The MiFID II framework aims at reclassifying large non-financial commodities traders as financial counterparties.
Questions and Answers on MiFID II and MiFIR commodity derivatives topics ESMA70-872942901-36 updated on 2 October 2018
MiFID II puts in place an 'ancillary activity test' that determines how much non-hedging (or speculative) commodity derivative or emission allowances derivative trading non-financial firms (NFCs) can conduct before this activity is no longer deemed 'ancillary to the main business' of the firm and the firm be obliged to seek a MiFID authorisation (MiFID II ancillary activity exemption).
Hence the largest NFCs active on commodity derivative or emission allowance derivative markets will need to seek a MiFID authorisation.
Two thresholds are used in MiFID II:
- one based on the value of contracts traded by the firm as a percentage of the overall EU market size for that commodity derivative or emission allowance derivative (the market share test), and
- one based on whether commodity derivative or emission allowance derivatives make up more than 10% of the firm's business (the main business test).
Both tests need to be passed to keep the exemption, however, the main business test has two, alternative, options:
a) the trading test, and
b) the capital employed test.
There is also the backstop mechanism to correct the results.
The European Commission while answering on 31 May 2018 to the ESMA’s letter confirmed that the ancillary activities tests must be calculated as many times as necessary for each separate person who trades in commodity derivatives within a group.
Moreover, in the European Commission’s opinion:
- Article 2(1)(j) MiFID II requires that the test of whether the MiFID activities are ancillary needs to be assessed for both MiFID activities (dealing on own account and providing investment services other than dealing on own account) 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.
Calculating exposures in "exotic derivatives"
In the answer to Question 11 (Questions and Answers on MiFID II and MiFIR commodity derivatives topics, Ancillary activity, updated on 4 October 2017) ESMA referred to the issue of the ancillary activity test calculations with respect to various instruments listed in Annex I, Section C(10) of MIFID II with an underlying which is not a commodity.
According to the ESMA these instruments must be treated consistently across all provisions concerning commodity derivatives in the MiFID II/MiFIR framework.
Therefore, all those commodity derivative contracts with underlyings that are subject to the position limit regime as specified in the said Q&As Position Limits Question 10 should also be counting towards the ancillary activity test calculations.
Other contracts within the C(10) scope should not be counted.
Considering the ESMA’s stance expressed in the said Q&As:
- Ancillary activity Question 11, and
- Position Limits Question 10;
it may be concluded that the ESMA’s approach to the ancillary activity test calculations for different types of commodity derivatives covered by Section C(10) of Annex I of MIFID II is as follows:
1. Freight rate derivatives (wet and dry freight)
According to the above ESMA's opinion, freight rate derivatives (wet and dry freight) should be included in the ancillary activity test calculations under MiFID II.
2. Derivative contracts relating to indices
ESMA also said that the ancillary activity test calculations should be applied to derivative contracts relating to indices if the underlying index is materially based on commodity underlyings as defined in Article 2(6) of Commission Delegated Regulation (EU) 2017/565 of 25 April 2016 supplementing Directive 2014/65/EU of the European Parliament and of the Council as regards organisational requirements and operating conditions for investment firms and defined terms for the purposes of that Directive.
ESMA considers that the underlying index derivative is materially based on commodities if such commodities have a weighting of more than 50% in the composition of the underlying index.
3. Commodity derivative contract in the form of a “spread” or “diff” contract
A commodity derivative contract in the legal form of a “spread” or “diff” contract is a contract that is cash-settled and whose value is determined by the difference between two reference commodities which may vary in type, grade, location, time of delivery, or other features.
Whilst having multiple commodity values underlying it, the commodity derivative is available on a trading venue as a single tradable financial instrument.
As a spread contract has no single commodity at a specific place or time as the underlying, it is not possible to link it to a single physical deliverable supply against a contractual obligation to physically settle the trade.
It is for this reason all spread contracts are cash-settled and not physically settled.
Therefore, according to the ESMA, spread contracts should be treated in the ancillary activity test calculations in the same manner as C10 commodity derivatives which do not have a physical underlying, such as weather derivatives.
4. Other derivatives listed in Section C10 of Annex I of MiFID
Other derivatives listed in Section C10 of Annex I of MiFID II and in Article 8 of Commission Delegated Regulation of 25 April 2016, according to the ESMA should be included in the ancillary activity test calculations under MiFID II, as the underlyings of such derivatives are not considered to be commodities as defined in Article 2(6) of Commission Delegated Regulation of 25 April 2016.
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