MiFID II Looming: Should Energy Companies be Concerned?

MiFID II will create a hedging exemption that guarantees the trading divisions of energy and other sectors companies remain exempt.

2017 will see the implementation of the next phase of the Markets in Financial Instruments Directive (MiFID II), which was created by EU regulators to increase competition and consumer protection in banking and equity-related financial services.

MiFID II is a regulatory cousin of EMIR and REMIT, which were introduced to address potential manipulation in derivatives and physical trading respectively. It expands beyond MiFID I’s original banking scope to take in aspects of commodity trading, which will amplify regulatory challenges for both European and U.S. commodity traders as well as energy market participants.

Will energy traders dealing in commodity derivatives still benefit being exempt from rules aimed at the banking they currently rely on? Waiting to see what happens is not an option. What must be done is understand MiFID II’s implications now and plan accordingly for readiness in 2017.

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Exemptions and overlapping regimes

The concern is that once the above mentioned exemptions are no longer in place, companies dealing in commodity derivatives could risk being treated as de facto financial institutions, whatever the nature of their business. This could result in the energy trading divisions of a transport or engineering company, for example, to have to abide by rules such as minimum capital requirements.

On paper there is a MiFID II exemption for firms that provide investment services for commodity derivatives, emissions allowances or emissions derivatives to customers or suppliers of their main business. However, to qualify for the exemption these activities must be considered “ancillary” to that company’s core business.

The risk therefore is that companies seen to be providing investment services, acting as a market-maker in commodity derivatives, or making use of algorithmic or high-frequency trading, might not qualify. Companies trading on their own account to optimize their physical energy assets, ‘should’.

It seems that if MiFID II will create a hedging exemption that guarantees, the trading divisions of energy and other sectors companies will remain exempt. However, the larger a group’s ancillary trading operation, the harder it could be to benefit from these narrowed exemptions.

An additional worry for companies that might find themselves re-categorized under MiFID II is overlapping with the EMIR (European Market Infrastructure Regulation) regulatory regime which is being rolled out now. Under EMIR, these companies may be treated as financial counterparties, and be subject to harsher standards in areas such as clearing, reporting and risk mitigation for OTC trades.

Not only has EMIR compliance caused confusion due to shifting timelines and definitions, it has also forced energy market participants across the board to increase their spending on IT investments. It is also unclear how MiFID II will treat physical energy forwards. These could end up being defined as OTC derivatives and therefore should also be subject to EMIR’s trading thresholds which, in certain scenarios, require both clearing and margining.

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Position limits

Under MiFID II, all energy market participants will be required to comply with limits on the net position firms can hold in commodity derivatives across the EU. Subsequently, so as to avoid market distorting positions, exchange and OTC commodity derivatives trades would be limited.

The hedging exemption mentioned above may well apply to position limits too, but only non-financial entities taking positions deemed to be directly reducing the risk of commercial activities.

However, the way the exemptions and limits will work in practice is still subject to extensive industry consultation, so there are still many unanswered questions how the new regime will eventually work.

How to prepare for MiFID II

The next 15 months leading to MiFID II implementation will be critical. We would recommend to first and foremost seek for clarity on the exact definition of hedging, particularly if you are hoping to make use of the ‘hedging exemption’. You should also understand how your positions will be aggregated and netted, as well as how economically equivalent contracts and the characteristics of an individual commodity will factor into the calculation. Last but not least, it will be key to ascertain whether physical forwards will be treated as OTC derivatives.

It is incredibly important that energy market participants build increased regulatory risk into their trading decisions, and they could start by thinking how changes in the regulatory interpretation of different transactions could affect a given portfolio, especially with regard to non-hedging activities.

On top of having to adapt hedging and risk management strategies, there are other actions you can now take to minimize regulatory risk exposure within MiFID II:

  • Trading on proprietary portfolios via a regulated market which, being established and fully regulated, could provide a measure of regulatory certainty about the classification and treatment of transactions.
  • Hiring additional compliance specialists.
  • Providing regulatory training for traders.
  • Investing in the right technology – an efficient Energy Trading and Risk Management (ETRM) system will highlight risk, guarantee that trades and related activities are compliant and that reporting is done by the book.

Start your ETRM system selection process start now, bearing in mind that a regulatory solution for commodity trading and corporate financial compliance is usually not a stand-alone application.

Direct connectivity to trade repositories should be a core capability. Hedge accounting, contract data, revenue allocation in line with new regulatory reporting requirements and other special functions also need to be factored in. So should the ability to install software on a captive system and maintain it internally, or the need to purchase a software-as-a-service (SaaS) contract and maintain it virtually in the cloud.

Being in a position to promptly upgrade and manage your regulatory compliance process will be key. If you want to be ready for the 2017 deadline, the best approach is to adopt a robust, intelligent and flexible solution.

— David Bernal is Senior Solutions Manager, EMEA for Allegro Development Corporation

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