In response to lengthy pressure from European commodity trading firms, the European Securities and Markets Authority (ESMA) has now promised to publish data by July that will prove key to determining whether they will have to comply with a sweeping new set of financial regulations.

But any comfort the industry will feel from being able to make progress in its preparations for the reworked Markets in Financial Instruments Directive (MiFID II) may be short-lived: The market size data will be released too late, will be incomplete and won’t help resolve other dilemmas firms face in the run-up to MiFID II’s launch date of Jan. 3, 2018, market participants say.

By that point, commodity trading firms will need to have gained a MiFID II license if they find they are in the scope of the new law, or have notified regulators that they are exempt. But it takes at least six months to obtain the license, so firms will need the data to carry out the ancillary exemption test before July to be able to work out whether they qualify for the exemption or if they have to apply for a license.

“On Dec. 31, firms are supposed to have all the data in place to make the calculation, make it, and have any authorization in place one day later,” says Christiane Leuthier, senior director of commodities at derivatives trade association FIA. “It simply doesn’t work.”

The UK’s Financial Conduct Authority, for example, has set July 3, 2017 as the final deadline for completed applications for licenses required in January 2018.

Mind The Gaps

Furthermore, ESMA has warned that there will be gaps in the forthcoming data, which is necessary for one of the two parts of the ancillary exemption test. The first part of the test requires firms to show that speculative trading has accounted for no more than 10 percent of their overall business over the past two or three years. Next, firms are allocated a share of the various markets in which they trade, based on the results of the first test. The larger a firm’s speculative activity as a proportion of its business, the smaller the market share threshold it is allocated. To work out how big their market share is, firms will need to know the total size of the various commodity derivatives markets in which they operate. This is the data they’ve been asking ESMA for.

But a source close to ESMA says the regulator’s data for 2015 will likely include only on-exchange trades; 2016 data will include over-the-counter (OTC) as well as exchange trades, but would only cover the second half of the year; and data for 2017 won’t be published until “several months” into 2018.

This will pose a real difficulty for firms as they are required to use an average of two—and a maximum of three—years’ worth of trading data going up to Dec. 31 of the year before the license is needed. So, to prepare for the 2018 regime, firms need to take the exemption test now using data that goes right up to the end of 2017.

As a result, firms will have to use estimated data for many of the calculations, which could introduce errors, market participants say.

For example, ESMA has not made it clear whether it considers total market size to consist of one or both sides of a trade. Any firm calculating market size based on both sides would have an estimate double the size of ESMA’s, if the authority decides to consider only one side. Firms are therefore being urged to be conservative in their market size estimates.

There are additional problems with the market share test. “A firm might be able to estimate and control its own activity, but its market share could change due to the actions of other participants,” says FIA’s Leuthier. “For the larger markets like Brent and WTI, this won’t be much of a problem, but in smaller markets, a firm’s competitors could have dropped out and its market share could have gone up without it changing its activity at all.”

Firms might then reduce volumes to stay under MiFID II thresholds, which would change the shape of the market data. “If everybody begins reducing the volume they trade in order to ensure they stay under those thresholds, then the market shrinks,” says Jonathan Whitehead, global head of commodities at Societe Generale. “This leaves firms in the situation where they make calculations based on the size of the market today and suddenly find the market has shrunk and they are over their allocation.”

So as things stand now, regulatory technical standard (RTS) 20 of MiFID II—which sets out the compliance timeframe—allows no time to run the calculations and notify regulators of the use of the exemption, let alone apply for a license.

That would put market participants in a precarious position, lawyers say. In many European Union jurisdictions, trading without necessary authorization carries both regulatory and legal consequences, including potential criminal sanctions. But the problems don’t stop there: The risk of transacting with a firm that is found to have been trading illegally could lead to a cautious trading climate in which firms trade less, say market participants and lawyers. 

“If you’re not sure if a counterparty should be licensed or not, that level of uncertainty might just mean you trade less with them,” says Brett Hillis, a London-based partner at law firm Reed Smith.

In the UK, any transaction carried out without a necessary license would be rendered void and unenforceable in a court of law. That could be problematic for banks as well as commodity firms. “This is something we’re investigating at the moment,” says SocGen’s Whitehead, who suggests that the possibility of unenforceable contracts could pose significant market risk. “Banks are not going to transact with a firm if they have a doubt as to whether that contract is enforceable. We would just keep away from it.”

Some firms plan to ask clients to sign representations—legal documents declaring a company’s regulatory status. These are used widely for compliance reasons under the European Market Infrastructure Regulation, with non-financial counterparties (NFCs) being asked to vouch for their status as either NFC-minus or NFC-plus, according to whether they breach certain EMIR thresholds. Applied to MiFID II, representations would state that, to the best of their knowledge, the firm is able to use the exemption. 

But Reed Smith’s Hillis notes that a representation that a firm is eligible for the ancillary exemption “can only be as good as the information that sits behind it… [and] not all the information is available.”

Firms may have an idea which counterparties might be most at risk of breaching MiFID II, but it’s difficult to have “any real conviction,” Whitehead says. “I think we’d be able to put a significant number of our clients—airlines, consumers, pure producers—in the ‘not covered by this’ category,” he says. “But there would always be some firms that you’re not quite sure of where they stand and what they are doing to address it. No firms have the bandwidth to have sufficiently in-depth conversations with hundreds of clients.”

Moreover, small companies operating in thinly traded markets may be most at risk of breaching their market share thresholds and failing the exemption test, say regulatory experts. These are also the firms that may be less aware of their obligations under MiFID II and therefore most at risk of breaching it.

“We get the sense that typically, the large firms won’t need to get a license,” says Jasper Jorritsma, a senior adviser on market structure issues at Dutch financial regulator the Autoriteit Financiële Markten (AFM). “The firms we are more worried about are the smaller firms that don’t have sophisticated compliance departments and may not quite understand that they could be in scope of MiFID II, and might be caught unawares.”

Many commodity firms are more concerned about counterparty risk than MiFID II compliance. “It may be tempting to think that almost all firms will make the right judgment based on the calculations they perform. But the MiFID II text creates the potential for firms to get it wrong,” says a regulatory affairs officer at a European energy firm. “I don’t really want to rely on the fact that every counterparty just happens to get it right. I think there’s a good chance that some of them will get it wrong, given the amount of uncertainty around these tests.”

Instruments and Costs

Yet another problem lies with the continued lack of clarity around whether certain transactions will be deemed financial instruments under MiFID II. If a transaction is not considered a financial instrument, it is not in scope of the law, so it is vital firms know the status of all their transactions before they take the exemption test. For example, MiFID II’s Annex 1, parts C6 and C7—intended to help clarify which commodity transactions will be in and out of scope—introduced a concept where the status of a transaction depends on the venue it is traded on. The rules introduce a new venue classification called an organized trading facility (OTF). Physical gas and power transactions traded on an OTF will not be considered financial instruments, but the same transactions traded on a regulated exchange or a broker-operated multi-lateral exchange would be. As brokers—and possibly exchanges—have yet to gain OTF classification, it is not currently clear how certain venues will be classified.

Despite the amount of uncertainty around the exemption, regulatory experts say erring on the side of caution and applying for authorization in case it is needed is not a viable option.

No firm wants to unnecessarily incur the cost of applying for a license, let alone the ongoing costs and capital requirements of running an authorized business. The European Federation of Energy Traders (EFET) estimates that a license could cost a typical larger energy firm between $3 billion and $6 billion. Authorized entities must adhere to a huge list of requirements that span trading, pre- and post-trade transparency, conduct of business and margining, and involve things such as providing investors with a clear best-execution policy, and recording all telephone conversations, meetings and electronic communications relating to all transactions.

Because of the costs involved, firms that need licensing are likely to restructure their business so they can split licensed activity into one legal entity and keep everything that’s exempt in another, consultants say. This is another reason they will want to know very clearly which of their activities need authorization before applying, so they can restructure in the most operationally efficient manner.

Once firms understand which of their activities might fall under regulatory scope, they will want to carry out a cost-benefit analysis, weighing up the implementation and ongoing costs associated with being authorized against the value a particular activity brings the firm, market participants say. Different firms will come up with different conclusions depending on future business plans, but some may explore whether it would be financially beneficial to move the activity out of the EU.

Additional considerations stem from Brexit and the impact it will have on market sizes. Due to the concentration of commodities markets in the UK, the country’s withdrawal from the EU—which will happen by the end of March 2019—is likely to have a huge impact on EU market size, market participants say.

Top-Down Solutions

Several trade associations, including FIA and EFET, believe there needs to be a transitional regime that would allow companies to operate under MiFID II without facing hefty penalties in early 2018. In the UK, FIA is urging HM Treasury to modify the underlying financial law. In Germany, a proposal for a transitional period is being considered by the country’s regulators.

Some associations want ESMA to establish a fully-fledged transitional regime, while others believe that boat has sailed since both level one and two texts of MiFID II have been finalized. Absent a transitional regime, AFM’s Jorritsma suggests regulators could “provide comfort to those who reasonably think they can rely on the exemption but then find out they can’t.”

As enforcement of MiFID II is the responsibility of national regulators, the stance they take on transitioning into the regime will be critical, say market participants. Jorritsma stresses the AFM will review any breach of MiFID II on a case-by-case basis. “If, for example, in 2016 a firm is well over its market share threshold and in 2017 hasn’t changed its activities at all, it would be quite difficult for it to argue that it couldn’t reasonably have anticipated needing a license,” he says. On the other hand, if an investigation reveals that a firm’s erroneous decision to claim exemption was based on robust data available at the time, that will be taken into consideration and the firm will be urged to seek authorization immediately, he says.

“The general stance we intend to take is that a firm needs to seek authorization as soon as it becomes aware that it needs it,” he says.

National regulators have the authority to ask firms that submit exemption notifications to justify them, possibly by presenting the data used in the calculations. But, in reality, the volume of notifications will likely make it impossible for regulators to scrutinize them all in that level of detail.  

“We expect notifications to be in the hundreds but, ultimately, there is no way of knowing how many there will be,” Jorritsma says. “We intend to check notifications in a risk-based manner, prioritizing checks on ones we consider higher risk.”

Meanwhile, ESMA says there will be more clarity around the data before July, and that it will issue further questions and answers “that will provide some clarity on the matter” in the coming weeks.