With MiFID II’s implementation date of 3 January 2018 fast approaching, investment firms need to prepare for the changes that will be brought about by the EU’s flagship regulatory policy. All-encompassing in its scope, MiFID II will implement regulatory changes that will impact the trading of all financial instruments. In an attempt to fulfil the European Union’s ethos of creating a European-wide regulatory framework for financial markets, MiFID II will increase investor protection, boost competition across financial markets, and introduce reinforced supervisory powers.
Since the implementation of MiFID I in November 2007, the complexity of financial markets has increased significantly. In recent years, more and more firms have started to trade in commodity derivatives, thereby causing a greater convergence between physical and financial markets. In 2012, Timothy Lane, Deputy Governor of the Bank of Canada, stated:
“…the financial system is linked with the commodities markets. Here, I mean the intricate web of global markets in which commodities are bought and sold, prices determined, and the producers and end-users of commodities hedge against unexpected movements in those prices. These markets are very important in determining the returns that Canadian producers earn for their output, as well as the risks they face.”
With global populations ever increasing, moreover, the demand on the world’s limited resources continues to grow, and the resulting increases in instances of price volatility has caused the commodity market to come under both political and regulatory scrutiny. Pressure is mounting on governments and international organisations to ensure that commodity market participants are regulated in a similar way to financial services and investment firms.
As a result, MiFID II will impose an expansive set of rules specifically relating to firms trading in commodity derivatives. One example is that, under MiFID II, trading venues will need to report to the relevant National Competent Authority (NCA) all commodity derivative positions held by its members and participants. As such, all investment firms trading commodity derivatives within a trading venue will need to report its positions to said trading venue. All of these reporting obligations will bring further challenges and complications to investment firms, and this article sets out to highlight these reporting changes, as well as the issues and challenges that will accompany them.
The various commodity derivatives that will need to be reported under MiFID include:
- Energy derivatives, metal derivatives, agricultural derivatives and other food derivatives
- Intangible derivatives e.g. climate derivatives
- Flow-based delivery derivatives e.g. electricity and gas
- Both cash-settled and physically-settled derivatives
- Derivatives for any of the other instruments covered e.g. baskets, indexes, swaps.
As they stand, the new reporting obligations will primarily affect investment firms that trade commodity derivatives via a trading venue. However, although thought to be rare, firms who trade economically equivalent over the counter (OTC) commodity derivative contracts will also have new reporting obligations.
MiFID II is comprised of both a Directive, known as MiFID II, as well as a Regulation, known as the Market in Financial Instruments Regulation (MiFIR). As a Regulation, MiFIR will be applied uniformly across all EU members states, whereas MiFID II, a Directive, will need to be transposed by each member state into national law. As such, the UK will use the rules in MiFID II to impose its own specific reporting obligations for investment firms trading commodity derivatives in the UK.
Weekly aggregate reports
Investment firms and market operators dealing in commodity derivatives or emission allowances will be required to make public weekly reports detailing the aggregated breakdowns of the positions held by different categories of persons for different commodity derivative contracts. The different categories include; investment firms or credit institutions, investment funds, other financial institutions including insurance undertakings and reinsurance undertakings (as defined in the Solvency II Directive), institutions for occupational retirement provision (as defined in the Occupational Pension Funds Directive), commercial undertakings, operators with compliance obligations under the EU Emissions Trading Scheme Directive, and, regarding emissions allowances, operators with compliance obligations under the Emission Allowance Trading Directive.
The weekly reports need only be submitted when the number of persons and their open positions exceed the minimum thresholds outlined in article 58(1) of MiFID II.
For investment firms in particular, the reports must differentiate between the positions which, in an objectively measurable way, reduce risk directly relating to commercial activities, and all other positions. In order to determine this, the firm may need to monitor its clients to determine whether their trades are speculative. One potential method for this is using the ‘non-financial entity’ exemption to determine whether the client is making a speculative or hedging trade.
Trading venues will need to submit a separate report for each of the relevant financial products being traded.
Daily position reports
In addition to the weekly reports, firms will also need to submit daily reports which detail the positions held by all persons, including the members or participants and the clients thereof, on that trading venue.
UK specific rules
All weekly reports will be accepted by the FCA, the UK’s competent authority, via e-mail with a link to the report as published on the firm’s website.
UK trading venues: participant reporting
A person trading within a trading venue in the UK must report to the relevant operator the details of their own positions held through contracts traded on that venue at least on a daily basis, as well as the positions of their clients, and the clients of their clients, until the end client is reached.
EEA investment firms who are members of a UK trading venue will also need to submit participant reports as if the firm were a UK firm. However, this will not apply if the firm in the EEA is subject to a corresponding rule imposed by its Home State competent authority.
Investment firms in the UK that trade outside of a trading venue must provide to the FCA a report with the complete breakdown of all of the positions held by that firm relating to economically equivalent over the counter (OTC) commodity derivatives, as well as those of their clients and the clients of those clients, until the end client is reached. Each report must be submitted by 21:00 GMT on the following business day. These reports only apply when the FCA is the relevant competent authority for the firm. Due to the specific nature of commodity derivatives, however, most commodity derivatives are traded via a regulated exchange, and very few firms are likely to trade economically equivalent OTC contracts.
Information that needs to be reported
There are a number of key pieces of information that will need to be detailed in the position reports submitted by firms. These include, but are not limited to, the date and time of the report submission, the date of the relevant trading day, the unique identifier reference number, the status of the report – i.e. an indication as to whether the report is new or is a previously submitted report being cancelled or amended. The report will also need to include a valid e-mail address for the position holder.
Both Investment firms and clearing firms are likely to send reports containing the same information. As such, instead of submitting duplicate reports, an investment firm may be able to delegate the responsibility or reporting to a clearing firm.
The timing of reports
Daily position reports will be accepted by the FCA from close of trading up to 21:00 GMT the following business day. The FCA will only use the latest valid reports received up until this time to calculate a person’s positions.
Reference data relating to the trading day is needed to validate the position reports and this is only made available by the European Securities and Markets Authority (ESMA) at 07:00 GMT the following day. As such, any position reports which are received before the reference data is made available will be ‘held’. This means that the report will not be fully validated until reference data for the trading day is available.
Where a firm identifies an error in a report, the FCA will accept amended or cancelled reports up to five years after the trading day to which the report refers, but these should be submitted as soon as possible. Reports should be cancelled when the error is in relation to the information that makes up the unique identification key for the position report, namely the report reference number, the date of the trading day, the venue product code, or the position holder ID. If the error does not affect this information, the report can be amended instead of cancelled. There is no upper limit for the number of times that a report can be amended within the five-year timeline.
The FCA will run data validation on all the reports received and will provide feedback files to each entity regardless of whether or not an error was detected in the reports. Any errors that are detected will be outlined in the feedback report.
Most firms are in agreement that in cases where the firm has reached the end of the day following the relevant trading day, and there are still positions which have not yet cleared, that firm should report them the following day once they have cleared.
Additional powers granted to National Competent Authorities (NCAs)
Under MiFID II, the relevant authorities will have the power to request from firms any relevant documentation regarding the size of the position or exposure entered via a commodity derivative, and any assets or liabilities in the underlying market. The authority could also request any person at the firm to take steps to reduce the size of the position or exposure, and could limit the ability of any person from entering into a commodity derivative.
In addition, the FCA will also have the power to request from any person information relating to a position that person holds in a contract to which a position limit relates, as well as trades the person has undertaken, or intends to undertake, in a contract to which a position limit relates. The FCA will then take steps ensure that these limits are adhered to.
The changes to reporting that will be brought about by MiFID II are complex, and it is important that firms have clear and efficient processes in place to ensure they are MiFID II compliant.
MiFID II related documents have grown since 2014 – we have tracked and uploaded over 150 documents in one of our RegDelta libraries mostly from EU and UK issuing bodies. We regularly discuss these latest documents and the areas under MiFID II in more detail in our MIG meetings.
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