The trading test (alternative descriptions: "derivatives ratio" or "proxy test" - all these terms are used interchangeably) serves for the determination whether the entity qualifies for the MiFID II ancillary activity exemption and represents, one of the two - alternative - methods of the main business test (MBT).
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Important update
Directive (EU) 2021/338 of the European Parliament and of the Council of 16 February 2021 amending Directive 2014/65/EU as regards information requirements, product governance and position limits, and Directives 2013/36/EU and (EU) 2019/878 as regards their application to investment firms, to help the recovery from the COVID-19 pandemic substantially modifies legal framework regarding MiFID ancillary exemption.
The said Directive set out new provisions regarding the ancillary activity tests and empowers the European Commission to adopt a delegated act specifying the relevant criteria.
The delegation was exercised by adoption on 14 July 2021 of the Commission Delegated Regulation supplementing MiFID II by specifying the criteria for establishing when an activity is to be considered to be ancillary to the main business at group level.
This modification is not reflected in the remainder of this article, which is mainly based on previous provisions. However, some parts remain applicable and some updates are included.
Commission Delegated Regulation (EU) 2017/592 of 1 December 2016 supplementing Directive 2014/65/EU of the European Parliament and of the Council with regard to regulatory technical standards for the criteria to establish when an activity is considered to be ancillary to the main business (ESMA's RTS 20) has included the trading test in the regulatory set-up as the alternative to the capital employed test.
The trading test compares the ratio of non-privileged derivatives trading in the group (numerator) to the total derivatives trading of the group (denominator).
The details of the trading test are stipulated in Article 3(1)(a), (3), (4) and (10) of the said Commission Delegated Regulation (EU) 2017/592 of 1 December 2016.
Article 2(1)(j) of MiFID II grants persons performing MiFID II activities in commodity derivatives, emission allowances and derivatives thereof an exemption if their activities are ancillary to their main business.
Article 2(4) of MiFID II requires ancillary activities of such persons to constitute a minority of activities at a group level.
Hence, the trading test compares the ratio of non-privileged derivatives trading in the group (numerator) to the total derivatives trading of the group (denominator).
Article 3(1)(a), (3) and (4) and (10) of the Commission Delegated Regulation (EU) 2017/592 of 1 December 2016 supplementing Directive 2014/65/EU of the European Parliament and of the Council with regard to regulatory technical standards for the criteria to establish when an activity is considered to be ancillary to the main business
Article 3
Main business threshold
1. The activities referred to in Article 1 shall be considered to constitute a minority of activities at group level where they comply with any of the following conditions:
(a) the size of those activities calculated in accordance with the first subparagraph of paragraph 3 does not account for more than 10% of the total size of the trading activity of the group calculated in accordance with the second subparagraph of paragraph 3;
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3. The size of the activities referred to in Article 1 undertaken by a person within a group shall be calculated by aggregating the size of the activities undertaken by that person with respect to all of the asset classes referred to in Article 2(1) in accordance with the same calculation criteria as that referred to in Article 2(2). The total size of the trading activity of the group shall be calculated by aggregating the gross notional value of all contracts in commodity derivatives, emission allowances and derivatives thereof to which persons within that group are a party to.
4. The aggregation referred to in the first subparagraph of paragraph 3 shall not include contracts where the person within the group that is a party to any of those contracts is authorised in accordance with Directive 2014/65/EU or Directive 2013/36/EU.
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10. The values resulting from the calculations referred to in this Article shall be denominated in EUR.
In the European Commission’s opinion 31 May 2018:
- Article 2(1)(j) MiFID II requires that the test of whether the MiFID activities are ancillary needs to be assessed for both MiFID activities (dealing on own account and providing investment services other than dealing on own account) individually, and on an aggregate basis,
- in practical terms this implies that if a person undertakes both activities, it must pass the ancillary activity test with respect to both MiFID activities and cannot be exempt from MiFID II merely by passing the test for one of the MiFID activities.
Numerator
To determine the size of the trading activity in order to compare it to the size of the main activity undertaken by the group the trading test takes into account volume of all trading activity in commodity derivatives, emission allowances or derivatives thereof measured in the gross notional value of the underlying.
It is taken "as a proxy” for the commercial activity that the person or group engages in as its main business. This proxy should be easy and cost efficient for persons to apply as it builds on data already required to be collected for the market-share test while at the same time establishing a meaningful test (Recital 7 of the Commission Delegated Regulation (EU) 2017/592 of 1 December 2016).
Recital 8 of the said Regulation further clarifies that this proxy is appropriate because "a rational risk-averse entity, such as a producer, processor or consumer of commodities or emission allowances, is deemed to hedge the volume of the commercial activity of its main business with an equivalent volume of commodity derivatives, emission allowances or derivatives thereof. Therefore the volume of all its trading activity in commodity derivatives, emission allowances or derivatives thereof measured in the gross notional value of the underlying is an appropriate proxy for the size of the main business of the group. As groups whose main business activities are not related to commodities or emission allowances would not use commodity or emission allowances derivatives as a risk-reducing tool, their trading in commodity derivatives, emission allowances or derivatives thereof would not qualify as hedging."
In the numerator, the following items are deducted from the volume of the overall trading activity undertaken by the person:
1. intra-group transactions as referred to in Article 3 of EMIR Regulation, serving group-wide liquidity and/or risk management purposes;
2. transactions in derivatives which are objectively measurable as reducing risks directly related to the commercial activity or treasury financing activity (i.e. hedging);
3. 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 Union or national laws, regulations and administrative provisions or by trading venues");
jointly: "privileged transactions" (Article 2(4) of MiFID II).
Trading activities conducted by a MiFID authorised firm within the group are also excluded from the said aggregation.
For the calculation of the numerator the notional amount of ETD option contracts should be determined with the use of the following formula (ESMA Opinion of 7 July 2017 on ancillary activity – market size calculation, ESMA70-156-165):
lot size/multiplier (number of underlying instruments to be delivered for one contract) * quantity (number of contracts traded) * strike price.
According to the document "Joint associations' Questions & Answers (Q&A) on Regulatory Technical Standard (RTS) 20 of the Markets in Financial Instruments Directive (MiFID II)" of 16 February 2017 the numerator of the proxy test is to be applied on the person (entity) level, by each entity within the same group dealing in derivatives and not on an aggregated group level.
The above organisations argue that "the clear wording under the first sub-paragraph of article 3(3) RTS 20 provides that the numerator is composed of the activities undertaken by “a person” within a group, i.e. the numerator is calculated on an individual person (entity) level".
Also the European Commission while answering on 31 May 2018 to the ESMA’s letter confirmed that the ancillary activities tests must be calculated as many times as necessary for each separate person who trades in commodity derivatives within a group.
Denominator
The total size of the trading activity of the group is to be calculated by aggregating the gross notional value of all contracts in commodity derivatives, emission allowances and derivatives thereof to which persons within that group are a party to.
However, there are doubts as to the denominator's scope, since the respective provision (Article 3 of the Regulation) is not explicit in that regard.
In the absence of clear restriction, it appears that the denominator is not limited to the EU activity and has the global reach.
According to the view presented in the aforementioned document Joint associations' Questions & Answers (Q&A) on Regulatory Technical Standard (RTS) 20 of the Markets in Financial Instruments Directive (MiFID II) of 16 February 2017, activities already authorised under MiFID I / II should be deducted equally from the numerator as well as denominator of the test where relevant.
Threshold's values
In principle, to pass the trading test the size of activities listed in the numerator must not account for more than 10% of the total size of the trading activity of the group (denominator)
However, given the application of the so-called "backstop mechanism", the final figures are as in the table:
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Proportion of non-priviledged commodity derivatives trading versus total EU commodity derivatives trading at group level (gross notional value)
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Oil | Gas | Power | Coal | Metals | Emissions |
Derivatives on other commodities, including freight and "exotic" (Section C 10 of Annex I to MiFID II) |
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Under 10%
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3% | 3% | 6% | 10% | 4% | 20% | 15% |
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10% - 49,9%
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1.50% | 1.50% | 3% | 5% | 2% | 10% | 7.50% |
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50% or greater
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0.60% | 0.65% | 1.20% | 2% | 0.80% | 4% | 3% |
Recitals 7 - 9 of the Commission Delegated Regulation (EU) 2017/592 of 1 December 2016 supplementing Directive 2014/65/EU of the European Parliament and of the Council with regard to regulatory technical standards for the criteria to establish when an activity is considered to be ancillary to the main business
(7) The size of the trading activity as used under the first method of the second test is taken as a proxy for the commercial activity that the person or group engages in as its main business. This proxy should be easy and cost efficient for persons to apply as it builds on data already required to be collected for the first test while at the same time establishing a meaningful test.
(8) This proxy is appropriate because a rational risk-averse entity, such as a producer, processor or consumer of commodities or emission allowances, is deemed to hedge the volume of the commercial activity of its main business with an equivalent volume of commodity derivatives, emission allowances or derivatives thereof. Therefore the volume of all its trading activity in commodity derivatives, emission allowances or derivatives thereof measured in the gross notional value of the underlying is an appropriate proxy for the size of the main business of the group. As groups whose main business activities are not related to commodities or emission allowances would not use commodity or emission allowances derivatives as a risk-reducing tool, their trading in commodity derivatives, emission allowances or derivatives thereof would not qualify as hedging.
(9) The use of commodity derivatives as a risk-reducing tool however cannot be considered a perfect proxy for all the commercial activity that the person or group conducts as its main business since it may not take into account other investments in fixed assets unrelated to derivative markets. In order to correct the potential mismatch between a group's trading in commodity derivatives and the actual size of its main business with regard, in particular, to small groups the first method of the second test should contain a backstop which recognises that the trading activity undertaken by the persons within the group should also not exceed a certain percentage of any of the thresholds set under the first test for each relevant asset class to be deemed ancillary. The higher the percentage of speculative activity within all trading activity of a group, the lower the threshold set under the first test.
Overall, the practical functioning of the test is based on dependency: the higher the percentage of the speculative activity within all trading activity, the lower this threshold, for example:
- if a firm's speculative trading activity is 10-50% of its total trading, it may be MiFID II exempt providing its market share is less than 50% of each threshold in the market share test e.g. 2% for metals, 1.5% for oil etc.
- if a firm's speculative trading activity is above 50% of its total trading, it may be MiFID II exempt providing its market share is less than 20% of each threshold in the market share test e.g. 0.8% for metals, 0.3% for oil etc.
Pursuant to legislators, calibrating the main business test in this way ensures that only relevant and sizable participants in European commodity derivative markets should be determined as not conducting their activities as ancillary to their main business.
Calculation frequency
With regard to the data basis for the annual calculation of the trading test, according to the view presented in the aforementioned document Joint associations' Questions & Answers (Q&A) on Regulatory Technical Standard (RTS) 20 of the Markets in Financial Instruments Directive (MiFID II) of 16 February 2017, firms should be allowed to consider a number of representative trading days during the calculation period as appropriate to the complexity of their business.
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Territorial scope |
With respect to the numerator of the proxy test, the wording under the first sub-paragraph of Article 3(3) of the Commission Delegated Regulation (EU) 2017/592 makes a reference to the calculation criteria of Article 2(2) and, therefore, the numerator of this test - analogously to the market share test - is limited to activities in the European Union.
In turn, the denominator of the proxy test is to be calculated on a world-wide group basis as the second sub-paragraph of Article 3(3) of the Commission Delegated Regulation (EU) 2017/592 refers to “all contracts...to which persons within the group are party to”.
In Recital (1) Commission Delegated Regulation (EU) 2017/592 it is stated that “In line with Article 2(11) of Directive 2013/34/EU of the European Parliament and of the Council', 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.”
Such stance is shared by Bundesverband der Energie- und Wasserwirtschaft (BDEW), European Federation of Energy Traders (EFET), EURELECTRIC, Energy UK, EUROGAS, Futures Industry Association (FIA) and International Oil and Gas Producers association (IOGP) in the document of 16 February 2017 "Joint associations' Questions & Answers (Q&A) on Regulatory Technical Standard (RTS) 20 of the Markets in Financial Instruments Directive (MiFID II)".
Calculation Frequency and Data Basis for Ancillary Activity Tests
Question:
Should the outcomes of each of the Ancillary Activity Tests be calculated on a daily basis during the calculation period and be based on all trading days per se?
Answer:
No. The RTS 20 distinguishes between the frequency of the Ancillary Activity Tests and the underlying data basis for these tests.
With regard to the calculation frequency article 4 (1) RTS 20 states that these calculations “shall be carried out annually in the first quarter of the calendar year that follows an annual calculation period”.
Therefore, firms can calculate the Ancillary Activity Tests only once during the first quarter of a year and are not obliged to calculate these tests on a more frequent basis during the calculation periods.
With regard to the data basis for this annual calculation of the Ancillary Activity Tests, firms should be allowed to consider a number of representative trading days during the calculation period as appropriate to the complexity of their business.
Furthermore, firms should be allowed to use the clearing threshold calculations performed for the purpose of compliance with article 10 of EMIR also for the purpose of the calculations for the Ancillary Activity Tests.
Reasoning:
RTS 20 doesn’t establish a binding daily calculation frequency within a calculation period.
This is because it speaks in article 4 (1) of an annual calculation to be carried out in the first quarter of the year that follows an annual calculation period.
Therefore, persons may perform the calculation only once during the first quarter of year.
With regard to the underlying data basis for this annual calculation, article 4 (1) RTS 20 speaks of a calculation “based on a simple average of the daily trading activities or estimated capital”.
We believe that an annual calculation based on all trading days (250 days) would impose overly burdensome calculations on MiFID II exempted firms.
In particular an annual calculation of the Capital Employed Test based on positions held on all trading days would be overly burdensome as it requires complex calculations of net and gross positions.
Also for such firms, which entire portfolios of privileged and non-privileged trading activities are clearly below the defined test thresholds, a calculation based on all trading days would not be meaningful and impose unnecessary burdens.
Finally, a calculation based on all trading days would not be more meaningful than a calculation based on representative days, given the seasonality of certain commodity trading activity.
Therefore, we are of the opinion that it is more proportionate that firms may perform the calculations of the daily trading activities or estimated capital as appropriate to the scope and complexity of their business and sufficient to provide a representative yearly notification to the competent authorities about the usage of the exemption.
For these reasons we are of the opinion that the calculations can be done with an appropriate, representative granularity, i.e., based on representative trading days (e.g. for the purpose of the Capital Employed Test positions held on the last Friday of each month or each quarter).
Furthermore the re-usage of EMIR clearing threshold calculations seems justified, in particular as under EMIR and MiFID II the definitions of financial instruments, hedging and intra-group transactions are the same.
Joint associations' Questions & Answers (Q&A) on Regulatory Technical Standard (RTS) 20 of the Markets in Financial Instruments Directive (MiFID II) of 16 February 2017
Regulatory chronicle
14 July 2021
26 February 2021
24 July 2020
10 July 2020
Documentation
2 October 2018 - ESMA Opinion on ancillary activity – market size calculation (ESMA70-156-478)
ESMA Opinion of 6 July 2017 on ancillary activity – market size calculation, ESMA70-156-165
Questions and Answers on MiFID II and MiFIR commodity derivatives topics ESMA70-872942901-36
Commission Delegated Regulation (EU) 2017/592 of 1 December 2016 supplementing Directive 2014/65/EU of the European Parliament and of the Council with regard to regulatory technical standards for the criteria to establish when an activity is considered to be ancillary to the main business, Article 3(1)(a), (3) and (4) and (10), Recitals 7 - 9
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