Introduced with the objective of fair competition and consumer protection in investment services, the MiFID II is grabbing headlines ever since its inception way back in 2011 - as a response to the global financial crisis. While MIFID II and MIFIR, in its entirety may be a colossal regulatory initiative, an area of special interest could be that of the regulatory standards surrounding the commodity derivatives.

The European Securities and Markets Authority (ESMA), in Q3 2015, submitted the draft Regulatory Technical Standards (RTS) on methodology for calculation and application of position limits for commodity derivatives traded on trading venues and economically equivalent OTC contracts, known as RTS 21 to European Commission (EC). In response, the EC notified ESMA of its intention to endorse the RTS 21 albeit with a certain amendments such as:

• Position limits for Commodity Derivatives with an agricultural underlying
• Methodology to address the cases where there is significant disparity between open interest and deliverable supply
• Definition of Economically Equivalent OTC Contracts

Key Amendments

MiFID II introduced a new position limits (caps) regime for commodity derivatives with the objective of preventing market abuse and addressing systemic risk. In order to ensure a harmonised approach for application of such limits across all the member states, ESMA’s draft RTS 21 provided a position limit framework within which the competent authorities (in each of the member state) are allowed to customise.

Position Limits for Commodity Derivatives with an Agricultural Underlying

This amendment is based on the request by the EC to either lower the baseline position limit from proposed 25% or to lower the minimum position limit than 5% for very liquid and highly traded agricultural commodity derivatives in spot and other months. This stems from the fact that high volatility in such derivatives would have significant impact on the actual food prices.

In the spirit of ensuring that the harmonised application of position limits is maintained, ESMA proposed an amended range of standard baseline (of deliverable supply and of open interest) permitting the national competent authorities to make customisations as necessary. Consequently, the minimum position limit  of agricultural commodity derivatives is revised to 2.5%. The revised baseline range now stands as 2.5% - 35% for agricultural commodity derivatives and 5% - 35% for others.

Also, to ensure that the revised minimum limit is applied to only liquid and highly traded agricultural contracts, ESMA proposed that these contracts should have a minimum open interest in spot or other months. The minimum open interest, therefore, is pegged at 50,000 lots over a consecutive three month period.

Addressing Disparity Between Open Interest and Deliverable Supply

In the draft RTS released in Q3-2015, ESMA deemed deliverable supply  and open interest as the baseline measures for spot and other months’ respectively. This is in the view that supply of the underlying commodity actually being available is of prime importance as the contract nears maturity while open interest which measures better liquidity when the contract is away from maturity, is a more apt measure for other months.

The EC opined that MiFID II should address the cases when there is significant disparity between open interest and deliverable supply - as such a disparity would create disorderly market conditions when a contract moves from other months to spot month. ESMA, in response, has introduced two key amendments to tackle the above concern.

Firstly, by expanding the definition of deliverable supply to include any substitute grades or types of a commodity, ESMA aims to increase the supply of commodity that can be delivered in settlement of a commodity derivative, thereby reducing the scale of discrepancies. Secondly, ESMA also provided clarification that national competent authorities would have the ability to adjust the position limits for other months if the open interest and deliverable supply differ significantly.

Definition of Economically Equivalent OTC Contracts

As per the Article 57(1) of Directive 2014/65/EU, the net position of a person in commodity derivatives is an aggregation of positions held in commodity derivatives on a trading venue and the positions held in Economically Equivalent OTC (EEOTC) contracts. The position limits imposed by ESMA would be applicable on this net position. It is in this context that EC proposed to widen the definition of EEOTCs to prevent circumvention of position limit system.

The current definition of EEOTCs is narrow in terms of specifying that the contractual conditions for OTC contracts such as date of delivery should be same as those contracts traded on venues for it to be deemed EEOTC. Since such a narrow definition may encourage non-consideration of similar on-venue contracts when establishing the net position and allows circumvention of position limits by spreading positions across OTCs and traded venues, EC proposed to broaden the current definition to preserve the spirit of position limits regime.

However, the flip side of too wide a definition would be netting-off of positions which may be only roughly similar and which would be detrimental to the overall principles of position limits and MiFID II. In order to tackle such diverse potential events, ESMA proposed to broaden the definition enough to strike an optimum balance.

As per the amended definition, an OTC contract with identical contractual specifications, excluding differences in terms of lot sizes, date of delivery and post-trade risk management arrangements, to an on-venue contracts would be deemed as EEOTC. A key point to note, though, is that the difference between the date of delivery between OTC contracts and on-venue contracts is limited to one day.

After Thoughts

A look at the changes proposed by EC and the subsequent amendments by ESMA would give us an indication of intent of the MiFID II, which is - maintaining market equilibrium and protecting investor interests. With the implementation dates now set for 2018, there is a lot of ground to cover and many more outstanding issues to settle. The fact that ESMA responded with amended regulatory technical standards well within the given time frame of six weeks in itself stands as a testimony to the urgency with which the regulatory bodies are moving.

Financial institutions, on their part, have even more work to do. It is a massive and wide-ranging project which affects the way financial institutions and markets work. With implementation date looming over, banks and financial institutions should be nimble enough to achieve compliance - on time. This involves impact analysis and organisational interpretation and scoping, transforming of rules to business requirements, mobilising resources, implementing data and reporting systems and revising governance & audit processes. The success of such a project relies on efficient coordination between financial firms, regulatory bodies, national competent authorities, market facilitators and customers. Evident enough, the clock is ticking.