|MiFID II position limits for commodity derivatives|
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New quantitative thresholds to be observed by commodity derivatives' traders
MiFID II Directive sometimes can be regarded as a really ground-breaking piece of legislation. This is also the case with respect to position limits, as MiFID II for the first time creates legal base enabling the imposition - across the European Union - of such mandatory restrictions on the size of commercial trading.
Verena Ross, Executive Director at the European Securities and Markets Authority (ESMA), in Keynote speech at IDX 2015, London, 9 June 2015 ESMA/2015/921) underlined the EU position limits framework requires a "Herculean task" of crafting a methodology which "has to bring a number of contradictory elements together:
- it has to apply to, and work for, both very liquid and very illiquid contracts;
- it has to provide for a consistent approach to avoid arbitrage opportunities whilst allowing sufficient flexibility to deal with a wide range of contracts;
- it has to ensure limits are low enough to avoid squeezes without killing off contracts with only two or three participants".
The above source makes, moreover, a reference to the US position limits regime, in place for several decades, with the CFTC expanding its existing framework, applying to 9 agricultural contracts, to 28 core physical commodity contracts - the most liquid contracts - and to contracts which are economically equivalent to them. This can't be compared to the the EU position limits architecture, which is far more extensive.
The quantitative dimension of the implementation challenges ahead of the European regulators has been estimated by the ESMA's Chair at the level of around 1,500 liquid contracts for which position limits will have to be established by national regulators before 2018 with ESMA having to produce an opinion for every single contract in the run-up to MiFID II coming into force (ECON MiFID II/MiFIR Scrutiny Session – 21 June 2016, Committee on Economic and Monetary Affairs European Parliament, Steven Maijoor, Chair, European Securities and Markets Authority, 21 June 2016 (ESMA/2016/940)).
The difference in volumes between the EU and the US position limits frameworks is really striking.
Position limits are, furthermore, the prominent MiFID II institution, as the compliance is required of all persons, regardless of whether they are exempt from the scope of MiFID II under the provisions of Article 2 MiFID II (no matter Article 2(1)(d) - own account exemption, Article 2(1)(j) - ancillary activity exemption or Article 2(1)(e) - EU ETS operators exemption).
At the same time the compliance with the position limits will be a challenging task for industries and will require robust internal procedures and reporting lines as firms will need to monitor aggregated positions across the globe and net any economically equivalent positions in real time (position limits are applicable not only at the end of each trading day but also throughout the trading day - at all times, this is particularly relevant when a commodity derivative is traded OTC outside the normal trading hours of a trading venue).
Only positions held by or on behalf of non-financials which are objectively measurable as reducing risks directly relating to commercial activity (i.e. hedging) will not count towards the limits (subject to the approval of the competent authority).
It is noteworthy in that regard that also some unauthorised firms will have to apply for exemptions from position limits.
MiFID II legislative framework for position limits makes possible to specify quantitative thresholds for the maximum size of a position in a commodity derivative that persons can hold. Hence, it is inherently involved with investment firms' and market operators' necessity to monitor expositions as well as to provide relevant client's information up to the position's ultimate beneficiary.
The respective MiFID II provisions are Article 69(1) and 69(2)(p), which clearly include, among supervisory powers granted to the EU Member States' competent financial authorities, also the general power to "limit the ability of any person from entering into a commodity derivative, including by introducing limits on the size of a position any person can hold at all times."
In principle, the said limits may be applied with respect to positions in commodity derivatives, no matter: physically or cash settled.
The broad, high-level categorisation for asset classes that will likely be used for the purposes of establishing position limits is as follows: Metals, Oil and oil products, Coal, Gas, Power, Agricultural products, Freight, Climatic variables, Inflation rates and economic statistics.
MiFID II position limits' scope
Position limits' scope should be considered firstly in terms of the types of markets and assets covered.
Thus, the position limit calculations include:
a. commodity derivatives traded on trading venues:
- OTF; as well as
b. OTC commodity derivatives contracts which are "economically equivalent" (the respective criteria are specified in the secondary legislation).
The preliminary observation is, however, position limits scope is restricted to commodity derivatives.
Mindful of the fact that every time MiFID II wishes to encompass emission allowances, it makes a specific reference thereto (multiple phrases "commodity derivatives, emission allowances and derivatives thereof") and considering such a reference is absent in Article 59 of MiFID II regulating the application of position limits (it literally names only "commodity derivatives") it is appropriate to infer, emission allowances are not subject to MiFID II provisions on position limits.
This opinion is supported, moreover, by the "commodity derivative" definition (Article 2(1)(30) of the MiFIR), where point 11 in Section C of the Annex I to MiFID II Directive (covering carbon credits) is not included.
Contracts in securities (such as exchange traded products (ETPs)), which have a commodities underlying, are, in the opinion of the European financial regulator, covered by the position limits arrangements since they are included within the definition of "commodity derivatives".
See more on the procedure for establishing position limits under MiFID II.
For the purpose of position limits regime "position" means the net accumulation of buy and sell transactions in a particular commodity derivative at a specific point in time that has yet to be closed out, expired, or exercised, as appropriate to the instrument concerned.
An alternative expression of this term is the "open interest" that is controlled by a person.
Market participants' positions will be monitored and position limits will be applied by the competent authorities with the use of data acquired through the MiFID II reporting system.
However, a practical difficulty may be the fact, as ESMA notes, "there is currently no universally adopted and harmonised set of product codes for identifying commodity derivatives. The two primary alternatives are the use of Alternative Instrument Identifier codes (AII) or the use of ISIN codes. A third, less optimal and more complicated alternative is to use a combination of both". The third alternative is not proposed by ESMA.
The requirement of Article 57(2) MiFID II for the quantitative thresholds for position limits to be 'clear', can, in principle, be fulfiled both: as a percentage relationship between a position and some measure of absolute deliverable supply or overall market size measure as well as an amount of lots of a specific contract on a trading venue or a quantity of the underlying in the contract (which may be tonnes, barrels, MWh, etc).
The legislative proposition ESMA made in December 2014 draft regulatory technical standard specified the position limits in lots (the lot being defined as the unit of quantity used by the trading venue on which the commodity derivative contract trades).
The draft Regulation of 28 September 2015 modified the methodology for the calculation of position limits. The underlying assumption became to differentiate between spot and other months' contracts.
In this renewed drafting ESMA maintained its proposal that position limits in the spot month should be based on deliverable supply but decided, based on feedback, that position limits in other months should be based on total open interest (with the reservation that where there is no underlying deliverable supply for a commodity derivative, the spot month position limit should be based on an open interest too).
In the Opinion, Draft Regulatory Technical Standards on methodology for calculation and the application of position limits for commodity derivatives traded on trading venues and economically equivalent OTC contracts, 2 May 2016, ESMA/2016/668 ESMA expressed the view deliverable supply for the spot month and open interest for other months' is appropriate metrics and the right approach.
"The supply of the underlying commodity actually available is what matters when the contracts are nearing maturity whereas it is much less relevant for maturities that can go years into the future where open interest as a reflection of liquidity is the much more readily available and relevant metric," ESMA said in the above document.
This conception gained a wide support in the ESMA's consultation.
The US example, where this methodology "appears to be working seamlessly in practice", have been also observed.
The aforementioned ESMA's Opinion of 2 May 2016 also revised the definition of deliverable supply.
In order to avoid causing disorderly markets as the spot month approaches, and to reduce the scale of discrepancies between deliverable supply and open interest, deliverable supply was specified to include any substitute grades or types of a commodity that can be delivered in settlement of a commodity derivative contract under the terms of that contract.
Moreover, it was clarified that the other months' limit should be adjusted if the open interest is either significantly higher or lower than the deliverable supply.
The said, revised ESMA's approach has been widely implemented in the subsequent Commission Delegated Regulation (EU) of 1.12.2016 supplementing Directive 2014/65/EU of the European Parliament and of the Council with regard to regulatory technical standards for the application of position limits to commodity derivatives.
"Spot month" definition
'Spot month' with reference to the position limits regime is understood broadly. The spot month period does not necessarily correspond to a time period which is a month but rather is specific to each commodity derivative contract and is the contract next to expire, as determined by the rules of the relevant trading venue, i.e. it could be 3 days, 2 weeks, 3 months etc.
A contract that is economically equivalent OTC to an exchange-traded derivative (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.
Spot month limits
Spot month position limits for cash settled and physically settled commodity derivatives are based on a percentage of deliverable supply and the baseline is set at the 25%.
The exception is the spot month position limits for cash settled commodity derivatives with no deliverable supply (commodity derivatives listed under Annex I, Section C10 e.g. weather) which are based on a percentage of total open interest in the spot month.
In the draft RTS of 28 September 2015 ESMA changed the earlier approach (as in the December 19, 2014 draft RTS), and adopted a more stringent formulation, i.e allowing Member States competent authorities to increase the 25% baseline position limit to only 35% and to decrease to 5% of the deliverable supply. By adopting this assymetric spread, ESMA has diminished the size of position limits in comparison with December 2014 methodology.
ESMA also noted that it is possible to adopt this more stringent approach as new and illiquid contracts will be subject to a special regime. Crafting a special regime for new and illiquid contracts has enabled to adopt a more demanding regime for other contracts. The resulting two tiered regime reflects better the different trading characteristics of the instruments.
Other months' limits
The other months' period is the whole of the curve of the contract, excluding the spot month period.
The other months' limits for both cash settled and physically settled commodity derivatives are based on a percentage of total open interest in the commodity contract excluding open interest in the spot month.
Other months' limits are calculated as 25% of average annual open interest, expressed in lots in the underlying commodity ('the baseline').
ESMA also adopted the assymetric spread for the other months, giving Member States competent authorities the power to adjust the baseline down to 5% and only up to 35% of open interest, taking into account the factors listed under Article 57(3)(a) to (g).
Lots as as a metrics for the baseline figures' calculation
Baseline figures for spot month as well as other months' limits are to be specified in lots which are defined as "the units of trading used by the trading venue on which the commodity derivative trades representing a standardised quantity of the underlying commodity" (Articles 9 and 11 of the Commission Delegated Regulation, respectively).
ESMA in Q&As referred specifically to the issue how lots should be established in the case of some kinds of energy contracts.
According to ESMA, where a lot is not defined for energy contracts, a lot should be the minimum quantity tradable of that commodity derivative, calculated as nominal * minimum number of contracts to be included in a trade.
Typically, for power base load contracts the lot is 24 MWh as the minimum amount tradable is one daily contract of 1 MW.
Similarly, for peak load contracts, a lot is equal to the number of hours in the peak load period (e.g. 12 MWh).
For gas and LNG, a lot will be 1 MWh, except for gas derivatives where the number of contracts traded as a unit is above this size.
New and illiquid contracts
Specific rules have been envisioned for new and illiquid contracts (see Article 15 of the Regulation of 1.12.2016).
Trading venues have been subjected to the obligation to notify the competent authority if the total open interest of any such commodity derivative reaches any of the amounts of lots or number of securities in issue over a consecutive three month period.
Article 15 states that new and illiquid contracts for which the total combined open interest in spot and other months’ contracts does not exceed 10,000 lots for a consecutive three-month period are assigned a position limit of 2,500 lots.
Therefore, any contract with a high variability would have to exceed the threshold of 10,000 lots of open interest on a daily basis based on end-of-day figures for three consecutive months before an individualised position limit has to be set for that contract (ESMA's clarification of 29.03.2017).
When calculating position limit in commodity derivative pursuant to MiFID II the size of a net position is relevant. Pursuant to Article 57(12)(c) MiFID II ESMA was required to develop draft regulatory technical standards to determine "the methodology for aggregating and netting OTC and on-venue commodity derivatives positions to establish the net position for purposes of assessing compliance with the limits."
The said provision also stipulates that criteria with respect to positions' netting must not facilitate the build-up of positions in a manner inconsistent with the objectives set out in MiFID II.
In its Final Report of 28 September 2015 ESMA underlined that for the purposes of the MiFID II position limits regime the person's position is established by:
i. summing up its positions in:
- the commodity derivative contracts,
- the same commodity derivative contracts, and
- economically a equivalent OTC contracts (EEOTC contracts);
and, where the person holds both long and short positions, in netting them down;
ii. aggregating its positions with the positions in that commodity derivative contract of its subsidiary undertakings (save for certain limited exceptions).
The terms "the same commodity derivative contract" and "the EEOTC contract" are explained below.
As regards the aggregation of positions within the corporate groupings the organisations EFET, Eurelectric, EUROPEX in the document Ensuring effective and efficient regulation of European commodity derivative markets of 4 September 2015 argued that positions' aggregation should be restricted to a person's fully consolidated subsidiaries only, however, the binding rules do not reflect explicitly this postulate.
Instead, Article 4 the Commission Delegated Regulation mandates the netting of positions of "subsidiary undertakings" and Recital 4 of the said Regulation refers to aggregation at the group level if a parent undertaking "can control the use of positions".
The said Recital 4 states:
"Directive 2014/65/EU requires that any positions held by other persons on behalf of a person should be included in the calculation of that person's position limit and for position limits to be applied at both an entity level and at a group level and it is therefore necessary to aggregate positions at a group level. It is appropriate to only provide for aggregation at the group level if a parent undertaking can control the use of positions. Accordingly, parent undertakings should aggregate positions held by their subsidiaries with any positions that the parent entity holds directly, in addition to the subsidiaries aggregating their own positions. Such aggregation can lead to positions calculated at the level of the parent undertaking which are larger or, due to a netting of long and short positions held by different subsidiaries, lower than at individual subsidiary level. Positions should not be aggregated at the level of the parent undertaking if the positions are held by collective investment undertakings which hold those positions on behalf of their investors rather than on behalf of their parent undertakings in cases where the parent undertaking cannot control the use of those positions for its own benefit."
Spot month and other months positions' separation
It appears, derivative contracts are capable of being aggregated or netted only after converted into the same metric, however such a "leveling" will rise difficulties with respect to positions with different tenor or maturity, different lot sizes or pricing currency or a similar but different underlying commodity.
As a consequence of different methodology to the calculation of position limits for spot and other months' contracts proposed by ESMA on 28 September 2015, it was envisioned, however, that netting should be applied separately to the spot month and other months' positions.
The respective Recital 3 of the Commission Delegated Regulation of 1.12.2016 provides for the following:
"Long and short positions in a commodity derivative of market participants should be netted off against each other to determine the effective size of a position a person controls at any point in time. The size of a position held through an option contract should be calculated on a delta equivalent basis. As this Regulation applies a different methodology to the calculation of position limits for spot and other months' contracts, such netting should be applied separately to the spot and other months' positions."
In the Q&As ESMA confirmed, moreover, that "position limits apply to net positions regardless of whether the net position is long or short. When calculating their positions, a person needs to aggregate their long and short holdings in spot contracts towards the spot month limit. They separately need to aggregate all their long and short positions for all other months towards the other months' limit."
Positions with different maturities for other months' limits must also be netted. According to ESMA persons must determine their net position for each commodity derivative for the other months' limit, as indicated in Article 3(4) of the Commission Delegated Regulation.
They should sum (or net, as appropriate) all individual positions across the curve excluding those positions in the spot month for that commodity derivative.
"Same commodity derivatives"
"The concept of the same commodity derivative should establish a demanding threshold to prevent persons from inappropriately netting positions across dissimilar commodity derivatives in order to circumvent and weaken the robustness of the position limit on the principal commodity derivative contract" (Recital 5 of the Commission Delegated Regulation of 1.12.2016).
A central competent authority has the responsibility for setting the position limits on the same commodity derivative, when the same commodity derivative is traded in more than one jurisdiction within the EU.
What constitutes "the same commodity derivative" is determined by the secondary legislation (Article 57(12)(d) of MiFID II).
In the ESMA's view, the 'same' is a subset of economically equivalent.
A commodity derivative is the same if it is at least economically equivalent.
In addition to be considered the same it must have other equivalent properties, such as accepting the same deliverable supply for settlement, and that the contracts are traded under, or with reference to, the same set of trading venue rules and form part of a single fungible pool of open interest.
ESMA notes that a cash-settled contract is not the same as a physically-settled contract and, by definition, an EEOTC contract cannot be the same as a contract that is traded on a trading venue under the rules of that trading venue.
"Same commodity derivative" in the ESMA's view is a contract traded on a trading venue which is economically equivalent to another commodity derivative traded on a trading venue with the additional requirement that both contracts form a single fungible pool of open interest, or, in the case of securitised commodity deriviatives, of securities in issue.
Article 5(1) of the Commission Delegated Regulation of 1.12.2016 has stipulated that a commodity derivative traded on a trading venue is considered the same commodity derivative as a commodity derivative traded on another trading venue where the following conditions are met:
(a) both commodity derivatives have identical contractual specifications, terms and conditions, excluding post trade risk management arrangements;
ESMA has explained on 29 March 2017 that commodity derivatives with "a single fungible pool of open interest" for the purposes of the above provision include those cleared by the same central counterparty (CCP) and those in interoperable CCPs which may be closed out against each other.
This term also includes other commodity derivatives with delivery obligations which are fungible and can be closed out against each other (for example, through the operational netting provided by a transmission system operator).
"Economically equivalent OTC contracts"
It has been proposed by ESMA that holdings in identical contracts, whether listed on the same trading venue or cross-listed on multiple trading venues, or contracts that meet the criteria of "economically equivalent OTC contract" (EEOTC), should be included within the calculation of a person's position whether held on the same venue, across multiple venues, or executed bilaterally OTC.
It is envisioned that the competent authority of the trading venue on which the commodity derivative is traded will set the position limit applicable to the commodity derivative and its EEOTC contract, regardless of where in the EU the EEOTC is traded.
In the Final Report of 28 September 2015 ESMA defined the EEOTC "as a contract which has the identical contractual specifications and terms and conditions, excluding post trade risk management arrangements, as a contract traded on a trading venue".
With respect to the issue of proper identification of EEOTC ESMA considered that "conclusive list of EEOTC contracts would be very helpful", but creating such a list "may be unworkable and would in any event need to be regularly updated."
Some hazards of mandatory netting of "economically equivalent" derivative contracts have been raised.
Among them is the fact that "economically equivalent" derivative contracts are not the same, and variations in national insolvency regimes may in many cases cause such contracts will not be able to be netted.
In effect, EFET, Eurelectric, EUROPEX and other organisations in the aforementioned document of 4 September 2015 asked the European Commission to support amendments to the draft RTS to:
(a) require the prior consent of all trading venues for the netting of economically equivalent contracts, and
(b) provide appropriate discretion for CCPs to determine where netting is permissible.
On the other hand, it was often commented, the definition of 'economically equivalent OTC contracts' is very narrow since the OTC contract must have not similar, but identical specifications to the contract on a trading venue, to qualify.
In case of very limited number of contracts falling under the EEOTC category, this would have a direct impact on restricted netting possibilities, and as a consequence, more firms impacted by position limits (see also: MiFID II position limits regime - be mindful of EEOTC (Economically-Equivalent OTC Contracts)!).
In the Opinion, Draft Regulatory Technical Standards on methodology for calculation and the application of position limits for commodity derivatives traded on trading venues and economically equivalent OTC contracts, 2 May 2016, ESMA/2016/668 ESMA acknowledged the concern that the definition of EEOTC is too specific and therefore may allow contracts that are similar to on-venue contracts not to be considered when establishing the net position of a specific market participant and thus allow circumvention of the position limit regime's purpose by spreading positions across exchange-traded and OTC contracts.
The argument, however, has been also raised that drafting the EEOTC definition in too wide a fashion carries an even higher risk of enabling circumvention of position limits by creating an ability to net off positions taken in on-venue contracts against only roughly similar OTC positions which would have the potential to undermine a general decision taken at Level 1.
ESMA has therefore covered two additional possibilities where the contractual specifications might not be identical but still qualify as EEOTC.
In case the specifications of the OTC contract in respect of lot sizes and delivery dates would be different from the on-venue contract this would not stop the OTC contract from being considered EEOTC.
However, in the case of delivery dates the divergence with the exchange-traded contract is limited to one day.
Different delivery locations will in ESMA's view, generally mean different economic characteristics.
Having given consideration to the benefits and drawbacks of aggregating contracts with different delivery arrangements, ESMA has decided not to propose amendments in this regard.
If, however, minor differences in delivery arrangements or other contract parameters are in future used with the apparent intent of circumventing the regime, ESMA may propose further amendments to the definition.
The above ESMA's approach has been finally implemented in Article 6 of the Commission Delegated Regulation (see box).
ESMA stated in paragraph 41 of its Consultation Paper of December 2014 that it regards the geographical scope of MiFID II Article 57 as bounded within the EU and Article 5(3) of draft RTS 30 of December 2014 only envisaged aggregation of positions with other positions held by other persons within the same group "in the European Union" to determine the final net position.
Market participants main proposal, in response to the above interpretation, was that netting across contracts traded in other jurisdictions should be permitted in order to ensure that position limits reflect the economic reality and the real risk exposure of a participant's activity.
They, moreover, argued that the term 'economically equivalent' OTC contracts is not defined by Level 1 and therefore there is scope for ESMA to provide for a broader definition.
ISDA Response to ESMA's MiFID II/MiFIR Consultation Paper of December 19, 2014 (p. 166) observed it is not clear from the consultation paper what ESMA's views are on the territorial scope of the position limits under Article 57 of MiFID II.
ISDA added, it would be important that Member States take a common approach to the scope of application of these requirements. Accordingly, ESMA should indicate how Member States should apply the requirements.
However, in the Final Report of 28 September 2015 ESMA sustained its initial stance that, as MiFID II does not address the possibility of the same derivative contract being listed on a third-country venue (i.e. a venue that is not a trading venue as defined by MIFID II), the geographical scope of Article 57 MiFID II is limited to the European Union.
Therefore the netting and aggregation of positions on third-country venues were not included within the draft RTS.
The conclusion is that the exposures in contracts traded outside of Europe will not be able to be netted.
Hence, firms engaged much in an extra-EU trading possibly approach the position limit sooner.
The categories of trades not capable of being netted off in the same group will in particular be non-MiFID OTC physical trades (that are not covered by MiFID Annex I Section C and, consequently, are not under the financial regulation) and the MiFID trades in financial instruments.
The above shortcoming is contested by the ISDA Response to ESMA's MiFID II/MiFIR Consultation Paper of December 19, 2014, which argues that the EU position limits regime should "allow netting on a broad basis in order to accurately reflect the fact that fabricators / manufacturers look to financial institutions / trading houses for supply of physical commodities (e.g. metal fabricators) and that these financial institutions / trading houses will hedge these physically settled forwards (e.g. non-MiFID financial instruments) with on venue commodity derivatives. To the extent that physical positions remain ineligible for netting, the risk position will not be accurately reflected and the limit will be reached quicker than if netting of OTC physical positions was permitted."
However, the provision at issue (Article 57(1) MiFID II) refers to commodity derivatives and not to the underlying commodity.
According to the ESMA's interpretation (ESMA's Discussion Paper on MiFID II/MiFIR of 22 May 2014, ESMA/2014/548, p. 413), Article 57(1), MiFID II requires physical holdings to be excluded from the calculation of a person's net positions (although such positions may be relevant for utilising the hedging exemption - see below).
Also in the Final Report of 28 September 2015 ESMA reiterated that providing that financial firms can net off positions in commodity deriviatives against physical inventory is neither desirable nor in line with MiFID II (p. 353).
The chances for the u-turn of the attitude seem small since the regulator clearly and consequently argues netting of instruments against physical holdings and instruments outside of MiFID II's scope is not permitted.
In the Final Report of 28 September 2015 ESMA referred to the fact that in establishing the exemption for wholesale energy products under the definition of C6 financial instruments, MiFID II expressed the intent that these instruments were subject to the REMIT regime and not the MIFID II.
Therefore, it was once more underlined it would be inappropriate for persons to be permitted to net, or be required to aggregate, instruments that are not financial instruments under MiFID II.
Equally, ESMA noted that Article 57(1) of MiFID II refers to the holdings of a person in a commodity derivative and EEOTC contracts: it does not refer to holdings of an underlying commodity and therefore the netting and/or aggregation of underlying physical assets is not considered to be within the intentions of MiFID II.
Usability of net positions held by clearing members
The net positions held by clearing members are not usable for the purposes of determining the positions of their clients for the application of position limits under Article 57 of MiFID II.
CCPs determine net positions at the level of their clearing members, which usually encompass the long and short position of many different clients unless held in individually segregated accounts.
A CCP may also see positions only for those contracts for which it provides a central counterparty service and not the EEOTC positions or any held at a CCP subject to interoperability.
Position limits apply at the level of the individual person, and net positions held at clearing level must therefore be disaggregated (stance of ESMA presented in the MiFID II Q&As).
Inevitably, the positions' netting for the purposes of position limits compliance will be complicated issue and will require strict attention as the rules in that regard may not always occur as clear as market participants could expect.
Ban on netting hedging positions against speculative trades
ESMA has explained on 29 March 2017 that once a hedging exemption has been granted (details on the hedging exemption from position limits framework see below) and positions in commodity derivatives are approved by the competent authority as risk-reducing, those positions fall outside the position limit regime and mustn't be netted against positions in derivatives which are not covered by the hedge exemption.
Otherwise, in the ESMA's opinion, the benefit of a risk-reducing position would be double-counted, by first being excluded from the limit and then being used to offset a speculative exposure.
Position limits' application to the "exotic derivatives" (various underlyings listed in Annex I, Section C(10) of MIFID II)
On 29.03.2017 ESMA has issued a clarification, taking the form of the Q&As document and setting out the approach to a number of different types of commodity derivatives covered by Section C(10) of Annex I of MIFID II, such as freight rate derivatives, indices, spreads, etc.
Freight rate derivatives (wet and dry freight)
Position limits should be applied to freight rate derivatives (wet and dry freight) based on the open interest both in the spot month and in the other months.
Derivative contracts relating to indices
Position limits should be applied to derivative contracts relating to indices if the underlying index is materially based on commodity underlyings as defined in Article 2(6) of Commission Delegated Regulation of 25 April 2016 supplementing Directive 2014/65/EU of the European Parliament and of the Council as regards organisational requirements and operating conditions for investment firms and defined terms for the purposes of that Directive.
ESMA considers that the underlying index derivative is materially based on commodities if such commodities have a weighting of more than 50% in the composition of the underlying index.
The spot and the other months’ limits should be based on open interest only, in accordance with Article 13(1) of the Commission Delegated Regulation of 1.12.2016 as no single measurable deliverable supply can be determined for the commodities contained within the index.
Commodity derivative contract in the form of a “spread” or “diff” contract
A commodity derivative contract in the legal form of a “spread” or “diff” contract is a contract that is cash-settled and whose value is determined by the difference between two reference commodities which may vary in type, grade, location, time of delivery, or other features.
Whilst having multiple commodity values underlying it, the commodity derivative is available on a trading venue as a single tradable financial instrument.
A spread contract is different to a spread trading strategy, when two or more commodity derivative contracts may be traded together in order to achieve a certain economic effect.
Such a strategy may be executed by a single action in a venue’s trading systems, but it remains composed of separate and legally distinct commodity derivatives which are executed as trades simultaneously.
As a spread contract has no single commodity at a specific place or time as the underlying, it is not possible to link it to a single physical deliverable supply against a contractual obligation to physically settle the trade. It is for this reason all spread contracts are cash-settled and not physically settled.
Therefore, spread contracts should be treated for the application of the ESMA methodology in the same manner as C10 commodity derivatives which do not have a physical underlying, such as weather derivatives. The open interest figure for the commodity derivative itself should be used as the baseline for both the Spot Month limit and the Other Months’ limit.
Other derivatives listed in Section C10 of Annex I of MiFID
For other derivatives listed in Section C10 of Annex I of MiFID II and in Article 8 of Commission Delegated Regulation of 25 April 2016, ESMA is not expecting the setting of any position limits as the underlyings of such derivatives are not considered to be commodities as defined in Article 2(6) of Commission Delegated Regulation of 25 April 2016.
The key point in respect of non-financial entities is that position limits do not apply to positions held which are objectively measurable as reducing risks directly related to the commercial activity of that non-financial entity. MiFID II reporting expressly requires to differentiate such positions from any other trades. Hedging exemption is not available to financial counterparties.
As MiFID II does not provide a definition of what a "non-financial entity" is, ESMA has clarified that it is the inverse of a "financial counterparty" as defined under EMIR.
In other words, a non-financial entity for the purposes of the position limits regime is the same as a non-financial counterparty under EMIR (ESMA's Final Report of 28 September 2015, p. 352).
According to Article 2(1) of the Commission Delegated Regulation 'non-financial entity' means a natural or legal person other than:
(a) an investment firm authorised in accordance with Directive 2014/65/EC,
(f) a UCITS and, where relevant, its management company, authorised in accordance with Directive 2009/65/EC8 of the European Parliament and of the Council,
A third-country entity is a non-financial entity if it would not require authorisation under any of the aforementioned legislation if it was based in the Union and subject to Union law.
"Positions objectively measurable as reducing risks directly related to the commercial activity"
The category of "positions objectively measurable as reducing risks directly related to the commercial activity" used in the Commission Delegated Regulation applicable to position limits significantly resembles EMIR Regulation, and, Article 10(4)(a) of EMIR, analogously, required ESMA to develop draft regulatory technical standards (RTS) based on a similar Level 1 text.
EMIR, however, includes reference to the "treasury financing activity", which is absent in the MiFID II position limits wording.
This discrepancy can be explained by the fact, the MiFID II position limits framework is restricted to commodity derivatives, and these instruments are not commonly used for the purpose of treasury financing.
The standard developed for the purpose of EMIR states that a derivative contract is objectively measurable as reducing risks directly relating to the commercial activity when, by itself or in combination with other derivative contracts it meets one of the following criteria:
1) it covers the risks arising from the potential change in the value of assets, services, inputs, products, commodities or liabilities that the non-financial counterparty or its group owns, produces, manufactures, processes, provides, purchases, merchandises, leases, sells or incurs or reasonably anticipates owning, producing, manufacturing, processing, providing, purchasing, merchandising, leasing, selling or incurring in the normal course of its business;
2) it covers the risks arising from the potential indirect impact on the value of assets, services, inputs, products, commodities or liabilities referred to in point (1), resulting from fluctuation of interest rates, inflation rates, foreign exchange rates or credit risk;
3) it qualifies as a hedging contract pursuant to International Financial Reporting Standards (IFRS), adopted in accordance with Article 3 of Regulation (EC) No 1606/2002 of the European Parliament and of the Council.
ESMA believes that the interpretation and consequent application of risk-reducing activity through position limits should be consistent (with the reservation that EMIR addressed this question only in relation to OTC trades) as far as possible with the RTS produced under EMIR.
Therefore, it was initially assumed, the EMIR-applicable interpretation which contracts are objectively measurable as reducing risks directly relating to the commercial activity can be applied by analogy.
Draft RTS of 28 September 2015 adopted the following assumptions with respect to hedging exemption for position limits:
1. Given the language of the hedging exemption for position limits is the same as that under Article 10(3) of EMIR, with the exception that it applies to commercial activities only and not to treasury activities, the EMIR definition for hedging is used as the basis of the position limits hedging definition.
The said hedging definition under EMIR has been amended for position limit purposes to the extent that it also applies to derivatives traded on trading venues. Elements, which refer to treasury activities, have been removed.
2. Position limits structuring for hedging replicates arrangements in the draft RTS for the hedging exemption under the ancillary activity exemption, the use of the clarification under the EMIR Q&A (question 10) has also been retained (with the spirit of this guidance included in a recital).
The regulators' stance behind is it is reasonable to require a firm to demonstrate some linkage between transactions and its hedging position.
It is, however, clearly explained by ESMA it does still permit portfolio hedging (ESMA's Final Report of 28 September 2015, p. 348).
The above conceptions have been subsequently codified in Article 7 of the Commission Delegated Regulation of 1.12.2016 (see box).
To conclude this thread, a broader reflection comes to mind. that from the systemic point of view, consistent perception of the hedging criterion across the MiFID II/MiFIR and EMIR legal frameworks can't be overestimated as any discrepancies would have significant potential to misguide the market and increase compliance costs. Hence, ESMA's efforts to exploit interconnections between these legal frameworks are fully reasonable.
Hedging exemption procedure
It needs to be stressed the hedging exemption does not operate automatically but requires a notification from the non-financial counterparty and regulatory approval.
The specific procedure by which non-financial entities that are holding positions for the purpose of risk-reduction may be exempted from the position limits regime (including how the relevant competent authority will approve such applications) is the domain of the MiFID II level 2 legislation.
The task of drafting in that regard was entrusted to ESMA by Article 57(12)(f) of MiFID II, ESMA was also required to specify how the relevant competent authorities should proceed to approve such applications.
In the above-mentioned Discussion Paper of 22 May 2014 the following remarks have been made when it comes to the potential scope of the said requirements:
1. MiFID II does not define to whom the notification of exemption should be made;
2. Notification is an exemption from the position limits regime in relation to holdings in a specific contract, ESMA has considered that this is the basis for the notification;
3. Therefore ESMA proposed that, for both persons that are incorporated in an EU Member State and persons that are incorporated in a third country, the notification should be made to the competent financial authority of the relevant trading venue (as a person may be eligible for an exemption in relation to certain contracts, i.e. related to its commercial activities, and not eligible for an exemption in relation to other, speculative, activities);
4. ESMA proposed a similar procedure to that defined under EMIR for the notification of exemptions from the EMIR clearing obligation;
5. As regards the timing for applications for the use of, and the subsequent approval of, the exemption, submissions would not have to be made prior to entering into a position in the relevant contracts, but, in order to avoid the use of position management powers, a person should ensure that a relevant exemption has been obtained before approaching the limits set for the size of a position;
6. Submissions most probably will be made online to the relevant competent authority by means of an electronic portal.
In the above Consultation Paper, ESMA underlined that the intention of MiFID II is that the exemption is available only in respect of specific positions: it is not a universal exemption for certain types of persons, which exempts them from position limits for all activities undertaken in all commodity derivative contracts, regardless of whether they are risk-reducing or speculative.
In the Final Report of 28 September 2015 ESMA supplemented the above considerations with the conclusion that a person should apply for an exemption from a position limit for risk reducing positions to the competent authority of the trading venue for that contract.
The competent authority may require the person to demonstrate that a specific position is risk reducing and may withdraw the exemption for that position if insufficient information is provided.
In terms of timelines, ESMA initially proposed that each competent authority would have up to 30 calendar days to consider the notification and decide whether to approve it, after which a reply will be given. However, after the stakeholders' opinions ESMA revised its approach and this timeline has been shortened from 30 to 21 calendar days.
Where a competent authority expects to oppose the use of the exemption, it may contact the person and give a short period of time in order to provide any relevant additional information before a final decision is made.
A number of market participants suggested replacing the proposed ex ante procedure with an ex post one, which would allow immediate trading. Others proposed an ex ante approval as a general rule but that nevertheless it should be possible for a firm to seek an ex post approval.
This was the case for example for EFET, Eurelectric, EUROPEX and other organisations, which observed in the aforementioned document of 4 September 2015:
"We believe the annual hedging exemption should be complemented with a mechanism for non-financial entities to seek position limit exemptions on an ex-post basis – for example to react to unexpected events such as outages at physical infrastructure. This mechanism should require prompt assessments by national competent authorities to minimise disruption and prevent disorderly trading."
However, ESMA commented upon this issue that replacing the proposed ex ante procedure with an ex post model would fall outside the legal powers available to ESMA in the process of the MiFID II implementation.
It is useful to add, in the respective Questions and Answers ESMA referred to the issue of the availability of the hedging exemption to the non-EU entities with positions above the limits.
The regulator's stance is non-financial entity from outside the European Union may apply for an exemption in the same manner as an EU firm would.
ESMA asked stakeholders for views regarding transitioning into new position limits, specifically, what period a position limit should be fixed for a specific contract (except in exceptional cases) and how much notice of subsequent adjustments to a position limit would respondents consider appropriate.
All respondents agreed with ESMA's proposal that position limits should be set for a fixed period rather and that amending them on a real time basis is not optimal.
Opinions varied, however, regarding the length of such a fixed period, depending on the type of commodity targeted or on the periodicity of the publication of the deliverable supply statistics. Approximately half of respondents proposed an initial period of two years followed by annual reviews.
Most of the respondents considered it important that there should be a sufficiently long notification period of changes to existing position limits to minimise potential market disruption. A majority supported a 3 to 6 month notice period for new limits although some respondents considered a shorter period would be manageable.
Respondents also noted that the notification period is strongly linked to a number of factors including: frequency of the periodic review, itself linked to the type of commodity and the access of deliverable supply data; the grandfathering of open positions prior to the revision; and, the level of the limits and of their revisions.
Position limits will be set at national levels, however, the common methodology is the matter of the MiFID II secondary legislation.
Moreover, ESMA has been also assigned with the task of ensuring that a single position limit effectively applies to the same contract irrespective of where it is traded.
The latter point, however, leads to concerns whether regulatory arbitrage between EU Member States in setting position thresholds will be possible.
Rigorous, and, on the other hand, more loose national caps on positions exhibit a potential to attract or deter investors in particular markets.
The question may arise whether business is capable in any way to strategically prepare for the functioning of position limits architecture.
It would rather be difficult since MiFID II exibits in that regard an extreme flexibility - national competent authorities possess powers to review position limits whenever there is "a significant change in deliverable supply or open interest or any other significant change in the market".
Apart from that, it should be noted supervisory powers of national financial authorities under MiFID II include the competence to request any person "to take steps to reduce the size of the position or exposure".
Conseqently, business plans and strategies as well as legal documentation of transactions must take account of the above - possibly unexpected - regulatory interventions.
To mitigate some of the above risks MiFIID II foresees the procedure for establishing the trading venue where the largest volume of trading takes place and the significant volumes.
Where the same contracts are traded in different Member States, there is a need to assign one competent authority to set a limit which applies in all relevant countries.
This assignment is made on the basis of the country in which the trading venue with the largest average daily volume is located.
Where the "same" commodity derivative is traded in significant volume on two or more trading venues in two or more Member States, the competent authority of the trading venue with the largest volume will be the central competent authority.
ESMA was required under Article 57(12)(d) to define what is a significant volume of trading in the same commodity derivative.
For clarity, ESMA noted that this will only be required where the same commodity derivative is traded on two or more trading venues within the European Union.
According to ESMA's initial proposal, where the same commodity derivative contract is traded on two or more trading venues within the European Union, the determination of a central competent authority would be required whenever there were at least three lots of open interest in the same commodity derivative contract simultaneously traded on more than one trading venue. A majority of the respondents agreed with ESMA's proposal on this matter, recognising the importance of establishing a framework in which avoiding position limits regime is not possible. Other considered the limit too low.
Although ESMA shared the view that the determination of the central competent authority is needed and an important piece of the regulatory regime, it also acknowledged that the regime entails inherent cost and would only be efficient beyond a higher significance threshold. Therefore, ESMA aligned the threshold for significant volumes with the threshold for new and illiquid contracts, thus adopting a consistent approach to the threshold.
Therefore ESMA considered a commodity derivative to be traded in significant volume, when:
i. it has an average daily open interest which is above 10,000 lots in the spot and other months' combined on a trading venue over a consecutive three month period; or
ii. in the case of securitised commodity derivatives defined under point (c) of Article 4(1)(44), when the number of units traded multiplied by the price exceeds an average daily amount of €1,000,000.
Largest volume is calculated over a period of one year.
ESMA noted that trading venues that list the same commodity derivative contract must 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.
The above considerations have taken the legislative form in the Article 5(2) of the Commission Delegated Regulation (see box).
Trading venues' controls as a separate, but interlinked framework
Article 57(8) MiFID II requires investment firms and market operators operating trading venues to apply position management controls. ESMA's view is that this regime will operate in tandem with position limits set by the national financial regulatory authorities described above.
ESMA's Discussion Paper on MiFID II/MiFIR of 22 May 2014, ESMA/2014/548 underlines that "these controls are a mandatory part of the new control framework and will necessarily interact closely with the ESMA position limits methodology and the relevant competent authority's position limits regime. Any position limits set by a trading venue using its position management powers will of necessity be of an equal or lesser size than that established by the relevant competent authority".
|Last Updated on Saturday, 22 April 2017 13:08|