MiFID II – Challenges for Commodity Derivatives Markets

Dewey & LeBoeuf LLP dl.com

MiFID II – Challenges for Commodity Derivatives Markets

Robert Finney, Partner

January 2012

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Agenda

●  Why are commodity markets caught up in financial regulatory reform?

●  International and European drivers and processes

●  Increased European regulatory capture of commodities

●  MiFID II: specific commodity proposals –  Focus on scope

●  Impacts and conclusions on scope issues

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Why are commodities markets caught up in regulatory reform?

●  High prices & volatility have socio-economic (& so political) impact –  Political populism

–  Perennial pariah treatment of “speculators” and “derivatives”?

–  Increased political rhetoric in recent years following price increases/volatility in energy as well as foodstuffs and metals

●  “Market” as a mechanism is being called into question –  Dirigiste price regulation vs framework for price discovery & efficiency

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International dimension to commodity market reform ●  Pressure in G20 → IOSCO Task Force on Commodity Futures

Markets (2008) –  Meant to temporary but has recommended permanence (2011)

–  March 2009 Report ♦  Price levels and volatility consistent with fundamentals: insufficient evidence

to blame speculation

♦  Recommendations on coordinating monitoring, analysis, investigation, etc.

–  2010: more politicised ♦  “improved functioning & transparency” agenda from G20

–  Focusing on ♦  Transparency of physical markets, supervision of derivatives markets

♦  Monitoring of financial markets in oil

♦  Moving on to agricultural commodities

–  “…recognises the varied nature of each different type of commodity…”

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European dimension

●  Commodity sector fought hard for key exemptions from MAD, MiFID and CRD –  And all three Directives are now being reformed

–  CESR/CEBS pre-crisis review of commodities is unfinished business

●  European drive for single market –  e.g. 3rd Energy Liberalisation Package

●  Pressure brought on/within EU institutions and G20

●  G20 commitments on derivatives clearing & trading are widely cast –  Commodities not excluded so issues for the different markets must be

considered

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Increased regulatory capture – physicals market

●  Energy –  Third Energy Reform Package

♦  in force 3 March, some transitionals

–  European Agency for the Cooperation of Energy Regulators (ACER) ♦  Opened 3 March (successor to ERGEG), energy equivalent to ESMA

–  Licensing & market abuse regulation in physical markets ♦  Regulation on Energy Market Integrity and Transparency (REMIT)

  addressing market abuse in physical gas and power markets

♦  Likely regulatory regimes for physical energy exchanges and traders

–  Emissions Trading Scheme (ETS) ♦  Auctioning Regulation (November 2010)

  applying some MAD, MLD and MiFID rules to spot emissions

♦  ETS review (2010-11)

●  Commodity Markets and Raw Materials policy (Feb 2011)

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Increased regulatory capture – derivatives ●  MiFID

–  To cover more commodity products & more market participants ♦  Favoured exemptions being deleted/restricted

♦  Knock-on effect on scope of EMIR and MAD II

–  More platform types and trading strategies to be regulated

–  Standardised “derivatives” might require trading on organised platforms ♦  EMIR: broad range of OTC “derivatives” to require reporting & clearing

–  Commodity position oversight and intervention

●  MAD II (directive & regulation) is broader ♦  More platforms and products

♦  Broader “inside information” definition for commodities

●  CRD IV legislative proposal (directive & regulation), July 2011 ♦  Basel III implementation

♦  Separate review for CRD-exempt, MiFID-regulated commodity dealers

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MiFID II: Specific commodities proposals – scope (1)

●  Capture specialist commodities/commodity derivatives traders –  By restricting/deleting exemptions widely used by utilities, other energy

traders and commodity dealers

–  2.1(k): “commodity dealers” exemption to be deleted

–  2.1(i): “ancillary business” exemption narrowed as follows ♦  Own account dealing limb: client order execution to be deleted

  Similar deletion from 2.1(d) exemption, but some helpful other clarification there

♦  Investment services limb   Own account dealing excluded

  Spot emissions added (emissions derivatives were already included)

  New limb to cover any investment services provision to affiliates, if ancillary

♦  Essential factors are specified for determining “ancillary”   Limits Level 2 flexibility

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●  Consequences of changes in exemptions –  Some unregulated firms will now need authorisation

♦  & changes of status and requirements for some regulated, non-MiFID firms (where these exist, as in UK)

–  Client categorisation of currently unregulated firms may change

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●  Scope of instruments widened –  Emissions allowances

♦  secondary spot trading (new C(11))

♦  Derivatives, whether physically or cash settled (C(4))

–  OTF-traded commodities – physically settled (C(6)) ♦  Extension into forward markets?

–  OTF-traded “exotics” (C(10))

–  Deletion of C(7) cleared/margined criterion is not proposed ♦  But changes could be made at Level 2 affecting C(7) and C(10)


MiFID II: Specific commodities proposals - Positions

●  Position disclosure, limits, oversight & intervention –  Commodity derivatives trading venues to:

♦  Provide detailed position-related information to regulators

♦  Publish aggregated data

♦  Establish position limits or alternative arrangements “designed to support liquidity, prevent market abuse, and ensure the orderly pricing and settlement conditions”

–  Stronger regulatory powers ♦  To require parties to explain and/or reduce positions

♦  To impose hard limits (OTC and on-exchange)   Not universal, but adopted when specified criteria are satisfied

♦  Note: regulators will also have a general (not commodity-specific) power to prohibit or restrict financial instruments, activities and practices


Impact on scope of EMIR & MAD II for energy/commodities

●  “derivatives contracts” in EMIR defined by reference to MiFID –  Affects scope of reporting and potential scope of clearing obligation

♦  Which derivatives & underlyings will be designated? e.g. commodities? –  Pressure for standardisation

●  Counterparty status under EMIR –  financial counterparties versus non-financial counterparties (NFCs) –  MiFID exemptions affect availability of NFC status –  Clearing may lead to changes in business models and contractual structures,

and thereby affect availability of exemptions

●  Increases chances of EEA versus Rest of World inconsistency/conflict on derivatives reporting and clearin

●  MAD/MAR scope widened by extension of “financial instruments” –  But other changes more significant

♦  e.g. “inside information” and extension of MAD/MAR scope to MTFs/OTFs

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Commercial impact & conclusions

●  MiFID II when combined with EMIR, MAD II, REMIT will have a major impact on energy and other commodity markets and their participants: –  Extension of MiFID scope is big factor in this:

♦  Deletion/restriction of exemptions + extension of “financial instruments”

●  Likely impact includes: –  Restructuring of trading and customer risk management operations

♦  To avoid or minimise MiFID regulatory capture & EMIR/MAD II/REMIT   Some will curtail their activities / customer offering: an opportunity for others!

  Some may relocate to Switzerland or Singapore (but 3rd country regimes)

–  Higher costs likely for market participants and counterparties/clients ♦  Costs of being regulated will be part of this, though many other factors

●  Early analysis and planning are crucial for business –  As with MiFID I in 2003/4 through 2007


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Dewey & LeBoeuf LLP

Dewey & LeBoeuf LLP dl.com

MiFID II – Challenges for Commodity Derivatives Markets

Robert Finney, Partner

January 2012

Documents

MiFID II – Challenges for Commodity Derivatives Markets