The European financial market's watchdog has updated on 31 May 2017 its Q&As on position limits framework under MiFID II.
The update relates to the ESMA's answer to the Question No. 2 (the original version thereof was issued on 19 December 2016) and deals with the problem of defining a lot in derivatives where the underlying asset is electricity.
Generally, for power derivatives a lot is calculated according to the formula:
Nominal = Unit of registration * number of relevant days (in delivery period) * relevant
hours (per day)
and this has not changed if looking at the earlier version of 19 December 2016.
Where a lot is not defined for energy contracts, a lot should be the minimum quantity tradable of that commodity derivative, calculated as nominal * minimum number of contracts to be included in a trade.
Regrettably, ESMA does not highlight changes made in its Q&As on commodity derivatives topics, there are no mark-ups or underlining, hence, the identification of the deletions or additions is somewhat burdensome.
But I have gone through this monotonous work and identified that ESMA has on 31 May 2017 substituted the phrase:
"Typically, for power base load contracts the lot is 24 MWh as the minimum amount tradable is one daily contract of 1 MW. Similarly, for peak load contracts, a lot is equal to the number of hours in the peak load period (e.g. 12 MWh)"
with the following one:
"If the minimum amount tradable were one daily contract of 1 MW, for example, the lot size would be 24 MWh for typical base load contracts or 12 MWh for peak load contracts, as the typical timeframe of peak hours corresponds to 12 per relevant day.
Whereas, if the minimum amount tradable is not a daily, but a monthly contract, a lot corresponds to the MWh that are to be delivered according to that contract (e.g. 720 MWh for base load contracts, considering a month composed of 30 days)."
Generally, the issue seems not so important and refers specifically to the minimum amount tradable that is a monthly contract.
It logically follows from the earlier ESMA's reasoning that a lot is in this case 720 MWh for base load contracts.
This is nothing revolutionary, but rather a simple follow-up to already established rules.
However, if the authority makes such subtle reinforcements to its previous comments it would be highly welcome if the changes made are more prominently highlighted in the text, so as to enable the reader to perceive the sense of the amendment at the first glance.
It is useful to remind in this context that the definition of the "lot" is essential for determining the so-called "baseline figures" equally for the "spot month" as well as for the "other months" position limits.
This differentiation, absent in the MiFID II itself (Article 57), has been introduced, after prolonged deliberations, by the Commission Delegated Regulation (EU) 2017/591 of 1 December 2016, and represents the reflection of the dilemma the EU legislators and regulators faced when analysing whether to build the EU position limits legal framework on:
(1) the percentage relationships or
(2) on amounts of lots of specific contracts or
(3) on quantities of the underlying in the contract (which may be tonnes, barrels, MWh, etc).
Finally, the said Regulation has established that the spot month position limit is based on the deliverable supply while the other months' limits are based on a percentage of total open interest, where:
- the spot month contract is the "commodity derivative contract in relation to a particular underlying commodity whose maturity is the next to expire in accordance with the rules set by the trading venue", and
- the other months' period in this context is the whole of the curve of the contract, excluding the spot month period.
Spot month position limit in a commodity derivatives is determined by the competent authorities of the EU Member States based on a baseline figure of 25% of the deliverable supply for that commodity derivative (Article 9 of the Commission Delegated Regulation (EU) 2017/591 of 1 December 2016).
This baseline figure must specified in lots which are defined as "the unit of trading used by the trading venue on which the commodity derivative trades representing a standardised quantity of the underlying commodity".
The exceptions are:
- spot month position limits for cash settled and physically settled commodity derivatives, which are based on a percentage of deliverable supply,
- spot month position limits for cash settled commodity derivatives with no deliverable supply (commodity derivatives listed under Annex I, Section C10 e.g. weather) which are based on a percentage of total open interest in the spot month.
The baseline figure for the other months' position limit in a commodity derivative is determined by the EU competent authorities by calculating 25% of the open interest in that commodity derivative (Article 11 of the said Commission Delegated Regulation (EU) 2017/591).
The baseline figure for the other months' position limits is also specified in lots which are defined in that regard in the same way as for the spot month position limit.
For the other months' position limit the EU competent authorities calculate the open interest in a commodity derivative by aggregating the number of lots of that commodity derivative that are outstanding on trading venues at a point in time.
Other months' limits are calculated as 25% of average annual open interest, expressed in lots in the underlying commodity ('the baseline').
The assymetric spreads are adopted for both formulas, giving the EU Member States competent authorities the power to adjust the baseline down to 5% and only up to 35%, taking into account the factors listed under Article 57(3)(a) to (g) of the said Regulation.
To conclude, it is clearly visible that the issue how the lots are defined is an important element of the entire EU position limits framework.
In this context the power and gas derivatives were given by the ESMA the special attention so far, but it can be supposed that also other assets will be subsequently analysed in detail.
Overall, the system can be assessed as a rather complex, but given the diversity of commodity derivatives, I'm afraid it was inevitable.