How To Understand The New Financial Regulations In European Law

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Seventh Annual MIG seminar:

The Impact of MiFID II and EMIR on Commodities

Hannah Meakin (Partner) and Cat Blake (Associate) 5 March 2014

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Overview

• MiFID II: What are “financial instruments”?

• Additions and amendments to the type of financial instrument that is within scope of MiFID

• MiFID II: Who is within the scope of MiFID II?

• Additions and amendments to the MiFID exemptions

• Are the “exemptions” really exemptions?

Position limits and position management powers Algorithmic trading and HFT

• The link with EMIR

How does MiFID II impact on post-trade obligations

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MiFID II: What are “financial instruments”?

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MiFID financial instruments: commodity derivatives

MiFID I Any changes? What’s the impact?

Commodity derivatives that must be cash settled or may be cash settled (other than by reason of default or termination)

No N/A

Commodity derivatives which can be physically settled provided they are traded on an RM, MTF or OTF except for REMIT wholesale energy products traded on an OTF which must be physically settled

Yes

• Includes such derivatives traded on an OTF

• The REMIT carve out – subject to an RTS

• Subset of these instruments which relate to coal or oil, are traded on an OTF and must be physically settled are subject to transitional provision in respect of EMIR obligations – subject to an RTS

• Inclusion of OTF potentially includes much wider category of instruments. Note that they will (subject to transitional provision) be in scope of EMIR and OTC for the purposes of EMIR. Impact on EMIR threshold calculations

• REMIT carve out – these products will not be in scope of MiFID or EMIR

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MiFID financial instruments: commodity derivatives

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MiFID I Any changes? What’s the impact?

Commodity derivatives that can be physically settled but are not traded on an RM, MTF or OTF, nor a REMIT instrument, are not for commercial purposes and which have the characteristics of other derivative financial instruments

Yes – RTS on derivative contracts that have “the characteristics of other derivative financial instruments”

Not yet clear

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MiFID financial instruments: commodity derivatives

MiFID I Any changes? What’s the impact?

Derivatives relating to climatic variables, freight rates or inflation rates or other official economic statistics or any other assets, rights, obligations indices or measures

not otherwise

mentioned that must be or may be cash settled (apart from default or termination); and have the characteristics of other derivative financial instruments having regard to whether they are traded on an RM, MTF or OTF

Yes:

• Now includes assessment of whether they are traded on an OTF

• RTS to be published on “having the characteristics of other derivative financial instruments”

Inclusion of OTF potentially includes much wider category of instruments

Potential impact of the RTS – not yet clear

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MiFID financial instruments

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• Emission allowances consisting of any units recognised for compliance with the requirement of the EU Emissions Trading Scheme are now MiFID financial instruments

• But are not EMIR instruments

• Note that derivatives on emission allowances remain both MiFID financial instruments and EMIR instruments

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MiFID II: Who is within scope?

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MiFID II: The common exemptions used by commodity market participants

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• The changes to the MiFID exemptions will have a significant effect on the commodities markets participants.

MiFID I exemption Still available? Any amendments?

2(1)(b) – “the group exemption”

Yes No

2(1)(d) – “the dealing on own account exemption”

Yes Now only applies to

financial instruments other than commodity derivatives, EUAs and derivatives on EUAs and has additional requirements

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MiFID II: The common exemptions used by commodity market participants

MiFID I exemption Still available? Any amendments?

2(1)(i) – “the ancillary business exemption”

Yes Significant amendments

have been made to this

exemption see

following slides

2(1)(k) “the

commodities dealer exemption”

No N/A

• Any firms which currently rely on any of these exemptions would be well advised to revisit and update their MiFID analysis

• NB there are other exemptions in MiFID, this presentation focuses on those which are commonly used by commodity market participants

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MiFID II: Exemptions – what’s the impact?

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Article 2(1)(i): Entities who, in relation to commodity derivatives, EUAs or EUA derivatives:

deal on own account

excluding those who deal on own account by executing client orders (execution of orders as an ancillary activity between two persons who main business on a group basis is neither the provision of investment services under MiFID nor banking services under the BCD should not be considered dealing on own account by executing client orders); or

provide investment services other than dealing on own account to the customers or suppliers of their main business

Provided:

In both cases, individually and on aggregate basis, this is an ancillary business to their main business when considered on a group basis;

Main business is not the provision of investment services under MiFID or banking services under BCD, nor acting as a market maker in relation to commodity derivatives;

They do not apply a high frequency algorithmic trading technique; and

They notify the relevant competent authority that they make use of this exemption on an annual basis and, on request, provide to the relevant competent authority the basis on which they consider the activity to be ancillary to their main business

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MiFID II: The exemptions

There are also new exemptions in relation to:

• Operators with compliance obligations under the ETS trading directive

• Transmission system operators under the electricity and natural gas directives and regulations

And optional exemptions for:

• JVs set up for the hedging requirements of local electricity undertakings or operators (as defined in the ETS trading directive)

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MiFID II: The exemptions

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Can we really describe them as exemptions any longer?

• Persons relying on new 2(1)(da) or (i) will be subject to the MiFID provisions in relation to algorithmic trading to the extent that they are members of or participants in a RM or MTF

• The position management and position limit powers of both the NCAs and ESMA apply to anyone with a commodity derivative position – regardless of whether they are exempt under any part of Article 2

• Product intervention powers of NCAs apply to anyone regardless of whether they are exempt under any part of Article 2

• The trading obligation in respect of OTC derivatives applies to EMIR NFC+s regardless of the fact that they are exempt under Article 2

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Active intervention in markets: position limits

• The four step process for setting of position limits for commodity derivatives:

Layer 1 • Competent authority shall impose position limits in line with technical standards determined by ESMA to prevent market abuse or support orderly pricing and settlement conditions

• Does not apply to hedging activity of non-financial entities

Layer 2 • ESMA opines on whether position limits are in line with objectives and methodology

Layer 3 • Competent authority can set more restrictive limits where objectively justified and proportionate taking account of liquidity and orderly market for 6 monthly renewable periods

Layer 4 • ESMA must opine on whether this is necessary

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Active intervention in markets: position management

• Trading venues must have position management powers for commodity derivatives:

Monitoring open positions

Access to information about positions

Require a person to terminate or reduce a position

Require a person to provide liquidity back into the market

• Competent authorities can:

Require information about size and purpose of position or exposure in a commodity derivative or underlying; and

Request a person to reduce positions and exposures in any derivative

• ESMA can:

Request information about size and position of any derivative and require a person to reduce it

Limit ability of a person to enter into a commodity derivative

To address a threat to viability of financial system or orderly functioning and integrity or competent authorities’ actions are inadequate

• Daily position reporting to competent authority by trading venues for commodity derivatives, emission allowances and derivatives on them

• Weekly report of aggregate positions by category of trader, commercial undertaking, investment firm etc.

to public

Complete breakdown of positions of members and clients to competent authority on request

Daily position reporting of own and client positions to trading venue by members of an RM or MTF and clients of an OTF

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The link between MiFID II/MiFIR and

EMIR

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MiFID II and EMIR: How they work together

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EMIR instruments

EMIR definition of derivative points to MiFID – if a particular product is a now a MiFID instrument (C4-C10) then it will be within scope of EMIR

In particular look out for what commodity derivatives are being traded on OTFs

Note the REMIT carve out – these will not be within scope of EMIR

Counterparty classification

A counterparty that is no longer able to rely on the MiFID exemptions and has to become authorised under MiFID will, upon such authorisation, become an FC for the purposes of EMIR

More onerous obligations under EMIR, and potential notifications to existing counterparties

The concept of OTC trading

Remember that EMIR classes any derivative trade not executed on a RM as OTC

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MiFID II and EMIR: How they work together

The transitional provision (Article 99 MiFID)

• Clearing and collateralisation obligations will not apply in relation to derivatives in relation to coal or oil that are traded on an OTF and must be physically settled (further details to be provided in an RTS) entered into by NFC+s or those firms that have to become authorised under MiFID for the first time as a result of MiFID II; and

• Such derivatives shall not be considered OTC derivatives for the purposes of the clearing threshold calculations of NFCs

Will be available for 42 months after the entry into application of MiFID II

Does not apply to the EMIR reporting and other risk management obligations

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MiFID II and EMIR: How they work together

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The Trading Obligation (Articles 24-27 MiFIR)

FCs and NFC+s must execute all transactions in derivatives which have been declared subject to the Trading Obligation on a Regulated Market, MTF, OTF or third country trading venue

The process for determining which derivatives will be subject to the Trading Obligation is similar to that for the Clearing Obligation. Although note that the derivatives must have been declared clearing eligible to be considered for the Trading Obligation

Applies to trades with third country counterparties who would be FCs or NFC+s if they were in the EU – the same as the Clearing Obligation under EMIR

Direct applicability to third country entities where contract has direct, substantial and foreseeable effect within the EU or where the obligation is necessary or appropriate to prevent the evasion of the MiFIR

Similarly to third country CCPs and TRs, the use of third country trading venues to satisfy the obligation will be subject to positive equivalence decisions by the Commission

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MiFID II and EMIR: How they work together

Portfolio compression

Investment firms providing portfolio compression required to make public through an APA the volume of derivative transactions subject to portfolio compression and the times they were concluded in accordance with Article 9 of MiFIR

Investment firms providing portfolio compression have to keep complete and accurate records of all portfolio compressions they organise or participate in (RTS to be published on this)

Indirect Client Clearing for exchange traded derivatives

Are permissible (but not required) provided that the arrangements do not increase counterparty risk and ensure assets and positions of the counterparty benefit from protection equivalent to that required by Articles 39 and 48 of EMIR (RTS to be published on this)

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A few conclusions

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1. Entities which deal on own account in commodity derivatives that are part of investment services or banking groups are unlikely to be exempt under MiFID II

2. Entities who currently rely on any of the exemptions mentioned in this discussion will need to revisit their current regulatory analysis

3. The required regulatory analysis under MiFID II is going to involve the analysis of the business (on a group level) against a number of metrics and measurements – is your business organised in a way that will allow you to do this?

4. Even if you are exempt, MiFID II and MiFIR will still impact your business

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Disclaimer

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