MiFID II – Implications for Commodity Firms

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ESMA and the national regulators have been heavily petitioned around the regulation of commodity derivatives.

Initially it was tasked with developing details on the limits that would apply to the size of positions which firms could hold in commodity derivative contracts so as to ensure dominant positions do not affect the orderly trading and settlement of these contracts.

In last year’s draft technical standards it was proposed that authorities could set limits for different commodity derivatives such that they could hold a position up to a limit between 10% and 40% of the deliverable supply of the contract. After consultation this limit will now be between 5% and 35% of deliverable supply or open interest, depending on the time to maturity. For non-financial firms there is a hedge exemption which will allow them to offset risks from commercial activities.

Presently there is an exemption for energy companies, agricultural businesses and food manufacturers who use commodity derivatives. ESMA was asked to set rules for when these firms’ speculative commodity trading would be in need of oversight from the regulators.

The aim is to strike a balance such that small companies or those who trade for commercial hedging purposes only should remain exempt. However those major speculative firms who directly compete with investment banks and other large traders will come under similar regulatory scrutiny.

Last month the FCA published their Commodities Trading Thematic Review, focusing on firms trading and broking in the Oil, Energy, Metals and Soft commodities sectors and reporting on the adequacy of their front office and market abuse controls. They also looked at governance arrangements, culture and processes in place to manage structural change on business.

The FCA made a number of observations;

Many firms have not embedded the lessons learned from recent market abuse cases in LIBOR, FX and Gold, believing that the commodity markets are too deep, liquid and with too many participants to be manipulated. They found there is a general unwillingness to consider how recent market manipulation cases can relate to specific markets and products which they trade.

If, as is the case with many of the firms surveyed, firms have not carried out a Code of Conduct (MAR 1) risk assessment they were unable to demonstrate adequate monitoring and surveillance of the risks of market abuse. Many firms could not demonstrate effective procedures to identify suspicious transactions and be able to escalate them to the FCA in the form of Suspicious Transaction Reports (STR) which are an important intelligence asset to the FCA allowing them to review instances of potential market abuse. In general, their understanding of their responsibilities on use of inside and market sensitive information is poor.

Few firms were able to demonstrate intraday management information (MI) or risk management. Monitoring and managing of credit, liquidity and market risk is less sophisticated in rather than outside the commodities sector.

At Objectivus we would recommend some simple solutions to alleviate a lot of the FCA’s concerns;

Integration of Compliance functions with the front office as much as possible. This can be achieved by allowing Compliance to have a permanent physical presence on the trading floor. Compliance should also attend regular trader/broker meetings. A strong message about the firm’s culture can be sent by linking compensation directly to cultural behaviours in the front office, for example, variable compensation can be dependent on completion of training, including market abuse training, language used in communications and the treatment of colleagues.

Establishment of Credit Valuation Adjustment(CVA) desks to demonstrate effective management of credit risk. The FCA found that many firms left their credit risk un-hedged with little management of individual or portfolio exposures.

An assurance on the robustness of the firm’s controls can be achieved by stress testing and scenario analysis of liquidity risk and more attention paid to concentration risks instead of looking at market risk solely on a portfolio basis.

In conclusion, the FCA will continue their supervisory work on commodities trading firms. With the introduction of MiFID II and expanded powers under MAR, more commodities trading firms are likely to be brought into the regulatory regime.

The Managing Partners at Objectivus are very experienced in many of the issues now facing commodity trading and broking firms through their involvement in businesses which have already undergone the necessary changes, for example FX, CFD, equity and fixed income markets.

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