|MiFID II ancillary activity ("commodity derivatives trader") exemption - Article 2(1)(j)|
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Why do I consider ancillary activity exemption from MiFID II to be the central point of interest for firms involved in commodity and carbon trading in the following years?
It follows from the two key legislative modifications brought by MiFID II with respect to this institution:
- firstly - from the need for annual notification of financial authorities by counterparties making use of this exemption,
- the second essential (and ground-breaking in nature) fact is that strict, quantitative parameters are to be established, which will delineate what trades and volumes can be understood as "ancillary".
Under the regulatory regime of MiFID I, Article 2(1)(i) exempts persons dealing on own account in financial instruments, or providing investment services in commodity derivatives to the clients of their main business, provided this is an ancillary activity to their main business, when considered on a group basis, and that the main business is not the provision of investment services within the meaning of MiFID or banking services under Directive 2000/12/EC.
This exemption and the one currently provided by Article 2(1)(k) of MiFID I are intended to cover commercial users and producers of commodities.
The European Securities and Markets Authority (ESMA) observed that the exemptions currently available "are effectively carried over under Article 2(1)(j) of MiFID II in similar but not identical terms.
However, the exemption that is currently available under Article 2(1)(k) of MiFID I will cease to exist thereby additional focus will be placed on those exemptions that are carried over."
“Ancillary” transactions for the purposes of the exemption at issue are transactions in financial instruments necessary to support physical trades.
Under MiFID I the criterion for determining when the activity was "ancillary" to the main business was traditionally understood as excluding dealing on own account for speculative purposes in the case of commodity producers (see FCA handbook) however, there were no quantitative criteria in that regard.
In the absence of quantitative criteria, market participants under MiFID I did not typically calculate the scale of their activities in specific instruments with regard to determining how much MiFID business they undertook compared to their main business.
Moreover, under MiFID I there were no requirements for market participants to notify competent authorities of the use of this exemption.
The effect of this status quo was supervisory practices under MiFID I on how to identify that an activity was "ancillary" to the main business of a person typically made a case-by-case assessment taking into account the variety of factors for key areas of business (such as revenues, profits, employees, etc.), additionally, they were not harmonised across the EU (Cost Benefit Analysis – Annex II Draft Regulatory and Implementing Technical Standards MiFID II/MiFIR of 28 September 2015 (ESMA/2015/1464), p. 414, 415).
The above-mentioned shortcoming of absent quantitative criteria is rectified by the MiFID's new embodiment and its subordinate legislation and this is the first key regulatory switch when it comes to MiFID II new legal environment for commodity and carbon derivatives markets.
Further, the most salient features of the new ancillary activity exemption under the new Article 2(1)(j) MiFID II framework are:
- its scope has been strictly defined and covers financial instruments' types i.e. commodity derivatives, emission allowances and derivatives thereof,
- persons dealing on own account when executing client orders mustn't benefit from this exemption (as well as from any other MiFID II exemption), and in effect must be covered by the MiFID II (see Recital 23 MiFID II).
Given, additionally, the extensive scope of MiFID II encompassing more and more commodity trades (see: Physically settled commodity derivatives in MiFID II) and the requirement for the above-mentioned annual notification to be reasoned on the request of financial authorities, it becomes obvious, the strict compliance and legal monitoring of these issues represents the fundamental prudence test for any commodity (as well as carbon) business venture.
The preferential treatment of hedging transactions under the new MiFID II ancillary activity exemption is undoubtedly helpful, but does not clear the entire spectrum of potential risks.
For the above reasons fully understandable are words of the ESMA Chair, Steven Maijoor, who, introducing the newly-developed September 2015 package of MiFID II draft regulatory technical standards, said:
However, it is to be noted a firm that "only engages in hedging in commodity derivatives markets, or has a trading activity deemed to be ancillary to its main business, will not be required to obtain a licence, regardless of its size" (European Banking Authority (EBA) Report on Investment Firms, Response to the Commission's Call for Advice of December 2014, EBA/Op/2015/20 (p. 23).
In the case of exemption under Article 2(1)(j) of MiFID II (sometimes called: "ancillary activity exemption" or "commodity derivatives trader exemption") persons must notify annually the relevant competent authority that they make use of this measure and upon request report to the competent authority the basis on which they consider that their activity is ancillary to their main business.
Details for the respective requirement are stipulated in the MiFID II itself, 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 (RTS 20), clarifications issued by the European Securities and Markets Authority (ESMA) in the form of Questions and Answers on MiFID II and MiFIR commodity derivatives topics (ESMA70-872942901-28), as well as in guidance of the EU national competent authorities.
The wording of the said provision indicates that the notification requirement has an "automatic" character, i.e. no request from authorities is needed to initiate the notification procedure.
As opposite, the factual and legal reasoning substantiating the firm's position, it carries out the "ancillary" activity, and, consequently, is exempted from MiFID II, is provided only upon request.
Personal scope of the notification requirement
With respect to the question who is under obligation to notify annually the relevant competent authority of the use of the ancillary activity exemption ESMA in the Questions and Answers, on MiFID II and MiFIR commodity derivatives topics (ESMA70-872942901-28) explained that:
"any (natural or legal) person that deals on own account or provides investment services in commodity derivatives as a regular occupation or business on a professional basis pursuant to Article 5 of MiFID II has to be authorised as an investment firm under MiFID II.
However, if the person meets the criteria for activities considered to be ancillary to the main business pursuant to Article 2(1)(j) and the provisions in RTS 20 and makes use of the ancillary activity exemption, then it has to notify annually the relevant competent authority that they make use of this exemption".
On 31 May 2017 ESMA said:
"Article 2(1)(j) of MiFID II exempts persons who deal in commodity derivatives on an ancillary basis under a number of conditions. One of these conditions is that they notify annually the relevant competent authority that they make use of this exemption. The notification needs to have been made for a firm to be able to rely on it.
ESMA added, moreover:
"When a person’s trading activity increases to such an extent that it can no longer be considered to be ancillary to its main business under Article 2(1)(j), the firm must apply to the competent authority for a license.
Those who have reasonable grounds for considering they will be able to benefit from the ancillary activity exemption should notify.
Where subsequently the market data indicates that this is not the case, the firm would be expected to apply for authorisation as soon as reasonably practicable."
According to the said ESMA Q&As, the notification must be made to the national competent authority "to which the person would need to apply for authorisation if it were unable to make use of the ancillary activity exemption".
At the earlier legislative stage ESMA had been proposing the rule that the competent authority, to which firms should make the annual notification, would be the authority in the jurisdiction in which the firms have their head office.
ESMA also noted, then, that entities situated in a third country which undertake ancillary activities in the EU wishing to benefit from the exemption should make the notification to the competent authority of the Member State where their branch is situated.
These arrangements should not, however, be interpreted as a requirement for firms to establish a branch in the EU as a pre-requisite to using the ancillary activity exemption.
The more detailed remarks on the complexities involved with the notifications for the MiFID II ancillary activity exemption are covered below under the headings "Group-relevance" and "Period for calculation".
Among potential preconditions for this exemption MiFID II lists (non-mandatorily and non-exhaustively) the proportion of ancillary and main businesses relative to:
The MiFID II recitals indicate that the said criteria should ensure that non-financial firms dealing in financial instruments "in a disproportionate manner" compared with the level of investment in the main business are covered by the scope of the MiFID II Directive.
In doing so, these criteria should take at least into consideration:
1) the need for ancillary activities to constitute a minority of activities at group level, and
2) the size of their trading activity compared to the overall market trading activity in the asset class.
The rationale of the ancillary activity tests is to check whether entities not subject to financial regulation should be required to acquire an authorisation due to the relative or absolute size of their activity in commodity derivatives, emission allowances and derivatives thereof.
Overall, the pertinent tests are designed as follows:
i. The first test (the "trading activity thresholds") expresses the relationship between "speculative" activity and the overall EU market activity in each class of commodity derivatives. The reasons are that firms having a significant share of the market in a particular class of derivatives will not be allowed to benefit from the exemption as they should compete with other market participants on a level playing field.
ii. The second test shall determine whether investment activity is large in size relative to what the entity does as its main business (the "main business thresholds").
"The two limbs of the test ("speculative" activity combined with market share) contribute to ensuring that the test does not capture very small firms with significant non hedging activities but limited market share for which the costs associated with the authorisation as a MiFID investment firm would not be justified by benefits in respect of market integrity or level playing field" (ESMA's Cost Benefit Analysis of 28 September 2015, p. 422).
Above assumptions - rooted in the Level 1 text - seem reasonable, but, particularly in this case, devil is in the details.
When it comes to the specific interpretation of the above criteria (set in closer detail in the MiFID II secondary legislation) the ESMA's Discussion Paper on MiFID II/MiFIR of 22 May 2014, ESMA/2014/548) proposed, initially, a sophisticated and, some may say, excessively complex desing.
This was followed by more conscise and transparent conceptions in the ESMA's Consultation Paper, MiFID II/MiFIR of 19 December 2014 (ESMA/2014/1570).
The ancillary thresholds proposed by ESMA in the December 2014 Paper were generally considered by same industries as excessively tight (see the example of the relevant correspondence).
On 28 September 2015 ESMA published Final Report Draft Regulatory and Implementing Technical Standards MiFID II/MiFIR (ESMA/2015/1464), where the initial ESMA's assumptions as regards the tests' construction underwent a major revamp.
The preliminary question may, however, arise what happens if the size of the trading activity of the firm compared to the overall market trading activity in the asset class will be above the threshold set in the level 2 legislation while ancillary activities of the firm will still constitute a minority of activities at a group level.
The European financial regulator has explained the intention is such firms to be captured by MiFID II. It follows, the two metrics are alternatives (have to be passed cumulatively in order for investment activities to be considered as ancillary and therefore an exemption from MiFID II to apply).
This conclusion is also confirmed by the ESMA's remark in the Consultation Paper, MiFID II/MiFIR of 19 December 2014 (ESMA/2014/1570) p. 508 (which clarifies a firm will be captured by the scope of MiFID II "if it either exceeds the threshold set in the ancillary activity test or if it exceeds the threshold set in the trading activity test") as well as the ESMA's Final Report of 28 September 2015 (p. 322) and ESMA's Cost Benefit Analysis of 28 September 2015 (p. 415).
Another key MiFID II assumption for ancillary test is that the assessments of the proportion of ancillary and main businesses are to be done on a group basis.
The 'group' is defined in Article 2(11) of Directive 2013/34/EU on the annual financial statements, consolidated financial statements and related reports of certain types of undertakings (Accounting Directive), and Article 4(1)(34) of MiFID II refers thereto.
Simply put (since the Accounting Directive in that regard is rather elaborate - see here for more detailed description of possible arrangements representing the "group" within the Accounting Directive's meaning), the "group" exists in every case where a dominant influence is exercised by one company over another.
In spite of suggestions for an expansion of the definition of control in order to include elements of indirect control, such as dominance over marketing channels, client relationships, IT infrastructure, administration and back-office procedures, given that Article 4(32) and (33) of MiFID II refers to Article 22 of the Accounting Directive, where elements of control are listed, and there is already understanding (also in other Directives) for this provision, there should't be an expectation that ESMA will give further guidance on the question of when a subsidiary is controlled by a parent undertaking for the purposes of defining main and ancillary activities.
One element deserves, however, to be particularly accentuated, namely the non-EU entities of a group are also covered by the "group" in the MiFID II meaning. The said provisions apply regardless of whether the group is headquartered inside or outside the EU.
The consequences of this regulatory interpretation may be significant, but the approach consisting in taking into account also non-EU activities of a group in relation to the group definition when looking at tests designed to identify ancillary activity is supported by strong argumentation:
- in view of the fact the main commercial activities of commodity firms are often located outside the EU, it is necessary to provide a full picture of the group's activities for competent authorities and in order to avoid loopholes;
- a group definition, which does not take into account global activities would give rise to competitive distortions;
- an "EU-only-approach" would require firms to differentiate between EU and non-EU activities in the financial reporting and accounting processes and, thus, require amendments to those processes;
- a global group definition is consistent with the group definition under Article 10 EMIR that refers to clearing thresholds.
Considerable burden for firms of obtaining global data under differing regulatory requirements and the fact that trading decisions are often taken or coordinated at a regional rather than at a global level are taken into account when setting this interpretation, however, in view of the above benefits, ESMA adheres to the definition of the group encompassing also non-EU activities.
Market participants were split over the question whether the calculations should be computed at the level of the group or of the person.
They argued that the MiFID licensing regime applies at person level. The ambiguity was also raised whether the group level approach would entail that all entities within the group would be required to obtain a MiFID license where a threshold is exceeded.
Refering to the above issues ESMA, however, observed that the MiFID regime distinguishes between on the one hand (i) the person who has to apply for an authorisation and can benefit from an exemption and, on the other hand, (ii) the requirements for the exemption to the authorisation regime.
The latter refer to the group. Both the licensing requirement and the exemption apply to persons. The persons who can apply for an exemption, i.e., persons dealing on own account or providing investment services, need to make sure that the activity is ancillary to their main business, either on their own personal basis, or regarding the group they belong to.
ESMA concluded that where in a group the thresholds are exceeded, the group has to ensure that the thresholds are not breached in the future, i.e. by setting up a MiFID licensed entity.
The above ESMA's approach is reflected in the Recital 1 of the 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 criteria to establish when an activity is considered to be ancillary to the main business.
In the Questions and Answers ESMA has, moreover, explained that all entities within a group, which cannot be considered as a non-financial group, are required to obtain authorisation as an investment firm under MiFID II, if they wish to trade commodity derivatives.
ESMA also underlined that any person that is party to a commodity derivative will need to notify its relevant National Competent Authority and that the notification to the said authority for that person is a condition for using the exemption.
The ancillary exemption applies to persons and this also applies to persons who are part of a group.
Therefore, it is not possible for a group to apply for an exemption on behalf of all the entities that the group contains.
Market share test
When it comes to the test for the size of the trading activity, the scope of the term "overall market trading activity" is particularly important, as representing the metric, the person's trading activity is compared to (MiFID II Directive leaves the room for the level 2 legislation for the detailed determination in that regard).
For practical reasons the term "overall market trading activity" is understood in this context as the European Union trading activity instead of the reference to the global scale (practical measurement difficulties are acknowledged by ESMA in the latter case).
Another key choice with respect to the potential "overall market trading activity" measurement's methods is between the number of contracts or gross notional value of contracts bought and sold during a specified period of time.
The latter indicator can be considered as more objective, given the flexibility the parties possess in allocating the trading volumes into individual contracts.
In that regard methods for calculation of clearing thresholds under EMIR Regulation pose a clear-cut analogy.
EMIR clearing thresholds as well as ancillary activity criteria for the purposes of MiFID II exemption both can be perceived as the borderlines differentiating sistemically important counterparties from those not impacting the financial system as a whole.
It seems logical, if the gross notional value of contracts has already been considered an appropriate metric for EMIR, there should be significant reasons for the adoption of different criterion for MiFID II. It seems that there aren't any in that regard.
Gross notional value has been adopted as the relevant metric for measuring trading volumes in calculating ancillary activity thresholds in the draft RTS attached to the ESMA's Final Report of 28 September 2015 and, finally, in 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.
The resemblance between EMIR institutions and MiFID II ancillary exemption is even more striking when it comes to asset-relevant issues (ESMA decided the size of the trading activity for the purposes of MiFID II ancillary exemption should be divided into the separate asset classes). This seems to reflect, among others, the markets' diversity, where markets for certain goods or assets are global in nature, while for others may be mainly regional.
Moreover, the ESMA's stance was that where an entity operates simultaneously in different markets, and is captured by MiFID within one market, it will fall under the scope of MiFID II for all its activities.
The above rule is reasoned by the fact that the firm can not be, in principle, MiFID-exempted for its, say, agricultural trading activities, and concurrently subjected to MiFID when it comes to, say, metals.
So, the specific exemptions notwithstanding (like for REMIT-related products (the so-called REMIT carve-out) or transitional oil and coal exemption), firm always comes into and leaves the MiFID licence requirements as an integral whole.
Under EMIR the analogous rule applies with respect to clearing thresholds where passing the threshold by the non-financial firm for one asset class, results in the clearing obligation for all asset classes (however, this principle is going to be changed by the European Commission Proposal for a Regulation of the European Parliament and of the Council amending Regulation (EU) No 648/2012 as regards the clearing obligation, the suspension of the clearing obligation, the reporting requirements, the risk-mitigation techniques for OTC derivatives contracts not cleared by a central counterparty, the registration and supervision of trade repositories and the requirements for trade repositories, COM(2017)208, of May 2017).
Overall, the onus of this test under MiFID II rests, among others, on the reasonable determination of the metric where as the numerator appears the "size of the trading activity of the firm", and as the denominator, "the overall market trading activity".
The European financial regulator initially anticipated to set this proportion at the relatively low level.
Draft regulatory technical standards included in the above-mentioned ESMA's Consultation Paper, MiFID II/MiFIR of 19 December 2014 (ESMA/2014/1570) proposed the uniform level of 0,5%, while ESMA's Final Report of 28 September 2015 differentiated thresholds depending on asset classes. Detailed methodologies applied in each of these approaches differed from each other.
Pursuant to the ESMA's Final Report of 28 September 2015 market share test compared the level of a person's trading activity against the overall trading activity in the European Union on an asset class basis to determine the person's market share in accordance with the following rules:
1. The size of the trading activity was determined by deducting the sum of the volume of the transactions referred to in points (a), (b) and (c) of the fifth subparagraph of Article 2(4) of MiFID II ('privileged transactions' - see below) from the volume of the overall trading activity undertaken by the group. Transactions executed in an entity of the group authorised under MiFID were also deducted.
2. The volume of the trading activity was determined by the gross notional value of contracts in commodity derivatives, emission allowances and derivatives thereof on the basis of a rolling annual average of the preceding three calendar years.
3. The overall market size was determined on the basis of trading activity undertaken in the European Union in relation to each asset class: metals, oil, coal, emission allowances and derivatives thereof, gas, power, agricultural products and other commodities.
4. Trading activity comprised trading in contracts traded ouside trading venues to which a person that was located in a EU Member State was party and contracts that were traded on trading venues located in a EU Member State.
5. As commodity markets differ significantly in terms of size, number of market participants, level of liquidity and other characteristics, different thresholds applied for different asset classes in relation to the test on the size of the trading activity, as follows:
(a) 4 % in relation to derivatives on metals;
The determination that the overall market trading activity takes into account only the EU activity did not resolve all pertinent problems. There were still some difficulties in performing calculations, in particular, regarding the overall market size in specific asset classes.
ESMA initially asserted it had no legal empowerment to establish such a benchmark, on the other hand it also said it intended to make data available on a best effort basis (ESMA's Cost Benefit Analysis of 28 September 2015, p. 417).
However, the said document acknowledges costs would be incurred by market participants to gather and aggregate data on own trading across a group of entities and of overall trading volume for each of the eight asset classes, where the non-financial firm would not rely on the overall market data made available by ESMA.
Commodity firms will incur, moreover, one-off staff and IT costs to compute their market share according to the test. On-going compliance costs may be incurred to perform those calculations on a periodic basis throughout the year to monitor where the firm's market share stands, rather than just once a year for notification purposes, as formally requested by Level 1.
The final set-up of the market share test for the MiFID II ancillary activity exemption has been determined in 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, its details and further legal developments involved are analysed in the article MiFID II ancillary activity exemption - market share test.
Main business test - minority of activities
MiFID II stipulates that ancillary activities must constitute a minority of activities at group level. In the above-mentioned Discussion Paper of 22 May 2014 ESMA proposed the approach that the ancillary activity in commodity derivatives, emission allowances and derivatives thereof could only be considered as constituting a minority of activities if it accounted for less than maximum 50% of the main business of the group. ESMA indicated, moreover, as the ancillary activity must be ancillary on an individual and on an aggregate basis, less than maximum 50% of the main activity at group level must represent all three elements:
- the capital for dealing on own account,
- the capital for the provision of other investment services to customers or suppliers, and
- the sum of these two factors.
In the Consultation Paper of 19 December 2014 ESMA reviewed and amended the suggested approach in relation to these calculations and took into account the overall activity of a group's main business without any further reductions.
Moreover, ESMA decided it was necessary to reduce the threshold significantly - to 5% only - "as otherwise even entities with a very low level of commercial activity would not exceed the threshold". The second reason for such radical threshold's reduction was the fact that in relation to this test only trading activity undertaken for non-hedging purposes had to be taken into account.
Hence, in the effect of the revised calculation methodology the ancillary test, as designed by the ESMA's Consultation Paper of 19 December 2014, included a comparison of the capital employed (see the remarks below on the interpretation and evolution of the approach as regards the "capital employed" metric) by the person seeking the exemption for trading activities undertaken in the EU for non-hedging purposes on the one hand, and the capital employed for the overall activity undertaken by the whole group globally on the other hand (threshold proposed to be set at 5%). There were no simple comparisons between the earlier threshold at 50 % and the revised 5 % level since each was based on different calculations methodology.
The EU financial regulator also clarified that the comparison of the ancillary activity against the main activity should be done by comparing all ancillary activities taken together against the main activity. Where a firm undertakes only one of the ancillary activities mentioned in Article 2(1)(j) (i.e. dealing on own account or providing investment services), it would only have to undertake the ancillary test on the basis of this individual ancillary activity.
Why the measure for "capital employed" has been considered not appropriate
MiFID II further stipulates thatin determining the extent to which ancillary activities constitute a minority of activities at group level "the capital employed for carrying out the ancillary activity relative to the capital employed for carrying out the main business should be considered. However, this factor shall in no case be sufficient to demonstrate that the activity is ancillary to the main business of the group."
ESMA, while preparing draft secondary legislation, initially consulted on a proposal that was based on considering the ratio of the capital employed for carrying out the ancillary activity to the capital employed for carrying out the main business.
Since MiFID II does not indicate explicitly, how the term "capital" should be interpreted, the following capital approaches were considered for the purposes of designating the scope for ancillary activity exemption:
Mindful of the fact MiFID-exempted firms are not required to perform regulatory capital calculations (CRD IV) this measure was considered as not useful for determining the scope for MiFID ancillary activity exemption.
Moreover, from the two remaining possibilities economic capital metric was also disregarded for its major drawbacks:
- lack of a clear definition (there are only available the more descriptive designations of the working capital, for instance as the "cost to carry out a business"),
- measurement difficulties (the possible use of profit and loss statement as a proxy would require specification of concrete items relevant for calculations),
- the perception of the working capital as revenue rather than a capital measurement,
-the necessity for firms to carry out new calculations instead of using some sort of already existing data.
For these reasons ESMA in the December 2014 papers preferred an accounting capital measure for ancillary activity calculations or, but only where this measure was not available, an economic capital indicator. Accounting capital measure was also adopted in the draft RTS of December 2014 for the ancillary test. The said draft RTS clarified, moreover, "capital" means capital encompassing total equity, current debt and non-current debt.
However, potential difficulties were noted, particularly in assigning capital under accounting capital measures to different activities, i.e. the ancillary activities, the group's main business and the privileged transactions.
Furthermore, the sectoral document Adjustment of ESMA's approach towards the ancillary activity exemption of 13 July 2015 acknowledged the fact for industrial firms "it is not common practice to allocate capital for certain activities (like trading or hedging activities or intra-group transactions)".
From practical point of view some proxies for the capital employed calculations were considered by industrial firms, in particular, the value of collateral engaged (initial margins and variation margins) as well as the value of the loss incurred on the trading activity (which, in fact, consumed the capital).
According to the ESMA's Cost Benefit Analysis of 28 September 2015 the responses received by ESMA demonstrated that no more than a couple of firms were able to provide the data needed to perform the test in a consistent way, i.e. using either accounting capital or the same proxy for all the components.
Comments indicated that the mandatory use of accounting capital or even the allocation of capital at this level of business would be a source of very significant costs whilst other proxies would not be of relevance either.
Acknowledging the above circumstances and in order to avoid the minority test being a source of very significant costs, ESMA decided in the draft RTS of 28 September 2015 to abandon the above conception and develop the main business test as an alternative approach.
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 criteria to establish when an activity is considered to be ancillary to the main business represents once more regulatory switch, as it included capital test, in the modified form, in Article 3(5) - (10) - for details see here.
Discontent over the methodology for calculation of the ancillary activity exemption thresholds and the revised main business test according to ESMA's September 28, 2015 Final Report
The ancillary activity thresholds' values (both 5% and 0,5% respectively), along with the accompanying calculations' methodology, proposed by ESMA in December 2014, sparked some industries' criticism and the opinions were voiced these thresholds "are so restrictive that they render the ancillary activity exemption without effect" and that they "do not respect the text and spirit of the adopted legislation" (see for example the Eurelectric concerns regarding proposed MiFID II implementing rules of 10 April 2015, which recommended the thresholds' setting at a substantially higher level - i.e. 20-25% for the capital employed test and around 15% for the market-share test).
In the above letter to European Commissioners Eurelectric argued, moreover, "companies should not fall under MiFID unless they fail both tests" - i.e. contrary to the rules proposed by ESMA, which advocated for an alternative character of both tests.
On 16 June 2015 Steven Maijoor, Chair European Securities and Markets Authority, (Opening Statement, Economic and Monetary Committee (ESMA/2015/936)) signalled that the ESMA draft text that went out for consultation in December 2014 was undergoing further major refinements.
Certain details of these potential modifications were revealed in MiFID in/out changes start to emerge.
Further light on specific methodologies with respect to potential modifications to the December 2014 ESMA approach was shed by the industry documents (see, for example: MiFID II ancillary activity exemption - test based on different categories of market size threshold).
Protracted lack of information and transparency on these important parameters effected in correspondence between the European Commission and some Members of the European Parliament.
More certainty was envisioned to be given in October 2015, since the end of September 2015 was set as the date for the conclusion of the common work of the European Commission's and ESMA's staff on the respective draft RTS (see the correspondence between the European Commission and ESMA: ESMA letter of 11 May 2015 (ESMA/2015/841) and the European Commission's response of 12 May 2015).
In order to establish whether the ancillary activity constitutes a minority of activities at group level, the main business test, as presented by ESMA in September 2015, assessed the size of the trading activity, excluding privileged transactions and transactions executed by authorised entities of the group, undertaken by the group in all asset classes (the numerator) against the size of the overall trading activity, including privileged transactions and transactions executed by authorised entities of the group, undertaken by the group in total for all asset classes (the denominator).
ESMA argued the size of the trading activity as used in the second test, including privileged transactions and transactions executed by authorised entities, was taken as a proxy for the commercial activity that the person or group does 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.
As the recitals to the September 2015 draft RTS state, "rational risk-averse entity, such as a producer, processor or consumer of commodities, will seek 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 turnover of commodity derivatives measured in the gross notional value of the underlying, which are purchased or sold is an appropriate proxy for the size of the main business of the group. Main business of group that is not related to commodities would not use commodity derivatives as a risk-reducing tool and therefore any co-existing trading in commodity derivatives would ab initio be speculative and unable to benefit from the ancillary exemption."
The main business test as designed by ESMA in September 2015 may inadvertently capture persons with a high proportion of trading which is neither privileged transactions nor executed in an authorised entity of the group but nevertheless have a very low level of trading activity in total.
In addition, hedging activity cannot be considered a perfect proxy for the commercial activity that the person or group conducts as its main business as it does not take into account other investments of commodity market participants in fixed assets unrelated to derivative markets.
Therefore, the main business test has been designed in the ESMA's September 2015 draft RTS as not solely operating on the basis of the application of this proxy but rather should contain a backstop mechanism which recognises that the trading activity undertaken by the persons within the group should also exceed a certain percentage of any of the thresholds set under the first test for each relevant asset class to be deemed non-ancillary.
The higher the percentage of the speculative activity within all trading activity, the lower this threshold. Calibrating the main business test in this way should ensure 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.
- 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.
Table: Market share thresholds by commodity group under ancillary exemption test pursuant to ESMA's Final Report of 28 September 2015
The backstop mechanism as set out in the table above has been finally implemented in Article 3(2) of the 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 criteria to establish when an activity is considered to be ancillary to the main business, however, entities passing the capital test (in the shape introduced by the European Commission in the said Regulation) are automatically given the highest market share thresholds.
ESMA's Final Report of 28 September 2015 includes also a graphical depiction in that regard, as follows:
Diagram source: ESMA's Final Report of 28 September 2015 (ESMA/2015/1464), p. 330
ESMA underlined, this alternative test should be a source of reduced compliance costs (as under the final draft RTS the data to be used in the main business test in the numerator is identical to the one used for the market share test), whilst delivering more reliable and consistent outcomes than the former capital test.
However, there were still concerns expressed by some industries (see for example Ensuring effective and efficient regulation of European commodity derivative markets of 4 September 2015) that the scale of a company's non-trading asset base remained irrelevant for ancillary activity tests.
The shortcoming behind the former way the calculations were carried out, was companies with an underlying physical business and a corresponding asset base would be treated the same way as companies which had not invested in and did not operate assets.
Some industries argued this would prevent a true assessment of the relationship between the trading activity and the rest of a group business involving the production, processing and supply of energy resources.
It was also questioned that hedging activity in financial instruments can or should be used as a proxy for a person's main business for the purposes of the exemption.
According to some industries, hedging activity was not a viable proxy as it ignored significant investments of commodity market participants in fixed assets and resource-intensive activities entirely unrelated to derivative markets.
Trading with end-consumers would also be a problem.
However, the main business test with the above backstop mechanism has been maintained in the respective Regulation finally adopted by the European Commission (along with the updated capital test).
Exclusions - privileged transactions
The above assessments and calculations with respect to both of the metrics envisioned by the MiFID II for ancillary exemption exclude (Article 2(4) of MiFID II):
(a) intra-group transactions as referred to in Article 3 of EMIR Regulation, serving group-wide liquidity and/or risk management purposes;
(b) transactions in derivatives which are objectively measurable as reducing risks directly related to the commercial activity or treasury financing activity (i.e. hedging);
(c) 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".
There is also a special treatment for trading activities conducted by a MiFID authorised firm within the group (see below).
Hedging for the purposes of the MiFID II ancillary exemption is to be understood in the way elaborated for EMIR (see: calculation of clearing thresholds under EMIR Regulation and the wording of Article 10 of the Commission Delegated Regulation (EU) No 149/2013 supplementing EMIR). This is expressly mandated by recital 21 MiFID II.
Equally, the ESMA acknowledged that Article 3 EMIR is sufficiently clear in determining what is defined as intra-group transactions serving group-wide liquidity and risk management purposes.
Consequently, MiFID II ancillary activity reference to intra-group transactions is redirected to Article 3 of EMIR (see the intra-group transaction under EMIR).
This referral requires, however, the reservation made on account of non-OTC derivatives (considering the divergences in scope of EMIR and MiFID II).
Hence, OTC derivatives as well as non-OTC derivatives, both having the hedge character, should be equally excluded for the purposes of MiFID II ancillary activity exemption.
Potential issue when applying hedging exemption on a cross-border basis may arise in connection with Article 3 of EMIR, which specifies that an EU counterparty can use this exemption with a counterparty in the same group but in a third country only where the European Commission has adopted an implementing act to deem the third country equivalent to the EU (Article 13(2) of EMIR).
Another aspect is the prescriptive approach adopted by ESMA with respect to the necessary content of internal policies and procedures (ESMA EMIR Q&As, OTC Derivatives Question 10) has been extended to MiFID - see in the box Article 5 of the ESMA's Draft of 28 September 2015 of the Commission Delegated Regulation supplementing Directive 2014/65/EU of the European Parliament and of the Council with regard to regulatory technical standards for criteria to establish when an activity is considered to be ancillary to the main business.
ESMA's Final Report of 28 September 2015 contains, however (p. 333), additional explanation from the EU financial regulatory body stating "ESMA disagrees that the positions taken are too restrictive and notes that it does permit portfolio hedging.
It is also reasonable to require a firm to demonstrate some linkage between transactions and its hedging position." Hence, the ESMA's view appears settled in that regard.
The implementation of the said arrangements will come with some costs on the part of market participants.
Non-financial firms making use of the EMIR clearing threshold exemption are required to compute risk reducing transactions already, but, to perform the ancillary activity tests, they will have to revisit calculations in order to include exchange-traded transactions (ETDs).
As ESMA's Cost Benefit Analysis of 28 September 2015 acknowledges (p. 424), firms "will incur one-off staff and IT costs for setting up calculation, and validation procedures of privileged transactions, including risk-reducing transactions, and on-going costs to run those calculations on a periodic basis. For non-financial firms that are using the EMIR exemption, costs may be substantially lower as they already have to identify risk-reducing transactions in respect of their OTC contracts. They would nonetheless still need to amend existing procedures to capture on ETDs."
Article 2(4) fifth paragraph, letter (c) of MiFID II grants permission to be classified as privileged transactions and thus to be set aside for the purposes of the ancillary activity calculations for “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 law or with national laws, regulations and administrative provisions, or by trading venues”.
Article 2(4)(c) of MiFID II establishes two alternatives of liquidity provision programmes that can be exempt from the ancillary activity calculations:
- one being based on requirements by regulatory authorities, and
- the other based on requirements imposed by trading venues.
Under both alternatives it is only the transactions carried out under the liquidity programme that are exempt but not the liquidity provider as a person.
As examples of transactions entered into to fulfil obligations to provide liquidity on a trading venue ESMA considered at the stage of the legislative process the mandatory market making requirements established by the UK energy regulator Ofgem obliging the large electricity suppliers to post the prices at which they buy and sell wholesale electricity on power trading platforms up to two years in advance and to trade at these prices.
ESMA provided, moreover, in the form of Q&As the following clarifications with respect to “obligations to provide liquidity” (Article 2(4)(c) of MiFID II).
Firstly, the term “obligations to provide liquidity” has been presented in the opposition to the related term market maker, which is used in Article 2(1)(j)(i) of MiFID II to determine the scope of the ancillary activity exemption and which is defined in Article 4(1)(7) of MiFID II.
As a consequence, a liquidity provider under Article 2(4)(c) of MiFID II in addition to providing liquidity on a continuous basis and being willing to deal on own account against its proprietary capital has to be under genuine obligations to carry out transactions.
Such obligations have to be specified in advance by the trading venue and have to be the subject of an enforceable agreement between the trading venue and the liquidity provider.
The obligations a trading venue requires liquidity providers to fulfil have to be transparent to other market participants and be applied in a non-discriminatory manner.
The obligations of any liquidity provider have to go clearly beyond the activities of any ordinary market participant providing liquidity in a more general sense by simply trading on the market.
The obligations should contain elements such as or comparable to quoting requirements with a maximum spread, a minimum volume, a minimum quote duration and, depending on the trading model, a maximum response time to provide quotes and a minimum participation rate.
In the ESMA's view, only transactions executed under these obligations should be considered privileged transactions as liquidity trades.
Emission allowances' treatment
Privileged transactions mustn't be extended beyond the above scope, particularly to activities exempt under Article 2(1)(e) - i.e. MiFID II exemption for EU ETS operators.
The conception that activities covered by the MiFID II exemption for EU ETS operators should not be counted when defining what is ancillary to the main business under MiFID II Article 2(1)(j) and (4) has been rejected by the EU financial regulator as it would result in enlarging the scope of privileged transactions mentioned in Article 2(4) - what is not in line with the MiFID II Level 1 text.
Pursuant to ESMA, transactions in emission allowances do not count towards the ancillary activity as far as can be considered as a part of the privileged transactions.
However, considering the ongoing process for MIFID II implementation, it seems, there is still room for discussion on the emission allowances' treatment with respect to the detailed way, in which ancillary-exemption thresholds' calculations are made.
First thing is, the existence and effects of the MiFID II exemption for the EU ETS operators should be carefully accounted for.
This exemption is designed for spot trading and the needs for surrendering CO2 units for the purpose of EU ETS compliance obligation were acknowledged also on the ground of the MiFID II level 1 text.
The second argument has a specific character, but seems important from the systemic point of view. Emission allowances traded spot will be classified financial instruments as of MiFID II entry into force.
But for ancillary exemption calculations data from earlier period are relevant i.e. the period when MiFID II formally was not in force and spot emission allowances had not changed their status yet. Hence, including them in the thresholds' calculations can't be assessed as sistemically consistent.
There is also another important element of this puzzle with respect to emissions trading.
As underlined in a letter of a group of national and European associations of 15 October 2015, emission allowances traded for compliance under the European Emission Trading Scheme are not excluded from the calculations of the MiFID ancillary activity exemption.
The said organisations argue, this means that non-financial counterparties operating industrial installations may find themselves caught by MiFID licensing requirements when they trade emission allowances through subsidiaries.
Exclusion of trading activities conducted by a MiFID authorised firm within the group
The rule that the aggregations made for the threshold's calculations should not include contracts resulting from transactions executed in an entitiy of the group authorised in accordance with MiFID or Directive 2013/36/EU originates from the ESMA's draft RTS of 28 September 2015.
The aforementioned ESMA's Cost Benefit Analysis of 28 September 2015 contains useful remarks in that regard - as follows (p. 418):
"The exclusion of trading activities conducted by a MiFID authorised firm within the group ensures that the test is neutral as to the structure of the group, i.e. whether or not it includes a MiFID authorised firm. As the purpose of the ancillary activity test is to assess the extent to which a firm undertakes non-authorised MiFID activities compared to its overall business, it sounds logic and reasonable to exclude MiFID licensed activities from the scope of ancillary activity in the first place. Such exclusion is also a means of ensuring that the ancillary exemption achieves its full effect. If the MiFID authorised firms' activities were not excluded from the calculation, this entails that a group with a MiFID licensed firm would fail the test, and keep failing the test every year. The only way of breaking that circle would then be to require all trading on own account or the provision of investment services in respect of commodity derivatives to be conducted through that MiFID authorised firm. This would mean that no other entities within the group would be able to trade on own account or provide investment services in respect of commodity derivatives, even for a minimal amount, in an ancillary way. Such outcome would question the very purpose of the ancillary activity exemption and could prove costly in terms of reorganisation within groups."
This exclusion was consistently upheld across subsequent editions of draft regulatory technical standards and maintained in the final Regulation despite the absence of the explicit delegation thereto in the Level 1 text.
Another contentious issue with respect to MiFID II ancillary activity exemption was the period of time for the assessment of the exemption's preconditions.
Recital 36 to MiFID II stipulates that, in order to benefit from the exemptions, the person concerned should comply on a continuous basis with the conditions laid down for the exemptions. In particular, if a person provides investment services or performs investment activities and is exempted from the scope of MiFID II because such services or activities are ancillary to the main business, when considered on a group basis, the person should no longer be covered by the exemption related to ancillary services where the provision of those services or activities cease to be ancillary to the main business.
ESMA for practical reasons and in order to allow for market participants to plan and operate a business in a reasonable way was considering an approach taking as a basis a rolling average of three years.
The notification requirement, however, as MiFID II clearly states, has to be made to the competent authority on an annual basis.
An interim approach was also considered for the process start-up.
It could potentially, as ESMA explained, define a starting date from which the data has to be collected that is necessary for the assessment of whether the person qualifies for the exemption and a second date at which the first calculation and notification to the competent authority has to be made. The first period from collecting the data to the first calculation/notification may be shorter than three years. The following calculations could then be made on an annual basis using a rolling approach until a period of three years can be taken into account on a rolling basis.
The solution adopted must be practical as well as viable, since firms are hardly able to move in and out of the MiFID regime at short time intervals.
Market participants argued, when considering all MiFID II transitory issues, it would be useful to have, practically, a minimum period of twelve months after a firm was deemed to be a MIFID II firm. Even this period of time may occur scarce for licensing proceedings and their preparation until a licence is granted by a financial regulator, as well as to implement the substantial reorganisation and new compliance obligations that a non-financial firm must establish if it becomes subject to a MiFID licensing regime.
It may be to a certain extent surprising that cognizant of the above facts ESMA proposed in December 2014 the approach as regards calculations for the ancillary activity annual test requiring that on 3 January 2017 (being the MiFID II original date of entry into force), persons/groups aiming to make use of the ancillary activity exemption for 2017 would be obliged to notify their national financial authority accordingly, based on the trading data from January 2016 to December 2016 (simple average of monthly input).
Moreover, on 3 January 2018 national financial authority would receive the notifications for the ancillary activity exemption of 2018, based on the trading data from January 2016 to December 2017 (simple average of 24 monthly inputs) and at the beginning of 2019 the interim period would end as the notifications to make use of the ancillary activity exemption for 2019 would be based on calculations using the 3 year rolling average procedure.
The timetable proposed by ESMA in December 2014 was considered entirely impractical and unworkable as it would give firms only 1 working day (2 January 2017) to carry out the calculations, prepare and submit the application for a MiFID II license and get the approval of the application.
It was, moreover, observed, ancillary thresholds' calculations in January 2017 with the use of 2016 data, would give rise to multiple inconsistencies when it comes to legal issues. Among those most oftenly invoked were:
Given the above circumstances it seemed necessary for regulator to revisit its approach regarding ancillary threshold calculations and the MiFID II phasing-in with respect to this process. The more viable thresholds calculations scenario would be based on 2017 data.
However, on 28 September 2015 ESMA proposed a modification capturing the transitory period as from July 2015 as indicated in the schedule below:
The above timetable was intended to allow firms having different accounting periods some time, following the end of the reference period, in order to perform the threshold calculations and to prepare the notifications for the competent authority.
According to the ESMA's Final Report of 28 September 2015, market participants asked ESMA to clarify that legacy transactions (i.e. historic transactions that may still have an open position at the start of the assessment period, would not count towards the thresholds) and that only trades entered into in the relevant assessment period would be included in the calculation. In that regard ESMA was of the view that legacy positions should not be an issue as the two tests are based on trading turnover – activity - over a defined period.
Market participants also asked ESMA to clarify that when applying for a MiFID license, firms should be able to continue performing its activities. A firm first exceeding a threshold, can technically no longer use the exemption and there will be a period of time (likely to be several months) during which the firm will be in the process of obtaining its license and during which that firm would probably and reasonably want to carry on the trading activities. Whilst ESMA recognises the legitimate concern expressed above, it also notes that is has no power to address this situation by implementing measures.
Another issue is, pursuant to ESMA, applicants will not be granted a "second chance" for the exemption in the way of a later reassessment after the firm has failed the annual test, in order to allow the firm reduce the trading activity in commodity derivatives to a level below the thresholds.
The European financial regulator is of the view that the general procedure relies on monthly inputs for 36 consecutive months, which provides several chances to check the firm's position against the thresholds and decide whether to reduce the trading in these instruments in order to fulfil the requirements to benefit from the exemption in the regular annual test.
ESMA set out the modified approach to transitory issues in the Opinion on draft RTS 20 on ancillary activity of 30 May 2016 (ESMA/2016/730) - see box below.
Finally, Article 4 of the Commission Delegated Regulation (EU) of 1.12.2016 introduced the following modifications to the previous calculations' approaches:
- preceding annual calculation periods, starting on 1 January 2015 must be accounted for, and
The calculations are to be carried out annually in the first quarter of the calendar year that follows an annual calculation period (for example, the 2018 calculation should use data from calendar years 2015, 2016 and 2017).
The reference period for the calculation of daily trading activities or estimated capital allocated to such trading activities may comprise only the most recent annual calculation period when the following conditions are met:
In other words, the last year only may be used, if:
- the last year is reduced by more than 10% of the first year, and
MiFID II Recitals explicitly mention that dealing on own account and ancillary activity exemptions can be used in conjunction (see box). This stance is also accepted by ESMA (see: Discussion Paper on MiFID II/MiFIR of 22 May 2014, ESMA/2014/548).
The ancillary exemption may also be cumulated with the MiFID II exemption for EU ETS operators.
As regards the last sentence of Article 2(1)(d) "ESMA is of the view that this sentence cannot be understood in a way that persons fulfilling the criteria of Article 2(1)(j) are not required to meet the conditions of Article 2(1)(d) in order to be exempt in relation to dealing on own account in financial instruments other than commodity derivatives, emission allowances and derivatives thereof.
The differentiation between Article 2(1)(d) and (j) reflects different criteria being applicable to different asset classes. Consequently, ESMA understands the second sentence of Article 2(1)(d) to determine that persons seeking exemption under Article 2(1)(j) are not in addition required to meet the conditions laid down in Article 2(1)(d) in order to be exempt for the exemption under Article 2(1)(j)" (see ESMA's Consultation Paper, MiFID II/MiFIR of 19 December 2014 (ESMA/2014/1570) p. 505).
|Last Updated on Thursday, 28 December 2017 11:24|