MiFID II ancillary activity exemption - capital employed test

Article 3(5) - (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

5. The estimated capital employed for carrying out the activities referred to in Article 1 shall be the sum of the following:

(a) 15 % of each net position, long or short, multiplied by the price for the commodity derivative, emission allowance or derivatives thereof;

(b) 3 % of the gross position, long plus short, multiplied by the price for the commodity derivative, emission allowance or derivatives thereof.

6. For the purposes of paragraph 5, point (a), the net position in a commodity derivative, an emission allowance or derivative thereof shall be determined by netting long and short positions:

(a) in each type of commodity derivative contract with a particular commodity as underlying in order to calculate the net position per type of contract with that commodity as underlying;

(b) in an emission allowance contract in order to calculate the net position in that emission allowances contract; or

(c) in each type of emission allowance derivative contract in order to calculate the net position per type of emission allowance derivative contract.

For the purposes of paragraph 5, point (a), net positions in different types of contracts with the same commodity as underlying or different types of derivative contracts with the same emission allowance as underlying can be netted against each other.

7. For the purposes of paragraph 5, point (b), the gross position in a commodity derivative, an emission allowance or a derivative contract thereof, shall be determined by computing the sum of the absolute values of the net positions per type of contract with a particular commodity as the underlying, per emission allowance contract or per type of contract with a particular emission allowance as the underlying. 
For the purposes of paragraph 5, point (b), net positions in different types of derivative contracts with the same commodity as underlying or different types of derivative contracts with the same emission allowance as underlying cannot be netted against each other.

8. The calculation of the estimated capital shall not include positions resulting from transactions referred to in points (a), (b) and (c) of subparagraph 5 of Article 2(4) of Directive 2014/65/EU.

9. The capital employed for carrying out the main business of a group shall be the sum of the total assets of the group minus its short-term debt as recorded in its consolidated financial statements of the group at the end of the relevant annual calculation period. For the purposes of the first sentence, short-term debt means debt with a maturity of less than 12 months.

10. The values resulting from the calculations referred to in this Article shall be denominated in EUR.

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, Recitals 6, 11 and 12

(6) The second test provides two methods for determining the size of the trading activity in order to compare it to the size of the main activity undertaken by the group. That test takes two forms in order to better reflect the underlying activities of the persons intending to use the exemption whilst minimising the regulatory burden and complexity of implementing the test. The capital test is provided as an alternative to the trading test in order to take into account of the economic reality of the very heterogeneous groups that need to undertake the assessment whether their trading is ancillary to their main business activities, including groups that undertake significant capital investments, relative to their size, in the creation of infrastructure transportation and production facilities, as well as investments which cannot be easily hedged in financial markets. As both forms of the second test cater for the different underlying economic realities of various groups both tests constitute equally suitable methods to determine whether the trading activity is ancillary to the main business of a particular group.

(11) The second method under the second test uses the estimated capital that a non- financial group would be required to hold against the market risk inherent in its positions arising from trading in commodity derivatives, emission allowances and derivatives thereof, other than those from privileged transactions, as a proxy for the amount of ancillary activities undertaken by the persons in a group. The framework developed under the auspices of the Basel Committee and implemented in the Union through the Capital Requirements Directive is used to apply a proportionate notional capital weighting to positions. Within this framework, the net position in a commodity derivative, emission allowance or derivative thereof shall be determined by netting long and short positions in a particular type of commodity derivative contract, emission allowance or derivative contract thereof, such as a future, option, forward or warrants. In determining the net position, netting should take place irrespective of where the contract is traded, the contract's counterparty or its maturity. The gross position in a relevant commodity derivative, emission allowance contract or a derivative contract thereof should, on the other hand, be calculated by adding the net positions of types of contracts that relate to a particular commodity or, emission allowance or derivative thereof. In this context, net positons in a particular type of commodity derivative contract, emission allowance contract or derivative contract thereof should not be netted against each other.

(12) Under the second method of the second test, the amount of the estimated capital of a group is then compared to the actual amount of capital employed of that group that should reflect the size of its main activity. The capital employed is calculated on the basis of the total assets of the group minus its current debt. Current debt should comprise debt that is due to be settled within twelve months. 

Questions and Answers, on MiFID II and MiFIR commodity derivatives topics

Question 9 [Last update: 31/05/2017]

Should the capital employed test be calculated only on the same positions as included in the market size test or for all commodity derivatives traded in the group?

Answer 9

Article 3(1) b) RTS 207 refers to the estimated capital employed for those activities referred to in Article 1 of RTS 20. According to Article 3(3) RTS 20 the size of the activities referred to in Article 1 shall be calculated by aggregating the size of the activities with respect to all of the asset classes referred to in Article 2(1). Accordingly, the numerator of the capital test is calculated on the basis of the same positions as included in the market size test as only those asset classes referred to in Article 2(1) shall be included.

Question 10 [Last update: 02/10/2018]

Should the denominator in the capital test under Article 3(9) of RTS 20 be calculated using consolidated accounts? Should firms use capital on a worldwide basis or just capital employed within the EU?

Answer 10

The RTS 20 capital test should be calculated using consolidated accounts. According to Article 3(9) of RTS 20, the capital employed for carrying out the main business of a group shall be the sum of the total assets of the group minus its short-term debt as recorded in the consolidated financial statements of the group at the end of the relevant annual calculation period.

Firms shall use capital employed on a worldwide basis when calculating the capital test.

Question 14 [Last update: 13/11/2017]

RTS 20 refers only to Article 360 of the CRR, while the ‘simplified approach for calculating regulatory capital requirements’ is contained in CRR Articles 357, 358 and 360. Is the text in RTS 20 self-contained or should firms refer to the whole of CRR?

Answer 14

Article 3(5)(6)(7) of RTS 20 replicates the content of Articles 360(1) and 357(3) of Regulation (EU) No 575/2013 of 26 June 2013 (CRR). RTS 20 contains the stand-alone test that needs to be performed without firms having to refer to the rest of the articles that relate to commodity derivatives in the CRR. However, firms may find it useful to refer to the EBA Q&A on clarification of the treatment of positions in commodities for the purposes of calculating net and gross positions according to Article 360(1) of CRR.

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, Explanatory Memorandum

With respect to the numerator (which denotes the capital employed for "speculative" trading activity) ESMA submitted five options. These options were assessed against the aims of creating a workable capital based test:

(1) Option 1 - Gross notional value of derivatives trading. This option has the benefit of simplicity and availability but, importantly, it is not a capital allocation measure. The use of "gross notional" is therefore not in line with the aim to establish a 'capital allocation' measure.

(2) Option 2 - Simplified approach derived from the Capital Requirements Regulation (Regulation 575/2013, CRR). This option is relatively simple, although groups may need some initial guidance on how to apply it in practice.
Option 2 has the advantage of being a capital measure (capital is calculated as 15% of the net derivative position plus 3% of the gross derivative position).

(3) Option 3 - Mark-to-market (MTM) valuation of speculative derivatives. This is not a capital measure, but rather a measure reflecting the "risk profile" or "financial exposure" of a firm. The measure is also subject to considerable volatility as the value of both positive and negative exposures is in permanent flux, in line with underlying markets. Furthermore, the mark-to-market measure exposes groups and competent regulators to the risk that results are unreliable as they would be exposed to considerable price volatility, notably on short positions.

(4) Option 4 - Approach based on margin requirements for exchange traded derivatives. Apart from not being a capital measure, this measure also has the disadvantage of overestimating the speculative activity of a company by including margin posted for hedging positions. But this measure could also underestimate speculative trading of a firm that speculates in OTC derivatives, where no margin needs to be posted.

(5) Option 5 - Approach based on the European Supervisory Authorities' methodology for margin requirements for OTC derivative contracts which are not centrally cleared. While this measure could be easily adapted for the purposes of MIFID II, ESMA did not submit a calibration methodology in how to apply this test in practice.

Based on the above assessment, the most suitable measure to determine the size of non- hedging trading activities is the one based on the simplified CRR method. This is because this metric is derived from an internationally agreed framework for regulatory capital and it gives a proportionate measure of the size of the positions in commodity derivatives. It is directly related to the gross amount of trading, which represents the activity in this sector. Other measures identified by ESMA are less sophisticated capital metrics, or measure the profit (or loss) of the trading position rather than the activity itself. On careful consideration of the most accurate measure and the complexity of implementation of the capital based test, the CRR metric is the most attractive.

With respect to the denominator (which denotes the capital employed in the pursuit of a group's main business activity), the following options were assessed:
(1) Accounting measure of Plant Property and Equipment ('PP&E'), or
(2) Total equity, or
(3) Other measures of financing (combining debt and equity).

PP&E is not suitable for intermediaries with low investment in PP&E, whereas total equity fails to reflect all the investments in operational infrastructure when they are financed through debt. A broader measure of financing, such as capital employed, would avoid these shortcomings. Capital employed would be calculated as the group's total equity plus its long- term liabilities or, alternatively, total assets minus short-term liabilities of the group.

ESMA, in its opinion of 30 May, signalled that such a wider measure of financing may be appropriate. This option would closely resemble the generally accepted measure of "capital employed" by combining total equity with long term debt. This metric is the most suitable to measure the capital employed in a diversified group's main activity.

There is, however, a risk that a total equity plus debt measure may be prone to overestimating a group's main business activity, as equity and debt could also be used to finance non-commercial or speculative assets of a company. The capital employed measure, would therefore have to be applied in a prudent manner. On balance, this shortcoming can be overcome by sufficiently prudent regulation. Capital employed would, therefore, remain the most suitable measure denoting a group's main activity.

With respect to the applicable threshold, ESMA, in its draft RTS of 28 September, proposed a 10% threshold. As the capital test, like the trading test ESMA proposed in the draft of 28 September, aims at capping the amount of speculative derivatives trading a group may engage in without requiring authorisation under MiFID II, it appears appropriate to retain a threshold of 10% also in relation to the capital test.