MiFID II/MiFIR application to the carbon market
- Category: MiFID application to the carbon market
MiFID II/MiFIR overall aims are to enhance the efficiency, resilience and integrity of financial markets.
It is to be achieved in particular by:
1. ensuring greater transparency: introduction of a pre- and post-trade transparency regime for non-equities and strengthening and broadening of the existing equities trade transparency regime;
2. bringing more trading onto regulated venues: creation of a new category of platforms to trade derivatives and bonds - the organised trading facilities (OTFs) - and of a trading obligation for shares on regulated venues;
3. fulfilling the Union's G20 commitments on derivatives:
- mandatory trading of derivatives on regulated venues,
- introduction of position limits and MiFID reporting requirements for commodity derivatives,
- broadening the definition of investment firm to capture firms trading commodity derivatives as a financial activity;
4. facilitating access to capital for SMEs: introduction of the SME Growth Market label;
5. strengthening the protection of investors: enhancement of the rules on inducements, a ban on inducements for independent advice and new product governance rules;
6. regulating high-frequency trading (HFT) imposing requirements on trading venues and on firms using HFT;
7. introducing provisions on non-discriminatory access to trading and post-trading services in trading of financial instruments notably for exchange-traded derivatives.
It is noteworthy, MiFID II is a package of EU legislation, which regulates both retail and wholesale investment business. MiFID II affects in particular investment banks, interdealer brokers. stockbrokers, investment advisers, corporate finance firms and venture capital firms, trading venues including:
- multilateral trading facilities (MTFs),
- Data Reporting Service Providers (DRSPs),
- investment managers;
but equally unregulated entities trading commodity derivatives and emission allowances.
Emissions allowances' treatment
The general approach under the Directive 2004/39/EC of the European Parliament and of the Council of 21 April 2004 on markets in financial instruments (MiFID I) consisted in excluding emission allowances from the scope of financial instruments, but capturing derivative contracts based on such allowances (with the exception of Romania, where EUA’s were already classified as financial instruments). Derivatives relating to emission allowances were within the MiFID I scope in case “they must or may be settled in cash or have the characteristics of other derivative financial instruments” (most common example, if they were traded on a regulated market or an MTF - see Article 38(3) of the Commission Regulation (EC) No 1287/2006 of 10 August 2006). This covered the overwhelming share of the EU carbon market consisting mostly in transactions in emission allowances in the form of derivatives (futures, forwards, options, swaps).
Under the MiFID II approach, however, the scope of the EU financial markets legislation has been extended to apply to the spot segment of the carbon market. This is achieved by classifying emission allowances (and other ETS compliance units) as financial instruments under MiFID (i.e. by listing them as a new class of financial instruments in Annex I Section C of the said Directive). MiFID II establishes emission allowances as a particular category of financial instruments under point (11) of Section C of Annex I of that directive, and lists derivatives of emission allowances under point (4) of Section C of the said Annex. In effect of MiFID II legislative modifications emission allowances will constitute financial instruments no matter at which trading venue they will be in circulation, what settlement method will be applied, or other specificities.
Commission Delegated Regulation (EU) 2019/1868 of 28 August 2019 amending Regulation (EU) No 1031/2010 to align the auctioning of allowances with the EU ETS rules for the period 2021 to 2030 and with the classification of allowances as financial instruments pursuant to Directive 2014/65/EU of the European Parliament and of the Council, Recital 8
In order to reinforce the integrity of the carbon market, since 2018, allowances are classified as financial instruments by Directive 2014/65/EU of the European Parliament and of the Council. Previously, Directive 2004/39/EC of the European Parliament and of the Council recognised only derivatives of allowances as financial instruments. The new classification brings the secondary market spot trade in allowances in the scope of, inter alia, Directive 2014/65/EU, Regulation (EU) No 596/2014 of the European Parliament and of the Council and Regulation (EU) No 600/2014 of the European Parliament and of the Council (9). However, the process of auctioning of allowances (primary market) is only in the scope of Regulation (EU) No 596/2014.
It is noteworthy that "the definition of commodity derivatives does not include derivatives of emission allowances, as point (4) of Section C of Annex I of MiFID II is not cross-referred to in the definition of commodity derivatives" (Consultation Paper ESMA's guidelines on information expected or required to be disclosed on commodity derivatives markets or related spot markets under MAR, 30 March 2016, ESMA/2016/444, p. 13).
UK Financial Conduct Authority (FCA) in the document Markets in Financial Instruments Directive II Implementation – Consultation Paper I (CP15/43), December 2015 (p. 267, 268) observes emission allowances under the MiFID II are covered in four, sometimes overlapping, ways:
1. Article 6(5) of the Auctioning Regulation deems as an investment service or activity the reception, transmission and submission of a bid for a financial instrument (the "five-day future" auction product) on an auction platform by an investment firm to which MiFID applies or a CRD credit institution.
2. the Auctioning Regulation also regulates bids for allowances in the form of two-day spot contracts,
3. an emission allowance is itself a financial instrument (Section C11 of the Annex I to the MiFID II),
4. an option, future, swap, forward rate agreement or any other derivative contract relating to emission allowances is included as a derivative under Section C4 of the Annex I to the MiFID II when it may be settled physically or in cash.
FCA notes there is "no explanation about how all this overlapping legislation fits together" but in the FCA's view, they work like this:
1. an emission allowance auctioned as a five-day future or a two-day spot contract is regulated under the Auctioning Regulation,
2. the five-day future auction product is a financial instrument and is regulated under MiFID, it is included under Sections C4 and C11 of the Annex I to the MiFID II,
3. the two-day spot contract product is also a financial instrument, it is included under Section C11, it is therefore also regulated under MiFID,
4. in the FCA's view an emission allowance (including when auctioned under the Auctioning Regulation) will not come within C1,
5. the Auctioning Regulation covers the reception, transmission and submission of a bid, this corresponds to the MiFID activities of the reception and transmission of orders in relation to one or more financial instruments, execution of orders on behalf of clients and dealing on own account,
6. the Auctioning Regulation provides certain exemptions for aircraft operators and others, these exemptions continue to apply whether or not a MiFID exemption is available, but only for bidding activities covered by the auction regulation,
7. the MiFID activities that apply to a product covered by the Auctioning Regulation are not limited to the MiFID activities listed in paragraph (5) of this list, all the MiFID investment services and activities apply to emission allowances auctioned as a financial instrument, therefore, for example, advising on bids for emission allowances auctioned as a five-day future is covered by MiFID.
Interestingly, also under the Australia carbon price framework emission allowances were classified as financial products. This reflects current legislative tendencies and the belief that the financial market infrastructure represents a more safe and efficient regulatory environment for emission allowances' trading than the earlier quasi-commodity arrangements.
Consequences of the carbon units' reclassification
The prominent effect of the described regulatory U-turn is the professional intermediaries in spot emissions trading have to apply for the MiFID licence. But market effects in this regard are obviously more far-reaching. The European Commission's MEMO-14-305 already was mentioning, in effect of MiFID II amendments "the spot market will be aligned with what is applicable to the EUA derivatives market".
Pursuant to the European Commission’s Report of 18 November 2015 on the functioning of the European carbon market (COM(2015) 576 final, p. 24) the above re-classification means that "MiFID2 rules applicable to traditional financial markets (those including carbon derivatives trade on leading platforms) will also apply to the spot segment of the secondary carbon market (transactions in emission allowances for immediate delivery in the secondary market, currently unregulated at EU level), putting it on equal footing with the derivatives market in terms of transparency, investor protection and integrity". The above Report of November 2015 refers, moreover, to some pieces of financial market legislation that will apply to the carbon market by virtue of cross-references to MiFID II definitions of financial instruments. This is, in particular, the case of Market Abuse Regulation (MAR), which covers transactions and conduct involving emission allowances, both on secondary markets and in the EU ETS auctions in the primary market.
According to the said Report of November 2015, similarly, a cross-reference to MiFID II in the Anti-Money Laundering Directive will trigger a mandatory application of customer due diligence checks by MiFID-licensed carbon traders to their clients in the secondary spot market in emission allowances (the said Report observes, due diligence checks are already mandatory in the primary market and in the secondary market in emission allowances' derivatives).
MiFID II and MAR adaptations to carbon market specificities are:
- specific exemptions from MiFID II for carbon market participants (including on the grounds of ancillary character of such activity to the core activity, essentially addressed to compliance buyers and entities trading on behalf of others on a limited scale);
- inside information disclosure duty only for largest participants/emitters;
- more detailed position reporting (but no position limits) by trading venues;
- treating emission allowances as a separate category under pre- and post-trade transparency obligations (to facilitate development of adapted implementing rules);
- full coverage of emission derivatives (similarly to derivatives with 'financial' underlying and unlike commodity derivatives).
See more detailed remarks on:
- specific MiFID II exemption for EU ETS operators (applicable to emission spot market), and
- MiFID II ancillary activity exemption (capturing spot and emission allowances' derivatives).
Oversight in the primary market will continue to be covered by the Auctioning Regulation, other than issues related to market abuse, where the Market Abuse Regulation (MAR) will be directly applicable.
MiFID II structure and legislative path - key dates and documents
MiFID II legal framework is made up at the the first level of the MiFID Directive (2014/65/EU) and the Markets in Financial Instruments Regulation (MiFIR - 600/2014/EU). MiFID is addressed to all Member States and as a directive is binding as to the result to be achieved, although leaving the choice of form and methods of implementation to the Eu Member States’ national authorities. MiFIR, being the EU regulation, is binding in its entirety and directly applicable, its content becomes law in the EU Member States without the need for domestic legislative intervention.
MiFID II and MiFIR are, formally, separate pieces of legislation, however, Recital 7 of the MiFID II clarifies that ‘both instruments should form the legal framework governing the requirements applicable to investment firms, regulated markets, data reporting services providers and third country firms providing investment services or activities in the Union. The Directive should therefore be read together with that Regulation’.
The legislative procedure leading to this major revamp of the EU financial legislation was prolonged and covered the following milestones:
- 20 October 2011 - the European Commission adopted two legislative proposals, a directive and a regulation, for the review of MiFID I.
- 14 January 2014 - the European Parliament and the Council reached political agreement on a compromise text (see the Council communication of 19 February 2014 as well as the final compromise texts of MiFID II and MiFIR: Markets in financial instruments: Council confirms agreement with EP).
The final legislative texts of MiFID II and MiFIR were approved by the European Parliament on 15 April 2014 and by the European Council on 13 May 2014.
The two texts were published on the Official Journal on 12 June 2014 and entered into force on the twentieth day following this publication – i.e. 2 July 2014:
- MiFID II: Directive 2014/65/EU of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments and amending Directive 2002/92/EC and Directive 2011/61/EU (OJ L 173, 12.06.2014, p. 349),
- MiFIR: Regulation (EU) No 600/2014 of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments and amending Regulation (EU) No 648/2012 (OJ L 173, 12.06.2014, p. 84).
MiFIR is a regulation, hence it will automatically become part of EU Member States' domestic laws on the date on which it applies. Given MiFID II date of effect is 2 July 2014, and it initially was planned to enter into force after 30 months, thus the original starting date for the compliance requirement was 3 January 2017.
The above MiFID II/MiFIR application date has been subsequently extended by 1 year - i. e. till 3 January 2018
Date of transposition of MiFID II into the EU Member States' national laws initially was 3 July 2016, and has been subsequently extended until 3 July 2017 (Article 93(1) of MiFID II - see Article 1(7) of the Directive (EU) 2016/1034 of the European Parliament and of the Council of 23 June 2016 amending Directive 2014/65/EU on markets in financial instruments).
The main milestones of the legislative process in this regard were:
1. The process has been ignited by ESMA (ESMA's Note of 2 October 2015 on MIFID/MIFIR implementation: delays in the go-live date of certain MiFID provisions (ESMA/2015/1514) and the European Parliament's Press release of 27 November 2015);
2. The European Commission has made the legislative proposition for the prolongation on 16 February 2016 (see:
- European Commissions' press release,
- European Commission's Proposal for a Regulation of the European Parliament of the Council amending Regulation (EU) No 600/2014 on markets in financial instruments, Regulation (EU) No 596/2014 on market abuse and Regulation (EU) No 909/2014 on improving securities settlement in the European Union and on central securities depositories as regards certain dates, 10.2.2016, COM(2016) 57 final, 2016/0034 (COD)),
- Proposal for a Directive of the European Parliament of the Council amending Directive 2014/65/EU on markets in financial instruments as regards certain dates, 10.2.2016, COM(2016) 56 final, 2016/0033 (COD);
3. On 7 April 2016 the European Parliament adopted the aforementioned European Commissions' proposal to postpone the MiFID II entry into force (see EU Lawmakers Approve MiFID II Market Rule Delay by One Year);
4. The legislative process for 1-year delay has been finalised:
- as regards MiFID II - with the adoption of the Directive (EU) 2016/1034 of the European Parliament and of the Council of 23 June 2016 amending Directive 2014/65/EU on markets in financial instruments,
- as regards MiFIR - with the adoption of the Regulation (EU) 2016/1033 of the European Parliament and of the Council of 23 June 2016 amending Regulation (EU) No 600/2014 on markets in financial instruments, Regulation (EU) No 596/2014 on market abuse and Regulation (EU) No 909/2014 on improving securities settlement in the European Union and on central securities depositories.
MiFID II Level 2 legislation
MiFID II empowers the European Commission to make secondary legislation in the form of:
- delegated acts (for example as provided for in article 4(2) MIFID to specify elements of the definitions),
- regulatory technical standards (RTS), and
- implementing technical standards (ITS).
Delegated acts under MiFID II may take the form of either directives or directly applicable regulations. Delegated acts are drafted and made by the European Commission, after receiving advice from the ESMA. The drafts for RTS and ITS under MiFID II are prepared by ESMA and are subject to public consultation, before endorsement and making by the European Commission. RTS and ITS under MiFID II take the form of regulations and are directly applicable. RTS and ITS are, however, technical in nature and according to Articles 10 and 16 of the Regulation (EU) No 1095/2010 of the European Parliament and of the Council of 24 November 2010 establishing a European Supervisory Authority (European Securities and Markets Authority) must not imply strategic decisions or policy choices. Moreover, the content of the RTS and ITS is to be delimited by the legislative acts on which they are based.
To sum-up: the bulk of Mifid II consists of RTS, which are drafted by the ESMA and then approved by the European Commission. But for 14 elements of the package, the the European Commission is mandated to adopt rules directly, with ESMA providing advice only – the so-called delegated acts. These include new requirements on best execution and research received by asset managers from banks.
The following RTS and delegated acts were published in the Official Journal of the European Union, L 87 on 31 March 2017 (all apply from 3 January 2018 except where noted):
RTS 1 on transparency requirements for trading venues and investment firms in respect of shares, depositary receipts, exchange-traded funds, certificates and other similar financial instruments – Article 19 will apply from 3 September 2018.
RTS 2 on transparency requirements for trading venues and investment firms in respect of bonds, structured finance products, emission allowances and derivatives – Article 18 will apply from 3 September 2018.
RTS 3 on the volume cap mechanism and the provision of information for the purposes of transparency and other calculations
RTS 5 on the direct, substantial and foreseeable effect of derivative contracts within the Union
RTS 6 specifying the organisational requirements of investment firms engaged in algorithmic trading
RTS 7 specifying organisational requirements of trading venues (Commission Delegated Regulation (EU) 2017/584 of 14 July 2016 supplementing Directive 2014/65/EU of the European Parliament and of the Council with regard to regulatory technical standards specifying organisational requirements of trading venues)
RTS 8 specifying the requirements on the market making arrangements and schemes
RTS 9 on the ratio of unexecuted orders to transactions
RTS 10 requirements to ensure fair and non-discriminatory co-location services and fee structures
RTS 11 on the tick size regime for shares, depositary receipts and, exchange traded funds – Article 5 will apply from 3 September 2018.
RTS 12 on the determination of a material market in terms of liquidity relating to halt notifications
RTS 13 on the authorization, organisational requirements and the publication of transactions for data reporting services providers – Articles 14(2) and 20(b) will apply from 3 September 2018.
RTS 14 on the specification of the offering of pre-and post-trade data and the level of disaggregation of data
RTS 15 on clearing access in respect of trading venues and central counterparties – Articles 15, 16, 17, 19 and 20 will apply from 20 April 2017
RTS 17 on the admission of financial instruments to trading on regulated markets
RTS 18 on the suspension and removal of financial instruments from trading reporting services providers
RTS 20 on the criteria to establish when an activity is considered to be ancillary to the main business
RTS 21 on the application of position limits to commodity derivatives
RTS 22 on the reporting of transactions to competent authorities
RTS 23 for the data standards and formats for financial instrument reference data
RTS 24 on the maintenance of relevant data relating to orders in financial instruments
RTS 25 on the level of accuracy of business clocks
RTS 26 on specifying the obligation to clear derivatives traded on regulated markets and timing of acceptance for clearing (STP)
RTS 27 on the data to be provided by execution venues on the quality of execution of transactions
RTS 28 on the annual publication by investment firms of information on the identity of execution venues and on the quality of execution
RTS on cooperation between authorities
MiFID II Delegated Regulation as regards organisational requirements and operating conditions for investment firms and defined terms for the purposes of that Directive
MiFID II Delegated Directive with regard to safeguarding of financial instruments and funds belonging to clients, product governance obligations and the rules applicable to the provision or reception of fees, commissions or any monetary or non-monetary benefits
MiFIR Delegated Regulation with regard to definitions, transparency, portfolio compression and supervisory measures on product intervention and positions – Article 23 will apply from 20 April 2017.
Level 3 Guidance
There is also available an extensive set of supportive documents issued by ESMA:
- MiFID II Guidelines, and
- Questions and Answers (Q&As) on MiFID II.
ESMA Guidelines are subject to the ‘comply or explain’ process in Article 16 of the said Regulation 1095/2010 and are addressed to competent authorities or, as the case may be, market participants. Under Article 16(3) of the Regulation 1095/2010 competent authorities and financial market participants must make every effort to comply with these. The competent authorities are required to notify ESMA whether they will comply or intend to comply with the ESMA’s Guidelines (with reasons for any non-compliance), financial market participants are not required to make such notifications to the ESMA.