Commodity firms are facing the biggest step change as a result of the greatly increased scope of Markets in Financial Instruments Directive II (MiFID II). Broad exemptions that could previously be used to take firms out of the scope of MiFID I, such as ‘dealing on own account’ or ‘ancillary trading activity’, have been removed or severely tightened. In addition, the commodity products considered to be financial instruments have been widened to include physically settled derivatives, emissions allowances and financial derivatives – regardless of their settlement method or trading venue.
This means commodity firms previously unaffected by MiFID I will be considered a financial services company and, from 3 January 2018, will be liable to the full set of MiFID II regulations – including commodity position limits. This challenge cannot be underestimated as commodity firms will be starting their journey towards compliance without the benefit of an infrastructure already put in place by MiFID I. Companies face three distinct challenges in meeting MiFID II requirements – strict European regulators, high costs and no introductory phase-in period.
Similar to the Dodd-Frank regulations in the US, the combination of position limits will extend across the group. The European Securities and Markets Authority (ESMA) has chosen to use the Accounting Directive’s definition of a ‘group’ – ‘a parent undertaking and all its subsidiary undertakings’. It is highly unlikely that firms’ existing systems will be capable of aggregating positions limits across the group in this fashion and the technology changes required to enable this will not be easy or cheap to implement.
However, US regulations only cover 28 commodity contracts, whereas European regulators are planning on having limits for all contracts. The Financial Conduct Authority has estimated that positions on 1,900 commodity derivatives will need to be monitored so it is clear that an automated solution is the only feasible option.
Although requirements already exist for position limit monitoring of some futures contracts, the new rules bring into scope ‘economically equivalent’ over-the-counter (OTC) contracts. This will require firms to identify these ‘equivalent’ contracts and have systems that can net these positions against future positions across the entire group. Furthermore, the rule states that the limit must not be breached at any time, meaning limits must be monitored intraday.
This is a significant technical challenge and estimated costs required to meet MiFID II requirements run into hundreds of millions of euros for the biggest commodity traders.
In addition to the implementation costs, there may also be significant commercial costs for firms. So far, the European regulations have not explicitly addressed how the rules will apply to commodity indices. However, under US regulations it is not permitted to net an index against futures hedges. This will be a major concern for firms that sell proprietary indices to institutional investors. If the European regulators follow the US’ lead, there will be an implicit cap on the amount of index business firms can conduct.
Despite defining an exceptionally onerous position limit requirement, that both national competent authorities and investment firms will struggle to be ready for, the European regulators have not proposed any phase-in period for the rules. Using prior legislation as a precedent, requests for phase-ins have not had much success. Perhaps the recent drop in oil prices may soften the regulators stance, but based on previous evidence, reliance on this outcome looks a risky strategy.
It is clear that implementing a position limit regime is high on the agenda for regulators on both sides of the Atlantic. Although the specific thresholds may not be known, firms need to start defining how they will approach the issues by:
As position limit monitoring will be a significant technical challenge, firms should be aiming for a project start in the third quarter of 2015. We have helped several large European investment banks address MiFID II and this includes defining solutions to the specific challenges related to trading commodities.