While derivatives markets are still getting to grips with the rollout of EMIR and REMIT, politics and regulatory regimes continue to evolve and extend their grasp. Energy market participants in particular are now facing a new set of MiFID rules, which reach beyond banking to impact commodity trading as well.
This growing compliance burden is a direct result of the financial crisis. European (and American) regulators have moved to grapple with market manipulation and address a set of commitments made by the G20 in 2009 to make financial markets more transparent and resilient, whilst improving investor protection.
EU regulators responded by creating the Markets in Financial Instruments Directive (MiFID) to increase competition and consumer protection in financial services, and a bifurcated regime (EMIR and REMIT) to address potential manipulation in commodity trading. These last two are rolling out now but even as they complete their implementation phase, MiFID II threatens to add to the compliance burden for commodity traders, whilst making it harder for businesses to operate under a hedging strategy.
Given the size of the market, a key concern with MiFID II is the potential loss of the exemptions from financial services rules currently enjoyed by energy trading firms. There is real worry that without these exemptions, energy trading firms could end up being treated as de facto financial institutions, the practical effect being a re-categorisation that misrepresents the nature of their business activities. If the energy trading arm of a large manufacturer were, for example, to be regulated in the same way as a bank, that could mean having to abide by rules such as minimum capital requirements.
On paper there is a MiFID II exemption for firms that provide investment services for commodity derivatives, emissions allowances or emissions derivatives; to customers or suppliers of their main business. However, to qualify for the exemption these activities must be considered “ancillary” to that company’s core business.
The risk therefore is that companies seen to be providing investment services, acting as a market-maker in commodity derivatives, or making use of algorithmic or high-frequency trading, might not qualify. Companies trading on own account to optimise their physical energy assets, ‘should’ qualify.
So MiFID II will, in theory, create a hedging exemption that ensures the trading arms of manufacturers and energy companies remain exempt. But size matters here. The larger a group’s overall ancillary trading operations, the harder it could be to benefit from these narrowed exemptions.
A further worry for companies that might find themselves re-categorised under MiFID II is overlap with the still-new EMIR regulatory regime. It could mean that these companies would be treated as financial counterparties under EMIR, subjecting them to more rigorous standards in areas such as clearing, reporting and risk mitigation for OTC trades.
The issue of reporting trades to a trade repository under EMIR has already compelled energy market participants across the board to up their IT investments significantly. More generally, EMIR compliance has caused no end of managerial headaches, not least by the number of re-thinks and changes to definitions and timelines that have plagued its rollout.
There is also a question mark over MiFID II’s treatment of physical energy forwards, which could see them defined as OTC derivatives. Should that happen they would be subject to EMIR’s trading thresholds as well, which, in certain scenarios, require both clearing and margining.
A Ceiling on Net Positions
Under MiFID II all energy market participants will be required to comply with position limits, e.g. limits on the net position firms can hold in commodity derivatives across the EU. That means exchange and OTC commodity derivatives trades would both be limited to prevent the creation of market distorting positions.
The hedging exemption I referred to earlier could, on current guidance, apply to position limits as well -- so long as a company is a non-financial entity taking positions deemed to be directly reducing the risk of commercial activities.
However, the way the exemptions and limits will work in practice is still subject to a lengthy industry consultation begun in May. The European Securities and Markets Authority (ESMA) which administers both MiFID and EMIR, released a consultation paper and a discussion paper that laid out its current thinking on MiFID II implementation and asking for industry input. The two documents encompass a whopping 864 pages, so plenty of questions linger about how the new regime will eventually work in practice.
What Happens Next?
MiFID II consists of a directive, which must be implemented by each EU Member State (a process meant to take another two years); and a regulation which is applies across the EU. As with EMIR and REMIT, technical standards and other secondary legislation will need to be drafted, agreed and adopted by ESMA before the new legislation is implemented. We are advising our customers to prepare for final MiFID II readiness by early 2017.
Over the next 18 months, here are three key things to watch for:
Clarity over how a market participant’s positions will be aggregated and netted. The issue of economically equivalent contracts and how the characteristics of an individual commodity will factor into the calculation
Whether or not physical forwards will be treated as OTC derivatives
An exact definition of hedging, which will be extremely important for companies hoping to make use of the ‘hedging exemption’
Derivative and energy traders need to look ahead to late 2016/17 and build increased regulatory risk into their trading decisions. A good place to start may be to consider how changes in the regulatory interpretation of different transactions could affect a given portfolio, especially with regard to non-hedging activities.
Hedging and risk management strategies will have to be revised and adapted as the final form of MiFID II becomes incrementally clearer. Although it is too soon to make major changes, there are things you can do now to mitigate exposure to regulatory risk.
One way may be to trade on proprietary portfolios via a regulated market. Because they are established and fully regulated, regulated markets could provide a measure of certainty about the classification and treatment of transactions.
Technology investments can also help mitigate regulatory risk by surfacing exposures and providing quick assurance that trades and related activities are compliant. This has already been shown through EMIR and REMIT, which compelled many companies to invest in or revisit their Commodity Trading and Risk Management (CTRM) systems. MiFID II could well necessitate another round of IT upgrades, particularly in the in the area of reporting to trade repositories.
While it is still too soon to make firm or detailed ETRM recommendations, beginning the due diligence process with trusted vendors should begin now. A regulatory solution for commodity trading and corporate financial compliance is generally not a stand-alone application. Contract data, hedge accounting, revenue allocation in line with new regulatory reporting requirements and other special functions do not happen in a vacuum. It is also vital to consider factors such as the ability to install software on a captive system and maintain it internally, or purchase a software-as-a-service (SaaS) contract and maintain it virtually in the cloud. Direct connectivity to trade repositories should also be a core capability.
When the first EMIR trade reporting deadline landed in February of this year, the market still wasn’t ready. After months of delay and re-think by EU regulators during EMIR’s rollout, a host of companies found themselves playing catch up, hurriedly (and expensively) trying to understand how to meet the new regime’s requirements, restrictions and definitions.
We must learn from the EMIR experience and take into account the many evolving aspects of regulatory regimes to start getting ready for MiFID II now. Adopting processes and systems that can adapt to an evolving rollout will no question be key to successful compliance.
By James Brown Senior Energy Consultant, EMEA for Allegro Development Corporation