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Pim Heemskerk25 September 2014

Coffee, you and MiFID 2!

Impact of MiFID 2 on derivatives

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© Simmons & Simmons 2008

Key impacts (1)

MiFID 2/MiFIR impacts derivatives business broadly…

• dealing on own account (e.g. narrowing of exemption)• senior management and internal controls (e.g. governance,

composition of board)• electronic trading (e.g. DMA, algotrading)• conduct of business (e.g. inducements, best execution)• product governance and intervention (e.g. extension of

complex product definition to embedded derivatives, intervention powers national regulators and ESMA)

extended and new rules on

financial instruments

and investment firms

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Key impacts (2)

…however

• commodity derivatives

• market structure

2 key impacts

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Key impacts (3)

Key impacts on derivatives market structure

Topic Article

Organised trading facilities (OTFs) 4(1)(23) and 20 MiFID

Pre-trade transparency on trading venues 8 MiFIR

Post-trade transparency on trading venues 10/21 MiFIR

Transparency for systematic internalisers (SIs) 14-18 MiFIR

Trading obligation 28 MiFIR

Mandatory clearing of ETDs 29 MiFIR

Indirect clearing of ETDs 30 MiFIR

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Key impacts (4)

Main objectives

risks of market

disorder

systemic risk

efficiency of financial

markets

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OTFs (1)

What is it?

Newly regulated multi-lateral system which is not a regulated market (RM) or a

multi-lateral trading facility (MTF) and in which multiple parties buying and

selling e.g. derivatives are able to interact in a way that results in a contract

Wide definition to capture all forms of trading venues in non-equities currently

outside of scope (e.g. swap execution facilities)

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OTFs (2)

Rationale for introduction

Greater transparency

Level playing field between trading venues

Capture trading on order books outside RM or MTF

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OTFs (3)

Key features

OTFs will be subject to the same pre- and post-trade transparency rules as

RMs and MTFs

Unlike RMs and MTFs, execution on, and access to, OTFs will be discretionary

OTFs will be subject to the conduct of business rules, best execution and client

order handling obligations

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OTFs (4)

Key features (cont’d)

An OTF will not be able execute against its own proprietary capital or that from

any entity that is part of the same group or legal person

An OTF will be restricted from linking up with another OTF for the purpose of

allowing orders from the different venues to interact with each other

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Pre-trade transparency (1)

What is it?

Publication by RM, MTF or OTF of current bid and offer prices and depth of

trading interests

Extended to e.g. derivatives admitted to trading on a trading venue (i.e. RM,

MTF or OTF), or which are clearing-eligible under EMIR

Transparency rules calibrated in Level 2 for different types of trading systems,

including order-book, quote-driven, hybrid, periodic auction trading and voice

trading systems

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Exemptions etc.

Exemption for portfolio compression

Regulator can give waivers of pre-trade transparency for e.g. illiquid

derivatives

Regulator can suspend pre-trade transparency for max 3 months if liquidity

falls below certain threshold

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Venue/IF

RM MTF OTF IF=SI IF≠SI

Now MiFID 2 Now MiFID 2 MiFID 2 Now MiFID 2 Now MiFID 2

No Yes No Yes Yes No Yes No No

Overview pre-trade transparency rules for derivatives

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Post-trade transparency (1)

What is it?

Publication by RM, MTF or OTF of price, volume, time an details of

transactions as close to real-time as is technically possible

Extended to of e.g. derivatives admitted to trading on a trading venue, or which

are clearing-eligible under EMIR

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Exemptions etc.

Exemption for portfolio compression

Regulator can authorise deferred publication for e.g. illiquid derivatives

Regulator can suspend post-trade transparency for max 3 months if liquidity

falls below certain threshold

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Venue/IF

RM MTF OTF IF=SI IF≠SI

Now MiFID 2 Now MiFID 2 MiFID 2 Now MiFID 2 Now MiFID 2

No Yes No Yes Yes No Yes No Yes

Overview post-trade transparency rules for derivatives

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Transparency for SIs (1)

What is it?

“An investment firm which, on an organised, frequent systematic and

substantial basis, deals on own account when executing client orders outside a

RM, an MTF or an OTF without operating a multi-lateral system”

Introduction of objective criteria to measure “frequent systematic and

substantial basis” at Level 2

Operation of an OTF and SI not allowed within the same legal entity

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Firm quote requirements

SI must make any quote it provides to one client available to all of its other

clients and must undertake to enter into transactions under the published

conditions with any other client to whom the quote is made available when the

quoted size is at or below a particular size

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Firm quote requirements (cont’d)

Only if

– financial instrument is traded on RM, MTF or OTF

– there is a liquid market

If no liquid market, SI must disclose upon request (regulator may give waiver)

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Firm quote requirements (cont’d)

SI will be allowed to update and, under exceptional market conditions,

withdraw quotes and

SIs will be allowed to establish “commercial policy” protections

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Trading obligation (1)

What is it?

In line with G20 Pittsburgh commitments, FCs and NFC+s must trade

derivatives of an EC designated class with FC and NFC+s on

– RM

– MTF

– OTF

Exemption for intragroup transactions and portfolio compression

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Designated class of derivatives

Eligible for trading obligation only if

– subject to EMIR clearing obligation

– admitted to one or more trading venues

– sufficiently liquid

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Sufficiently liquid

To be determined in Level 2 considering

– average frequency of trades (trading days, trades, or both?)

– average size of trades (total turnover divided by trading days or trades?)

– number and type of active market participants (members doing at least on

transaction, being contractually committed to provide liquidity, or both

members and their clients?)

– average size of spreads (end-of-day bid-ask spreads of most liquid market?)

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Designated class of derivatives (cont’d)

ESMA proposes trading obligation to EC 6 months after EC approval of EMIR

clearing obligation

ESMA register of classes of derivatives subject to trading obligation

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Extraterritoriality

Third country venue with MiFIR equivalence eligible for trading obligation upon

recognition by EC

Trading obligation also applicable to derivatives transactions:

– between FC/NFC+ and third-country FC/NFC+ equivalent parties under EMIR

– having a direct, substantial and foreseeable within the EU

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Our regulatory team for Dutch clientsRezah StegemanPartnerE: [email protected]

Aron BerketProfessional Support OfficerE: [email protected]

Pim HeemskerkSupervising AssociateE: [email protected]

Joyce KerkvlietSupervising Associate E: [email protected]

Guido RothPartnerE: [email protected]

Janice RoepnarainSupervising AssociateE: [email protected]

Manon HosemannPrincipal CounsellorE: [email protected]

Niek Groenendijk AssociateE: [email protected]

Bernard VerbuntPartnerE: [email protected]

Dirk-Jan GerritsAssociateE: [email protected]

Charlotte StalinPartnerE: [email protected]

Wiren GowricharnProfessional Support OfficerE: [email protected]

Pieter KortbeekAssociateE: [email protected]

Coffee, you and MiFID 2!

Jonathan Melrose 25 September 2014

Impact of MiFID 2 / MiFIR - Commodities

© Simmons & Simmons LLP 2014. Simmons & Simmons is an international legal practice carried on by Simmons & Simmons LLP and its affiliated partnerships and other entities.

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Commodity Derivatives – Background to the changes under MiFID II Policy developments since MiFID 1

Communique of G20 finance ministers and central bank governors 15 April 2011 – commodity derivatives markets should be subject to appropriate regulation and supervision: therefore certain exemptions to be modified (MiFID 2, Recital (19))

G20 summit in Pittsburgh on 25 September 2009 agreed to improve the regulation, functioning and transparency of financial and commodity markets to address excessive commodity price volatility. Note also the Commission Communications of 28 October 2009 on ‘A Better Functioning Food Supply Chain in Europe’, and of 2 February 2011 on ‘Tackling the Challenges in Commodity Markets and Raw Materials’.


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Commodity Derivatives – Background to the changes under MiFID II (continued) IOSCO Principles for the Regulation and Supervision of Commodity Derivatives

Markets, endorsed by the G20 summit in Cannes on 4 November 2011 which called for market regulators to have formal position management powers, including the power to set ex ante position limits as appropriate. (MiFID 2, Recital (125))

Concerns relating to the spot secondary markets in emission allowances (MiFID 2, Recital (10))


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Key Changes

Scope - additional commodity derivatives within MiFID II

Exemptions - reduction in the number of exemptions available to commodity dealers

Introduction of position limits for commodity derivatives

Position reporting for commodity derivatives

Position management

…and other provisions applying to derivatives generally


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Scope of financial instruments

Extended scope

Impacts - for example: – Impact on authorisation requirements – Impact on EMIR/EMIR reporting obligations – Impact on Transaction Reporting

In relation to commodities MiFID II scope will cover: – Cash settled commodity derivatives (i.e. must be cash settled or may be

cash settled at the option of one of the parties) – Physically settled commodity derivatives (i.e. that can be physically settled)

traded on an RM, MTF or OTF – Carve out for ‘wholesale energy products within the scope of REMIT that

are traded on an OTF and must be physically settled;


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Scope of financial instruments (continued)

– certain transitional relief (to July 2020) relating to EMIR in relation to relating to EMIR for “C6 Energy Derivative Contracts” relating to coal or oil that are traded on an OTF and must be physically settled (the clearing obligation and risk mitigation techniques will not apply to C6 energy derivative contracts entered into by an NFC+ or by non-financial counterparties authorised for the first time as investment firms as from 3 January 2017; will not be considered to be OTC derivative contracts for the purposes of the clearing threshold)

Other physically settled commodity contracts not being for commercial purposes and having the characteristics of other derivative financial instruments

Exotic derivatives – cash settled (as above) or otherwise having the characteristics of other derivative financial instruments

Emission allowances


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Scope of financial instruments: Level 2 - Consultation Paper MiFID/MiFIR – ESMA 2014/549 Annex 1, C6 Derivatives

Draft Technical advice focusses on clarifying the concept of “must physically be settled”

Consideration of operational netting in the gas and power markets

Also to be considered – extent of meaning of oil for the purposes of the C6 energy derivatives definition

(6) Options, futures, swaps, and any other derivative contract relating to commodities that can be physically settled provided that they are traded on a regulated market, and/or an MTF, or an OTF, except for wholesale energy products traded on an OTF that must be physically settled;


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Scope of financial instruments: Level 2 - Consultation Paper (continued)

Draft technical advice 1. Contracts must be physically settled if:

i. the party to the contract entitled to receive the underlying commodity has an unrestricted and unconditional right to physical delivery;

ii. there is no option for either party to replace physical delivery with cash settlement; iii. the obligations under the contract cannot be cancelled out against obligations from other

contracts between the parties concerned. 2. The existence of force majeure provisions do not prevent a contract from being characterised

as "must be physically settled" for the purposes of further specifying wholesale energy products under Section C 6 and C 6 energy derivative contracts.

3. The existence of other bona fide clauses rendering it impossible to perform the contract on a physical settlement basis do not prevent a contract from being characterised as "must be physically settled" for the purposes of further specifying wholesale energy products under Section C 6 and C 6 energy derivative contracts.

4. Contracts that are physically settled have a broad range of delivery methods including the following: i. physical delivery of the relevant goods themselves; ii. delivery of a document giving rights of an ownership nature to the relevant goods or the

relevant quantity of the goods concerned (such as a bill of lading or a warehouse warrant); or


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Draft technical advice (continued)

iii. another method of bringing about the transfer of rights of an ownership nature in relation to the relevant quantity of goods without physically delivering them (including notification, scheduling or nomination to the operator of an energy supply network) that entitles the recipient to the relevant quantity of the goods.


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Scope of financial instruments: Level 2 - Consultation Paper (continued) Annex 1, C7 Derivatives

(7) Options, futures, swaps, forwards and any other derivative contracts relating to commodities, that can be physically settled not otherwise mentioned in point 6 of this Section and not being for commercial purposes, which have the characteristics of other derivative financial instruments, having regard to whether, inter alia, they are cleared and settled through recognised clearing houses or are subject to regular margin calls;


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Scope of financial instruments: Level 2 - Consultation Paper MiFID/MiFIR – ESMA 2014/549 (continued)

Draft technical advice A contract should be considered as having the characteristics of other derivative financial instruments if it is standardised and if it trades in line with conditions outlined in the following paragraphs. The contract must neither be a spot contract nor a contract for commercial purposes only in line with the conditions outlined below. 6. A contract should be considered as standardised if parameters such as the price, the lot, the

delivery date or other terms are determined principally by reference to regularly published prices, standard lots or standard delivery dates.

7. A contract should be considered as traded in such a way as having the characteristics of other derivative financial instruments if: i. it is traded on a third country trading venue that performs a similar function to a

regulated market, an MTF or an OTF as far as contracts within the scope of Section C 6 of Annex I to Directive [new MiFID] are concerned;

ii. it is expressly stated to be traded on, or is subject to the rules of, a regulated market, an MTF, an OTF as far as contracts within the scope of Section C 6 of Annex I to Directive [new MiFID] are concerned or such a third country trading venue; or

iii. it is [note; no longer “it is expressly stated to be …”] equivalent to a contract traded on a regulated market, an MTF, an OTF contract within the scope of Section C 6 of Annex I to Directive [new MiFID] or such a third country trading venue, with regards to the price, the lot, the delivery date or other terms.


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8. A spot contract should be defined as a contract for the sale of a commodity, asset or right, under the terms of which delivery is scheduled to be made within the longer of the following periods: i. two trading days; ii. the period generally accepted in the market for that commodity, asset or right as the

standard delivery period. 9. A contract should not be classified as a spot contract if there is an understanding between the

parties to the contract that delivery of the underlying is to be postponed and not to be performed within two trading days or the period generally accepted in the market. This rule should apply irrespective of the explicit terms contained in the contract.

10. A contract should be considered to be for commercial purposes if: i. it is entered into with or by an operator or administrator of an energy transmission grid,

energy balancing mechanism or pipeline network and it is necessary to keep in balance the supplies and uses of energy at a given time,

ii. it is... (ESMA WILL CONSIDER ADDING OTHER EXAMPLES OF CONTRACTS FOR COMMERCIAL PURPOSES FOLLOWING THE CONSULTATION).


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Scope of financial instruments: Level 2 - Consultation Paper (continued) Annex 1, C10 Derivatives

(10) Options, futures, swaps, forward rate agreements and any other derivative contracts relating to climatic variables, freight rates or inflation rates or other official economic statistics that must be settled in cash or may be settled in cash at the option of one of the parties (other than by reason of default or other termination event), as well as any other derivative contracts relating to assets, rights, obligations, indices and measures not otherwise mentioned in this Section, which have the characteristics of other derivative financial instruments, having regard to whether, inter alia, they are traded on a regulated market, OTF, or an MTF, are cleared and settled through recognised clearing houses or are subject to regular margin calls;


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Draft technical advice Derivative contracts relating to an underlying in Section C 10 of Annex I should be classified as having the characteristics of other derivative financial instruments if they fulfil one of the following conditions:

i. they are settled in cash or may be settled in cash at the option of one or more of the parties to the contract, other than by reason of default or other termination event;

ii. they are traded on: a. a regulated market; b. an MTF; or c. an OTF if the contract is within the scope of Section C 6 of Annex I;

iii. they fulfil the conditions imposed for derivative contracts under Section C 7. 12. Derivative contracts relating to the following underlyings should also be considered as

derivative contracts within the scope of Section C 10 of Annex 1 if they meet the criteria established in that Section and those established in the paragraph above. i. telecommunications bandwidth; ii. commodity storage capacity; iii. transmission or transportation capacity relating to commodities, whether cable, pipeline or other means; iv. an allowance, credit, permit, right or similar asset which is directly linked to the supply, distribution or consumption of energy derived from renewable resources;


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v. a geological, environmental or other physical variable; vi. any other asset or right of a fungible nature, other than a right to receive a service, that is

capable of being transferred; vii. an index or measure related to the price or value of, or volume of transactions in any

asset, right, service or obligation; and viii. actuarial statistics.


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Scope of financial instruments: definitions Text of modified definitions

(5) Options, futures, swaps, forward rate agreements forwards and any other derivative contracts relating to commodities that must be settled in cash or may be settled in cash at the option of one of the parties other than by reason of default or other termination event;

(6) Options, futures, swaps, and any other derivative contract relating to commodities that can be physically settled provided that they are traded on a regulated market, and/or an MTF, or an OTF, except for wholesale energy products traded on an OTF that must be physically settled;

(7) Options, futures, swaps, forwards and any other derivative contracts relating to commodities, that can be physically settled not otherwise mentioned in point 6 of this Section and not being for commercial purposes, which have the characteristics of other derivative financial instruments, having regard to whether, inter alia, they are cleared and settled through recognised clearing houses or are subject to regular margin calls;

(10) Options, futures, swaps, forward rate agreements and any other derivative contracts relating to climatic variables, freight rates or inflation rates or other official economic statistics that must be settled in cash or may be settled in cash at the option of one of the parties (other than by reason of default or other termination event), as well as any other derivative contracts relating to assets, rights, obligations, indices and measures not otherwise mentioned in this Section, which have the characteristics of other derivative financial instruments, having regard to whether, inter alia, they are traded on a regulated market, OTF, or an MTF, are cleared and settled through recognised clearing houses or are subject to regular margin calls;

(11) Emission allowances consisting of any units recognised for compliance with the requirements of Directive 2003/87/EC (Emissions Trading Scheme).


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Scope of financial instruments: definitions (continued) Additional definitions

A couple of additional definitional points: “Commodity derivatives” is a defined expression in MiFID2/MiFIR and relates not only to Annex 1, Section C (5), (6), (7) and (10), but also transferable securities’ securities giving the right to acquire or sell any such transferable securities or giving rise to a cash settlement determined by reference to a commodity or an underlying referred to in C10 “Wholesale energy products” is defined in REMIT to mean the following:

• contracts for the supply of electricity or natural gas where delivery is in the EU • derivatives relating to electricity or natural gas produced, traded or delivered in the EU • contracts relating to the transportation of electricity or natural gas in the EU • derivatives relating to the transportation of electricity or natural gas in the EU

“C6 Energy Derivative Contracts” - options, futures, swaps, and any other derivative contracts mentioned in Section C.6 of Annex I relating to coal or oil that are traded on an OTF and must be physically settled;


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Exemptions for commodity dealers narrowed

MiFID II restricts the exemption available to those participating in the commodity derivative markets

Own account dealing exemption:

The current exemption, which is relevant for firms that do not provide any investment services or activities other than dealing on own account, has been narrowed such that it is not available where the dealing on own account is in commodity derivatives, emission allowances or derivatives in emission allowances.

It also does not apply to firms which: – are market makers; – are members of or are a participant in a regulated market or multilateral

trading facility (MTF) or have direct electronic access to a trading venue;


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Exemptions for commodity dealers narrowed (continued)

– apply a high frequency algorithmic trading technique; or – deal on own account when executing client orders.


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Former exemptions for specialist commodities firms

Exemption for firms whose main business is dealing on own account in commodities and/or commodity derivatives has been removed (MiFID 1, 2.1(k)).

The current exemption available to firms that deal on own account in financial instruments or provide investment services in commodity derivatives or exotic derivatives contracts to the clients of their main business, provided this is ancillary to the main business of their group will not be available where: – the dealing on own account in question amounts to the execution of client

orders; – other investment services are provided other than (i) on an intra-group basis

or (ii) services provided in respect of commodity derivatives, exotic derivatives, emissions allowances or derivatives thereof to the customers or suppliers of their main business;


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Former exemptions for specialist commodities firms (continued)

– the dealing or provision uses high frequency algorithmic trading techniques (MiFID 1 2.1(i) / MiFID II 2.1(j))

Optional Exclusions

Firms which:

(d) provide investment services exclusively in commodities, emission allowances and/or derivatives thereof for the sole purpose of hedging the commercial risks of their clients, where those clients are exclusively local electricity undertakings and/or natural gas undertakings; or

(e) provide investment services exclusively in emission allowances and/or derivatives thereof for the sole purpose of hedging the commercial risks of their clients, where those clients are exclusively relevant operators


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Exemptions for commodity dealers narrowed (continued) Optical Exclusions (continued)

In both cases the clients must jointly hold 100 % of the capital or voting rights of those persons, exercise joint control and are exempt under point (j) of Article 2(1) of MiFID II if they carry out those investment services themselves.

Certain analogous regulatory requirements must nonetheless be imposed.


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Exemption for commodity dealers narrowed: Level 2 ESMA Discussion Paper MiFID/MiFIR – ESMA 2014/548 ESMA to draft Level 2 RTS to specify criteria for activity to be considered ancillary

A key component of these provisions will be clarifying the quantitative and qualitative criteria for determining what is to be considered ‘ancillary’ to the main business of the group.

Key areas of debate in ESMA Level 2 discussion papers, include: – Whether a global approach to definition of group should be used. – Should economic or accounting capital be used as a measure trading

activity. – What should the relevant thresholds be. – Intragroup transactions; hedging transactions and transactions to fulfil

liquidity obligations on a trading venue where required by regulatory authorities or trading venues


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Exemption for commodity dealers narrowed: (continued)

Still much uncertainty in this area.

In relation to derivatives transactions objectively mitigating risks relating to the commercial or treasury financing activity ESMA considers the EMIR Level 2 wording should be taken into account According to EMIR Level 2, an OTC derivative contract is objectively measurable as reducing risks directly relating to the commercial activity or treasury financing activity of the non-financial counterparty when, whether by itself or in combination with other derivative contracts, and whether directly or through closely correlated instruments, it meets one of the following conditions:

• it covers risks arising from the potential change in the value of assets, services, inputs, products, commodities or liabilities that the non-financial counterparty or its group owns, produces, manufactures, processes, provides, purchases, leases, sells or incurs or reasonably anticipates owning, producing, manufacturing, processing, providing, purchasing merchandising, leasing selling or incurring in the normal course of business;

• it covers the risks arising from the potential indirect impact on the value of assets, services, inputs, products, commodities or liabilities referred to in the first bullet point, resulting from fluctuation of interest rates, inflation rates, foreign exchange rate or credit risks;

• it qualifies as a hedging contract pursuant to International Financial Reporting Standards (IFRS) adopted in accordance with Article 3 of Regulation (EC) No 1606/2002.


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Exemption for commodity dealers narrowed: (continued) Text of modified exemptions

(b) persons providing investment services exclusively for their parent undertakings, for their subsidiaries or for other subsidiaries of their parent undertakings;

(d) persons dealing on own account in financial instruments other than commodity derivatives or emission allowances or derivatives thereof and not providing any other investment services or performing any other investment activities in financial instruments other than commodity derivatives or emission allowances or derivatives thereof unless such persons: (i) are market makers; [‘market maker’ is defined as a person who holds himself out on the

financial markets on a continuous basis as being willing to deal on own account by buying and selling financial instruments against that person’s proprietary capital at prices defined by that person];

(ii) are members of or participants in a regulated market or an MTF or have direct electronic access to a trading venue;

(iii) apply a high-frequency algorithmic trading technique; or (iv) deal on own account when executing client orders;

Persons exempt under points (a), (i) or (j) are not required to meet the conditions laid down in this point in order to be exempt. (e) operators with compliance obligations under Directive 2003/87/EC who, when dealing in

emission allowances, do not execute client orders and who do not provide any investment services or perform any investment activities other than dealing on own account, provided that those persons do not apply a high-frequency algorithmic trading technique;


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Exemption for commodity dealers narrowed: (continued) Text of modified exemptions (continued)

(j) persons: (i) dealing on own account, including market makers, in commodity derivatives or emission

allowances or derivatives thereof, excluding persons who deal on own account when executing client orders; or

(ii) providing investment services, other than dealing on own account, in commodity derivatives or emission allowances or derivatives thereof to the customers or suppliers of their main business;

provided that: — for each of those cases individually and on an aggregate basis this is an ancillary

activity to their main business, when considered on a group basis, and that main business is not the provision of investment services within the meaning of this Directive or banking activities under Directive 2013/36/EU, or acting as a market-maker in relation to commodity derivatives,

— those persons do not apply a high-frequency algorithmic trading technique; and — those persons notify annually the relevant competent authority that they make use of

this exemption and upon request report to the competent authority the basis on which they consider that their activity under points (i) and (ii) is ancillary to their main business;


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Exemption for commodity dealers narrowed: (continued) Text of modified exemptions (continued)

(n) transmission system operators as defined in Article 2(4) of Directive 2009/72/EC or Article 2(4) of Directive 2009/73/EC when carrying out their tasks under those Directives, under Regulation (EC) No 714/2009, under Regulation (EC) No 715/2009 or under network codes or guidelines adopted pursuant to those Regulations, any persons acting as service providers on their behalf to carry out their task under those legislative acts or under network codes or guidelines adopted pursuant to those Regulations, and any operator or administrator of an energy balancing mechanism, pipeline network or system to keep in balance the supplies and uses of energy when carrying out such tasks.

That exemption shall apply to persons engaged in the activities set out in this point only where they perform investment activities or provide investment services relating to commodity derivatives in order to carry out those activities. That exemption shall not apply with regard to the operation of a secondary market, including a platform for secondary trading in financial transmission rights;


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Position Limits

MiFID II introduces a new regime of position limits which shall require competent authorities to establish and apply:

Position limits on the size of a net position which a person can hold at all times in commodity derivatives that are traded on regulated markets, MTF, OFTs and economically equivalent OTC contracts.

Limits will be set on the basis of all positions held by a person and those held on its behalf at an aggregate group level.

Position limits will not apply to positions held by or on behalf of a non-financial entity and which are effectively measurable as reducing risks directly relating to the commercial activity of than non-financial entity.

The purpose of the position limits is to

prevent market abuse;

.


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Position Limits (continued)

support orderly pricing and settlement conditions, including preventing market distorting positions, and ensuring, in particular, convergence between prices of derivatives in the delivery month and spot prices for the underlying commodity, without prejudice to price discovery on the market for the underlying commodity.

ESMA is required to develop draft regulatory technical standards to determine the methodology for calculation that competent authorities are to apply in establishing the spot month position limits and other months’ position limits for physically settled and cash settled commodity derivatives based on the characteristics of the relevant derivative.

The methodology for calculation shall take into account at least the following factors: – the maturity of the commodity derivative contracts; – the deliverable supply in the underlying commodity;


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– the overall open interest in that contract and the overall open interest in other financial instruments with the same underlying commodity;

– the volatility of the relevant markets, including substitute derivatives and the underlying commodity markets;

– the number and size of the market participants; – the characteristics of the underlying commodity market, including patterns of

production, consumption and transportation to market; – the development of new contracts.

ESMA is also required to take into account experience regarding the position limits of investment firms or market operators operating a trading venue and of other jurisdictions.

Process and ESMA opinion


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Where the same commodity derivative is traded in significant volumes on trading venues in more than one jurisdiction, the competent authority of the trading venue where the largest volume of trading takes place (the central competent authority) shall set the single position limit to be applied on all trading in that contract.


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Position Limits: ESMA Level 2 Consultation and Discussion Paper ESMA in Level 2 Discussion Paper proposals cover:

the methodology that should be applied in establishing the spot month position limits and other months’ position limits for physically settled and cash settled commodity derivatives;

the criteria and methods for determining whether a position qualifies as reducing risks directly relation to commercial activities – suggests EMIR Level 2 basis discussed above;

the methods to determine when positions of a person are to be aggregated within a group;

the criteria for determining whether a contract is an economically equivalent OTC contract to that traded on a trading venue; and


33 / 23212200V2

Position Limits: ESMA Level 2 Consultation and Discussion Paper (continued) the methodology for aggregating and netting OTC and on-venue commodity

derivatives positions to establish the net position for purposes of assessing compliance with the limits.


34 / 23212200V2

Position Reporting Commitment of Trader Report and Position Reports to Regulators

Trading venues which trades commodity derivatives or emission allowances/ derivatives are required to: – publish a weekly Commitment of Trader Report with the aggregate

positions held by the different categories of persons for the different commodity derivatives or emission allowances /derivatives / traded on the/trading venue and communicate that report to the relevant competent authority and to ESMA;

– provide the relevant competent authority with a daily Position Report for Regulators i.e. a complete breakdown of the positions held by all persons, including the members or participants and their clients, on that trading venue, at least on a daily basis.


35 / 23212200V2

Position Reporting (continued) Commitment of Trader Report and Position Reports to Regulators

Commitment of Trader Reports are to specify the number of long and short positions by category of persons, any changes since the previous report, percent of total open interest represented by each category, and the number of persons in each category.

The obligation only applies when both the number of persons and their open positions exceed minimum thresholds

Commitment of Trader Reports and Position Report for Regulators are to differentiate between: – positions identified as positions which in an objectively measurable way

reduce risks directly relating to commercial activities; and – other positions. Members or participants of regulated markets, MTFs and clients of OTFs are to be required to provide this information


36 / 23212200V2

Position Reporting (continued) Direct Position reports

Investment firms trading in commodity derivatives or emission allowances/ derivatives outside a trading venue are to be required to provide the relevant competent authority of the trading venue at least on a daily basis with a complete breakdown of their positions taken in commodity derivatives or emission allowances/derivatives traded on a trading venue and economically equivalent OTC contracts, as well as of those of their clients and the clients of those clients until the end client is reached


37 / 23212200V2

Position Reporting – Level 2 Position reporting thresholds – Consultation Paper

Draft technical advice 1. The obligation for a trading venue to make public a weekly position report for commodity

derivatives or emission allowances or derivatives thereof will apply when the following two thresholds must be met:

i. 30 open position holders are active in a given contract on a given trading venue; and ii. the absolute value of the gross long or short volume of total open interest, expressed in the

number of lots of the relevant commodity derivative, exceeds a level of four times the deliverable supply in the same commodity derivative.

2. These thresholds are cumulative and both must be met before the obligation to make public a report applies. The thresholds shall apply separately to each commodity derivative that is listed on a trading venue.

3. The 30 position holders threshold shall apply in aggregate across all of the categories and there does not have to be a minimum number of position holders in any single category.

4. However, where there are four or fewer position holders active in a given category, the number of position holders in that category shall not be reported

5. Where the thresholds above are triggered for the first time, that trade venue shall seek to publish its first weekly report as soon as it is feasibly practical, but in any event no later than 3 weeks from the date on which the thresholds are first triggered.

6. Where the thresholds are no longer being met, that trading venue shall continue to publish the weekly report for a period of three calendar months after which, if the thresholds have not been met during the period, publication of the report for that contract may cease.


38 / 23212200V2

Position Reporting – Level 2 (continued) Position reporting thresholds – Consultation Paper (continued) Discussion Paper

The Discussion Paper addresses the basis, scope and mechanics of position reporting.


39 / 23212200V2

Position Management Trading Venues

Trading venues which trade commodity derivatives are required to apply position management controls, including powers to: – monitor the open interest positions of persons; – access information, including all relevant documentation, from persons

about the size and purpose of a position or exposure entered into, information about beneficial or underlying owners, any concert arrangements, and any related assets or liabilities in the underlying market;

– require a person to terminate or reduce a position, on a temporary or permanent basis as the specific case may require and to unilaterally take appropriate action to ensure the termination or reduction if the person does not comply; and

– where appropriate, require a person to provide liquidity back into the market at an agreed price and volume on a temporary basis with the express intent of mitigating the effects of a large or dominant position.


40 / 23212200V2

Position Management (continued) Relevant Competent Authority

Position limits are to be imposed by competent authorities.

Competent authorities shall in addition be able to impose temporary position limits in exceptional cases, valid up until 6 months.

ESMA

Coordination

ESMA to perform a facilitation and coordination role in relation to measures taken by competent authorities


41 / 23212200V2

Position Management (continued) Position Management

ESMA may: – request from any person all relevant information regarding the size and

purpose of a position or exposure entered into via a derivative; – require any such person to reduce the size of or to eliminate the position or

exposure; – as a last resort, limit the ability of a person from entering into a commodity

derivative.

These steps may only be taken where: – the measures address a threat to the orderly functioning and integrity of

financial markets, including commodity derivative markets and including in relation to delivery arrangements for physical commodities, or to the stability of the whole or part of the financial system in the EU;


42 / 23212200V2

Position Management (continued) Position Management (continued)

– a competent authority or competent authorities have not taken measures to address the threat or the measures taken do not sufficiently address the threat;

ESMA must ensure that the measure: – significantly addresses the threat to the orderly functioning and integrity of

financial markets, including commodity derivative markets and including in relation to delivery arrangements for physical commodities, or to the stability of the whole or part of the financial system in the EU or significantly improve the ability of competent authorities to monitor the threat;

– does not create a risk of regulatory arbitrage


43 / 23212200V2

Position Management (continued) Position Management (continued)

– does not have any of the following detrimental effects on the efficiency of financial markets that is disproportionate to the benefits of the measure: reducing liquidity in those markets, restraining the conditions for reducing risks directly related to the commercial activity of a non-financial counterparty, or creating uncertainty for market participants.

– ESMA is also required where relevant to consult the Agency for the Cooperation of Energy Regulators or the public bodies competent for the oversight, administration and regulation of physical agricultural markets before taking any measures.

– ESMA is required to give not less than 24 hours notice to relevant competent authorities before the measure is intended to take effect or to be renewed other than in exceptional circumstances.


44 / 23212200V2

Position Management – Level 2 Consultation Paper

Draft technical advice 1. In describing those scenarios which may constitute "a threat to the orderly functioning and

integrity of financial markets or to the stability of the whole or part of the financial system in the Union", the scenarios under Article 24(1) and (3) of the Short Selling Regulation (No 918/2012 of 5 July 2012) should be taken into account and alignment between the two pieces of legislation effected to the extent possible. The following factors and criteria set out in the Short Selling Regulation are relevant criteria for determining the existence of a threat to the stability of the (whole or part of the) financial system in the Union. i. serious financial, monetary or budgetary problems which may lead to financial instability

concerning a Member State or a bank and other financial institutions deemed important to the global financial system;

ii. a rating action or a default by any Member State or banks and other financial institutions deemed important to the global financial system;

iii. substantial selling pressures or unusual volatility causing significant downward spirals in any financial instrument related to any banks and other financial institutions deemed important to the global financial system;

iv. any relevant damage to the physical structures of financial institutions from a natural disaster or terrorist attack; and

v. any relevant disruption in any payment system or settlement process, in particular when it is related to interbank operations.


45 / 23212200V2


Draft technical advice (continued) 2. The above list of circumstances is not exhaustive and may be of different relevance for the

financial and commodities derivatives markets. Therefore, in addition to the above circumstances enumerated under the Short Selling Regulation, the following factors and criteria should also be considered as relevant in determining the existence of a threat to the orderly functioning and integrity of financial markets and commodity derivative markets: i. disruption to the supply of a commodity, leading to a significant reduction of deliverable

supply (through, for example, a production outage); ii. significant and abrupt rise in the demand of a commodity; iii. a significant position in a certain commodity held by one person, or persons acting in

concert, in one or several trading venues, through one or several market members; and iv. de facto inability by a trading venue to exercise its own position management powers

because a business continuity event prevents it from carrying on business in the normal way.

3. In relation to ESMA requiring "the appropriate reduction of a position or exposure entered into via a derivative", "appropriate" action may differ on a case by case basis. The following factors and criteria are relevant indicators when determining what is "appropriate": i. nature of the holder of the position (e.g. producer, consumer, financial institution, etc.); ii. size of the position vis-a-vis the size of the market in the relevant derivatives;


46 / 23212200V2



iii. size of the position vis-a-vis the market in the physical market, e.g. deliverable supply; iv. the direction of the position (short/long) v. the purpose of the position (hedging or financial exposure); vi. the experience of a position holder in holding positions of a given size, and, if applicable,

of making/taking delivery of a given commodity; vii. other positions held by the position-holder in the underlying market (related physical

positions) or in different maturities of the same derivative; and viii. method of delivery.

4. The following criteria and factors are relevant when determining the situations where a risk of regulatory arbitrage could arise: i. whether the same contract is traded in a different venue, as a result of fragmentation of

liquidity across different trading venues, or OTC; ii. whether a substantially equivalent contract is traded on a different venue or OTC (similar

and interrelated, but not considered part of the same fungible open interest); iii. the effects of the decision on the market of the underlyings; iv. the effects of the decision on markets and participants not subject to ESMA's position

management powers; and v. likely impact on the orderly functioning and integrity of the markets if no decision were

taken (do-nothing-scenario).


47 / 23212200V2


Draft technical advice (continued) 5. Situations caused by an NCA's failure to act as opposed to its inability to sufficiently address

a threat should be distinguished principally by analysis of the powers available to the NCAs. If the NCA has at its disposal sufficient regulatory powers to address fully the threat at that time, without further reference to another NCA, but does not take such action this will be considered a strong indicator that the NCA has failed to act. Where one or more of the factors listed pursuant to Article 45(1)(a) occur in one or more other jurisdictions as well as in its own jurisdiction, it should be considered that an NCA may be unable to address fully a threat rather than has failed to address the threat.

48 / L_LIVE_EMEA1:23212200v2 © Simmons & Simmons 2008

Contact details

Jonathan Melrose T +44 20 7825 4514 E [email protected]

49 / L_LIVE_EMEA1:23212200v2 © Simmons & Simmons 2008

Further information from Simmons & Simmons

Legal Headwinds

http://www.elexica.com/en/Resources/Newsletter-Listing/Legal-Headwinds-NL

MiFID 2 Tracker

http://www.elexica.com/en/Resources/Microsite/MiFID-2-Tracker

Commodity Derivatives Regulation Tracker

http://www.elexica.com/en/Resources/Microsite/Commodity-Derivatives


24/ L_LIVE_EMEA2:969739v2

simmons-simmons.comelexica.com

elexica.com is the award winning online legal resource of Simmons & Simmons© Simmons & Simmons LLP 2014. All rights reserved, and all moral rights are asserted andreserved.This document is for general guidance only. It does not contain definitive advice. SIMMONS& SIMMONS and S&S are registered trade marks of Simmons & Simmons LLP.

Simmons & Simmons is an international legal practice carried on by Simmons & SimmonsLLP and its affiliated practices. Accordingly, references to Simmons & Simmons meanSimmons & Simmons LLP and the other partnerships and other entities or practicesauthorised to use the name “Simmons & Simmons” or one or more of those practices as thecontext requires. The word “partner” refers to a member of Simmons & Simmons LLP or anemployee or consultant with equivalent standing and qualifications or to an individual withequivalent status in one of Simmons & Simmons LLP’s affiliated practices. For furtherinformation on the international entities and practices, refer to simmons-simmons.com/legalrespSimmons & Simmons LLP is a limited liability partnership registered in England & Waleswith number OC352713 and with its registered office at CityPoint, One Ropemaker Street,London EC2Y 9SS. It is authorised and regulated by the Solicitors Regulation Authority.A list of members and other partners together with their professional qualifications isavailable for inspection at the above address.

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