The MiFID II ancillary activities tests must be calculated for each separate person who trades in commodity derivatives within a group, said the European Commission on 31 May 2018.
Is it good or bad, someone may ask. It depends, lawyers usually answer.
I think, it is bad, firstly, for the European legislators and agencies that after many years of the MiFID II legislative process (extended additionally by 1-year delay of entry into force) the law enacted is of such a poor quality that the European central financial regulator (ESMA) is unclear as to its key parameters and must ask the European Commission to explain the rules.
The aggravating factor is, additionally, that the whole issue arises several months after the respective deadline for market participants (3 January 2018) has passed (the said deadline was for the submission of the notification informing national regulators that the entity intends to use the MiFID II ancillary activity exemption).
The recent tone of the prolonged story how the ancillary activity exemption under the MiFID II should look like was provoked by the European financial watchdog ESMA, which invited the European Commission on 9 April 2018 to clarify owhether the ancillary activity test should be performed at the group or single entity olevel (ESMA70-154-5851).
In principle, is is commendable that the ESMA undertakes efforts to agree with other stakeholders on the common interpretation of the rules, but, nevertheless, it also means, that it wasn’t the problem for the European legislators to set for market participants an impassable deadline, involved with severe consequences (i.e. being subject to MiFID II or not), while the legislator itself and an oversight agency had at that time no clear view on the concrete manner of the complex calculations, market participants were required by law to perform.
It is also useful to note that the contentious issue (group/entity level of calculations) does not relate to a small, negligible detail but the fundamental calculations’ approach - influencing all subsequent qualifications.
I suppose, the whole issue represents a blatant example, how the law shouldn’t be enacted (last, but not least, the market data, which were required to perform the necessary threshold calculations were also partly missing as of required notification’s deadline on 3 January 2018).
It is not the intention of this post to quote many earlier, mutually contradictory, regulatory clarifications on the substance of the problem at issue – starting from the first drafts of the MiFID II Directive.
The problem is that in the European Union legal framework the above stance of the European Commission still does not prejudge any future judicial decisions on the issue and - in itself - contains some hidden, potentially undesirable, implications.
This ambiguous legislative piece, the cause for the whole mess, is RTS 20 (Commission Delegated Regulation (EU) 2017/592 of 1 December 2016 supplementing Directive 2014/65/EU of the European Parliament and of the Council with regard to regulatory technical standards for the criteria to establish when an activity is considered to be ancillary to the main business).
While interpreting the provisions of the said Regulation, the European Commission’s letter of 31 May 2018 reminds that Article 2(1)(j) of MiFID II applies the ancillary activity test by comparing the MiFID activities that a person is engaged in with the commercial activities of the person or the group of which the person forms part.
In the European Commission’s opinion, in the said manner the rules accommodate varying commercial group structures whereby groups divide their business activities into separate legal entities to match the different stages in the commercial value chain.
As the European Commission further observes, within a group the legal entity facing the market for trading in financial instruments is rarely if ever identical with the legal entity which undertakes, e.g., extraction or production activities.
Based on the above observations the European Commission draws a conclusion that:
- in line with the structure of Article 2(1)(j) MiFID II, the reference to "persons within a group" in Delegated Regulation 2017/592 requires that the ancillary activities test needs to be calculated by each person within a group that engages in either of the two relevant MiFID activities mentioned in the said provision (i.e. dealing on own account and providing investment services in relation to commodity derivatives);
- the ancillary activities test must be calculated as many times as necessary for each separate person who trades in commodity derivatives within a group.
The above view has been reasoned by the fact that an authorisation pursuant to MiFID II cannot be obtained by a group of entities which, taken together, do not have a single legal personality, but should be obtained by the relevant entity (or entities) within that group.
The Commission also invokes the evidence, which show that a representative sample of the major European energy and agricultural groups conduct the MiFID activities described in Article 2(1)(j) MiFID II through a single trading entity (which, in turn, is based on a variety of prudential and commercial considerations, like capital requirements for trading activities, credit quality and netting opportunities).
The European Commission concludes the said short interpretation with a remark that, in practice, the ancillary activity test will need to be performed only once for each group within that sample.
Referring to the this problem I have one simple question: if the MiFID II ancillary activities tests must be calculated for each separate person who trades in commodity derivatives within a group - as the European Commission said on 31 May 2018 - why on earth the Recital 1 of the RTS 20 (which was adopted by the same European Commission) reads (emphasis added):
“The assessment whether persons are dealing on own account or are providing investment services in commodity derivatives, emission allowances and derivatives thereof in the Union as an activity ancillary to their main business should be performed at a group level”?
Can anyone understand this?
This Byzantine style of lawmaking was evidently unclear even to ESMA’s professionals, familiar with the whole MiFID II legislative process from its very beginning.
Another problem - if you follow the European Commission suggestion (saying that as groups conduct the MiFID activities described through a single trading entity, in practice, the ancillary activity test needs to be performed only once for each group within that sample) it is easily to be trapped within regulatory labyrinth.
If only the above single trading entity submits the notification for ancillary activity exemption, it will not be possible to structure potential future transactions in commodity or emission allowances involving other group’s legal entities (for example undertaking the said extraction or production activities), which have not fulfilled this regulatory formality. And sometimes, particular market conditions may require so.
Another important thread of the European Commissions’ short letter to the ESMA is involved with the fact that under Article 2(1)(j) of MiFID II an ancillary activity exemption may be obtained in respect to two types of MiFID activities in relation to commodity derivatives (or emission allowances or derivatives thereof), i.e.:
- dealing on own account and
- providing investment services (other than dealing on own account).
The European Commission refers in that regard to the MiFID II rule that in order to benefit from the exemption, these two MiFID activities need to be ancillary to the main business of the person or the group of which this person forms part.
In the European Commission’s opinion:
- Article 2(1)(j) requires that the test of whether the MiFID activities are ancillary needs to be assessed for both MiFID activities individually, and on an aggregate basis,
- in practical terms this implies that if a person undertakes both activities, it must pass the ancillary activity test with respect to both MiFID activities and cannot be exempt from MiFID II merely by passing the test for one of the MiFID activities.
Hence, to perform ancillary activity tests it is important to precisely differentiate between dealing on own account and providing other investment services (in the light of point 3 of Section A of the Annex I of MiFID II dealing on own account is part of the broader category of investment services and activities).
In principle, dealing on own account under the MiFID II Directive is the same as trading against proprietary capital (in other words - putting its own books at risk).
It may consist in acting either:
- purely the firms’ own proprietary trades (market making including) or
- filling orders that the firm has received from a client (positions arising from client servicing, for example where a firm acts as a systematic internaliser or executes an order by taking a market or 'unmatched principal' position on its books).
The category of dealing on own account can be divided under MiFID II into two sub-categories:
- matched principal trading (if a firm executes client orders by standing between clients on a matched principal basis (back-to-back trading), it is both dealing on own account and executing orders on behalf of clients),
- "principal capacity" - being a flag covering all, other than matched principal trading, forms of dealing on own account.
Hence, it may be concluded that when a firm fills an order from a client, this does not automatically mean that this firm does not deal on own account in this operation - the metric for this determination is whether the firm is trading against proprietary capital, i.e. whether it is putting its own books at risk.
Let’s hope that firms will be able precisely classify trading activities between these two categories when performing ancillary activity exemption tests.