Firms trading commodity derivatives through U.S. markets will already be familiar with the CFTC’s regime for reporting commodity futures and options transactions and position limits that was first introduced in 2011 under section 737 of Dodd-Frank. MiFID II introduces a similar regime for commodity derivatives traded on European venues. In this paper, we consider the background to, and detail of, the new requirements, and look at the practical steps that affected firms should be taking ahead of the introduction of the new regime in January 2018.
This paper forms part of MiFID II: understanding and practical preparation – an ACA Compliance (Europe) series of communications prepared to help our clients understand this significant reform of the European regulatory landscape and determine the direct and indirect implications for their own businesses.
Who is caught and which contracts are covered?
By narrowing the current exemption for commercial firms who trade commodity derivatives, MiFID II will bring commodity derivatives traded on venue, as well as ‘economically equivalent’ OTC contracts, within regulatory scope (unless such trading activity is ‘ancillary’ to the main business of a firm and that main business is not financial services). Being within scope of the regulations means the instruments will become subject to reporting requirements (when traded by MiFID investment firms) and position limits. Additionally, the broader definition of ‘financial instruments’ shall also encompass Emission Allowances (and related derivatives), which shall be subject to the position reporting requirements but not the position limits.
AIFMs and UCITS managers should note that, while they are not subject to the position reporting requirements, they are still required (as are all persons participating on a trading venue) to calculate their net position and comply with the Regulator-imposed position limits in relation to the commodity derivatives contracts they trade.
Where is this new regime coming from?
The impetus for this change in approach dates back to the G20 summit in 2009, where the protection of consumers, depositors and investors against abusive market practices was a key consideration. In light of this, it was agreed that the regulation, functioning and transparency of the commodities markets must be improved to address excessive price volatility. Adding to this, the G20 summit in 2011 endorsed the IOSCO Principles for the Regulation and Supervision of Commodity Derivatives Markets, which called for market regulators to have formal position management powers. MiFID II grants national regulators powers to obtain information from any person regarding the size and purpose of their position in a commodity derivative contract, along with provision to require reduction.
When will I need to report?
Below we have summarised the various instances when a MiFID investment firm may find themselves within scope of the obligation to report position size.
Trading on-venue – MiFID investment firms trading in commodity derivatives on regulated markets, MTFs and OTFs must provide the trading venue where they act as market participants with the details of their own positions held through that venue on at least a daily basis. This shall include positions taken on behalf of clients, and clients of those clients, and so on. For most buy-side firms, this will be the fund or managed account.
Trading off-venue – MiFID investment firms trading in commodity derivatives (and economically equivalent OTC contracts) outside a venue must provide the competent authority of the trading venue where that commodity derivative is traded with a complete breakdown of their commodity derivative positions taken at least daily. Again, this includes clients until the end client is reached. The FCA has indicated these reports are to be submitted to it (where it is the relevant competent authority) for each business day, by 1700 GMT of the following business day.
Multiple venues – Where a commodity derivative is traded in significant volume on trading venues in different jurisdictions, the report must be made to the competent authority of the venue that has the largest volume in that contract.
What information do I need to report?
Economically equivalent– To prevent firms from avoiding the rules (both on reporting and position limits), the definition of economically equivalent contracts has been expanded to now cover OTC contracts with identical contractual specifications, excluding differences relating to lot sizes, delivery dates and post-trade risk management arrangements, to a venue-traded contract.
Calculating position – Where a firm holds long and short positions in a commodity derivative, they shall net those positions for the purpose of reporting the net position in relation to that commodity derivative to the competent authority or trading venue. Their position shall be the aggregation of positions held:
- in the specific commodity derivative;
- in identical contracts traded on other EU venues; plus
- all “economically equivalent” OTC contracts.
Further guidance on what is mean by “economically equivalent” OTC contracts is provided in the Level 3 Regulatory Technical Standards, stating that it will cover contracts that have identical contractual specifications, terms and conditions.
Additionally, net positions for ‘spot months’ contracts (contract regarding a particular commodity whose maturity is the next to expire under the relevant venue rules) and ‘other months’ contracts (non-spot month contracts) must be calculated separately. Further, in a group context, parent entities are to calculate their net position by aggregating their own net position with that of all of their subsidiaries. However, a parent of a collective investment undertaking shall not aggregate where it does not in any way influence the investment decisions.
Format of the reports – ESMA is due to release a sixth Implementing Technical Standards paper during the course of 2017, which shall detail the format of the daily and weekly position reports.
How will the data be used?
Venue transparency – Venues where commodity derivatives (including emissions allowances) are traded will be required to publish weekly, a report on the aggregate positions held by each category of person (distinguishing between certain types of investment firms, as well as commercial firms) for each commodity derivative contract on their venue. This report will be sent to the venue’s competent authority and ESMA itself. Additionally, a complete breakdown of positions held by all participants on each venue will be provided daily by the venue to its competent authority.
Supervisory powers – National competent authorities will have the additional power to require/demand anyone to provide information on or concerning a position they hold in a contract to which an established position limit relates. They may also limit the ability of a person from entering into commodity derivatives (including imposing position size limits - discussed below) and shall notify ESMA of these.
How and when to do position limits kick in?
As mentioned above, national regulators will be required to set positions limits in each commodity derivative contract traded on a trading venue, as well as economically equivalent OTC contracts. Such limits shall be set on the basis of all positions held by or on behalf of a person at an aggregate, group level. For contracts traded on UK exchanges (and their economically equivalent OTC contracts), the FCA shall be responsible for calculating and publishing such limits, and has indicated its Market Conduct Sourcebook (MAR) will contain a link to the updated figures.
The national regulators, in setting the limits, will be required to follow ESMA’s methodology else explain the difference in approach, and shall be required to re-evaluate a limit where there is a significant change in deliverable supply, open interest, or any other significant market change. Again, the Level 3 Regulatory Technical Standards provide further clarity in specifying ESMA’s methodology, under which the positions limits may range between 5-35% of deliverable supply. These figures reflect a lowering of the imposable limits following industry pushback against the 10-40% suggested in the original draft of the standards.
Not surprisingly, regulators are permitted to impose sanctions for breaches of set limits, which the FCA has made clear it fully intends to enforce. For most buy-side firms, given the average number and volume of commodity derivative positions taken, the risk of hitting position limits, and hence being forced to reduce positions, is probably relatively low. Nevertheless, firms need to build the capability to monitor limits imposed by the regulators.
How should I prepare my firm?
- Evaluate current position monitoring and reporting capabilities –identify existing resources that can be utilised and what additional resources may be required to abide by this new area of monitoring and reporting.
- Determine an appropriate solution – of course, the complexity behind a monitoring and reporting solution would need to be proportionate to a firm’s relevant trading activity, i.e. the volume, frequency and nature of commodity derivatives traded. Do note, the FCA has warned firms to take heed of trading venues updating their terms and conditions to accommodate their own additional reporting requirements and controls around limits.
- Test the proposed solution – procedures are only as good as those tasked with implementing them. Firms should adopt adequate fail-safes and secondary checks, ensuring these are effectively used to prevent the firm from falling foul of the obligations.
- Update the firm documentation – once an adequate methodology and fail-safes have been developed, the firm’s compliance documentation would need to be updated to reflect the changes in regulation and procedure.
- Train relevant members of staff – given the seriousness of a breach, staff training would need to be undertaken in order to ensure that both front and back-office staff are familiar with the applicable regulations and how their firm complies with them.
How ACA can help
The monitoring and reporting of commodity derivatives positions and limits forms part of ACA’s MiFID II implementation plan, developed to assist firms in assessing the impact of, and establishing adequate measures to comply with, the incoming rules under MiFID II. In relation to commodity derivatives, this would entail assessing which trading activity is within scope, which measures would be appropriate for monitoring the firm’s own position as well as regulator-imposed limits, and which alerts/fail-safes would need to be established to prevent breach.
In addition to working with a firm to develop a personalised implementation plan, we would also work alongside operations, trading, and compliance/risk staff in helping each understand their role under the new requirements and what measures their firm has taken to ensure compliance.
Please contact Adil Khan, Martin Lovick or your regular ACA consultant with any specific questions or concerns on this e-mail related to this paper.