Directive 2014/65/EU on markets in financial instruments (MiFID II) was issued on last July 12, and it will enter into force at the beginning of 2017 to replace current directive 2004/39/EC (MiFID). MiFID II, together with its relevant regulation 2014/600/EU (MiFIR), crowns intense efforts by European lawmakers, launched with regulations 1227/2011/EU (REMIT) and 648/2012/EU (EMIR), aimed at harmonising national regulatory frameworks and at ensuring the transparency of financial markets and, as a consequence, of the energy ones.
1. From MiFID I to MiFID II
The Italian Consolidated Finance Act (TUF), which implements MiFID in Italy, provides that 1. the exercise of investment services and activities 2. at a professional level and 3. vis-à-vis the public should, on principle, be reserved to banks and investment firms (so-called SIM). Investment services and activities comprise a series of transactions (including dealing on own account) that become relevant for the purposes of reserved activities solely when referred to "financial instruments". Since the latter also include, with certain provisos, commodities derivatives contracts (including electricity and natural gas) , it is easily understood why the notion of "financial instrument" has been at the core of the interpretation debate within the energy industry under MiFID and, subsequently, why it became the object of intense lobbying while drafting MiFID II. Indeed, it is obvious that the broader becomes the definition of financial instruments in order to comprise contractual categories that are typical of the energy arena, the more the scope of reserved activities and consequent entry barriers grow for those energy markets operators that are not banks or that, at least, do not have the financial means (or the industrial plans) to become authorised as an investment firm. Without thus expressing any value judgement, we observe that this is exactly what occurred with MiFID II, which is marked by a prominent vis expansiva in the energy markets deriving, on one hand, from expanding the definition of financial instrument and, on the other hand, from restricting those exemptions that the European lawmaker knew to be more widely (and legitimately) used by energy traders. The consequences upon the latter are sensational and go well beyond the necessity for them to obtain an authorisation as investment firms. As illustrated below, indeed, the new regulatory framework arising from the combined provisions of EMIR, MiFID II and MiFIR significantly widens the panoply of obligations that apply to derivatives and, therefore, to energy commodities derivatives as well, and to the parties that trade in such products. But let us proceed in an orderly fashion. In order to understand this subject, we first need to accurately define the boundaries of the new definition of financial instrument within the energy field, then to appreciate the limited leeway arising from the reformed exemption regime and, lastly, to analyse the consequences upon energy traders, at least by macro-areas.
2. Commodities derivatives and the new definition of financial instruments
As mentioned above, the definition of financial services and activities, and therefore, ultimately, the scope of reserved activities, are based on the notion of financial instrument. However, the European legislative framework also applicable to the energy sector provides other adjacent concepts. In particular, reference is made to the following macro-categories:
2. wholesale energy products;
3. commodity derivatives;
4. C6 energy derivative contracts;
5. emission allowances.
An actio finium regundorum is therefore appropriate, such as, taking its cue from
MiFID, will clarify the new boundaries
among such notions under MiFID II (Figure 1).
The current MiFID does not provide for a self-sufficient definition, but it contains, instead, a list of financial instruments in a relevant annex (Annex I). This list includes three specific classes of "commodities derivatives" that are elevated to the category of "financial instruments" (assuming, therefore, a genus ad species relationship with regard to the former), in case the following features are met:
(i) cash settlement, possibly at one of the parties' discretion, other than by reason of default or other termination event resolution event (C5 definition); or
(ii) possibility of physical settlement of the underlying commodity and trading on a regulated market or MTF (C6 definition); or
(iii) possibility of physical settlement of the underlying commodity and absence of commercial purposes and characteristics of other financial instruments (for example, clearing by way of clearing house or margin call) (C7 definition).
The MiFID Regulation further clarifies the C7 definition, otherwise obscure and subjective, specifying that a contract can be traced back to it if the following circumstances jointly recur:
- trading (or assimilability to trading) on a regulated market, a MTF or a similar trading facility in a third party Country;
- clearing by way of clearing house or margin call;
- delivery is not spot;
- the counterparty is not the operator of an energy grid (or of a balancing mechanism) for the purposes of balancing.
As mentioned above, on one hand, MiFID II expands the definition of financial instrument, by introducing a new category of commodities derivatives and, on the other hand, it widens the C6 definition. In detail, (i) emission allowances (EUA) are now considered financial instruments for all intents and purposes (C11 definition) and (ii) the C6 definition is expanded to include commodities derivatives traded on an organised trading facility (OTF). However, the C6 definition now provides for a specific exception for 1. "wholesale energy products" 2. traded on an OTF 3. that must be physically settled. Whereas it is clear that 'wholesale energy products' means the category defined and regulated by REMIT, there is no understanding, on the contrary, why the European lawmaker has deemed to limit the scope of the exception by adding the requirements mentioned above sub 2. and 3., instead of sic et simpliciter excluding such category from the scope of MiFID II. Moreover, this becomes the object of a more pressing doubt when one reads the "Frequently Asked Questions" (FAQ) on MiFID II published on the European Union website. Indeed, such document excludes tout court that wholesale energy products are included within the scope of MiFID II! Now, in the opinion of the authors, albeit most desirable from a market perspective this does not appear to be correct and the best (and most prudential) construction is the literal one, based on which: (i) it is necessary that the requirements mentioned above sub 2. and 3. are met for the purposes of applying the C6 exception, and (ii) the scope of such exception is limited to the sole category of commodities derivatives set forth under the C6 definition. It follows that, if wholesale energy products can be subsumed under the definitions of commodities derivatives under items C5 or C7, both the former REMIT and the former MiFID II regime could concomitantly apply. It is obvious that such an application overlap would not benefit the energy trading industry. We can but hope that, upon adopting the relevant delegated acts, the Commission and ESMA will shed more light on the issue.
Lastly, MiFID II introduces, as a species of former C6 commodities derivatives, the new category of "C6 energy derivatives contracts" for the sole purpose of exempting them, albeit only temporarily, from the application of the EMIR regime. More specifically, such category 1. comprises 1. coal or oil derivatives 2. traded on an OTF 3. that must be physically settled.
MiFID provides for a wide range of general exemptions, which energy traders operating in commodities derivatives can currently benefit from. In particular, besides the general exemption for intra-group activities, the latter have recourse to one of the following three exemptions, as the case may be:
1. Dealing on own account exemption: with some exceptions, set forth in favour of entities that do not provide investment services or perform investment activities other than dealing on own account;
2. Ancillary exemption: set forth in favour of entities trading financial instruments on their own account or providing investment services in commodities derivatives or providing the so-called exotic derivatives to clients of their main business, provided that the former amounts to an ancillary activity to their main business as considered at the group level, and provided that such main business is not the provision of investment services or banking services included in reserved activities;
3. Specialization exemption: set forth in favour of "persons whose main business consists of dealing on own account in commodities and/or commodity derivatives", not applicable, however, if such entities belong to a group whose main business consists in the provision of other investment or banking services included in reserved activities. Such exemption, to some extents tautological, is currently the most invoked by energy traders.
This situation is destined to radically change with the advent of MiFID II.
3.1 Elimination of the dealing on own account exemption and of the specialization exemption
First, the dealing on own account exemption is no longer available, since the same expressly excludes dealing on own account of commodity derivatives (besides emission allowances and relevant derivatives). Secondly, the specialization exemption has been completely removed.
3.2 Rewording of the ancillary exemption
The only exemption specific to trading commodities derivatives (besides emission allowances and relevant derivatives) remains the ancillary exemption , which is solely available to persons:
(i) dealing such financial instruments on own account (including market makers, but excluding those trading on own account in execution of clients' orders);
(ii) providing investment services in financial instruments, other than dealing on own account, but solely to clients and suppliers of their main business.
Moreover, such exemption is subject to the following strict limitations:
- the activity must be ancillary to the main business (considered at group level) and the latter must not consist in the provision of investment services (or banking services) or in market making activities on commodities derivatives and
- no high-frequency algorithmic trading technique must be applied.
Finally, operators benefitting from such exemption are required to submit a yearly notice to the competent authority, also specifying, if requested by the latter, the basis on which they deem the ancillary requirement to exist.
3.3 Special and optional exemptions
A special exemption applies also to persons liable to ETS directive dealing in emission allowances on own account. Such exemption, obviously, does not apply to emission allowances derivatives.
Finally, it is barely worthwhile mentioning some exemptions that have limited practical momentum for energy traders. First, the exemption for transmission systems operators (TSO) or for operators of energy balancing mechanisms when carrying out their institutional tasks.
Secondly, each Member State may introduce exemptions for some activities that are authorised and regulated at the national level (so-called optional exemptions). As far as relevant herein, we remind: (i) the exemption for undertakings (normally joint-ventures) dealing in commodities derivatives (besides emission allowances and the relevant derivatives) to provide hedging in favour of utilities that wholly own the former or that exercise joint control on them and benefit from the ancillary exemption and (ii) the exemption for undertakings (normally joint-ventures) dealing in emission allowances (and relevant derivatives) to provide hedging to persons liable to ETS that wholly own the former or that exercise joint control on them and benefit from the ancillary exemption.
Energy traders currently relying on MiFID exemptions should reconsider their prior assessment. In particular, the wording of the new ancillary exemption is such as to no longer enable regulated entities (in Italy, banks and investment firms) to trade in commodities derivatives by way of subsidiaries that are not authorised as investment firms. Vice-versa, the elimination of the specialization exemption will no longer allow utilities to continue to trade in commodities derivatives without being incorporated as an authorised investment firm, with all the relevant consequences in terms of organisation, equity, business rules of conduct and monitoring.
However, also for those entities that will continue to benefit from an exemption, the combined provisions of EMIR, MiFID II and MiFIR introduce obligations that not only go well beyond the necessity for the relevant authorisation, but also, in some instances, apply even to entities that are not authorised as investment firms.
4.1 EMIR: clearing and reporting obligations
First of all, the relevant definition of "derivative contract" (if OTC-traded) for the purposes of the obligations set out under EMIR directly refers to the categories of financial instruments from C4 to C10 currently provided under MiFID and, therefore, later under MiFID II. However, this implies that "emission allowances" do not fall within the scope of EMIR, whereas "derivatives contracts on emission allowances" do (provided that they are OTC-traded).
Non-financial counterparties (NFCs), and therefore energy traders as well, dealing in "OTC derivatives contracts" are subject to the following obligations:
1. obligation to verify that the portfolio of OTC derivatives contracts does not exceed the clearing threshold (NFC+);
2. obligation to apply some risk-mitigation techniques with reference to the OTC derivatives contracts that are not subject to clearing obligations;
3. obligation to notify the Italian Stock Exchange Commission (Consob) and ESMA when the clearing threshold sub 1 is exceeded and the possible consequent return under the clearing threshold;
4. obligation to clear the OTC derivatives contracts belonging to a derivatives category that has been declared liable to such obligation via a central counterparty (CCP) (so-called "clearing obligation");
5. obligation to report the derivatives contracts to an authorised trade repository (so-called "reporting obligation").
However, a specific exemption for "C6 energy derivative contracts" is provided: until July 3 2020, the clearing obligation will not apply to such contracts, provided that they are entered into by NFCs. Moreover, such contracts will not be relevant for the purposes of calculating the clearing threshold.
4.2 MiFID II: new position limits and position reporting obligations
MiFID II introduces the concept of position limits for commodities derivatives with the explicit intent to prevent market abuse and distortions. In particular, the competent authorities in each Member State are required to assess, in accordance with technical standards prepared by ESMA, limits on the size of the net position that a person (at group level) can hold in commodity derivatives on trading venues (that is to say, regulated markets, MTFs and OTFs) and in economically equivalent OTC contracts, on penalty of sanctions. Such limits, however, do not apply to positions held by NFCs, directly or indirectly, for hedging purposes and it is also possible to set a unique limit where a relevant quantity of the same derivative contract is traded on trading venues in more than one jurisdiction. Investment firms or market operators operating commodities derivatives trading venues must be endowed with supervision powers, which include at least the powers to: (i) monitor and access the broadest available information on open positions, (ii) require a person to terminate or reduce a position and (iii) where appropriate, require a person to provide liquidity back into the market at agreed prices and quantities with the intent to mitigate the effects of large positions.
MiFID II also sets out the following pervasive disclosure and notification obligations:
(i) if certain thresholds are exceeded, investment firms or market operators operating commodities derivatives (or emission allowances and relevant derivatives) trading venues: (a) will issue a weekly report of the aggregate positions held by the various categories of persons for each different financial instrument and (b) will deliver such report to the competent authority and to ESMA;
(ii) on request, investment firms or market operators operating commodities derivatives (or emission allowances and relevant derivatives) trading venues, at least on a daily basis, will provide to the competent authority a complete breakdown of all market participants (and their clients);
(iii) investment firms (not all traders, therefore) dealing in OTC commodities derivatives (or emission allowances and relevant derivatives), at least on a daily basis, will provide to the competent authority a complete breakdown of their positions (and of their clients', of their clients' clients and so on and so forth, down to the final customer);
(iv) participants to trading venues, at least on a daily basis, will provide to investment firms or to market operators operating commodities derivatives (or emission allowances and relevant derivatives) trading venues detailed information on their positions (and on their clients', and on their clients' clients, and so on and so forth, down to the final customers).
4.3 MIFIR: trading obligation
Financial counterparties (FCs) and NFC+ must enter into transactions (other than intragroup transactions) with other FC or NFC+ in derivatives contracts declared liable to trading obligations solely on: (i) regulated markets, (ii) MTFs, (iii) OTFs or (iv) trading venues in third party countries that the Commission has cleared as meeting reciprocity requirements (so-called trading obligation).
The cost-benefit ratio of this regime is all to be discovered. If, on one hand, market opacity will surely decrease and the containment capacity of systemic risk will increase, on the other hand, hedging strategies will be deterred, there will be less contract versatility and more monitoring burdens (also upon trading venues operators) and complexity/onerousness on operators. The increased market concentration, conversely, can be regarded as either a cost or a benefit, depending on one's viewpoint.