The main fundamental change MiFID II brings into the commodity market is that the scope of financial instruments will include physically-settled derivatives traded on an OTF (except for those already regulated under REMIT).
MiFID II Amendments
Physically settled derivatives traded on regulated markets, MTFs and OTFs => financial instruments
This is consistent with the original European Commission's conception, which was to include into the financial instruments' scope all commodity contracts:
(1) traded on any type of trading venue and
(2) that can be physically settled (both preconditions to be applied cumulatively).
The underlying motives were economic equivalency of these commodity contracts to financial instruments and their ability to be used like financial instruments as well as exposition to similar risks (see MEMO/14/305).
It needs to be noted, however, that physically settled commodity derivatives were already within the scope of MiFID I if they were traded on regulated markets or MTFs, hence, in essence, an OTF has only been added to the above MiFID-relevant set of trading venues.
Firms trading commodity derivatives who were not authorised under MiFID I need to examine whether they can continue to remain exempt from authorisation under MiFID II.
"Under MiFID I, trades of wholesale energy products that are physically settled are generally not considered to be "financial instruments"" said Eurelectric in the letter to European Commissioners on 10 April 2015 (EURELECTRIC concerns regarding proposed MiFID II implementing rules).
The key terms that need to be accounted for when thinking about MiFID II regulation for physically settled commodity derivatives are:
- "REMIT carve-out", and
Both represent the exceptions to the general rule that all commodity derivatives contracts traded on any type of trading venue that can be physically settled must be subject to financial market regulation and, equally, both were added at later stages of the MiFID II legislative process.
MiFID II Annex I Section C6 Financial instruments
"Options, futures, swaps, and any other derivative contract relating to commodities that can be physically settled provided that they are traded on a regulated market, a MTF, or an OTF, except for wholesale energy products as defined in Article 2 paragraph 4 of Regulation (EU) No 1227/2011 traded on an OTF that must be physically settled"
Section C6 of Annex I excludes wholesale energy products within the scope of REMIT that are traded on an OTF and that must be physically settled. Therefore, these excluded wholesale energy products do not qualify as financial instruments and are consequently outside the scope of MiFID, EMIR and the CRD IV package ("REMIT carve-out").
It needs to be underlined that wholesale energy products as defined in REMIT in order to remain outside MiFID II must be physically settled (Level 2 measure sets out details on this).
The reason for exclusion of wholesale energy contracts covered under the Regulation on the integrity and transparency of the wholesale energy markets (REMIT) from the scope of financial instruments was that these contracts "are subject to a certain level of regulation and supervision comparable with financial markets legislation and so their exclusion is justified as a proportional amendment to avoid unnecessary dual regulation" (at least MEMO/14/305 explains the issue in this way).
Indeed, REMIT created almost entirely self-standing legal framework for specifically designated scope of products and, in the absence of the REMIT carve-out, these measures would be, at least partially, overlapping.
This argument does not equally apply to the second exclusion (for coal and oil - the so-called "C6 energy derivatives contracts"), for which the decisive factor for the specific treatment were the lacking clearing habits and the need for a smooth transition. Thus, the transitional provision was foreseen, under which competent authorities are able to exempt from certain EMIR requirements the oil and coal derivatives which are traded non-financial counterparties on an OTF and must be physically settled (i.e. the C6 energy derivatives contracts).
The C6 energy derivatives contracts under MiFID II mean options, futures, swaps, and any other derivative contracts mentioned in Section C6 of Annex I relating to coal or oil that are traded on an OTF and must be physically settled.
Article 95 MiFID II
1. Until 3 January 2021:
(a) the clearing obligation set out in Article 4 of Regulation (EU) No 648/2012 and the risk mitigation techniques set out in Article11(3) thereof shall not apply to C6 energy derivative contracts entered into by non-financial counterparties that meet the conditions in Article 10(1) of Regulation (EU) No 648/2012 or by non-financial counterparties that shall be authorised for the first time as investment firms as from 3 January 2018; and
(b) such C6 energy derivative contracts shall not be considered to be OTC derivative contracts for the purposes of the clearing threshold set out in Article 10 of Regulation (EU) No 648/2012. C6 energy derivative contracts benefiting from the transitional regime set out in the first subparagraph shall be subject to all other requirements laid down in Regulation (EU) No 648/2012.
2. The exemption referred to in paragraph 1 shall be granted by the relevant competent authority. The competent authority shallnotify ESMA of the C6 energy derivative contracts which have been granted an exemption in accordance with paragraph 1 and ESMA shall publish on its website a list of those C6 energy derivative contracts.
The increased significance of C6 energy derivatives contracts under MiFID 2 is involved with the fact that in the transitional period after the entry into force of the MiFID II Directive, until 3 January 2021:
- by non-financial counterparties below the EMIR clearing threshold, or
- by non-financial counterparties that will be authorised for the first time as investment firms as from the date of entry into application of the Directive; and
(b) such C6 energy derivative contracts will not be considered OTC derivative contracts for the purposes of the EMIR clearing threshold (Article 95 MiFID II).
It needs to be stressed these C6 energy derivative contracts benefiting from the above-mentioned transitional regime will be subject to all other applicable EMIR requirements - other than the collateralisation risk mitigation techniques as well as the EMIR reporting requirement.
It follows, special treatment for commodity derivatives traded on a regulated markets, MTFs and OTFs after entry into force of MiFID II Directive has been reserved for OTF-traded and physically-settled:
3) wholesale energy products defined in REMIT.
It is, however, noteworthy, as opposite to the "REMIT carve-out" (REMIT-defined wholesale energy products), which has a permanent, unconditional and comprehensive character, the exemption for oil and coal:
1) is conditional (exemption can be granted by the relevant competent authority),
2) is temporary (untill 3 January 2021),
3) has limited extent (refers only to exhaustively-listed EMIR provisions),
4) still leaves C6 energy derivatives contracts categorised in the scope of financial instruments - which entails being subject to other MiFID II provisions, position limits including.
MiFIR recitals accentuate that the technical standards specifying the clearing obligation in accordance with EMIR must take transitional exemption for C6 energy derivative contracts into account and do not impose a clearing obligation on derivative contracts captured. The national competent authority has to notify ESMA of the C6 energy derivative contracts, which have been granted an exemption in accordance with the above provisions. ESMA's task is to subsequently list exempted instruments on the ESMA's website.
Article 90(4) MIFID II
By 1 January 2019 the Commission shall prepare a report, after consulting ESMA and ACER, assessing the potential impact on energy prices and on the functioning of the energy market as well as the feasibility and the benefits in terms of reducing counterparty and systemic risks and the direct costs of C6 energy derivative contracts being made subject to the clearing obligationset out in Article 4 of Regulation (EU) No 648/2012, the risk mitigation techniques set out in Article 11(3) thereof and their inclusion incalculating the clearing threshold pursuant to Article 10 thereof.
If the Commission considers that it would not be feasible and beneficial to include those contracts, it shall submit, if appropriate, a legislative proposal to the European Parliament and the Council. The Commission shall be empowered to adopt delegated acts in accordance with Article 89 of this Directive to extend the 42-month period referred to in Article 95(1) of this Directive once by two years and a further time by one year.
At the latest by 1 January 2019 the European Commission is required to prepare a report assessing the potential impact on energy prices and on the functioning of the energy market as well as the feasibility and the benefits in terms of reducing counterparty and systemic risks and the direct costs of C6 energy derivative contracts being made subject to the following EMIR provisions:
- the clearing obligation (Article 4), and
- the risk mitigation techniques (Article 11(3)), and
- inclusion in calculating the clearing threshold (Article 10).
If the Commission considers that it would not be feasible and beneficial to include these contracts, it will submit, if appropriate, a legislative proposal to the European Parliament and the Council. The Commission will, moreover, be empowered to adopt delegated acts to extend the transitional period once by two years and once by one year (Article 90(4) MiFID II).
When the derivative contract "must be physically settled"?
The element that is common to both categories of OTF trading excluded from the general MiFID II rules i.e. the permanent exemption for REMIT wholesale energy products and the temporary exemption for oil and coal C6 energy derivatives contracts is they "must be physically settled".
Recital 10 of MiFID II gives only general indications for the precise meaning and scope of this expression, referencing to the delegated act and mandating to take into account "at least the creation of an enforceable and binding obligation to physically deliver, which cannot be unwound and with no right to cash settle or offset transactions except in the case of a force majeure event or other bona fide inability to settle physically.
Enforceable and binding obligation
An enforceable and binding obligation to physically deliver is considered to exist if the party to the contract entitled to receive the underlying commodity has an unrestricted and unconditional right to physical delivery.
It is also required, there must be no option for either party to the contract to replace physical delivery with cash settlement or to cancel out the contractual obligation for physical delivery by netting against other contractual obligations (see ESMA's Consultation Paper on MiFID/MiFIR of 22 May 2014 (ESMA/2014/549), p. 279).
Broad range of delivery methodologies
The term "physically settled" is interpreted by the European financial regulator to incorporate a broad range of delivery methodologies including:
i. physical delivery of the relevant goods themselves;
ii. delivery of a document giving rights of an ownership nature to the relevant goods or the relevant quantity of the goods concerned (such as a bill of lading or a warehouse warrant); or
iii. another method of bringing about the transfer of rights of an ownership nature in relation to the relevant quantity of goods without physically delivering them (including notification, scheduling or nomination to the operator of an energy supply network) that entitles the recipient to the relevant quantity of the goods.
The technique for "operational netting" as a specific form of settlement in power and gas markets does not prevent a contract from being considered as "must be physically settled". The European financial regulators' view is the performance of such practices in energy markets is not in itself the sole determinant for the application of financial regulation (see ESMA's Technical Advice to the Commission on MiFID II and MiFIR of 19 December 2014, ESMA /2014/1569, p. 403). However, in order to remain beyond the scope of financial regulation operational netting must be understood as a process required by the rules or requests of a Transmission System Operator (TSO) or an entity performing an equivalent function at the national level which must not be at the discretion of the parties to the contract.
Operational netting is handled in different ways in different Member States of the European Union, however, there is the number of features common, which clearly delineate this process from other offsetting.
These key distinctive characteristics of the operational netting in the power and gas markets include:
- a third party, such as a TSO, requires the parties to the contract to net the flows at the point of delivery for operational efficiency and balancing of network capacity,
- the participants have to have all operational arrangements and approvals in place to make and take physical delivery as though it were taking place on a gross basis,
- nominations to the TSO happen on a net basis for administrative convenience rather in accordance with the instructions and operational rules of the TSOs,
- operational arrangements do not involve the netting of contracts or transactions, which remain separate and provide for transfer of title.
The significant observation is, moreover, operational netting of power and gas contracts still results in physical delivery, albeit on a net basis, by contrast, contracts not for physical settlement are characterised as those which do not require entering into contractual arrangements with system operators, registering of contracts with system operators, submitting of schedules and are not subject to balancing rules. Overall, it appears operational netting will not be on the collision course with MiFID II new rules for physically settled commodity derivatives.
Force majeure clauses and other bona fide inability to perform
ESMA notes in the case of force majeure that no instrument can be a 100% accurately described as "must be physically settled", as practically all instruments appear to contain such force majeure provisions that would prevent physical delivery. Therefore ESMA considers that the existence of force majeure provisions should not prevent a contract from being characterised as "must be physically settled" for the purposes of further specifying wholesale energy products under Section C6 and C6 energy derivative contracts. The same applies to other bona fide inability to perform the contract on a physical settlement basis.
The above assumptions took the form of legal language in Article 5 and Recitals 3 and 4 of the 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.
This thread is further commented upon in the separate article: Contracts that must be physically settled" under the MiFID II framework.
Commodity derivatives 'having the characteristics of other derivative financial instruments'
Criteria for differrentiating commodity derivatives traded outside regulated markets, MTFs, and OTFs are described in the separate article: Commodity derivatives having the characteristics of other derivative financial instruments.
MiFID II carbon credits' treatment
MiFID II, however, does not contain an exemption for firms specialising in professional emissions trading on own account, consequently, such emissions brokers which are not licensed under MiFID will be squeezed out of the market.
Effects of subjecting derivatives market participants to MiFID II requirements
When the conditions for MiFID II exemptions are not fulfiled it means falling within the scope of MiFID II, which, among others, results in authorisation requirements, being subject to the trading and clearing obligation, potentially being subject to prudential requirements under CRD IV and the application of multiple orher regulatory restrictions.
The regulatory impact have been shortly assessed in the ESMA's Discussion Paper on MiFID II/MiFIR of 22 May 2014, ESMA/2014/548 and the below remarks refer thereto.
If firms cannot make use of an exemption under MiFID II, capital requirements under the new banking regulatory framework will apply to them. The CRR (Regulation (EU) No 575/2013 of the European Parliament and of the Council of 26 June 2013 on prudential requirements for credit institutions and investment firms and amending Regulation (EU) No 648/2012 imposes quantitative requirements and disclosure obligations pursuant to Basel III recommendations on credit institutions and investment firms, including own funds definition, minimum own funds requirements and liquidity requirements. However, under Article 498 (1) of CRR some commodity dealers falling within the scope of MiFID II are transitionally exempt from the CRR's provisions on own funds requirements until 31 December 2020 if their main business consists exclusively of providing investment services or activities relating to commodity derivatives (for details see CRR commodity dealers exemption).
Moreover, investment firms falling within the scope of MiFID II will be considered to be financial counterparties rather than non-financial counterparties under Article 2(8) EMIR. Therefore, they will not be able to benefit from the clearing thresholds easement available to the latter under Article 10 EMIR.
Clearing hedging exemption
Hedging exemption under EMIR is not available for financial counterparties.
An additional consequence of being classified as a financial counterparty will be that the trading obligation (i.e. the obligation to trade derivatives which are subject to the clearing obligation and sufficiently liquid on certain trading venues only, cf. Article 28 MiFIR) would apply in full without being subject to a threshold (besides financial counterparties trading obligation applies also to NFCs+).
For firms that will fall under MiFID II it is also worth keeping in mind that the hedging exemption in relation to the position limits regime will only apply to non-financial entities as Article 57(1) of MiFID II states that position limits shall not apply to positions held by or on behalf of a non-financial entity which are objectively measurable as reducing risks directly related to the commercial activity of that non-financial entity.
Preceding remark applies also to pre-trade transparency requirements - derivative transactions of non-financial counterparties which are objectively measurable as reducing risks directly related to commercial activity or treasury financing activity of the non-financial counterparty or of the group are not subject to pre-trade transparency requirements in accordance with Article 8(1) MiFIR.
Regulatory uncertainties relating to physically settled commodity derivatives under MiFID I
UK FCA statement of 11 September 2013
"Physically settled gas and power forwards that are traded on multilateral trading facilities (MTFs) are 'financial instruments' for the purposes of MiFID, and 'OTC derivatives' or 'OTC derivative contracts' for the purposes of EMIR."
Clear and uniform regulatory set-up for physically-settled commodity forwards, as implemented through the MiFID II, can't be overestimated. Under MiFID I in application until 3 January 2018 the situation is more complex.
When someone refers for instance to the UK FCA statement of 11 September 2013 (classifying the physically-settled commodity forwards traded on MTFs as 'financial instruments' for the purposes of MiFID I, and 'OTC derivatives' or 'OTC derivative contracts' for the purposes of EMIR) or to the ESMA letter to the European Commission of 14 February 2014 acknowledging that the different transpositions of MiFID across EU Member States mean that 'there is no single, commonly adopted definition of derivative or derivative contract in the European Union', there should be no doubt that the regulatory intervention, as implemented in MiFID II, was extremely needed.
ESMA letter to the European Commission of 14 February 2014 on physically settled commodity forwards
"With reference to physically settled commodity forwards, it should be noted that the interpretation and application of definitions in points 6 and 7 of Section C of Annex I to MIFID (C6 and C7) is not convergent across the EU. These definitions have given rise to the following queries:
a. C7 explicitly applies to "futures" and "forwards" whereas C6 omits any reference to forwards.
Consequently, there are divergent views with regard to whether physical forwards traded on a regulated market or a MTF fall within MiFID's scope.
b. C6 and C7 apply to instruments which can be "physically settled". However, "physically settled" is not a defined term under MiFID. Further, C5 refers to instruments that "must be settled in cash or may be settled in cash at the option of one of the parties" whereas C6 and C7 refer to instruments that "can be physically settled".
Consequently, determining what is meant by can, may and must be physically settled should be considered for the identification of the contracts that fall within the definition of derivatives.
Contracts under point a. above and for which the definitions under point b. are relevant, are not clearly identified as derivatives across the Union."
The European Commission letter of 26 February 2014 to ESMA on this issue (Markt/G3/PO/or/(2014) s. 510569) practically postpones the wind-up of the problem till the MiFID II implementing acts, which means we will face the regulatory uncertainty until 3 January 2018 (i.e. the MiFID II entry into force).
MiFID II Articles 90(4), 95, Annex I Section C6
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, Article 5, Recitals 3 and 4
ACER's Recommendation No 01/2015 of 17 March 2015 on the regime applying to the derivative contracts referred to in Section C.6 of Annex I of MiFID II which have the characteristics of wholesale energy products that must be physically settled according to Article 4(1)(2), second subparagraph, and Article 89 of MiFID II