Seventh Annual MIG seminar: The Impact of MiFID II and EMIR on CommoditiesHannah Meakin (Partner) and Cat Blake (Associate)5 March 2014

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Overview• MiFID II: What are “financial instruments”?

• Additions and amendments to the type of financial instrument that is within scope of MiFID

• MiFID II: Who is within the scope of MiFID II?• Additions and amendments to the MiFID exemptions• Are the “exemptions” really exemptions?

– Position limits and position management powers– Algorithmic trading and HFT

• The link with EMIR– How does MiFID II impact on post-trade obligations

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MiFID II: What are “financial instruments”?

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MiFID financial instruments: commodity derivatives MiFID I Any changes? What’s the impact?Commodity derivatives that must be cash settled or may be cash settled (other than by reason of default or termination)

No N/A

Commodity derivatives which can be physically settled provided they are traded on an RM, MTF or OTF except for REMIT wholesale energy products traded on an OTF which must be physically settled

Yes• Includes such derivatives

traded on an OTF• The REMIT carve out – subject

to an RTS• Subset of these instruments

which relate to coal or oil, are traded on an OTF and must be physically settled are subject to transitional provision in respect of EMIR obligations – subject to an RTS

• Inclusion of OTF potentially includes much wider category of instruments. Note that they will (subject to transitional provision) be in scope of EMIR and OTC for the purposes of EMIR. Impact on EMIR threshold calculations

• REMIT carve out – these products will not be in scope of MiFID or EMIR

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MiFID financial instruments: commodity derivativesMiFID I Any changes? What’s the impact?Commodity derivatives that can be physically settled but are not traded on an RM, MTF or OTF, nor a REMIT instrument, are not for commercial purposes and which have the characteristics of other derivative financial instruments

Yes – RTS on derivative contracts that have “the characteristics of other derivative financial instruments”

Not yet clear

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MiFID financial instruments: commodity derivativesMiFID I Any changes? What’s the impact?Derivatives relating to climatic variables, freight rates or inflation rates or other official economic statistics or any other assets, rights, obligations indices or measures not otherwise mentioned that must be or may be cash settled (apart from default or termination); and have the characteristics of other derivative financial instruments having regard to whether they are traded on an RM, MTF or OTF

Yes:• Now includes assessment of

whether they are traded on an OTF

• RTS to be published on “having the characteristics of other derivative financial instruments”

Inclusion of OTF potentially includes much wider category of instruments

Potential impact of the RTS – not yet clear

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MiFID financial instruments• Emission allowances consisting of any units recognised for

compliance with the requirement of the EU Emissions Trading Scheme are now MiFID financial instruments

• But are not EMIR instruments• Note that derivatives on emission allowances remain both MiFID

financial instruments and EMIR instruments

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MiFID II: Who is within scope?

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MiFID II: The common exemptions used by commodity market participants

• The changes to the MiFID exemptions will have a significant effect on the commodities markets participants.

MiFID I exemption Still available? Any amendments?

2(1)(b) – “the group exemption”

Yes No

2(1)(d) – “the dealing on own account exemption”

Yes Now only applies to financial instruments other than commodity derivatives, EUAs and derivatives on EUAs and has additional requirements

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MiFID II: The common exemptions used by commodity market participants

MiFID I exemption Still available? Any amendments?

2(1)(i) – “the ancillary business exemption”

Yes Significant amendments have been made to this exemption – see following slides

2(1)(k) – “the commodities dealer exemption”

No N/A

• Any firms which currently rely on any of these exemptions would be well advised to revisit and update their MiFID analysis

• NB there are other exemptions in MiFID, this presentation focuses on those which are commonly used by commodity market participants

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MiFID II: Exemptions – what’s the impact?Article 2(1)(i): Entities who, in relation to commodity derivatives, EUAs or EUA derivatives:

• deal on own account• excluding those who deal on own account by executing client orders (execution of

orders as an ancillary activity between two persons who main business on a group basis is neither the provision of investment services under MiFID nor banking services under the BCD should not be considered dealing on own account by executing client orders); or

• provide investment services other than dealing on own account to the customers or suppliers of their main business

Provided:• In both cases, individually and on aggregate basis, this is an ancillary business to

their main business when considered on a group basis;• Main business is not the provision of investment services under MiFID or banking

services under BCD, nor acting as a market maker in relation to commodity derivatives;

• They do not apply a high frequency algorithmic trading technique; and• They notify the relevant competent authority that they make use of this exemption on

an annual basis and, on request, provide to the relevant competent authority the basis on which they consider the activity to be ancillary to their main business

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MiFID II: The exemptionsThere are also new exemptions in relation to:• Operators with compliance obligations under the ETS trading

directive• Transmission system operators under the electricity and natural

gas directives and regulations

And optional exemptions for:• JVs set up for the hedging requirements of local electricity

undertakings or operators (as defined in the ETS trading directive)

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MiFID II: The exemptionsCan we really describe them as exemptions any longer?

• Persons relying on new 2(1)(da) or (i) will be subject to the MiFID provisions in relation to algorithmic trading to the extent that they are members of or participants in a RM or MTF

• The position management and position limit powers of both the NCAs and ESMA apply to anyone with a commodity derivative position – regardless of whether they are exempt under any part of Article 2

• Product intervention powers of NCAs apply to anyone regardless of whether they are exempt under any part of Article 2

• The trading obligation in respect of OTC derivatives applies to EMIR NFC+s regardless of the fact that they are exempt under Article 2

Active intervention in markets: position limits• The four step process for setting of position limits for commodity

derivatives:Layer 1 • Competent authority shall impose position limits in line with technical

standards determined by ESMA to prevent market abuse or support orderly pricing and settlement conditions

• Does not apply to hedging activity of non-financial entitiesLayer 2 • ESMA opines on whether position limits are in line with objectives and

methodology

Layer 3 • Competent authority can set more restrictive limits where objectively justified and proportionate taking account of liquidity and orderly market for 6 monthly renewable periods

Layer 4 • ESMA must opine on whether this is necessary

Active intervention in markets: position management• Trading venues must have position management powers for commodity derivatives:

• Monitoring open positions• Access to information about positions• Require a person to terminate or reduce a position• Require a person to provide liquidity back into the market

• Competent authorities can:• Require information about size and purpose of position or exposure in a commodity derivative or

underlying; and• Request a person to reduce positions and exposures in any derivative

• ESMA can:• Request information about size and position of any derivative and require a person to reduce it • Limit ability of a person to enter into a commodity derivative• To address a threat to viability of financial system or orderly functioning and integrity or competent

authorities’ actions are inadequate• Daily position reporting to competent authority by trading venues for commodity derivatives, emission

allowances and derivatives on them• Weekly report of aggregate positions by category of trader, commercial undertaking, investment firm

etc. to public• Complete breakdown of positions of members and clients to competent authority on request • Daily position reporting of own and client positions to trading venue by members of an RM or MTF

and clients of an OTF

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The link between MiFID II/MiFIR and EMIR

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MiFID II and EMIR: How they work togetherEMIR instruments

• EMIR definition of derivative points to MiFID – if a particular product is a now a MiFID instrument (C4-C10) then it will be within scope of EMIR

• In particular look out for what commodity derivatives are being traded on OTFs• Note the REMIT carve out – these will not be within scope of EMIR

Counterparty classification• A counterparty that is no longer able to rely on the MiFID exemptions and has to become

authorised under MiFID will, upon such authorisation, become an FC for the purposes of EMIR• More onerous obligations under EMIR, and potential notifications to existing

counterparties

The concept of OTC trading• Remember that EMIR classes any derivative trade not executed on a RM as OTC

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MiFID II and EMIR: How they work togetherThe transitional provision (Article 99 MiFID)• Clearing and collateralisation obligations will not apply in relation

to derivatives in relation to coal or oil that are traded on an OTF and must be physically settled (further details to be provided in an RTS) entered into by NFC+s or those firms that have to become authorised under MiFID for the first time as a result of MiFID II; and

• Such derivatives shall not be considered OTC derivatives for the purposes of the clearing threshold calculations of NFCs

Will be available for 42 months after the entry into application of MiFID II

Does not apply to the EMIR reporting and other risk management obligations

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MiFID II and EMIR: How they work togetherThe Trading Obligation (Articles 24-27 MiFIR)• FCs and NFC+s must execute all transactions in derivatives which have been declared subject to the

Trading Obligation on a Regulated Market, MTF, OTF or third country trading venue

• The process for determining which derivatives will be subject to the Trading Obligation is similar to that for the Clearing Obligation. Although note that the derivatives must have been declared clearing eligible to be considered for the Trading Obligation

• Applies to trades with third country counterparties who would be FCs or NFC+s if they were in the EU – the same as the Clearing Obligation under EMIR

• Direct applicability to third country entities where contract has direct, substantial and foreseeable effect within the EU or where the obligation is necessary or appropriate to prevent the evasion of the MiFIR

• Similarly to third country CCPs and TRs, the use of third country trading venues to satisfy the obligation will be subject to positive equivalence decisions by the Commission

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MiFID II and EMIR: How they work togetherPortfolio compression

• Investment firms providing portfolio compression required to make public through an APA the volume of derivative transactions subject to portfolio compression and the times they were concluded in accordance with Article 9 of MiFIR

• Investment firms providing portfolio compression have to keep complete and accurate records of all portfolio compressions they organise or participate in (RTS to be published on this)

Indirect Client Clearing for exchange traded derivatives

• Are permissible (but not required) provided that the arrangements do not increase counterparty risk and ensure assets and positions of the counterparty benefit from protection equivalent to that required by Articles 39 and 48 of EMIR (RTS to be published on this)

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A few conclusions1. Entities which deal on own account in commodity derivatives

that are part of investment services or banking groups are unlikely to be exempt under MiFID II

2. Entities who currently rely on any of the exemptions mentioned in this discussion will need to revisit their current regulatory analysis

3. The required regulatory analysis under MiFID II is going to involve the analysis of the business (on a group level) against a number of metrics and measurements – is your business organised in a way that will allow you to do this?

4. Even if you are exempt, MiFID II and MiFIR will still impact your business

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