MiFID2/MIFIR for Commodities MarketsKey considerations for commodity trading firms

1

The revised Markets in Financial Instruments Directive (MiFID2) was passed into European law in April 2014. It represents a fundamental change for the European financial markets, especially for energy and commodity firms that deal in financial instruments.

This change is likely to require not only a major implementation effort on the part of previously unregulated entities but also a reassessment of business models and the legal entity structures for a host of market participants. Given the breadth and depth of MiFID2, it is likely to entail far more than just a compliance exercise.

Since the introduction of MiFID1 in November 2007, there has been a substantial increase in the level of competition and complexity within financial markets, including an influx of players using commodity derivatives. As the market in related financial products has grown, the orderly functioning and integrity of commodities markets has come under both political and regulatory scrutiny.

The 2008 financial crisis served to highlight flaws and weaknesses within the existing regulation which resulted in a wide-ranging review of the original MiFID legislation. The resulting revisions under MiFID22 not only look to address these weaknesses, but also broaden the scope of the regulation with a renewed focus on commodity markets and trading.

With commodity market risk management tools and techniques advancing, the evolving convergence, and dependency between physical and financial markets has become ever more apparent. To reflect this development, MiFID2 has been extended to cover instruments and activities that bridge both markets — increasing the scope to capture more commodity players requiring authorization as investment firms. This carries broader implications for the industry, including corporate and non-financial firms.

Understanding the prospective impacts of MiFID2 becomes even more important when considering the wider range of regulatory reforms. The introduction of European Markets Infrastructure Regulation (EMIR)3 and changes to the market abuse regime for commodity markets i.e., the revisions brought by MAD2/MAR4 and the introduction of Regulation for Energy Market Integrity and Transparency5 (REMIT), etc. will, in combination with MiFID2, potentially subject commodity market participants to compliance obligations more akin to those experienced by financial service and investment firms.

To this end, the response to regulatory compliance for commodity firms will more than likely extend beyond simply minor operational changes, to a broader rationalisation of the organisation and, in many cases, require a review of the firm’s overall strategy. Given many technical aspects of MiFID2 are still being considered, commodity firms should not delay determining a response which looks not only at minimising impact but also at identifying potential business opportunities.

While MiFID2 comes into force in January 2017, preparations must start now.

1. DIRECTIVE 2004/39/EC of the European Parliament and of the Council on markets in financial instruments 21 April 2004 2. DIRECTIVE 2014/65/EU of [..] on markets in financial instruments 15 May 2014, REGULATION (EU) No 600/2014 of [..] on markets in

financial instruments and amending Regulation (EU) No 648/2012 15 May 20143. REGULATION (EU) No 648/2012 of [..] on OTC derivatives, central counterparties and trade 4 July 20124. DIRECTIVE 2014/57/EU of [..] on criminal sanctions for market abuse 16 April 2014, REGULATION (EU) 596/2014 of [..] on market

abuse 16 April 20145. REGULATION (EU) No 1227/2011 of [..] on wholesale energy market integrity and transparency 25 October 2011

Are you covered by MiFID2?

MiFID2, like its predecessor, applies across the EU and EEA member states and, with limited exceptions, applies to firms providing "investment services or activities", as defined by the regulation. In addition to considering what sort of investment services or activities a firm undertakes, the regulation also considers the type and quantity of "Financial Instruments" a firm trades. MiFID2 is intended to capture more commodity instruments than the existing regulation, including physically settling contracts in some cases.

The rules around precisely which firms fall into scope of MiFID2 can be complex and require close consideration by firms that trade commodities.

Even if a commodity firm escapes full regulation under MiFID2, a number of requirements will apply regardless to firms who trade in-scope commodity instruments, including adherence to regulatory position limits across commodity classes as we as the compulsory reporting of positions in such commodities.

2MiFID2/MIFIR for Commodities Markets

Until now, commodity firms have largely escaped full regulation under MiFID as a result of broad exemptions made available for commodity trading firms, and other ‘non-financial’ organisations that use regulated ‘Financial Instruments’ predominantly for commercial purposes.

The changes under MiFID2 are significant in that they remove or limiting the exemptions available to commodity trading and other non-financial firms, as well as broaden the scope of instruments for both physically and financially settled commodity derivatives, classifying more of them as ‘Financial Instruments.’

Why is this important for commodity firms?

Changes to ‘Financial Instruments’ applicable to commodity firms (Annex 1 – Section C of MiFID)

Changes to exemptions applicable to commodity firms (Article 2 of MiFID)

► The term ‘Forwards’ has been added to certain definitions by which commodity derivatives (and potentially physically settled FX*) will be treated as ‘Financial Instruments’ where:

► i) they ‘must’ or ‘may’ be settled in cash (C5), or

► ii) they are physically settled and for non-commercial purposes (C7)

► A new platform, an ‘Organised Trading Facility’ (OTF), has been added to the list of regulated platforms which includes ‘Regulated Market’ (RM), ‘Multilateral Trading Facility’ (MTF) and ‘Systematic Internaliser’ (SI), by which instruments traded on the venue will be considered Financial Instruments (C6). However:

► A carve out exclusion is granted explicitly for wholesale energy products covered by REMIT (i.e., gas and power) traded on OTFs that can be physically settled;

► ‘National Competent Authorities’ (NCAs) can offer a temporary six year exemption for ‘Non-financial’ firms from including such instruments in the clearing threshold calculation and from the risk mitigation requirements under EMIR for physically settled oil and coal derivatives traded on an OTF.

► Emission Trading Scheme (‘ETS’) allowances have been incorporated (C10).

► The ‘commodity dealer’ exemption [Art.2(1)(k)] ‘persons whose main business consists of dealing on own account in commodities and/or commodity derivatives‘. This exemption has been completely removed under MiFID2.

► The ‘ancillary activity’ exemption [Art 2(1)(j)] is available for firms dealing in commodity derivatives provided it is ‘ancillary’ to their main business and does not comprise ‘investment services’ (as defined by the regulation). Under MiFID2 this exemption requires that quantitative measures be applied to justify whether such activities are ancillary to the main business (applied at group level).

► The ‘dealing on own account’ exemption [Art 2(1)(d)] has been explicitly reworded to exclude commodity derivatives under MiFID2 although this can still be used cumulatively by commodity firms in conjunction with the ‘ancillary activity’ exemption i.e., ‘execution of orders in Financial Instruments between non-financials directly without further intermediation by third parties’ treated as ‘ancillary’ and not ‘dealing on own account while executing client orders’. This combined exemption may provide relief for treasury financing activities for some corporates.

*Note: The directive definitions (as part of MiFID) require transposition into National Law by domestic NCAs – which could lead to differences in interpretation and differences in treatment between member states.

” In commodity derivatives, MiFID2 brings a whole new regulatory regime …

… firms cannot hold back on developing their implementation plans until all the details are available.”David Lawton, Director of Markets, at the FCA (UK) MiFID2 Conference 2014

3

MiFID2 introduces a number of measures specifically aimed at regulating commodity market participants. The overall compliance burden applicable to commodity trading organisations will depend on their scope of regulated activities under MiFID2 as a regulated investment firm, along with the nature and size of their trading activity with respect to Financial Instruments.

New requirements impacting commodity firms?

Market infrastructure

► MiFID2 has extended the categories of regulated platforms to incorporate OTFs. This is likely to capture a number of platforms used for commodity trading beyond traditional exchanges, including broker crossing platforms, subjecting them to rules governing platform operations (including trade execution and transparency).

► MiFIR, the Regulation, requires that derivatives which are deemed by ESMA as eligible for clearing under EMIR, must be traded on a regulated venue i.e., either an RM, MTF, SI or OTF (this only applies to Financial Counterparties ‘FC’ and Non-financial Counterparties, above the clearing threshold i.e. NFC+).

► Commodity derivatives traded on regulated categories of platform will be considered ‘Financial Instruments’ and therefore subject to both MiFID platform requirements and potentially EMIR obligations (requiring compulsory clearing and inclusion in ‘NFC’ threshold calculation.)

Position limits/controls

► Commodity derivatives traded on regulated venues will be subject to position limits and position management controls applied by the relevant platform operators.

► Position limits will be applied on the aggregate net position a ‘person’ (and ‘group’) can hold at any time in a certain commodity derivative, but will not apply to positions held by NFC entities where trades are deemed to be for ‘commercial purposes’.

► Venue operators are also required to implement position management controls for commodity derivatives, which may force participants to reduce or terminate positions where limits are exceeded, or in some cases introduce liquidity to illiquid markets where requested to do so.

► Reports on positions must be made available by venue operators, however these reports will rely on data submitted by market participants on their positions (potentially on a daily basis).

Trade transparency/reporting

► Regulated Trading venues will be required to meet pre- and post-trade disclosure requirements, which will require additional data to be supplied by market participants

► Pre- and post-trade transparency requirements will not apply to transactions undertaken by NFCs deemed “for commercial purposes”

► Regulated firms under MiFID2 are required to report ‘execution of transactions’ in Financial Instruments to an approved reporting mechanism (‘ARM’) on a T+1 basis

4MiFID2/MIFIR for Commodities Markets

Regulated firms are likely to be subject to authorization under domestic regulatory frameworks in addition to MiFID2. In addition, commodity firms may become subject to regulatory capital requirements in future following a review of the exemption currently extended to the sector.

Domestic regulatory frameworks

► Governance and controls to ensure business activity and accompanying risks are appropriately measured and managed.

► Appropriate business conduct rules to ensure integrity is upheld for the respective regulated activities.

► An independent compliance function responsible for monitoring and policing regulated activities as well as being actively involved in setting and enforcing the rules for assessing client acceptance.

Regulatory Capital Requirements

► Non-commodity investment firms regulated by MiFID are subject to regulatory capital requirements under the Capital Requirements Directive (CRD) and Capital Requirements Regulation (CRR), collectively referred to as CRD IV.

► A temporary exemption applies to CRD IV, which precludes commodity trading firms from these requirements until the end of 2017.

► This exemption is due for review prior to the 31 December 2017, and will require a public consultation to begin no later than 31 December 2015.

What does MiFID2 mean for a diverse commodities market?

Commodity market participants comprise a diverse range of firms that include commodity trading houses, asset-backed traders (such as utilities and oil producers), commodity end-users and financial institutions such as banks. The size and complexity of these organisations can range from small regional players to large, global organisations with trading activities spanning across multiple legal and regulatory jurisdictions.

The overall impact of MiFID2 across these firms is unlikely to be uniform. For those falling into scope of the regulation, much will depend on how the organisation is structured from a legal entity perspective, precisely what regulated activities they perform, and what regulated instruments are traded by each entity.

The extent to which such firms are experienced in dealing with large, complex framework regulation such as MiFID2 will undoubtedly also have a bearing on its impact. For instance, banks that trade commodities, some asset-backed traders and commodity trading houses already have regulated entities under the existing MiFID (typically structured to reduce their overall “regulatory footprint”). This might however be an entirely new experience for smaller, regional European players, or foreign firms looking to enter the European market.

Regardless, once regulated under MiFID2, firms will become subject to a rigorous set of governance and conduct of business standards (in addition to the other impacts specific to commodities outlined in this paper).

There are two main indirect impacts all commodity firms should also consider. The first relates to other market regulation, the applicability of which depends on the scope set by MiFID2, including EMIR, MAD2/MAR and capital requirements regulation (discussed further on the next page). The second, which applies regardless of whether a firm is MiFID2 regulated or not, is the potential impact on market structure and liquidity for some commodity classes, brought by changes to the market mix and cost of trading as a result of new regulation.

5

While MiFID2 will form a broad bedrock of European financial market regulation, its reach extends to many other areas of market regulation. Regulatory boundaries comprising the scope of regulated activities and instruments for financial and energy market regulations, including EMIR, MAD2/MAR and REMIT directly reference MiFID2.

For commodity trading firms, it is therefore important to understand the linkages between these regulations, their corresponding interaction and the potential knock-on effects should particular instruments or activities be incorrectly or inconsistently interpreted.

The graphic below highlights some of these linkages and their potential impacts.

The MiFID2 nexus: the link with EMIR, REMIT, MAD2 and Capital Requirements regulation

EMIR ► The classification of an entity as either a financial counterparty (FC) or non-

financial counterpart (NFC) is directly dependant on whether the entity is MiFID regulated. The narrowing of scope exemptions under MiFID2 means that more commodity trading entities may become classified as FCs, carrying with it the more stringent compliance requirement, including compulsory clearing for certain instruments.

► The scope of traded commodity instruments covered by EMIR is set by MiFID. This is potentially significant when considering the changes to the definition of “Financial Instrument” under MiFID2.

► MiFID2 does, however, explicitly exclude certain physical gas and power trades from scope, as well as excludes certain oil and coal contracts from certain EMIR requirements* for a “transitional” period of 42months.

Regulatory capital regulation ► Investment firms regulated by MiFID are subject to capital requirements

under the Capital Requirements Directive (CRD) and Capital Requirements Regulation (CRR). Commodity firms have thus far benefited from a general exemption from such requirements.

► While a review of whether or not to extend the exemption for commodity firms is due to take place before 31 December 2017, the applicability of capital requirements rules will remain linked to MiFID2 definitions.

► While the outcome of this review and the ultimate applicability of capital requirements regulation to commodity firms are not certain, this is a critical strategic consideration for commodity firms.

► The narrowing of available exemptions under MiFID2 in this context should be carefully considered.

MiFID2

6MiFID2/MIFIR for Commodities Markets

The boundaries between the regulations with respect to oversight and enforcement by domestic authorities also need to be clearly defined. This will be important for commodity firms that may have limited existing dialog with their domestic financial regulators and energy market regulators.

Market abuse regulation ► The scope of traded commodity instruments covered by the revised Market

Abuse Directive and Regulation (MAD2) is set by MiFID2. This includes those instruments traded on regulated venues as defined by MiFID2, including RMs, MTFs * as well as OTFs, the new category of trading venue.

► Further to the above, implicitly included in scope are Emissions Allowances consisting of any units recognized for compliance with the requirements of EU Emissions Trading Scheme.

► The MiFID2 definitions explicitly excludes physical gas and power “wholesale energy products” from scope and therefore from scope of MAD2. These will instead be subject to specific market abuse and manipulation provisions under REMIT**.

*Not covered by the original MAD **Power and gas derivatives traded on an MTF will be covered by REMIT until MAD2 enters into force

Domestic regulation ► As required for all EU Directives, the relevant elements of MiFID2 (i.e., the

elements laid out in the Directive itself, which is distinct from the Regulation) must be transposed into domestic law.

► Although the primary reason for MiFID2 being drafted as both a Regulation as well as a Directive was to ensure that such inconsistencies in interpretation between member states be removed as far as possible to ensure a level playing field, there remains the possibility for jurisdictional differences in interpretation.

► Commodity firms should pay particular attention to this potential in the context of existing differences in interpretation between member states with regard to the original MiFID.

MiFID2

7

MiFID2 will present significant challenges for a number of commodity trading firms, with the introduction of new obligations for authorized entities. However, the impact is likely to extend beyond pure compliance. Knock-on impacts on market structure and liquidity are likely to affect non-regulated market participants.

Whilst largely dictated by the scale and complexity of your trading operations, the extent to which MiFID2 impacts your firm should also be considered in combination with the broader regulatory change environment. A comprehensive compliance response should be more than just a tactical response, and should not only consider requirements for ongoing compliance but further feed into business strategy and business continuity plans.

Firms are recommended to consider both operational and strategic perspective, when considering the impacts of MiFID2 while weighing up a compliance response. A number of considerations are outlined below:

Is your organization ready for MiFID2?

Strategic Operational

► Have you considered whether structural realignment from a legal entity perspective may be required to drive organizational and compliance efficiencies with respect to the MiFID2 requirements, and to benefit from exemptions where possible?

► Have you taken a strategic view of the optimal type/mix of trading venue(s) on which to execute post MiFID2 implementation?

► Do you fully understand the extent and purpose of the group’s trading activities from a MiFID2 perspective (for both external and intragroup trading activities), and how these activities influence the firm’s scope and impact under MiFID2?

► Have you considered the potential change to the market environment and structure in respect to liquidity and costs of venue-based trading post MiFID2?

► Have you constructed position-limit scenarios in order to evaluate their potential impact on both your trading strategy and operations per trading venue and jurisdictional location?

► Have you considered how the regulatory capital implications of CRD IV (the scope of which is set by MiFID2) might impact your operating costs and revenues in the context of your broader strategic objectives?

► Do you have the necessary systems, controls and documentation in place to appropriately calculate and evidence exemption criteria in a timely manner?

► Have your trading desks and associated operations teams developed methodologies to segregate hedging and proprietary activity from a system, process and risk management perspective?

► Have you considered the potential impacts on credit risk procedures and policies in line with the position-limit changes that MiFID2 will prescribe?

► Have you considered the potential impacts of MiFID2 on trading venues across your group structure, and between your trading and treasury functions?

► Do you have the necessary system and procedures in place, to accommodate position management and position reporting requirements on your own positions and/or those on behalf of your clients?

► Have you considered the potential challenges that MiFID2 will pose to your group structure from a funding and capability perspective, once available exemptions are exhausted ?

► Do you have the necessary control framework in place, to ensure that ongoing MiFID2 compliance is evidenced accurately and processes are performed as documented?

8MiFID2/MIFIR for Commodities Markets

Commodity trading firms are advised to undertake an immediate high-level impact assessment to determine, at a minimum, the applicable scope boundaries, legal entity structure and business model impacts as well as to establish an implementation roadmap to effect the necessary organizational response.

Preparations should begin now …

Phase 1Initial MiFID study

Phase 2Impact assessment

Phase 3Strategic analysis

Phase 4Implementation roadmap

► An analysis of relevant group activities to identify relevant activities that could be in the scope of MiFID2

► Develop a view on relevant exemption criteria applicable to the firm’s activities

► The group “quick scan” will also define the plan for the impact assessment and the strategic analysis

► Develop scenarios to test the firm’s business model and the extent to which its activities will be impacted

► Perform impact assessment that covers the relevant MiFID2 areas and highlights the key impacts on the firm’s business

► Consider potential knock-on impacts of other non-MiFID regulations

► Determination of potential senior management responses to minimize the impact of MiFID2

► Consider possible legal entity restructuring options

► Outline restructuring options based on geography, capital and commercial viability with compliance as a core pillar

► Develop a detailed, prioritized implementation road map to implement the appropriate response

► The road map should cover legal entity restructuring, activity migration, market infrastructure selection/connectivity etc.

► Compliance review and development of evidence “defence file”

• • •

9

Experience gained from the implementation of the original MiFID regulation demonstrated the inherent complexity, cost and risks for firms navigating such regulation. Given the limited guidance and precedent often accompanying such regulation, it is strongly advised that firms implement a rigorous program of assurance to ensure such costs and risk are reasonably reduced. Such a program may be managed and resourced internally, or with the support of an external advisor with the right level of knowledge and experience. EY has the skills and experience to help you.

How EY can help …

Implementationassurance

► Rapid gap assessment with existing regulatory obligations

► Support in defining appropriate risk measurements/metrics for support of i) market monitoring framework, ii) hedge effectiveness and iii) intragroup exemptions

► Review of extended group obligations and applicability for cross border trading

► Development of “defence file” to demonstrate compliance in the case of investigation

► Assessment of valuation methodologies and credit processes

► Review of compliance with permissions in relation to domestic financial regimes

► Review of “onboarding” of regulation-related service vendors, including review of contractual arrangements

► Internal training on regulatory awareness and compliance

Ongoing compliance

► Ongoing validity assessment of “hedge” determination with regard to trading activities in relation to EMIR/MIFID2

► Carry out regular “dawn raid” test exercises to live-test compliance

► Regular assessment of governance framework and the effectiveness of your compliance function

► “Hedge accounting” support to satisfy regulatory “safe harbour” exemptions

► Internal audit review of regulatory compliance programs and ongoing compliance integrity

► Regular review of internal compliance monitoring framework, including position-limit monitoring

► Regulatory-focused review in respect of due diligence for new transactions

► Regulatory capital and trade funding review for group

10MiFID2/MIFIR for Commodities Markets

EY has a team of experienced professionals who understand commodity markets and who will work with you to understand the requirements under the regulation, formulate a response appropriate to your market and activities, and assist you in implementing it in an effective, cost-efficient manner. We have the regional and global reach to help support you with your global response to the regulation.

The Commodities Markets teams are based in London, Houston and other major centers across Europe and they bring together a range of skill sets and experience needed to deliver insights and services specific to the commodity trading market. Our team includes industry-experienced professionals many of whom have worked in the front, middle and back offices of leading energy and commodity trading organizations.

The Team’s experience in commodity trading is diverse and provides a broad range of advisory and assurance services to a large number of leading European energy and commodity trading organizations across multiple asset classes, including energy, metals, softs and renewables.

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