ICIS briefing: The updated markets in financial instruments directive

Last updated May 2018

On 3 January 2018 the updated markets in financial instruments directive (MiFID II) will come into force, adjusting existing EU legislation originally aimed at improving liquidity across the European Economic Area (EEA). The rules carried components around capital controls and were revised in the wake of the financial crisis.

Other legislation designed to improve transparency provision has been enacted in combination with MiFID rules.

One of the key aims of MiFID II was to bring more of the traded commodity markets space within its scope. Any commodity or energy trader that falls under MiFID II needs to operate more like banks or investment firms. Falling under MiFID means an energy trader would need increased capital reserves, costs towards clearing, and a big emphasis on risk management, to name just three areas of impact.

While MiFID II was widened to capture more of the commodity space, companies can still get an exemption from the directive, if they can prove their trading activity supported the core business, rather than being the core business. This is known as the ancillary services exemption, although there have been issues with companies claiming this exemption due to uncertainty over the tests needed

One of the other main points for energy traders in MiFID was that it introduced position limits on commodity derivatives and position reporting.

MiFiD II also created a new type of trading venue, known as an organised trading facility (OTF). These were expected to become the dominant trading venue for a lot of physical power and gas forwards, but so far this has largely not been the case..

Background

The original MiFID rules came into force in 2007, replacing existing legislation called the investment services directive (ISD). They aimed to create a single market for financial instruments across the EEA, consisting of the, at that time, 27 EU member states plus Iceland, Norway and Lichtenstein.

The ISD enabled companies to provide investment services throughout the European Economic Area on the basis of home member state authorisation, known as the financial passport. Original MiFID rules expanded the scope of the passport to cover commodity derivatives, aimed at bringing new participants to illiquid or underserved markets.

Most companies falling within the scope of MiFID also had to comply with the capital requirements directive, setting conditions for the regulatory capital a firm must hold.

The rules initially had little impact on energy companies, which were not affected in the same way as banks. The financial crisis of 2008 forced a rethink, with Brussels focussing on financial regulation, particularly with regard to transparency, and how to avoid a repetition of the issues that led to a global recession.

That said, MiFID exemptions for commodities were extended until 2014 in late 2008.

Despite this consideration, many felt a lack of transparency on fundamental drivers of wholesale energy markets was hampering liquidity. As companies were exempt from MiFID provisions to improve information provision, laws were proposed in 2010 called the regulation of wholesale energy market integrity and transparency (REMIT).

In 2014 the European market infrastructure regulation (EMIR) was enacted, obligating companies to report transactions on financial derivatives, although the majority of over-the-counter (OTC) physically-settled power and gas trades were excluded.

Physical power and gas trades

While MiFID II’s scope was extended to commodities, power and gas did gain a special status. This was because power and gas trade already fell under the REMIT regime. As a result, power and gas forwards that must be physically settled would not be considered derivatives, which was significant for energy traders when calculating if they needed to gain a MiFID licence (explained later).

This became known as the ‘REMIT carve out’. However, what was considered a physical power and gas forward that must be physically settled became a big point of contention. In the end, the European Commission said traders must have proportionate arrangements in place, to be able to make or take delivery of the underlying commodity, for it to be considered a physical power or gas forward. This has effectively meant most OTC contracts such as those assessed by ICIS are not considered derivatives, and so do not count towards MiFID thresholds.

Ancillary services exemption

It took a while for the two tests that energy traders could use to calculate if they can get an exemption from MiFID to be finalised. For the purpose of this briefing, ICIS will concentrate on the final versions rather than going through the iterations.

The first was a market size test. A company’s position in an asset class such as gas or power derivatives must be under a certain commodity-specific threshold when compared with total market size. See table for thresholds.

ESMA struggled to get the data for firms to be able to do these calculations. In the end they released partial data, while suggesting firms approximate for the missing data (click here to read story).

For the second test, companies can choose between two methods. They can either look at how the capital they employ for trading compares with their total capital employed, or consider how their speculative activity compares with their total trading activity.

There are ongoing issues with ancillary services exemption, the first being that companies need a unique legal entity identifier (LEI) to apply for the exemption. Many did not have this ahead of 3 January 2018, and had been granted a six-month reprieve in order to trade, but were still not able to apply for the exemption without it.

The second problem is uncertainty over whether the economic tests apply on a group level or individual form level for companies with multiple divisions. ESMA called for greater clarity on this in April 2018.

Position limits

MiFID II also created a new type of trading venue known as an OTF. Power and gas trades must be transacted on an OTF to be considered physical contracts that must be delivered.

Under MiFID II, for a trading platform to be classified as an OTF, its operator has to use its own discretion to decide when to place or remove an order, and whether or not to match a specific order with others.

The rules to operate a multilateral trading facility (MTF) are closely aligned with regulated marketplaces, which are generally exchanges, under MiFID II.

Activity on power exchange EEX’s OTF platforms has been limited since the introduction of MiFID II, indicating that many companies have not been affected by the regulation.

Trading venues

MiFID II also created a new type of trading venue known as an OTF. Power and gas trades must be transacted on an OTF to be considered physical contracts that must be delivered.

Under MiFID II, for a trading platform to be classified as an OTF, its operator will have to use its own discretion to decide when to place or remove an order, and whether or not to match a specific order with others.

The rules to operate a multilateral trading facility (MTF) will be closely aligned with regulated marketplaces, which are generally exchanges, under MiFID II.
Timeline

April 2018 – ESMA calls for clarity on whether economic tests required to claim an ancillary services exemption apply on a group-wide level or to single entities within a larger company.

January 2018 – MiFID II launches.

September 2017 – The UK’s Financial Conduct Authority (FCA) releases a list of types of products that will have position limits under MiFID II.

June 2017 – ESMA publishes energy market size data for the MiFID in/out test. Businesses can avoid being regulated under MiFID II if they can prove trading activity is not the company’s core business.

April 2017 – ESMA announces that voice brokered and automated trading systems will be able to receive a new trading venue status as part of the regulation. Physically-settled deals carried out on new venues classified as organised trading facilities will not count towards thresholds that, if hit, would see traders treated more like financial institutions. This is opposed to volume transacted on regulated markets and multilateral trading facilities.

January 2017 – European Council approves regulated technical standards including position limits regime and the tests that companies will have to pass to remain exempted.

December 2016 – Commission revises in/out tests, saying traders will be able to include capital investments in physical assets and other areas when determining if they need to operate under MiFID II rules.

June 2016 – European Parliament approves delay in MiFID II rules, saying this was necessary to give market participants and regulators enough time to implement the legislation. MiFID II now set to start one year later on 3 January 2018.

January 2014 – Agreement between European Commission, Parliament and Council on MiFID II.

November 2007 – Original MiFID legislation enacted.
Recent ICIS news links

11 April 2018 17:23

ESMA asks European Commission to clarify MiFID II tests scope

07 February 2018 17:00

MiFID II introduction did not disrupt energy markets – EEX CEO

15 January 2018 17:26

MiFID II regulation kicks in but confusion remains

18 September 2017 05:30

OTC energy markets will be subject to MIFID II position limits

4 September 2017 17:31

FCA lists energy derivative products that will be subject to UK position limits

30 June 2017 16:41

ESMA publishes energy market size data for MiFID in/out test

19 January 2017 15:33

New MiFID in/out test could reduce impact on energy markets

26 April 2016

MIFID delegated act defines physically settled forwards

15 January 2014

Electricity and natural gas forwards avoid mandated clearing