In July 2020, the European Commission (“the Commission”) published targeted amendments to the Markets in Financial Instruments Directive (MiFID II), proposing – among other ideas – to restrict application of the commodity derivatives position limits regime to non-agricultural critical or significant contracts, and changing the ancillary activity exemption test for non-financial commodity derivative market participants. The so-called “MiFID Quick Fix” was recently approved by the European co-legislators and was published in the EU Official Journal on 26 February 2021.1 In this article, therefore, we seek to summarise the relevant amendments and the rationale behind them, as well as provide views about the timeframe for the application of the revised regime. Finally, we briefly discuss the upcoming review of UK MiFID, including the UK commodity derivatives regime, and we address Brexit-related implications for persons seeking to rely on the ancillary activity exemption.
Who is this article relevant to?
This article is relevant to financial and non-financial participants in European commodity derivative markets, such as investment firms, banks, asset managers, commodity producers and commodity traders, as well as operators of European trading venues listing commodity derivatives. Financial and non-financial participants in European commodity derivative markets include both companies located or established in the European Union (EU), in the United Kingdom (UK) or in any other non-European Economic Area (EEA) jurisdiction.
Explanation of terminology used
- Ancillary activity exemption: Means an exemption from the obligation to obtain investment firm authorisation for:
- Persons dealing on own account, including market makers, in commodity derivatives or emission allowances or derivatives thereof, excluding persons who deal on own account when executing client orders, or
- Persons providing investment services, other than dealing on own account, in commodity derivatives or emission allowances or derivatives thereof to the customers or suppliers of their main business, provided that – among other conditions – this activity is ancillary to their main business.
- Position limit: Means a limit on the size of exposure a person (position holder) can have in a single commodity derivative contract.
- Trading venue: Means a regulated market, a multilateral trading facility (MTF) or an organised trading facility (OTF), licensed and regulated in accordance with the provisions of MiFID II.
The wider context and background to the Commission’s proposals
Responding to international developments and the 2011 G20 commitments in respect of regulating commodity derivative markets, the Commission proposed in 2013 to introduce in European law a position limits regime. This turned out to be the most politicised piece of the MiFID II legislative review, with public discussion and activists’ engagement focussed mainly on alleged speculative activities of financial institutions in agricultural commodity derivative markets and their adverse effects on pricing of food products, but also pointing to “excessive speculation” in other asset classes, notably metals. The outcome was an extremely broad position limits regime, applicable to all commodity derivative contracts, in all asset classes, traded on European trading venues and economically equivalent OTC derivatives. In accordance with the public register available at the website of the European Securities and Markets Authority (ESMA), the bespoke position limits regime currently applies to nearly 50 liquid commodity derivative contracts listed on trading venues in the EU and Norway.2 Further hundreds are subject to the de minimis limit of 2,500 lots for contracts with a combined open interest in spot and other months’ interests not exceeding 10,000 lots over three months. In the UK, the Financial Conduct Authority lists 78 commodity derivative contracts subject to bespoke position limits and over 400 subject to the de minimis limit.3
Key elements of the reform
The industry has long criticised the broad scope of the European position limits regime. It has often contrasted it with the much more targeted regime that exists at the federal level in the United States. Not surprising, therefore, that when in November 2019 ESMA launched its call for evidence on position limits and position management controls in commodity derivatives, it received over 40 responses. In a rare example of cross-industry alignment of views, all respondents supported the ESMA proposal to reduce the scope of positon limits to a more limited set of significant or critical contracts.4
With the commodity derivatives regime being highlighted by the Commission as one of the priority areas for the MiFID II review, there was therefore broad expectation that amendments would be proposed in the course of 2020. It happened sooner than anticipated as the COVID-19 outbreak forced re-prioritisation of the Commission’s legislative works. On 24 July 2020 the Commission proposed a set of targeted amendments to MiFID II (the “MiFID Quick Fix”) as part of a wider Capital Markets Recovery Package and which included – alongside a set of amendments to various investor protection-related provisions – substantive changes to the functioning of the commodity derivatives regime.
These amendments were approved by the European co-legislators – the European Parliament and the Council – in December 2020, following often contentious debate concerning in particular the scope of changes to the position limits regime and to the ancillary activity exemption test.5 Agreement has nonetheless has been reached and the main changes to the MiFID II commodity derivatives regime include the following:
- Position limits: Agreeing with the Commission’s proposal to significantly narrow down the application of the position limits regime, the co-legislators restricted it to critical or significant contracts, with the exception of agricultural products, in particular products used for human consumption. Commodity derivatives will be considered as critical or significant where the sum of all net positions of end position holders constitutes the size of their open interest and is at a minimum 300,000 lots on average over one year. Exempted from the application of the position limits regime will be securitised derivatives which relate to a commodity or an underlying as referred to in Section C(10) of Annex I MiFID II. ESMA is mandated to develop draft regulatory technical standards to specify the agricultural commodity derivatives and create a list with critical or significant commodity derivatives subject to position limits.
- Hedging exemption: The co-legislators agreed to extend the hedging exemption – beyond the currently applicable one for positions held by, or on behalf of, a non-financial entity, and which are objectively measurable as reducing risks directly relating to the commercial activity of that non-financial entity – to certain positions held by, or on behalf of, a financial entity. The hedging exemption will be available only to a financial entity that is part of a predominantly commercial group and is acting on behalf of a non-financial entity in such group and which holds positions that are objectively measurable as reducing risks directly relating to the commercial activity of that non-financial entity. In addition, benefiting from the hedging exemption will be positions held by financial and non-financial counterparties that are objectively measurable as resulting from transactions entered into to fulfil obligations to provide liquidity on a trading venue. Further details on the operation of the amended hedging exemption – including the relevant procedures applicable to financial entities and those providing liquidity on trading venues – are to be developed by ESMA and by the Commission by means of regulatory technical standards.
- “Same contract”: The Commission proposed to delete the notion of “same contract” for commodity derivatives and to replace it with a cooperative approach between national competent authorities. In the final text of the MiFID II Quick Fix amendments, the co-legislators agreed to replace the existing provisions by new rules aligned with the reduced scope of the position limits regime. The revised approach will therefore be applicable to the competent authorities of the trading venues where agricultural commodity derivatives and critical or significant commodity derivatives that are based on the same underlying and that share the same characteristics are traded. They will be required to put in place cooperation arrangements for data exchange. The single position limit is to be set by a competent authority of the trading venue where the largest volume of trading takes place, following consultation with other competent authorities concerned. Any disputes arising in the course of setting such single position limit are to be settled by ESMA.
- Position management controls: Noting that significant differences exist between trading venues in respect of position management controls, the Commission proposed – and the co-legislators agreed – to mandate ESMA to further clarify the content of position management controls taking into account the characteristics of the relevant trading venues.
- Ancillary activity exemption: The Commission proposed to simplify the current ancillary activity test by deleting all quantitative elements and reverting to a solely qualitative approach. However, in light of the opposition of certain Member States, the final text provides for a mandate for the Commission to adopt – by 31 July 2021 – a delegated act setting out the criteria determining when an activity is to be considered to be ancillary to the main business at a group level. Among other considerations, the criteria are to reflect:
- Whether the net outstanding notional exposure in commodity derivatives or emission allowances or derivatives thereof for financial settlement traded in the EU, excluding such instruments traded on a trading venue, is below an annual threshold of EUR 3 billion;
- Whether the capital employed by the group to which the person belongs is predominantly allocated to the main business of the group; or
- Whether the size of those activities does not exceed the total size of the other trading activities at group level.
In addition, the Commission is mandated to review – by 31 December 2021 – the impact of the ancillary activity exemption in relation to emission allowances and derivatives thereof, and to propose, if appropriate, a legislative proposal to amend that part of the exemption.
The amendments will therefore result in substantive – and arguably welcome – changes to the functioning of the European commodity derivatives regime. That said, adaptation to this new regime will require action by commodity derivatives markets participants - for example, in adjusting automated position limits monitoring systems and arrangements.
Timeline for application of the new European commodity derivatives regime
The MiFID Quick Fix entered into force on 27 February 2021, i.e. one day following its publication in the EU Official Journal. Member States have until 28 November 2021 to transpose its provisions to their national legal frameworks, in time for the entry into application of the new regime on 28 February 2022. Prior to the MiFID Quick Fix becoming applicable, ESMA has until 28 November 2021 to develop draft regulatory technical standards and submit them to the Commission for final review and adoption. With the intended application of the revised regime starting just three months later, it is fair to say that the timeline for the development and adoption of the required Level 2 measures is rather ambitious.
In anticipation of the upcoming positon limits regime change, on 19 March 2021 ESMA issued a public statement on its supervisory approach to position limits.6 Noting that the new regime will become applicable in early 2022 and reminding market participants that it cannot dissaply EU law, ESMA nonetheless called on national competent authorities “to not prioritise their supervisory actions towards entities holding positions in commodity derivatives, other than agricultural commodity derivatives, with a net open interest below 300,000 lots” and also “to not prioritise their supervisory actions towards positions that are objectively measurable as resulting from transactions entered into to fulfil obligations to provide liquidity on a trading venue”.
Brexit implications for MiFID review and ancillary activity test application
The MiFID Quick Fix review is the first piece of European securities market legislation that was amended – but did not become applicable – prior to the end of the Brexit transitional period on 31 December 2020. As such, it did not form part of the retained EU law in the UK. That said, the UK is expected to move swiftly with the adoption of changes to its legislative and regulatory framework for securities markets, including commodity derivatives. On 19 April 2021, the Chancellor announced a plan for UK capital markets reform, which will be undertaken by HM Treasury and the FCA in the course of 2021.7 This reform will include a comprehensive review of several priority areas, including rules governing market structure, pre- and post-trade transparency for shares, bonds and derivatives, the cost and distribution of market data and commodity derivative markets. On 28 April 2021, the FCA published its first consultation paper as part of the broader review. This is focused on UK MiFID conduct and organisational requirements. The FCA’s consultation is expected to be followed by a broader consultation document to be published by Treasury in June 2021, and which will address – among other issues – position limits for commodity derivatives.
Another Brexit-related issue that is important to mention is the application of the ancillary activity test by non-financial entities that – being located in either the UK or one of the EU Member States – trade commodity derivatives on trading venues located on the opposite side of the English channel or enter into bilateral OTC derivative contracts with counterparties on the other side. The following are two key points to note:
- Persons based in the EU: Mindful of the upcoming changes to the ancillary activity test as described above, for the duration of the current ancillary activity test the question of the use of UK trading data remains very relevant. To this end, ESMA confirmed in its November 2020 public statement that data concerning trading activity in the UK will be included in ESMA’s annual estimation of the market size of commodity derivatives and emission allowances for all those preceding years during which the UK was a member of the EU.8 Since the currently applicable ancillary activity test, requires a person to calculate the size of its trading activity by reference to a three-year period preceding the year in which the calculation takes place, the application of the test in 2021 will in practice remain unchanged as it covers data for 2018, 2019 and 2020 (i.e. period when the UK was a member of the EU and the duration of the transitional period when EU law was applicable in the UK). The phase-out of the UK data should begin in 2022, which would be the first year when UK data would not be included in one of the reference years (2021), but by this time the revised EU ancillary activity test should be operational.
- Persons based in the UK: As both MiFID II and its secondary legislation (including Commission Delegated Regulation (EU) 2017/592 specifying the criteria to establish when an activity is considered to be ancillary to the main business) formed part of the retained EU law in the UK at the expiry of the transitional period, currently the ancillary activity test remains unchanged.9 To this end, persons established in the UK and seeking to rely on the ancillary activity exemption in 2021, must take into account for the purpose of calculation of their trading activity both activities undertaken in the EU and in the UK, and by referencing the overall market trading activities undertaken in the EU and in the UK.
How we can help
Our team has extensive experience in advising all types of European, UK and third-country participants in commodity derivative markets. We help clients to prepare for legislative change by advising on legal and regulatory requirements, as well as on practical aspects of their application from the perspective of operational systems and controls adaptation. We also assist clients with internal investigations and responses to potential enforcement action by the regulatory authorities. Unlike most other law firms, Norton Rose Fulbright offers a blend of advisory and contentious legal, compliance and government relations skills in one cohesive team.