Directive 2014/65/EU on markets in financial instruments (MiFID II) will enter into force on 3 January 2018 and will introduce significant changes to the way that agriculture commodity market participants can engage in transactions in financial instruments. In order to continue transacting in financial instruments – such as commodity or foreign exchange (FX) derivatives – as of 03 January 2018 a person will have to be either authorized or exempt. MiFID II significantly restricts the current exemptions from the authorization requirements available to non-authorized persons. Finally, all commodity derivatives will be subject to position limits and reporting obligation.
Authorized or exempt? Ancillary activity test
In order to continue transacting in financing instruments post-03 January 2018 a person will have to be either authorized or exempt. MiFID II changes the way the exemption regime for non-authorized persons operates and all currently exempt persons will need to re-assess their eligibility for exemptions. Article 2(1)(j) MiFID II (aka the “ancillary activity exemption”) is the only exemption specifically designed for commodity derivatives market participants. It provides an exemption from the general authorisation requirement for persons who deal on own account in commodity derivatives, emission allowances, and derivatives thereof or provide investment services in these financial instruments to customers or suppliers of its main business, subject to two cumulative conditions: (1) that the relevant activity constitutes “a minority of activities at a group level”; and, (2) that the relevant activity accounts for a small proportion of “overall market trading activity in that asset class. The requirement to conduct relevant analysis at the group level can prove challenging, in particular to large and diversified multinational corporates active in agriculture markets.
The conditions of the Article 2(1)(j) MiFID II exemption are further specified in Commission Delegated Regulation 2017/592 (aka “RTS 20”), which prescribes a test for persons seeking to use the ancillary activity exemption. This test consists of two cumulative parts, i.e. a market share test and a main business test. In July 2017 the European Securities and Markets Authority (ESMA) published the long awaited, albeit incomplete, market data for over the counter (OTC) and exchange-traded (ETD) commodity derivatives, necessary to complete the market share test. The overall market size for agriculture commodity derivatives amounted to EUR 555,731 million for ETDs and EUR 865,313 million for OTC derivatives (data for 2016), and EUR 1 019,671 million for ETDs (data for 2015). OTC data for 2015 and overall market size data for 2017 have not been published to date. There has been no indication from ESMA when the remaining data set can be expected to be published.
Finally, it is important to note that in accordance with MiFID II, persons will be required to continuously monitor their trading activity as Article 2(1)(j) MiFID II requires submission of annual notifications to national competent authorities (NCAs). At the time of writing of this article some of the NCAs have opened their notification gateways, including the UK Financial Conduct Authority (FCA) and French Autorité des Marchés Financiers (AMF). Mindful of the risk of prospective bottlenecks as we approach the MiFID II application date, it is advisable that firms have their calculations and analysis done in advance and ready for submission once the relevant NCA opens its notification portal. Conversely, firms that will not meet the ancillary activity exemption need to take into consideration the time needed to secure Article 5 MiFID II authorisation.
How do you manage your FX exposures?
In addition to Article 2(1)(j) MiFID II, the majority of agriculture commodity market participants engage in transactions in FX derivatives, usually in order to hedge risks stemming from their commercial operations. Article 2(1)(d) MiFID II sets out an exemption for persons dealing on own account in derivatives other than commodity derivatives, emission allowances or derivatives thereof and as such it is not specific to commodity derivatives market participants.
This exemption is structured differently to Article 2(1)(j) MiFID II, in so far as it does not apply volume thresholds but focuses on the mode of execution of trading activities. Generally, persons being members or participants of a regulated market or multilateral trading facility (MTF) or having direct electronic access to a trading venue (regardless of their regulatory status) will be prohibited from using the exemption. Following “quick fix” MiFID II review in early 2016 the legislators added an exclusion to this list of prohibited activities for non-financial entities who execute transactions “which are objectively measurable as reducing risks directly relating to the commercial activity or treasury financing activity of those non-financial entities or their group”. Vaguely drafted and supported by limited regulatory guidance, this exclusion has caused inevitable interpretation questions amongst market participants.
Commodity derivatives position limits and reporting
Article 57 MiFID II introduces position limits for commodity derivatives traded on EU-based trading venues and economically equivalent OTC contracts (EEOTC). The new position limits regime will apply to all persons with positions, held directly or indirectly, in commodity derivative contracts in scope, regardless of their establishment, domicile, or regulatory status. However, non-authorized persons can use the exemption for the positions that are objectively measurable as reducing risks directly relating to the commercial activity of that person (aka the “hedging exemption”). Persons planning to use the hedging exemption will have to submit a suitable application to their NCA. Again, at the time of writing of this article, both the UK FCA and French AMF were at a forefront of NCAs ready to facilitate market participants’ timely compliance with MiFID II requirements as both NCAs launched their respective systems for submitting hedging exemption applications.
However, with less than 60 days for MiFID II to go live, the complete list of position limits published by the NCAs and approved by ESMA is nowhere to be seen. The procedure set out by Commission Delegated Regulation (EU) 2017/591 (aka “RTS 21”) requires the NCAs to submit draft position limits prior to publication to ESMA for a formal review and opinion. Suffice to say, this process has not been particularly efficient and caused significant delays to the timely publication of the limits across all commodity derivatives asset classes.
In August 2017 ESMA published the first of three opinions on the Article 57 MiFID II position limits, approving limits proposed by the French AMF in respect of Euronext Rapeseed, Corn and Milling Wheat No 2 contracts. The AMF proposes to vary spot month limits based on the time remaining until expiry, with a lower limit closer to contract expiry date. Following that, in late October 2017 ESMA published additional three opinions in respect of the FCA-proposed position limits for agricultural futures contracts traded on ICE Futures Europe, including London Cocoa Future, Robusta Coffee Futures and White Sugar Future. At the time of writing, position limits for UK Feed Wheat Futures remained to be published by the FCA. ESMA list of liquid contracts published in October 2017 includes no other agriculture commodity derivative traded on EU trading venue will be subject to bespoke limits, other than those discussed above. New and non-liquid contracts will, however, be subject to de minimis limits.
Finally, while non-authorized persons will not be directly subject to position reporting under Article 58 MiFID II, it is important to consider that certain information regarding positions may be requested by investment firms that will be required to submit EEOTC position reports on behalf of their clients. Positions in exchange-traded commodity derivatives will be reported by trading venues.