Staying clear of regulation: narrowing options?
MiFID II is a mammoth piece of legislation, and with the publication of ESMA's Final Report, which sets out draft Regulatory Technical Standards that cover a wide range of issues, it is clear that commodities firms face a tougher task if they wish to avoid being regulated under the new MiFID regime.
The intention behind MiFID II is to capture a range of commodity firms previously excluded from the legislation, and address any competitive distortions arising from the current MiFID exemptions.
The MiFID II draft RTSs cover two areas that are specific to commodities firms trading derivatives. RTS 20 relates to detailed tests for assessing whether a commodities firm will be exempt from MiFID II. RTS 21 relates to position limits in relation to commodities derivative positions.
This client alert focuses solely on RTS 20, as all commodities firms will have to consider this issue in the first instance. It is expected that the significant tightening and removal of certain exemptions and the changes to the application of the exemptions will bring about a sea change to the way commodities firms carry on business and in the business structure of a regulated group that also trades commodities as an asset class.
Changes to the existing MiFID commodities exemptions
Currently, most firms who deal principally in commodities – but who also buy and sell MiFID financial instruments in connection with their business – rely on one or other of two exemptions in particular.
These exemptions are Article 2(1) (i) and Article 2 (1) (k).
Article 2 (1) (i) is an exemption which applies where a firm deals on own account in financial instruments or provides investment services in commodity derivatives to clients of their main business and:
- This is an ancillary activity to their main business when considered on a group basis; and
- The main business is not the provision of investment services under MiFID or banking services under CRD.
Article 2(1) (k), the so-called "commodities dealer" exemption, applies where a firm deals on own account in commodities and/or commodity derivatives. This exemption will be deleted in its entirety under MiFID II, which means that in the UK, the option to obtain FCA authorisation for a group company as in-house arranger or agent using the so called "with or through" exemption to conduct some speculative trading, which was caught by FSMA, may no longer be available.
The scope and application of the new "ancillary activity" exemption under MiFID II
Under MiFID II, the old Article 2 (1) (i) exemption has been significantly narrowed to become the new Article 2 (1) (j), the so-called "ancillary activity" exemption.
This new ancillary activity exemption covers firms who:
- Deal on own account, including market makers, in commodity derivatives, emission allowances or derivatives thereof, excluding persons who deal on own account when executing client orders; or
- Provide investment services, other than dealing on own account, in commodity derivatives or emissions allowances or derivatives thereof to the customers or suppliers of their main business.
In both cases the exemption is conditional on each of the two types of activities being an ancillary activity both individually and on an aggregate basis to the person's main business when considered on a group basis.
ESMA has expressed the view that taking into account Recitals 24 and 25 of MiFID II, the execution of orders in financial instruments between two non-financials directly and without any further intermediation by third parties is not covered by the term "dealing on own account when executing client orders". This reaffirms that commodities firms can rely on this exemption when carrying on trading with each other.
Additionally, the main business on a group-wide basis must not be the provision of investment services under MiFID II or banking services under CRD/ Banking Consolidation Directive.
Other requirements are that the business must not be a market making business for commodity derivatives, and that the firm must not apply a high frequency algorithmic trading technique.
The new narrower ancillary activity exemption will make it difficult for a regulated group to have an unregulated commodity derivative trading subsidiary. Further, the removal of the commodity dealer exemption will have a significant business impact on the agency trading structure that is used by many unregulated commodities groups, and which allows a single regulated entity in the group to trade as agent on behalf of unregulated group companies.
One possibility to address this is for the commodities firm to be split out from the regulated group, in order to fulfil the criteria of the ancillary activity exemption. It is, however, also relevant to note that a degree of flexibility in the structuring of the business activities is provided for under MiFID II. The ancillary activity exemption can be combined with certain additional exemptions introduced under MiFID II.
For example, Article 2(1)(d), the general own account dealing exemption covers firms trading all other types of financial instruments aside from commodity derivatives, emission allowances etc., provided the firm is either a direct participant of an RM or MTF, or if it has direct electronic access. Effectively, a firm relying on the ancillary activity exemption that also seeks to rely on the general own account dealing exemption would need to fulfil the conditions applicable to each exemption separately.
N.B. In order to make use of the exemption you MUST notify your Competent Authority on an annual basis that you plan to make use of the exemption – otherwise you will be expected to be authorised to carry on this type of MiFID business.
In addition, if you are using the exemption, the Competent Authority is empowered to ask you to provide the information required to assist them in confirming that the activity is indeed ancillary to your own activity.
Draft RTS 20
While the new exemption is different in certain aspects from the previous exemption (i) the main difference between the exemptions is that the new draft RTS will create specific quantitative tests for evaluating the extent to which the commodity derivatives business of an entity is truly ancillary to the business of the group as a whole. This will create an external, objective, pan-European calculation which can be used by a national competent authority, or ESMA or the Commission, to check whether business is truly ancillary.
ESMA makes it clear in the Final Report that they consider that the policy rationale for this, and for the narrowing of the commodities exemptions, is to require commodities firms which play a significant role in the markets and undertake sizeable speculative or financially focused activities to compete on a level playing field with banks and investment firms who are active in the same space.
The concept of "group" activity
The exemption is only available where the two types of activities are ancillary on an individual and on an aggregate basis to the person's main business when considered on a group basis.
So how is a group defined?
ESMA has selected the definition used in the EU's Accounting Directive (Article 2(11) of Directive 2013/34/EU).
The clearest description of what is intended is found in Recital 1 to the RTS:
"a group is considered to comprise the parent undertaking and all its subsidiary undertakings and includes entities domiciled in the Union and in third countries regardless of whether the group is headquartered inside or outside the Union."
How is ancillary activity tested?
The RTS requires two separate tests to be employed for the determination of whether the relevant business of the firm is ancillary to the main business on a group-wide basis. These tests are cumulative, meaning that in order to rely on the exemption, you must not exceed the relevant thresholds under each test.
Further, each test involves a separate calculation for the relevant thresholds of each commodity asset class. This means that if you trade in more than one commodity asset class, exceeding the thresholds for a single commodity asset class is sufficient to bring you into the scope of the MiFID II/ MiFIR licensing requirement.
The first test
Test one: "market share" threshold
In order to determine the commodities firm's market share and whether it is a large participant exceeding the thresholds, the level of the firm's trading activity when considered at a group level is compared to the overall market trading activity in the particular commodity asset class in the EU.
The overall size of the financial market in the particular asset class will be the gross notional value of all contracts traded either on an EU trading venue by a person located within or outside of an EU member state, or traded off-venue by a person located within an EU member state, added to the gross notional value of any contracts traded on an EU trading venue. So the focus is on trading volumes within the financial market for a particular asset class within the EU. (See Art 2(3) of the RTS).
However, no mechanism has been created to allow anyone to assess the overall size of each of these EU markets. ESMA notes that most respondents to its CP urged ESMA to take the responsibility to provide such figures. In the Final Report ESMA simply notes this – but says that there is no obligation imposed on ESMA to provide these figures. It is difficult, however, to see how a coherent and agreed set of figures can be achieved unless ESMA undertakes this task.
Article 2 of the RTS defines eight different asset classes for commodities and a trading activity threshold above which an entity would be a large participant. The thresholds are calibrated for different asset classes depending on the size, number of participants, level of liquidity and other characteristics of the relevant commodity market.
The asset classes and thresholds are:
- 4% - derivatives on metals
- 3% - derivatives on oil and oil products
- 10% - derivatives on coal
- 3% - derivatives on gas
- 6% - derivatives on power
- 4% - derivatives on agricultural products
- 15% - derivatives in relation to other commodities including freight
- 20% - emission allowances or their derivatives
Article 2(2) provides that the size of trading activity of the commodities firm is to be calculated by aggregating the gross notional value (in euros) of all contracts within the relevant asset class to which the firm is a party.
The size of the trading activity of the firm is not all trading activity by the firm in the EU. A firm is entitled to deduct so called "privileged transactions" from its total trading activity undertaken in the EU at a group level.
These privileged transactions are set out in Article 2(4) of MiFID II and are:
- intra-group transactions (as defined in EMIR) that serve group-wide liquidity or risk management purposes.
- transactions in derivatives which are objectively measurable as reducing risks directly related to the commercial activity or treasury financing of group entities.
- transactions in commodity derivatives and emission allowances entered into to fulfil obligations to provide liquidity on a trading venue where such obligations are required by regulatory authorities in accordance with EU law or with national laws, regulations and administrative provisions – or by trading venues.
Recital 13 of RTS 20 does recognise that it may not be possible to hedge a commercial risk by using a directly related commodity derivative contract: a contract with exactly the same underlying and settlement date as the risk being covered. In such case, a person may use proxy hedging through a closely correlated instrument with a different but very close underlying in terms of economic behaviour to cover its exposure. In addition to proxy hedging, macro- and portfolio hedging may also constitute hedging.
Further, ESMA makes it clear that where, for example, a privileged transaction is based upon hedging and risk management there must be a clear link between the commodity derivative/commodities exposure of the group and the hedging transaction. Where more speculative instruments are mixed within a risk management position, for example, ESMA says that a firm must have a risk management system and process in place for distinguishing between instruments connected to commodities exposures and exposures which are more speculative in nature.
However, ESMA gives no guidance on how to draw this distinction or put it into practice in a way which is operationally effective. The responsibility of designing a workable system seems to fall on the commodities firms.
The volume is to be calculated on the basis of a rolling annual average of gross notional value over the preceding three calendar years in each asset class within the EU (Article 4 of the RTS). All trading on (1) an EU trading venue (2) or off venue by an EU entity within the group or (3) off venue by a non-EU group entity with an EU entity should be included within the calculation (see Recital (4)).
What constitutes a risk reducing transaction is set out in Article 5 of the RTS.
One of three criteria must be met:
- the transaction reduces the risks arising from the potential change in value of assets, services, inputs, products, commodities or liabilities that the person or its group owns, produces, manufactures, processes, provides, purchases, merchandises, leases, sells or incurs… in the normal course of its business.
- it covers the risks arising from the potential indirect impact on the value of assets, services, inputs, products, commodities or liabilities referred to in (a) resulting from fluctuation of interest rates, inflation rates, foreign exchange rates or credit risk.
- it qualifies as a hedging contract under IFRS adopted in line with EU legislation.
Test two: the group-wide "main business" threshold
For test two ESMA has moved away from use of "capital" as a means of measuring whether the activities that were speculative were a minority of the overall business of the group.
The new test two assesses the size of the trading activity, excluding privileged transactions and transactions executed by EU authorised entities of the group, undertaken by the group in all asset classes against the size of the overall trading activity including privileged transactions and transactions executed by EU authorised entities of the group, undertaken by the group in all asset classes.
The total trading activity, i.e. including privileged transactions and transactions out of authorised entities, is treated as a proxy for the commercial activity the group or entity undertakes as its main business. ESMA, however, recognises that this is not a perfect proxy as it is possible for a commodity firm with a low level of trading to be captured if it does not conduct much privileged transactions or do not have many, if any, authorised entities in its group. Consequently, ESMA introduces a back-stop mechanism as a check to the proxy-based test. The RTS takes into account the fact that commodity firms might invest in assets unrelated to derivatives markets.
Art. 3 states that ancillary activity will be considered as constituting a minority activity of the group if it does not account for more than 10% of the total size of the trading activity of the group.
Art. 3(2) also indicates two other situations where the trading activity will be regarded as a minority activity:
- where the activities are more than 10% but less than 50%, and the size of the trading activity for each asset class is less than 50% of the threshold for that asset class (e.g. less than 10% of the market for emission allowances and their derivatives).
- where the activities are more than 50%, and the size of the trading activity for each asset class is less than 20% of the threshold for that asset class (e.g. less than 4% of the market for emission allowances and their derivatives).
Consequently, if the trading activity that does not include privileged transactions, and transactions out of authorised entities is a minority of the overall trading activity, that would tend to confirm that it is "ancillary" and within the exemption.
So if a group is below the thresholds for test one, and also passes test two, then it comes within the exemption.
However, note that the RTS says (Recital (2)) that if you fail the test for one asset class then you will be subject to MiFID II in all asset classes in which you operate.
Business impact and compliance issues
In practice, what this means is that if you fail the tests, you will have to create a MiFID-authorised entity and put your commodities derivatives business into that entity. You must be MiFID II compliant by 3 January 2017 and apply for FCA authorisation in advance, and there is a long lead time as the FCA has six months from receipt of a properly completed application to make its decision. Where a firm is no longer able to rely on a MiFID II exemption, 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. So although all the detail is still not clear, you need to start thinking about this now.
If you do not fall within the exemption, the knock-on effect is that you will also fall within scope of the regulatory capital requirements framework under CRD IV through MiFID II and will be counted as a financial counterparty (as opposed to a non-financial counterparty) for the purpose of EMIR.
Being classified as a financial counterparty has ramifications under both MiFID II/MiFIR and EMIR.
- The trading obligation for derivatives which are subject to the clearing obligation and sufficiently liquid on trading venues under Article 28 of MiFIR will apply in full without being subject to a threshold.
- Financial counterparties also cannot benefit from the hedging exemption in relation to the position limits regime under Article 57(1) of MiFID II, the pre-trade transparency requirements under Article 8(1) of MiFIR and the clearing thresholds or the hedging exemption under Article 10 of EMIR.
Timing of the assessment
Both tests are to be carried out on an annual basis by commodity firms/groups with commodities derivatives business in the EU who are not MiFID-authorised. The calculation period is from 1 July to 30 June.
In order to allow for market participants to plan and operate a business in a reasonable way, and to take into account seasonal patterns of its activity, the calculation of the tests should be based on a period of three years. Therefore, entities should perform the two-pronged assessment on an annual basis by calculating a simple average of three years on a rolling basis. This will form the basis of the annual notification to the Competent Authority.
If you rely on the current commodities exemptions, you need to start thinking about whether you will fall within the new narrower exemption.
If you are not likely to be able to use the exemption, you need to think hard about how you will reorganise your business and set about obtaining authorisation.
Even if you fall within the exemption, you will still have to register with your regulator annually that you rely on the exemption.
You need to have a system so that you can provide information to the regulator to show you are below the thresholds set out in the two tests if you rely on the exemption.