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Coffee, you and MiFID 2! Impact of MiFID 2 / MiFIR - Commodities Jonathan Melrose 19 February 2015

Commodity Derivatives Background to the changes under MiFID 2 Policy developments since MiFID 1 Communique of G20 finance ministers and central bank governors 15 April 2011 commodity derivatives markets should be subject to appropriate regulation and supervision: therefore certain exemptions to be modified (MiFID 2, Recital (19)) G20 summit in Pittsburgh on 25 September 2009 agreed to improve the regulation, functioning and transparency of financial and commodity markets to address excessive commodity price volatility. Note also the Commission Communications of 28 October 2009 on A Better Functioning Food Supply Chain in Europe, and of 2 February 2011 on Tackling the Challenges in Commodity Markets and Raw Materials. 2 / 23212200V2

Commodity Derivatives Background to the changes under MiFID 2 (cont d) IOSCO Principles for the Regulation and Supervision of Commodity Derivatives Markets, endorsed by the G20 summit in Cannes on 4 November 2011 which called for market regulators to have formal position management powers, including the power to set ex ante position limits as appropriate. (MiFID 2, Recital (125)) Concerns relating to the spot secondary markets in emission allowances (MiFID 2, Recital (11)) 3 / 23212200V2

Key Changes Scope - additional commodity derivatives within MiFID 2 Exemptions - reduction in the number of exemptions available to commodity dealers Introduction of position limits for commodity derivatives Position reporting for commodity derivatives Position management and other provisions applying to derivatives generally 4 / 23212200V2

Level 2 timeline - where are we now? Delegated Acts Consultation Paper May 2014 draft Technical Advice; Final Report December 2014 ESMA Technical Advice Issues covered Financial Instruments definition C6, 7 and 10 Annex 1 Position Reporting Thresholds RTS/ITS Discussion Paper May 2014; Consultation Paper December 2014 Issues covered Ancillary Activity Art 2.1(j) exemption (Draft RTS 28) 5 / 23212200V2

Level 2 timeline - where are we now? (cont d) Methodology for calculating Position Limits (Draft RTS 29) Application of Position Limits (Draft RTS 30) Position Reporting (Draft RTS 30) 6 / 23212200V2

Scope of financial instruments - Commodities Extended scope Who is affected/what are the impacts? Both regulated and unregulated entities for example: Impact on authorisation requirements Impact on EMIR/EMIR reporting obligations Impact on Transaction Reporting 8 / 23212200V2

Scope of financial instruments Commodities (cont d) In relation to commodities MiFID 2 scope will cover broadly: Cash settled commodity derivatives (i.e. must be cash settled or may be cash settled at the option of one of the parties) Physically settled commodity derivatives (i.e. that can be physically settled) traded on an RM, MTF or OTF, subject to exceptions Other physically settled commodity contracts not being for commercial purposes and having the characteristics of other derivative financial instruments Exotic derivatives cash settled (as above) or otherwise having the characteristics of other derivative financial instruments Emission allowances 9 / 23212200V2

MiFID 2 Revised Definitions changes from MiFID1 (5) Options, futures, swaps, forward rate agreements forwards and any other derivative contracts relating to commodities that must be settled in cash or may be settled in cash at the option of one of the parties other than by reason of default or other termination event; (6) Options, futures, swaps, and any other derivative contract relating to commodities that can be physically settled provided that they are traded on a regulated market, and/or an MTF, or an OTF, except for wholesale energy products traded on an OTF that must be physically settled; (7) Options, futures, swaps, forwards and any other derivative contracts relating to commodities, that can be physically settled not otherwise mentioned in point 6 of this Section and not being for commercial purposes, which have the characteristics of other derivative financial instruments, having regard to whether, inter alia, they are cleared and settled through recognised clearing houses or are subject to regular margin calls; 10 / 23212200V2

MiFID 2 Revised Definitions changes from MiFID1 (10) Options, futures, swaps, forward rate agreements and any other derivative contracts relating to climatic variables, freight rates or inflation rates or other official economic statistics that must be settled in cash or may be settled in cash at the option of one of the parties (other than by reason of default or other termination event), as well as any other derivative contracts relating to assets, rights, obligations, indices and measures not otherwise mentioned in this Section, which have the characteristics of other derivative financial instruments, having regard to whether, inter alia, they are traded on a regulated market, OTF, or an MTF, are cleared and settled through recognised clearing houses or are subject to regular margin calls; (11) Emission allowances consisting of any units recognised for compliance with the requirements of Directive 2003/87/EC (Emissions Trading Scheme). Note Commodity derivatives is also defined to include transferable securities giving rise to a cash settlement determined by reference to a commodity or an underlying referred to in C10 11 / 23212200V2

Commodity Definitions - transitionals Certain transitional relief (to July 2020) relating to EMIR in relation to relating to EMIR for C6 Energy Derivative Contracts relating to coal or oil that are traded on an OTF and must be physically settled the clearing obligation and risk mitigation techniques will not apply to C6 energy derivative contracts entered into by an NFC+ or by non-financial counterparties authorised for the first time as investment firms as from 3 January 2017 will not be considered to be OTC derivative contracts for the purposes of the clearing threshold) C6 Energy Derivative Contracts - options, futures, swaps, and any other derivative contracts mentioned in Section C.6 of Annex I relating to coal or oil that are traded on an OTF and must be physically settled 12 / 23212200V2

Commodity Definitions - what is currently happening Interim measures under MiFID 1 Consultation on Guidelines on the application of C6 and C7 of Annex 1, MiFID 1 (September 2014) Reason for Guidelines Commission Letter to ESMA 26.02.2014 Inconsistent Interpretations impact on EMIR Key Issues C6 (stipulated commodity derivatives which can be physically settled, traded on an RM/MTF) does not refer to forwards ESMA view included under any other derivatives Clarification of which contracts fall within C5, 6 and 7 according to settlement type 13 / 23212200V2

Interim measures MiFID 1 Guidelines (cont d) Clarification of which contracts fall within C5, 6 and 7 according to settlement type Guidelines on physically settled non exhaustive list of delivery methods subject to consultation 14 / 23212200V2

Status of Level 2 - Final Report ESMA Technical Advice C6 Derivatives Covers criteria for determining when wholesale energy contracts must be physically settled new and contentious, proposal that the contract must contain provisions ensuring that the parties have proportionate arrangements in place to be able to make or take delivery of the underlying commodity must establish unconditional, unrestricted and enforceable obligations to deliver and take delivery of the underlying commodity must not be possible to replace physical delivery with cash settlement the obligations under the contract cannot be offset against obligations from other contracts between the parties (subject to payment netting) 15 / 23212200V2

ESMA Technical Advice (cont d) Clarifications relating to: Operational netting in the power and gas markets Force majeure Bona fide inability to settle Default clauses Non exhaustive examples of methods of physical settlement 16 / 23212200V2

ESMA Technical Advice cont d C7 Derivatives Largely follows the current MiFID1 Level 2 concepts (Art 38), apart from the clearing criterion Extends the trading criteria to extend to third country equivalents of OTFs and contracts expressly stated to be subject to the rules of an OTF (as well as, in both cases, regulated markets/mtfs) The concept of contracts being equivalent to (rather than expressly stated to be equivalent to a contract traded on an a regulated market, MTF or OTF or third country trading venues has been added. This has given rise to concerns within the industry. The commercial purpose carve out remains limited (applying to certain energy infrastructure providers) - ESMA remains open to extend this to other specific cases 17 / 23212200V2

Exemptions for commodity dealers narrowed Narrowing of exemptions Who is affected/what are the impacts: unregulated commodity market participants impacts include authorisation requirements, knock on impact on EMIR and the ability to use hedge exemption for position limits own account dealing exemption in Article 2.1(d) now excludes from its scope own account dealing in commodities derivatives or emission allowances The general own account dealing exemption incidentally also now excludes from its scope: market makers dealing using a high frequency algorithmic trading technique and members of/participants in a regulated market or multilateral trading facility (MTF) /having direct electronic access to a trading venue, as well as clarification that dealing on own account when executing client orders is also out of scope 19 / 23212200V2

Comparison of Article 2(1)(i) MiFID I to Article 2(1)(j) of MiFID 2 This Directive shall not apply to: (i) (j) persons: (i) dealing on own account in financial instruments, including market makers, in commodity derivatives or emission allowances or derivatives thereof, excluding persons who deal on own account when executing client orders; or (ii) providing investment services, other than dealing on own account, in commodity derivatives or derivative contracts or emission allowances or derivatives thereof included in Annex I, Section C 10 to the clients customers or suppliers of their main business; 20 / 23212200V2

Comparison of Article 2(1)(i) MiFID I to Article 2(1)(j) of MiFID 2 provided that: for each of those cases individually and on an aggregate basis this is an ancillary activity to their main business, when considered on a group basis, and that main business is not the provision of investment services within the meaning of this Directive or banking services activities under Directive 2000/12/EC 2013/36/EU, or acting as a market-maker in relation to commodity derivatives, those persons do not apply a high-frequency algorithmic trading technique; and those persons notify annually the relevant competent authority that they make use of this exemption and upon request report to the competent authority the basis on which they consider that their activity under points (i) and (ii) is ancillary to their main business; 21 / 23212200V2

What is happening at Level 2 Consultation and draft RTS on meaning of ancillary activities For the exemption to apply - necessary to fall below the thresholds for both the minority of activities test/ancillary activities test and the trading activities test minority of activities test/ancillary activities test relates to the proportion of relevant activities carried on in the EU the trading activities test is a broader test and relates to the percentage of overall trading in the relevant market Also proposed that a de minimis test of 0.25% of the overall market trading activity in each of the relevant asset classes would not be required to undertake the minority of activities test in these circumstances Annual notification required if fall within the exemption 22 / 23212200V2

Minority of activities Test Capital employed by group for carrying out eligible activity in the EU must account for less than 5% of the capital employed for carrying out the main business of the group in the EU and third countries Deduct the capital employed in privileged transactions by the group in the EU from the capital employed by group for carrying out eligible activity in the EU Deduct from capital employed in trading activity by a MiFID licensed group entity from the capital employed for the eligible activity Eligible activity own account dealing and other services in commodity derivatives/emission allowances /derivatives to customers/suppliers of main business of group 23 / 23212200V2

Minority of activities Test (cont d) Privileged Transactions are broadly: intragroup transactions that serve group wide liquidity or management purposes hedging transactions (transactions objectively measurable as reducing risks directly relating to commercial activity or treasury financing activity, including non OTC derivatives - EMIR tests to be applied transactions in commodity derivatives/emission allowances to fulfil obligations to provide liquidity on a trading venue where required by regulatory authorities or trading venue Capital is proposed to be capital encompassing total equity, current debt and non-current debt as calculated from balance sheets and financial statements 24 / 23212200V2

Trading Activity Test Trading activity in commodity derivatives of the group in the EU must be less than 0.5% of the overall market trading activity in the EU in the relevant asset classes. Deduct Privileged Transactions and trading activity by MiFID licensed entities within the group from the group s overall trading activity in the EU Data from Trade Repositories to be used in calculating overall trading activity Exceeding threshold in any one asset class will result in the exemption not being available 25 / 23212200V2

Ancillary Activities Consultation Key issues and industry reaction For example: size of thresholds definition of capital geographical scope 26 / 23212200V2

Other exemptions Article 2.1 (n) transmission system operators as defined in Article 2(4) of Directive 2009/72/EC or Article 2(4) of Directive 2009/73/EC when carrying out their tasks under those Directives, under Regulation (EC) No 714/2009, under Regulation (EC) No 715/2009 or under network codes or guidelines adopted pursuant to those Regulations, any persons acting as service providers on their behalf to carry out their task under those legislative acts or under network codes or guidelines adopted pursuant to those Regulations, and any operator or administrator of an energy balancing mechanism, pipeline network or system to keep in balance the supplies and uses of energy when carrying out such tasks. Only applies where persons perform investment activities or provide investment services relating to commodity derivatives in order to carry out the relevant activities Does not apply with regard to the operation of a secondary market, including a platform for secondary trading in financial transmission rights; 27 / 23212200V2

Other exemptions (cont d) Article 2.1(e) operators with compliance obligations under Directive 2003/87/EC who, when dealing in emission allowances, do not execute client orders and who do not provide any investment services or perform any investment activities other than dealing on own account, provided that those persons do not apply a high-frequency algorithmic trading technique 28 / 23212200V2

Other Optional Exemptions Firms which: Article 3 (d) provide investment services exclusively in commodities, emission allowances and/or derivatives thereof for the sole purpose of hedging the commercial risks of their clients, where those clients are exclusively local electricity undertakings and/or natural gas undertakings; or Article 3(e) provide investment services exclusively in emission allowances and/or derivatives thereof for the sole purpose of hedging the commercial risks of their clients, where those clients are exclusively relevant operators. In both cases the clients must jointly hold 100 % of the capital or voting rights of those persons, exercise joint control and are exempt under point (j) of Article 2(1) of MiFID II if they carry out those investment services themselves. Certain analogous regulatory requirements must nonetheless be imposed. 29 / 23212200V2

Issues - Position Limits, Position Management and Position Reporting MiFID 2 introduces a new regime of position limits, position management and position reporting. Purpose: to prevent market abuse; to support orderly pricing and settlement conditions, including preventing market distorting positions, and ensuring, in particular, convergence between prices of derivatives in the delivery month and spot prices for the underlying commodity, without prejudice to price discovery on the market for the underlying commodity. Who is affected/what are the impacts: persons holding relevant positions and OTC economically equivalent contracts intended to go through to the level of the ultimate client applies to all persons whether or not authorised, although note the hedging exemption only applies to non financial entities 31 / 23212200V2

Position Limits The new position limit regime requires competent authorities to establish and apply: Position limits on the size of a net position which a person can hold at all times in commodity derivatives that are traded on regulated markets, MTF, OFTs and OTC economically equivalent contracts. Limits will be set on the basis of all positions held by a person and those held on its behalf at an aggregate group level. Position limits will not apply to positions held by or on behalf of a non-financial entity and which are effectively measurable as reducing risks directly relating to the commercial activity of than non-financial entity. Proposals Baseline figure of 25% of deliverable supply for both spot and forward months NCAs may increase/decrease by up to 15% (so maximum will be 40% and minumum 10%) 32 / 23212200V2

Position Limits - Methodology ESMA has consulted on/drafted regulatory technical standards to determine the methodology for calculation that competent authorities are to apply in establishing the spot month position limits and other months position limits for physically settled and cash settled commodity derivatives based on the characteristics of the relevant derivative. The methodology for calculation addresses: the maturity of the commodity derivative contracts; the deliverable supply in the underlying commodity; the overall open interest in that contract and the overall open interest in other financial instruments with the same underlying commodity; the volatility of the relevant markets; the number and size of the market participants; 33 / 23212200V2

Position Limits - Methodology (cont d) the characteristics of the underlying commodity market, including patterns of production, consumption and transportation to market; the development of new contracts. ESMA is also required to take into account experience regarding the position limits of investment firms or market operators operating a trading venue and of other jurisdictions. 34 / 23212200V2

Position Limits - Application Consultation and draft RTS Risk reducing positions similar approach as EMIR Non financial entity - any entity that is not a financial entity; proposals relating to third country equivalents Definition of group - person and its subsidiaries but not sister companies whole position basis where partially owned subsidiaries Jurisdictional coverage Suggestion that Article 57 limited to the EU 35 / 23212200V2

Position Limits - Application (cont d) Narrow definition of OTCEE OTC A contract which explicitly refers to a commodity derivative that is traded on a trading venue; or is valued on the basis of the same or equivalent grade that is deliverable at the same location, or another equivalent location so long as the other delivery location has similar economic characteristics, and is deliverable on the same date as that of a commodity derivative that is traded on a trading venue. Industry reaction 36 / 23212200V2

Position Reporting Commitment of Trader Report and Position Reports to Regulators Trading venues which trades commodity derivatives or emission allowances/ derivatives are required to: publish a weekly Commitment of Trader Report with the aggregate positions held by the different categories of persons for the different commodity derivatives or emission allowances /derivatives / traded on the/trading venue and communicate that report to the relevant competent authority and to ESMA; and provide the relevant competent authority with a daily Position Report for Regulators i.e. a complete breakdown of the positions held by all persons, including the members or participants and their clients, on that trading venue, at least on a daily basis. 37 / 23212200V2

Position Reporting (cont d) Commitment of Trader Report and Position Reports to Regulators Commitment of Trader Reports are to specify the number of long and short positions by category of persons, any changes since the previous report, percent of total open interest represented by each category, and the number of persons in each category. The obligation only applies when both the number of persons and their open positions exceed minimum thresholds Commitment of Trader Reports and Position Report for Regulators are to differentiate between: positions identified as positions which in an objectively measurable way reduce risks directly relating to commercial activities; and other positions. Members or participants of regulated markets, MTFs and clients of OTFs are to be required to provide this information. 38 / 23212200V2

Position Reporting (cont d) Direct Position reports Investment firms trading in commodity derivatives or emission allowances/ derivatives outside a trading venue are to be required to provide the relevant competent authority of the trading venue at least on a daily basis with a complete breakdown of their positions taken in commodity derivatives or emission allowances/derivatives traded on a trading venue and economically equivalent OTC contracts, as well as of those of their clients and the clients of those clients until the end client is reached. 39 / 23212200V2

Position Management Position Management Operators of trading venues required to apply position management controls Role of national competent authorities Role of ESMA ESMA may: request from any person all relevant information regarding the size and purpose of a position or exposure entered into via a derivative; require any such person to reduce the size of or to eliminate the position or exposure; as a last resort, limit the ability of a person from entering into a commodity derivative. 40 / 23212200V2

Position Management (cont d) Safeguards These steps may only be taken where: the measures address a threat to the orderly functioning and integrity of financial markets, including commodity derivative markets and including in relation to delivery arrangements for physical commodities, or to the stability of the whole or part of the financial system in the EU; a competent authority or competent authorities have not taken measures to address the threat or the measures taken do not sufficiently address the threat. ESMA must ensure that the measure: significantly addresses the threat to the orderly functioning and integrity of financial markets, including commodity derivative markets and including in relation to delivery arrangements for physical commodities, or to the stability of the whole or part of the financial system in the EU or significantly improve the ability of competent authorities to monitor the threat; 41 / 23212200V2

Position Management (cont d) does not create a risk of regulatory arbitrage does not have any of the following detrimental effects on the efficiency of financial markets that is disproportionate to the benefits of the measure: reducing liquidity in those markets, restraining the conditions for reducing risks directly related to the commercial activity of a non-financial counterparty, or creating uncertainty for market participants. ESMA is also required where relevant to consult the Agency for the Cooperation of Energy Regulators or the public bodies competent for the oversight, administration and regulation of physical agricultural markets before taking any measures. ESMA is required to give not less than 24 hours notice to relevant competent authorities before the measure is intended to take effect or to be renewed other than in exceptional circumstances. elaboration in Technical Advice 42 / 23212200V2

Further information from Simmons & Simmons Legal Headwinds http://www.elexica.com/en/resources/newsletter-listing/legal-headwinds- NL MiFID 2 Tracker http://www.elexica.com/en/resources/microsite/mifid-2-tracker Commodity Derivatives Regulation Tracker http://www.elexica.com/en/resources/microsite/commodity-derivatives Simmons & Simmons 2008 43 / L_LIVE_EMEA1:25282406v2

Contact details Jonathan Melrose T +44 20 7825 4514 E jonathan.melrose@simmons-simmons.com Simmons & Simmons 2008 44 / L_LIVE_EMEA1:25282406v2

simmons-simmons.com elexica.com Simmons & Simmons 2008 45 / L_LIVE_EMEA1:25282406v2