Financial regulation of the energy and commodity trading sector – what is happening and what could it mean?

The final Regulatory Technical Standards (RTS) for large parts of MiFID II/MiFID were published shortly before the writing of this article. These rules will have an impact on many Investment
February 1, 2016 - Editor
Category: Regulation

The final Regulatory Technical Standards (RTS) for large parts of MiFID II/MiFID were published shortly before the writing of this article. These rules will have an impact on many Investment Companies and other financial institutions, and will have a significant impact on their business models as well as day to day operations.

The final Regulatory Technical Standards (RTS) for large parts of MiFID II/MiFID were published shortly before the writing of this article. These rules will have an impact on many Investment Companies and other financial institutions, and will have a significant impact on their business models as well as day to day operations.

Those primarily trading energy and commodity derivatives have previously enjoyed an exemption from MiFID. However, the current set of rules puts this exemption in danger, with significant consequences for those affected, and in certain respects the entire market. This change is only the latest step that sees financial regulation further impacting this part of the market. The tug of war between energy regulators and financial regulators has been going on for some time. This article will give a brief overview of the different elements in play, the consequences, and the possible outcomes.

Who regulates the energy market?

The energy market falls between two stools: On the one hand, for many, the trading of energy is very much part of being in the energy business, i.e. the business of extracting a fuel, using it to generate power, and then transmitting and distributing it. On the other hand, the practices around such trading are in many cases the same, or very similar, to the world of financial derivatives trading. In fact, in many cases, actual trading of say gas and power derivatives is an integral part of the energy supply chain, and its trading is fundamental to working in the market successfully.

As a result of this “duality”, those who trade energy (usually classified as “gas and power”) find themselves regulated by two groups of entities: On the one hand, the “wholesale market” divisions of energy regulators, such as Ofgem in Great Britain or “BNetZa” in Germany, will regulate aspects of the activity. On the other, financial regulators such as the FCA or BaFin will also be involved, in participant when derivatives are involved. At the European level, CEER or ACER will look at matters from the energy perspective, and ESMA will from a financial one.

A combination of events that have taken place in recent years, such as the 2007/8 crisis and also alleged abuse in energy and commodities, has seen pressure to shift regulation from the energy to finance. In some cases, one could consider this shift to be a set of unintended consequences. However the evidence would suggest that there is more intent behind the shift than first meets the eye.

For those in other commodities, such as oil, coal, agriculture or metals, for example, the issue is less well defined. In many cases there is no “commodity regulator” as such. Thus any non-derivative trading activity may in some cases be left with less supervision (although it would still come under various types of legislation).

The story so far: EMIR and REMIT

It is possible to trace the change (at least in Europe) back to the birth of EMIR, which was born out of the G20 declaration in 2009 that followed the financial crisis, that also led to similar initiatives in other parts of the world, such as Dodd Frank in the US, and the rules that are coming from the MAS. The rationale behind these rules was the avoidance of systemic risk. Derivatives, it was argued, pose such a risk, and must therefore be:

  • Reported to trade repositories
  • Cleared wherever possible
  • Be subject to additional risk management requirements.

However, the European interpretation of these requirements required all those trading derivatives to report to trade repositories, since EMIR follows a “two sided reporting” regime. Some risk management measures, such as portfolio reconciliation, also apply to all market participants.

Thus, with the coming onto force of EMIR trade reporting in February 2014, those who trade in energy, and commodities found themselves part of a significant reporting regime. For many, this was their first experience of such regulation, and in many cases was seen to be a “project”, that will “go away”. As those in the financial sector will testify, this is a mistake, and trade reporting is now seen as the major work stream that it is. It was not altogether helpful that it is in fact very difficult to report some commodity derivatives properly under the current EMIR definitions (and it will be even harder when the Level II validations come in soon).

REMIT1 on the other hand is a set of rules specifically designed for gas and power trading. It aims to promote transparency and integrity in the EU gas and power markets (whether financial or physical) and comes with an associated data reporting regime, that is due to commence on October 7th 2015. Being aimed solely at the energy market, it is administered by energy regulators, project managed by ACER2.

Despite being part of the energy industry, there are close parallels and links to financial regulation. In fact gas and power derivatives reporting under EMIR must be forwarded by the Trade Repository to ACER, thus removing the requirement for market participants to “double report”.

On top of that, REMIT’s rules around abuse bear a close resemblance to the types of anti-abuse rule found in finance, i.e. MAD, MAD II and MAR. Except that there is also a physical element, which makes the rules harder to apply, and surveillance harder to run.

Is a commodity trading company NFC or FC, NFC+ or NFC-?

As most readers will already know, EMIR has different levels of rule for different categories of company, divided along two axes: Firstly, a market participant can be a financial counterparty (FC) or non-financial counterparty (NFC). Secondly, if an NFC, the entity can either be above the clearing threshold3 (NFC+) or below it (NFC-).

In the vast majority of cases, those who trade energy and com-modities have thus far been classified as NFC-. This includes some large players. Such a classification is arrived at because the majority of trading activity has been classified as a “hedge” under the EMIR rules, and it therefore does not contribute to the threshold.

Being an NFC- relieves the entity of several responsibilities, the key one of which is mandatory clearing. If energy companies were to be required to clear a large proportion of their trades, the capital required to support their trading operations would increase dramatically. While it is the case that quite a bit of activity is cleared in any case, the introduction of mandatory clearing may significantly increase the capital required. As we shall see, there is not much enthusiasm for such a requirement.

MiFID – the current exemption

In addition to being out of mandatory clearing (for the most part), those who primarily trade commodities have enjoyed a general “commodity dealer exemption” under MiFID Article 2(1)k

As a result of this, the majority of market participants have not had to comply with rules such as best execution, capital requirements that apply to financial institutions, and governance requirements. There have been some cases in which a commodities company has seen fit to set up a “MiFID compliant entity”, in which case that entity would need to comply with the rules, but this is usually limited to a portion of the business and is not widespread. Even in these cases, the entity is classified as a “Commodity Dealer” under financial regulation, which brings with it some carve outs, separate transitional arrangements and exemptions.

Why is the status quo in danger?

The status quo, that is, the non-application of many financial rules to the energy and commodity industry, already started to crumble with the introduction of EMIR. Rules such as those around trade reporting, and portfolio reconciliation were new for the sector, even if in some cases some best practices are already observed. (For example, there are industry initiatives to ensure timely confirmations).

This trend is set to continue: In terms of rule change there are various dangers to the current status: The MiFID Article 2(1)k exemption will be dropped from MiFID II. Separately, ESMA’s proposals as part of the EMIR review include one to drop the hedge exemption from threshold calculation, and the definition of a derivative with respect to physical trades is in flux.

The key issue though is the push to bring the energy and commodity business under increasing financial regulation, in some cases shifting the focus away from energy regulators. This is very much a battle being fought – being fought for by the financial side of the industry and against by market participants, their industry associations, and also in some cases by the energy regulators themselves.

Danger from exemption loss – proposal

The proposal that keeps most market participants awake at night is the one which changes the exemptions. The blanket commodities exemption is gone, leaving market participants reliant on the “ancillary exemption”. This requires the entity to prove that trading is an “ancillary activity” to the company as a whole in order to keep the exemption.

The proposed new exemption rules themselves are highly controversial and have been subject to change. The draft RTS4 published at the end of last year required two tests: The “capital test” and the “market size” test.

The capital size test required the entity to show that the capital required to support their trading in derivatives consumed less than 5% of group capital. Surrounding this are complex and contentious definitions of each element involved: capital, a “derivative” and also a “privileged transaction”, which would not count towards the total.

The original market size test required the entity to show that their trading activity did not occupy more than 0.5% of the total EU market, in any of eight commodities: Gas, power, oil, emissions, coal, agriculture, metals and “other”. The denominators have not yet been published. It was calculated by various bodies that a very large proportion of market participants would lose their exemption. This would turn them into “MiFID regulated entities” with all that it brings: classification as an FC under EMIR, CRD IV, pre and post trade transparency reporting and a great deal more.

Push back

It is no surprise that these proposals have led to a great deal of push back from the industry. Shortly after publication EFET5 conducted a study across their members. At the MiFID open hearing in Paris that took place in February 2015, it was stated by a representative that “very few members will be able to remain exempt if the current proposal goes ahead. This will have a severe impact on the wider economy with a two digit billion euro order of magnitude. This could lead to a loss of liquidity with an estimated cost of four billion euros to the energy industry, which translates to twenty euros per household.”

The push back also came from the wider commodities trading world. A report by Trafigura6, published earlier this year, argued vehemently against the MiFID II proposals, and the concept of bringing the commodity trading world into financial regulation in general. The push back also came from some unexpected places. For example, a February 2015 edition of the publication “Farmers Weekly” alerted those who trade forward agricultural products of the dangers of MiFID II.

Energy regulators have also been pushing back. The CEER7 stated in a letter written in April 2015 that: “the proposals for the MiFID II Delegated Acts could have profound negative effects on the cost of trading in the energy market and make it harder for new firms to enter the market.”. The letter also states: “Energy trading is already subject to effective supervision by REMIT. Avoiding duplication ensures effective functioning of energy trading including sufficient liquidity which ultimately results in benefits to consumers.”

ACER, have also pushed back, as have industry associations such as Europex and EURElectric.

Further Proposal

Following the push back on the draft RTS, rumours circulated in the market of a new draft RTS, which modified the original proposal. This version of the RTS has never been published by ESMA. However, its alleged contents have been revealed by several publications. The changes mentioned mainly relate to the ancillary activity tests:

Firstly, the “capital test” has been removed completely. Instead, only a market size test remains. However, rather than having a blanket threshold of 0.5% per asset class, the thresholds differ. For example power has a different threshold to gas, which has a different threshold to emissions. In addition, these thresholds vary according to the proportion of non-privileged transactions (i.e. “non hedges etc.) a company has compared to the overall size of the trading book. In short, the thresholds are higher, if you carry out less speculative activity. Thus, a matrix of thresholds is proposed. Some of the definitions also changed.

There would be “winners and losers” if this proposal replaced the official draft RTS. On the one hand, large groups whose main activ- ity is not trading would lose, since they could no longer use their non-trading activity to pass the capital test. On the other hand, many of the thresholds are higher, and as high as 20% in some cases. Therefore smaller players would benefit, even if they were speculators.

Despite these changes the push back continued. However the final RTS, published on the 28th September closely resembled the new structure just outlined.

What is a derivative?

Financial regulation generally applies to financial instruments – and yet many trades in commodities and energy result in physical delivery. Some physically delivered trades are pure forwards whereas others are executed on venues, which may be regulated markets, MTFs etc. Physical spot exchanges are also used.

The question of which forward trades are classified as derivatives is a key one. The key definitions are found in MiFiD Annex I Section C. Paragraphs 6 and 7 in particular, define which physical forwards are “in”. In MiFID I these read as follows:

(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;

(7) 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

Whereas under MiFID II they are written:

(6) Options, futures, swaps, and any other derivative contract re- lating 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;

(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;

Note firstly, that in the past, (and at the moment), in effect, only forwards traded on an exchange or MTF are covered. The original C7 paragraph in fact covers very little activity.

The MiFID II version changes this somewhat. Firstly, products traded on an OTF are now covered, with OTFs comprising the majority of platforms in the sectors.

Secondly, some caveats are removed, especially in C7 around margining.

Also note the “REMIT carve out”, highlighted in blue. This is a compromise created so that gas and power trades, already covered in part by REMIT are not covered. However the use of the word “must be physically settled” narrows this significantly.

This topic could fill another entire large article of its own, and so we will not delve into more details here. However do note that one other key addition in MiFID is emission certificates. While derivatives of emissions were always “in”, the certificates themselves were not. From January 2017 onwards the actual certificates will be financial instruments.

The EMIR review – what has been proposed?

ESMA’s response to the EMIR review at the end of the summer contained several items that are of interest to the sector. The key issues surround the clearing thresholds, and the calculations around establishing the status of “NFC-“, as opposed to “NFC+”. The paper produced by ESMA8 argues that the current hedge exemption used for calculating the threshold should be abolished. Instead, the simple total gross notional value should be used to calculate whether the position is above or below threshold. As we saw earlier, the hedge exemption is the key pillar for many energy and commodities companies staying under the threshold. Instead of the current exemption, it is proposed that it be removed and the thresholds be “re-calibrated”. Clearly, many energy and commodity traders will be brought into mandatory clearing by this move, at least as NFCs, which does give rise to some transitional arrangements.

The other part of the review which could have an impact on some energy and commodity companies, is the recommendation that FCs should be obligated to report both sides of the trade when executed with a “small NFC”. For those not deemed as small, there is the danger that the reporting requirement will become more complex. Those who become FCs (via the loss of exemption under MiFID) will be required to carry out delegated reporting for all smaller NFCs. Those larger companies who remain as NFC will not have a new obligation per se. But those smaller companies with which they trade will be a disincentive to provide them with business compared to an FC. As a need will arise for all such larger companies to provide a delegated service.

Are energy and commodity companies “systemic?”

A key objection to the imposition of financial regulation of the commodities market is that it is not “systemic”. The basis of many of the new rules, such as EMIR, has been the avoidance of systematic risk. It is argued that the commodities and energy trading sectors do not pose a risk to the world’s financial system, and therefore should not be subject to these rules.

It has been argued by many that the imposition of the rules comes at a cost to the industry. We have already seen the claim by EFET that MiFID could raise each Europeans citizens’ energy bills. Other impacts could be a loss of liquidity in many of the markets, and also leave it more open to abuse than it was.

ESMA argued against this as part of the EMIR review response. In it they attempt to show that the NFC market in general can be stratified into “large” and “small” NFCs. It is claimed that the small NFCs indeed pose little systemic risk, and should therefore be relieved of many requirements. However, the larger NFCs, would, according to ESMA’s calculations, pose a larger systemic risk. Furthermore the paper attempts to show that much of this risk arises due to trading in commodity derivatives.

While the figures are based on data that has been submitted to trade repositories, there are many assumptions in the calculations around parties reporting their status incorrectly and others which can all be seen in the paper. It is certainly possible to dispute these assumptions. However, even so, the document would appear to show the financial regulators’ direction, and desire to cover the commodities market.

How will it go? – Recent evidence

The battle lines are drawn between the energy and commodity trading industry (including energy regulators) and the financial ones. The push back from the industry has continued from the initial draft RTS, continuing with further objections through the summer. Even recently, a letter9 was written from several industry associations to the European Commission, reiterating the objections already lodged.

However, the intent of the financial regulators is clear: There is a clear desire to regulate the industry. Evidence for this can be seen not only in the EMIR review, but also in other statements coming from the financial side. For example, the FCA recently issued a review of the commodities market10. While the review has some positive things to say about the industry, it took a negative view on the anti-abuse measures and culture within many firms (with notable exceptions). For example, the review states: “At the majority of firms, trader/broker understanding of their responsibilities on use of inside and market sensitive information was poor.”

Several days later, Ofgem released an open letter11 reiterating the anti-abuse provisions of REMIT. This letter from an energy regulator coming out so soon after the one from a financial one shows both sides looking to show that they can properly oversee the market. The letter concludes: “We will continue to monitor GB wholesale electricity and gas markets. Where appropriate, we will take action to follow up on potential breaches of REMIT, including failures to register, report transactions or publically disclose inside information in a timely and effective manner.”

To summarise, while there seems to be a great deal of resistance from the energy and commodities side, the evidence would suggest that financial regulators are keen to press ahead with their oversight of the market.

What are the consequences?

Now that the final draft MiFID II RTS has been published, it will soon be possible to know if a large proportion of the market is pulled into financial regulation, there will be several impacts.

The primary consequence is the use of capital: mandatory clearing, other mandatory margin and CRD IV capital requirements. This may necessitate a rethink of the business model of many market participants. Innovation will be required as to how to properly capitalise the business.

There will also be many other regulations to meet which will require those in energy and commodities to scale up their regulation capability, both in business and technical terms, in a “banking like” manner.

In terms of the battle, if it is the case that the industry is caught, the next level of negotiation will be around the “commodity dealer” regime, so that even when caught, the requirements suit the industry. For example it is conceivable that the rules around eligible capital could be tailored to suit those whose main assets are physical.

The industry has also predicted some dire consequences, such as a drying up of liquidity, departure or relocation of market participants, and increased prices to consumers. In a short time we will know how much of the market is affected. And after that, only time will tell what the market will look like once the rules kick in.


  1. Examined in detail in the Rocket Issue 4
  2. Agency for the Coordination of Energy Regulators
  3. The threshold is breached if the outstanding gross notional is over either €1bn in credit or equity derivatives or €3bn in commodities, FX or interest rate derivatives
  4. Regulatory Technical Standard
  5. The European Federation of Energy Traders
  6. “Not Too Big To Fail: Systemic Risk, Regulation, and the Economics of Commodity Trading Firms” – Craig Pirrong Feb 15
  7. Council of European Energy Regulators
  8. Review on the use of OTC derivatives by non-financial counterparties – August 15
  9. “Ensuring effective and efficient regulation of European commodity derivative markets” – September 15
  10. Market Watch number 49
  11. Prohibition of market abuse under the Regulation on wholesale energy market integrity and transparency (EU) No 1227/2011 (REMIT)- September 15

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