Commodity market participants raise concerns that Europe’s new rules to implement MiFID will impact their ability to trade in commodity derivatives.
Later this year, Europe’s market regulators will put the final touches on the rules that will implement MiFID II, the latest edition of the Markets in Financial Instruments Directive. While the primary goal is to increase competition and consumer protection in investment services, commodity market participants are deeply worried that the new rules will have a disruptive impact on trading in commodity derivatives, causing many companies to reduce their trading or withdraw altogether.
MiFID II came into force in July 2014 and will begin to apply in January 2017. The market is now waiting for the European Securities and Markets Authority to finalize the technical and implementation standards, known as RTS and ITS, that will determine the critically important details of the new regulatory framework.
Since last December, when ESMA released a consultation on its draft rules, commodity market participants have voiced their concerns about the potential impact in a blizzard of public statements and letters to government officials. ESMA officials have shown some willingness to address these concerns by revising the rules, but even so the new regulatory regime is likely to cause deep structural changes in how commodity derivatives markets function.
Broader Scope
One of the biggest changes is that many more firms will be affected. MiFID II has broadened the range of financial instruments that are captured compared to its predecessor MiFID I and has narrowed the exemptions that many commodity trading firms previously benefitted from, greatly expanding the number of commodity firms that may be swept into the new regulatory framework. It also gives national regulators the authority to set position limits on both exchangetraded and over-the-counter commodity derivatives.
For oil merchants, food processors and other non-financial companies active in the physical commodity markets, this will create a whole new compliance challenge. In order to qualify for an exemption, traders and compliance managers will have to make sure that their commodity derivative trading activities are “ancillary” to their physical business at the group level. They also must consider the size of their trading activity in any particular commodity derivatives market compared to the overall EU trading activity in that same market.
Many commodity market participants are worried that the proposed thresholds are far too low and would force a host of non-financial firms to comply with rules that were designed for banks, hedge funds and other financial players. ESMA officials have acknowledged this concern, but argue that the purpose of the test is to capture large non-financial players that are ”substantially involved” in speculative trading, as mandated in the MiFID II legislation.
“ESMA is certainly willing to approach this important test cautiously,” ESMA Chairman Steven Maijoor said at a July 15 hearing before the European Parliament’s Economic and Monetary Affairs Committee. “However, let me also emphasise that the public discussion often goes in the wrong direction suggesting that the ESMA test is not right because it may require a MiFID license for some non-financials.”
“That is the whole point of the test in the first place,” he continued. “The exemptions from financial regulation should be narrowed, opaque parts of the market should be reduced, and large non-financial players conducting activities identical to financial players should compete on a level playing field.”
Fear of Fragmentation
Although MiFID II will not come into effect until January 2017, the nature of the regulatory process requires firms to start planning far in advance. That means a firm has to determine whether it is in scope or not well before the January 2017 deadline.
If firms who are currently classed as non-financial counterparties decide to apply for a license to operate under MiFID II, this will require them to apply to become regulated entities with their National Competent Authority. It can take up to six months for an NCA to act on such an application, so in effect firms need to make strategic decisions fairly soon, probably by the start of 2016.
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FIA Europe Backs Capital Relief for Commodity Firms On July 23, FIA Europe joined with the European Federation of Energy Traders and the International Swaps and Derivatives Association in publishing a position paper regarding the capital requirements regime for commodities. The paper calls for a three-year extension of the exemptions for commodity firms that are due to expire at the end of 2017, and urges the European Commission to consider the concerns of commodity firms about the potentially harmful impact of these rules on European commodity markets. “Such an extension would allow sufficient time for the European Commission to consider thoroughly the nature and risk profile of commodity firms in the context of the ongoing review of the capital requirements regime,” the paper said. “The extension is also needed because the commodities markets may be significantly altered as a result of simultaneous and interrelated regulatory developments, e.g. the implementing measures of the recast Markets in Financial Instruments Directive II (MiFID II).” The three associations pointed out that essential elements of MiFID II remain to be agreed, which makes it impossible to determine which commodity contracts and companies will be subject to MiFID II and the related capital regime. “A more accurate and detailed assessment may only be feasible once MiFID II starts applying from January 3, 2017,” they warned. |
Once regulated, they will be classed as a financial institution and so have to comply with what applies to financial institutions, notably the stringent capital adequacy rules of the Capital Requirements Directive (CRD IV). This leads to another crucial issue for commodity market participants. The capital adequacy rules are written for banks, and very few if any commodity trading firms are set up to meet those sorts of requirements.
“The big problem for us is capital,” said a compliance officer of a medium-sized commodity merchant and financer who spoke on condition of anonymity. “We are not a systemically important firm, so making us or many of our peers comply with capital market rules to me doesn’t really make sense. It would be strategy changing if capital costs were to be prohibitive.”
The potential market impact has alarmed commodity traders to such a degree that some of the world’s largest commodity firms have banded together to make joint appeals to government officials. In June, top executives from six leading firms—BP, E.ON, Mars, RWE, Shell and Vitol— joined with several exchanges and trade associations in expressing their concerns to Jonathan Hill, EU Commissioner for Financial Stability, Financial Services and Capital Markets Union. They stressed that their companies depend on “well functioning commodity markets” to serve their customers, and warned that new regulations carry a “significant unintended risk” of damaging these markets, increasing the cost of hedging, and causing greater volatility in commodity prices.
"We are particularly concerned by the extension of rules that have been developed for publicly listed securities markets and credit markets to commodities in MiFID II,” the group wrote. “We believe the collective effect of these rules will be to increase the cost of price discovery and hedging via the unintended consequence of liquidity fragmentation in wholesale markets,” the letter said.
This comes on top of a related trend that also threatens to reduce liquidity. Over the last several years, a number of large banks, including Barclays, Deutsche Bank, J.P. Morgan, Morgan Stanley and UBS, have drastically cut back their participation in commodity markets. Although some of their operations have been taken over by commodity players, the new owners are not likely to play the same market- making role as the banks. This is particularly important in the OTC markets, which are very important for certain types of hedging.
“My biggest concern is liquidity,” said Clive Furness, managing director of Contango Markets, at a panel discussion on commodity markets at the FIA’s IDX conference in June. “We’ve seen the banks exiting and I don’t think we’ve seen the last of that.”
Furness added that commodity trading firms tend to interact with the derivatives markets in a different way than banks because of their vertical integration. A company that owns physical in-frastructure in different parts of the supply chain may be able to offset much of its risks internally, reducing the amount of risk that it needs to offload into the derivatives markets.
“That will have a massive liquidity impact on all of the commodity markets,” he said. “It will make the illiquid contracts untradeable and the very liquid ones patchy at best.”
Uncertainty Over Position Limits
Another major issue facing the industry is uncertainty around the calculation of position limits, a key component of the new regulatory regime introduced by MiFID II. Exchanges, banks and trading firms are trying to anticipate what the regulatory authorities will use to calculate deliverable supply, currently likely to be the key component in the calculation of position limits.
For oil merchants, food processors and other non-financial companies active in the physical commodity markets, MiFID II will create a whole new compliance challenge.
The suggested position limit for each commodity derivative is 25% of deliverable supply, but national regulators will be able to adjust this baseline figure by 15%—so a minimum of 10% and maximum of 40%—based on seven factors: maturity, deliverable supply, open interest, volatility, number and size of market participants, characteristics of the underlying market and the development of new contracts.
This leaves a great deal still to be determined, causing much uncertainty for market participants. “You cannot underestimate the incredible amount of market disruption that this ‘unknown’ causes,” Kirstina Combe, head of regulation at London Metal Exchange, said during the IDX panel.
National regulators will establish and apply position limits not only for commodity derivatives traded on trading venues but also economically equivalent contracts traded over the counter.
ESMA believes the scope for economically equivalent contracts should be narrow so it doesn’t dilute the integrity of position limits. As such, it has proposed that the OTC contract should be referenced to a contract traded on a trading venue in the European Union, or it should have fundamentally the same characteristics with regard to the contract specification as the exchange-traded one.
Limited Offset
This makes things particularly difficult for banks. The limits apply to their positions on a net basis, so a long position in a trade with one customer can be offset by a short position with another. But a contract that is not considered economically equivalent, such as a swap traded outside of Europe, cannot be added to this calculation, which has the effect of reducing their capacity to offer hedges to their customers.
“Banks tend to hedge their risk on a portfolio level,” Tony Ricci, commodities compliance officer at BNP Paribas, explained at the IDX panel. “You might do a Singapore gasoil swap and hedge it with a Brent future because they are correlated. That would then give the banks flexibility to lay off the risk that they are taking on by providing risk management to corporates.”
“If (banks) can’t lay that risk off, it’s going to be costlier for corporates to hedge,” he added. “If you’re at your limit on a European exchange, there isn’t much option other than running with the risk, which banks don’t want to do. Worst case scenario, you are going to have to turn down corporates in terms of providing risk management services."
