How do financial regulations impact clearing and margining in energy and commodities?
The European and global banking scene has been embroiled in a slew of changes in the clearing and margining world over the last years, with the rules on variation margin for uncleared OTC deals coming imminently.
The entire investment firm community is caught by the uncleared margin requirements, while EMIR mandatory clearing proceeds at its own pace. This has not only led to many operational challenges, but also increased the importance of margin and capital optimisation.
In the energy and commodities world, life is, as always, slightly different, with these rules having a lower impact, at least for now. This is for several reasons, of which two are key:
- Most entities are non-financial counterparties
- Many of the products traded are not “financial instruments”
Firstly, the majority of energy and commodity traders are, at this stage not investment firms, and considered under EMIR to be “Non-Financial Counterparties” (NFCs). As a non-investment firm, the majority of firms are exempt from MiFID. The applicability of EMIR and the uncleared margin rules in the European jurisdiction depends on whether the entity is over the clearing threshold. Those above the threshold, a group known as “NFC+”, will be subject to much of the uncleared margin regime, and also mandatory clearing under EMIR, as Category 4 counterparties.
An entity is over the clearing threshold if the total outstanding gross notional value for trades which are not ‘risk reducing’ is over one of these asset class totals:
- Commodity derivatives- €3bn
- Credit derivatives– €1bn
- Equity derivatives – €1bn
- FX derivatives – €3bn
- Interest rate derivatives – €3bn
A 30 day average must be calculated by NFCs on a daily basis. In the event that one of the threshold values is exceeded, the entity must notify the National Competent Authority and after a transitional period becomes an NFC+, where the more onerous rules apply. For commodities companies, the usual focus is, as expected, the commodities threshold (see Figure 1).
There are several detailed rules around the calculation of the threshold in commodities, not least of which is the fact that the notional of a commodity in not a fixed value, but is instead defined as volume times price. There are many issues to consider in the calculation, for example which volume to use (is it the original volume or remaining volume?) and which price?
In terms of defining the trades in scope, those executed on a Regulated Market (RM), i.e. an exchange, generally do not contribute to the total, unless the RM in question is in a non-recognised third country. The calculation is performed for any trades in the global group in a non-investment firm entity. As a result, those with significant positions on exchanges in non-recognised third countries have experienced issues with their totals. The rules around determining which trades are ‘risk reducing’ and the appropriate record keeping around it also need to be respected.
What is a derivative?
Of more significance is the definition of what constitutes a derivative, and is therefore included in the total calculation. A trade is defined as a derivative under EMIR if it meets one of the criteria in MiFID Annex I sections C4 to C10. Of particular interest are paragraphs C6 and C7, which deal with physical forwards, of which many are traded by commodity and energy companies. Under MiFID I, and therefore currently under EMIR, C6 states that the following are financial instruments:
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;
In effect, any physical forward traded on an exchange, or MTF (Multilateral Trading Facility) is a financial instrument, and therefore contributes to the clearing threshold calculation. On 6 May 2015 ESMA issued new guidelines on how section C should be applied (ESMA/2015/675), which replaced the guidance in the original MiFID Implementing Act (EC 1287/2006). The relevant section primarily specifies the meaning of ‘physical’.
Section C7 deals with off venue trades:
Options, futures, swaps, forwards and any other derivative contracts relating to commodities, that can be physically settled not otherwise mentioned in C.6 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;
The guidelines go into a great deal of detail on this definition, but in effect state that in order to be a financial instrument, the trade must be:
- Equivalent to an instrument on an RM or MTF, whether in the EU or third country
- Not “spot”
- The pricing is standardised so that the price, lot, delivery date or other terms are principally determined with reference to regular published prices, standard lots or delivery dates
- There are appropriate clearing or margining arrangements.
When EMIR started to apply, very few commodity traders, and even fewer energy traders, became NFC-. While it is in reality hard for a product to comply with section C7, many trades are executed on exchanges or broker platforms. The run up to EMIR saw many broker platforms, which had until then been classified as MTF, change their status to “non MTF”. This was often brought about by introducing a discretionary element to its operation. An MTF was required to have non-discretionary operation, and this change offered an option for entities to execute physical forwards in such a way that they were not derivatives.
This, combined with the fact that trades executed on an RM are in any case not included in the total, resulted in the majority of companies in the sector being classified as NFC-. As a result, such companies are not subject to either mandatory clearing, or the uncleared margin rules.
Changed product definitions under MiFID II
MiFID II introduces several changes to Annex I Section C, and in particular C6 and C7. C6 under MiFID II reads as follows:
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, a MTF, or an OTF, except for wholesale energy products traded on an OTF that must be physically settled;
There are two important changes here: firstly, the scope of caught physical forwards has been extended to cover trades executed on an OTF, an Organised Trading Facility. It is likely that the majority of multilateral non MTF and non RM platforms will be classified as OTF, which will bring those products into scope.
The second change however, is equally important, namely the exclusion of “wholesale energy products” executed on an OTF which “must be physically settled”, which is distinct from the phrase “can be physically settled”, found in the main part of the paragraph. This exclusion is known as the “REMIT carve out”, due to the fact that any trade which falls under this clause would be caught by REMIT’s1 requirements. The guidelines for the MIFID I version are replaced by text in Article 5 of the MIFID Delegated Act of 25th April 2016, which defines the requirements for “must be physically” settled.
In all likelihood, many products in gas and power will benefit from the carve out, although this assumes that the current non MTF broker platforms will become OTF, and that the products are successfully specified as “must be physically settled”. Those trading non-gas and power forwards will have a larger impact.
Section C7 has also been updated and under MiFID II reads:
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;
The Delegated Act also further details how this section is to be applied, in some cases defining and in others narrowing the definition. Note that there is no REMIT carve out in this section, which could well have the effect of pushing some currently off venue trades onto venues, which is in line with one of the original MiFID II objectives.
Coal and oil – transitional arrangement
MiFID II Article 95 specifies transitional arrangements for “C6 energy derivatives” contracts, which refers to those in coal and oil. More precise definitions are found in the MIFID II Delegated Act Article 6. Such derivatives do not contribute to the EMIR clearing threshold, nor will they come under the clearing obligation, until 3 July 2020. Therefore a section of the market will remain NFC- until the transitional arrangement ends.
The EMIR review
ESMA issued a report on 13th August 20152 as part of the EMIR entitled “Review on the use of OTC derivatives by non-financial counterparties”, which was the first of four reports issued. The report indicated that on the one hand, many small NFCs had been caught by EMIR, which had led to a heavy burden on companies who make only occasional or ‘light’ use of derivatives. On the other hand, the report claimed that many ‘large’ NFCs currently had the status of NFC-, despite the fact that some may consider them to be systemic. Amongst the recommendations was the proposed removal of the “hedge exemption” from the clearing threshold calculation, with a corresponding increase in the level of the thresholds. This would take larger NFCs over the threshold, and make the calculation easier for the smaller ones. Other parts of the report suggest further compromises for “smaller NFCs”.
While there has not been much discussion on this proposal, it was mentioned again in the report into EMIR produced in late 2016 by the European Commission. It remains to be seen if the proposal will make its way into EMIR, which would likely lead to several energy and commodity traders becoming NFC+
Exemptions under MiFID II – The Ancillary Activity test
Commodity and energy traders may use the “commodity dealer exemption 2(1)k” of MiFID I to remain outside of the rules, although some choose to set up regulated entities to undertake certain investment services. MiFID II removes this blanket exemption, which means that entities are required to obtain authorisation from the National Competent Authority, unless they are able to use one of the remaining exemptions. In most cases this will involve using the “Ancillary Activity” exemption found in Article 2(1)j, which requires those who primarily deal in commodity derivatives to show that speculative trading is ‘ancillary’ to the main business. The test is defined in Regulatory Technical Standard 20, which has undergone many changes and versions. RTS 20 was adopted by the European Commission on the 1st December.
The adopted version requires entities, or an individual entity, and in some respects a group basis, to pass two tests (see Figure 2):
- “Market Size” – showing that trading activity in commodity derivatives is below one of eight thresholds, in each commodity. All activity must be below all of the thresholds.
- “Main business” – that the main business of the entity is NOT speculative derivatives trading. This can be shown in one of two ways:
- Derivatives ratio – that the ratio of speculative to total derivatives trading is less than 10%. If above 10% the test can still be passed using lower thresholds.
- Capital – that the capital allocated to speculative derivative trading is under 10%.
“Speculative” is defined as a “non-privileged” transaction. A privileged transaction can be one of:
- Trades between two internal legal entities that serve liquidity or risk management purposes.
- “Risk reducing” trades.
- Trades undertaken for mandated liquidity provision.
The details around the rules are complex and intricate and will be examined in a future edition of Rocket. However, it is import to note that the definition of “commodity derivative” uses the same basis as EMIR.
As a result of the exemption removal, some commodity and energy traders will likely become FC, bringing them into the margining regime of EMIR and the uncleared margin rules.
Margining in physical energy, security in commodities
Whilst non-financial trades are not governed by financial regulation, in fact margining is used extensively in many forms of energy trading. In particular most forms of on-venue trading will be cleared, for example by intermediaries such as ECC or Nordpool clearing. Much bilateral trading is also governing by margining agreements, such as EFET3 Credit Support Annexes, which work in similar ways to ISDA CSAs.
Other forms of physical commodity trading are also ‘secured’ in different ways. For example, physical cargo trades, such as oil tankers, are secured using letters of credit or other forms of trade finance. While these types of security are not strictly speaking a replacement for margining, the impact is still one of risk mitigation. Thus, a status change of a trade from financial to physical does not necessarily mean that no merging will take place.
However, it is safe to say that due to the factors mentioned here, a large proposition of the market is not bound by many of the mandatory margining and clearing requirement being experienced by the financial sector.
What will happen?
While the majority in the sector are not bound by the rules, we have seen that a great deal of activity is in fact already margined and cleared. We can expect merging and clearing to take greater significance in the sector due to several factors:
Firstly, some entities will become “FC” due to the exemption removal under MiFID II. Secondly, the results of the EMIR review, and the impact of the change in the definition of derivatives under MIFID II, could cause more entities to become “NFC+”.
Finally, the changes in the financial sector are likely to cause those who are investment firms to push margining and clearing onto NFC-s, leading to an overall increase in capital and margin being required to support trading. Due to the factors outlined here, the coming years are likely to see the importance of the rules that currently impact most financial companies taking further hold in the energy and commodity world.
- The Regulation of the wholesale Energy Market Integrity and Transparency EU 1227/2011
- ESMA 2015/1251
- European Federation of Electric Traders
This article was first published in edition 9 of Rocket, our magazine. Download available Rocket editions here, and save your up to date address in your profile to to indicate your interest in receiving a printed copy of the magazine. Copies are also available to purchase and subscribe to via the shop.
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