies and systems to be able to provide a sufficiently "disaggregate" view of the hedging portfolio by identifying and counting in speculative components of that overall risk-reducing portfolio within the position limits. The RTS 21 approach to hedging is, therefore, consistent with the approach taken in RTS 20.
ESMA also clarifies in RTS 21 that the evolution of a risk would not call into question or trigger a re-evaluation as to whether a position entered into to reduce a risk at the outset may cease to be considered risk-reducing in hindsight. At a later stage, of course, additional positions may be used to offset the new form of risk.
ESMA considers that non-financial entities should apply to the relevant competent authority of the trading venue on which the relevant contract trades for the use of the hedging exemption in respect of holdings in a specific contract. The application should provide a clear and concise overview of their commercial activities in respect of an underlying commodity, the associated risk position in commodity derivatives contracts, which may then form the basis of requiring a particular firm to reduce the size of their derivative positions.
Where "objectively justified and proportionate", competent authorities can impose limits on firms’ positions which are more restrictive than other limits in place. They can require a reduction of the size of the positions on a national or a pan-European basis for a period of not exceeding six months at a time, if the grounds for the restriction continue to be applicable. If not renewed after that six-month period, they shall automatically expire. Competent authorities shall publish on their website the details of the more restrictive limits they decide to impose.
Where competent authorities decide to impose more restrictive limits, they shall notify ESMA. The notification shall include a justification for the more restrictive limits. ESMA shall, within 24 hours, issue an opinion on whether it considers that the more restrictive limits are necessary to address the exceptional case. The opinion shall be published on ESMA’s website. Where a competent authority imposes limits contrary to an ESMA opinion, it shall immediately publish on its website a notice fully explaining its reasons for doing so.
ESMA is responsible for overseeing competent authorities in their exercise of these powers to ensure consistency across Member States. ESMA also has the power to demand information on positions, and to limit a firm's positions, but it must first satisfy itself that:
- This addresses a threat to the orderly functioning and integrity of 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 financial system in the EU; and
- Competent authorities have not already taken sufficient action before taking further steps.
Wider commodity derivatives compliance requirements and implications
In addition to position limits and position management controls imposed as a regulatory intervention, commodity derivatives traders are required to comply with a wider range of position limits, management controls and position reporting requirements under MiFID II/ MiFIR.
Under MiFID II, all commodity derivative trading venues are required to impose clear, transparent and non-discriminatory position limits on the number of contracts which market participants can enter into over a specified period of time, or adopt alternative position management controls to require traders to terminate or reduce their positions or to provide liquidity back to the market.
Such trading venues will have to publish a weekly report providing details of aggregate positions which are held by the different categories of traders, including the clients of those not trading on their own behalf, and make this available to the relevant competent authority at least on a daily basis. This requirement would apply when both the number of persons and their open positions exceed minimum thresholds.
Positions that fall within the hedging exemption to the position limits remain subject to such MiFID II position reporting requirements. For monitoring purposes, investment firms trading commodity derivatives are also required to submit position reports on a daily basis of ETD (including the "same" commodity derivatives) and EEOTC to competent authorities or central competent authorities on positions held by themselves and their clients, until the end client chain is reached.
Market impact and territorial scope
Commodity derivatives traders will need to navigate and position themselves amidst remaining uncertainties in terms of the application of the position limits, hedging exemption and other overlapping compliance requirements.
The extent to which ESMA's efforts to calibrate the regime could help the industry to establish the compliance systems and controls to manage their commodity trading positions effectively within these limits, and not to adversely impair effective risk management through hedging or dampen market responsiveness and efficiency is still open to question.
It may be a comfort to firms that only trading with a nexus to a venue established or operating in the EU will be caught. ESMA has reiterated that it considers that the territorial scope of Article 57 of MiFID II does not apply to the "same" derivative contract traded on a third country venue outside the EU.
Neither Level 1 nor RTS 21 specifies how the scope of the EU position limits regime will interact with third country regimes or how the limits will apply to third country firms. In the absence of express words to the contrary, it appears that third country firms that trade ETD or enter into a EEOTC will be caught. A clarification that third country firms that only trade EEOTC with no direct link to a ETD in the EU should remain outside of the EU regime would be welcome.