On 1 April 2020, the European Securities and Markets Authority (ESMA) released two publications concerning the commodity derivatives regime under MiFID II. This includes ESMA’s final review report on position limits and position management in commodity derivatives, and technical advice on weekly position reports published by trading venues on open positions per category of stakeholders.
Key points to note:
- Prevention on market abuse: In respect of one of the objectives of the position limits regime, which is to prevent market abuse, ESMA generally agreed with the views expressed by the majority of stakeholders that position limits “on their own have little impact on market integrity”. ESMA is, nevertheless of the view, that position limits “can contribute to the prevention of market abuse by limiting the ability of counterparties to make use of a dominant position to secure the price of a commodity derivative or of the underlying commodity at an artificial level”. However, it also acknowledges that the fact that commodity derivatives are subject to both position reporting and transaction reporting, the combination of both measures can help competent authorities to identify potential market abuse.
- Impact on orderly pricing and settlement conditions: Whilst acknowledging stakeholders’ feedback highlighting the role of commodity derivatives trading venues towards ensuring orderly pricing and settlement conditions, ESMA remains of the view that position limits “are a means to address the potential for large positions in commodity futures and options markets to prejudice orderly market functioning” and that the biggest benefits thereof are delivered in spot month. ESMA agrees that “improperly calibrated position limits may potentially impact the interaction between supply and demand” and as such affect price discovery. Overall, ESMA is of the view that “the size of members’ positions around maturity can indeed have an impact on the orderly settlement of a commodity derivative and should therefore be monitored by trading venues, together with orders and transactions as part of position management controls”.
- On-venue v OTC trading: ESMA is of the view, having analysed available data, that “there is no evidence of a shift of trading in commodity derivatives from on-venue to OTC trading as a result of the introduction of the position limit regime that would have required to be considered and addressed”. In further notes – in relation to Brexit considerations – that no trading in metal, oil and coal contracts is currently taking place in EU-27, and in all commodity derivatives contracts trading is concentrated on the UK trading venues.
- Methodology and competing venues: ESMA notes that the great majority of stakeholders supported its rationale for levelling the playing field for commodity derivatives with the same physical underlying that are traded on different trading venues. To this end, ESMA suggests to amend the Level 1 text by deleting the concept of “same contract” and replacing it with “a more cooperative approach” between national competent authorities and to set the baseline for the other months’ limit for competing contracts based on the same underlying and sharing the same characteristics using the open interest of the most liquid contract. ESMA proposes to assume a coordinating role and will help to settle disagreements between national competent authorities as to whether commodity derivatives traded on their respective trading venues share the same characteristics and are price correlated.
- C(6) carve-out: Despite overwhelming stakeholders’ input in support of the C(6) carve-out, ESMA remains “generally unconvinced” about the arguments put forward in this respect. It notes that the C(6) carve-out did not result in bringing more trading onto the trading venues, which was its underlying objective. ESMA also disagrees with the views expressed that the REMIT instruments are fundamentally different from other financial instruments in so far as they are “used for hedging purposes, because most of them are physically settled or because trading does not include retail participation”. Finally, dismissing arguments raised by the stakeholders that in the event of removal of the C(6) carve-out, energy market participants will be unable to benefit from the ancillary activity exemption, ESMA notes that “no evidence has been provided to support this assumption”. ESMA understands that in case of the C(6) carve-out removal, position reporting “would be a source of additional costs for energy firms trading those instruments”, but does not share stakeholders’ views about risks potential duplication of reporting obligation. That said, and in response to the leading question in its consultation paper, i.e. whether the C(6) carve out creates an unlevel playing field and as such should be reconsidered, ESMA notes that none of the stakeholders raised such concerns and consequently in the light of “the lack of perceived unlevel playing field arising from the C(6) carve-out no further policy proposal appears to be required”.
- Liquidity in commodity derivatives: Acknowledging stakeholders’ overwhelming support for amending the Level 1 text in order to limit the scope of position limits to significant or critical contracts, ESMA agrees that “the scope of position limits should be limited to commodity derivatives where position limits can play of valuable role, i.e. to well-developed critical contracts where price formation takes place and that have a role in the pricing of the underlying commodity and other related commodity derivatives.” Commodity derivatives outside the scope of the position limits regime would remain within the scope of position reporting, as well as other obligations – such as pre-and post-trade transparency, transaction reporting and position management controls.
- Hedging exemption for financial counterparties: Responding to stakeholders’ comments asking for an extension of the hedging exemption from position limits to financial counterparties providing liquidity to trading venues, ESMA proposes to introduce in the Level 1 text “a narrowly defined hedging exemption” for such counterparties. Such exemption would be available “where, within a predominantly commercial group, a person has been registered as an investment firm on a voluntary basis and acts as a market facing entity of the group” and it would apply to positions held by such person that are hedging risks stemming from commercial activities of the non-financial entities of the group. ESMA does not consider such an arrangement an extension of the hedging exemption, but rather a “transfer” to the financial counterparty of the group of the hedging exemption otherwise available to non-financial counterparties of the same group. ESMA does not suggest introducing further hedging exemptions for financial counterparties.
- Position management: Despite the mixed feedback received from stakeholders, ESMA is of the view that “there would be benefits in enhanced convergence in the application of position management controls across EU trading venues”. To this end, ESMA suggests that examples of such position management measures that it suggested in the consultation paper, e.g. accountability levels, expiry and delivery limits, could be further considered in the context of amendments to Level 2 text. It also considers that the Level 1 text could be amended to ensure that trading venues have the power to obtain information from its members or participants on “related positions entered by a person on other trading venues or OTC, where appropriate, to the benefit of efficient position management controls”.
- Impact of Brexit: In a separate section of its report, ESMA notes that the post-Brexit “EU commodity derivatives landscape will have a dramatic impact on the ancillary activity test and more specifically on the market size test” in so far as more entities will not meet the ancillary activity threshold requirements and will be deemed financial entities. ESMA shares stakeholders’ concerns and calls on the Commission to consider appropriate changes to Level 1 provisions and the criteria for the ancillary activity exemption set out therein, and in particular the quantitative test approach.
- Weekly position reports: Finally, in its technical advice, ESMA suggests amending certain provisions of Commission Delegated Regulation (EU) 2017/565 setting out an obligation for trading venues to publish weekly reports on open positions per category of stakeholders, by replacing the condition of a ratio of open interest compared to deliverable supply to assess the size of open interest triggering the publication of weekly reports with a threshold of 10,000 lots in open interest. In addition, and in order to protect confidentiality of individual positions, ESMA suggests that for contracts where a category of persons would include less than five active position holders, the weekly position report published would include no information for that category of persons.
These reports will provide feedback to the ongoing review of both MiFID II and MiFIR that is currently undertaken by the European Commission (please see our note on the Commission’s public consultation and note that its deadline has been recently extended by additional 4 weeks). Publication of legislative proposals amending MiFID II and MiFIR is expected later this year.