Following the publication late last year by the European Securities and Markets Authority (ESMA) of draft Regulatory Technical Standards (RTS) for the implementation of MiFID2/MiFIR, the Baltic has been working hard via the FCA, the UK Treasury, ESMA and numerous government contacts in Brussels to ensure that draft rules which would have been potentially damaging to the FFA market, were changed.
This note sets out the problems and what has been achieved by the Baltic, supported by certain Baltic members. The published RTS are subject to final approval processes, but are unlikely to be further changed.
On 28 September 2015 the European Securities and Markets Authority (ESMA) submitted the final draft of its Regulatory Technical Standards (RTS) for MiFIR and MiFID II to the European Commission. The original draft RTS, published by ESMA in Consultation Papers in December 2014 and in February of this year, gave rise to a number of very serious concerns because of their potential impact on non-financial companies involved in trading freight derivatives and on the freight derivatives market itself. The principal concern was that many shipping and commodities firms with offices in Europe which use FFAs to hedge their exposure to freight rates would need to be regulated as financial firms under the proposed rules. This would burden them with additional capital and compliance costs and they would therefore be forced to choose either to withdraw from hedging activity or move all of their businesses to another jurisdiction.
The Baltic Exchange, along with a number of its members, was actively engaged with ESMA during the consultation process, both via written submissions and through direct face to face meetings, including with Verena Ross, Executive Director of ESMA in Paris, as well as with EU politicians and officials in Brussels. ESMA appears to have taken most of our concerns on board and the final RTS include a number of significant changes from the original draft which seem to mean that most, if not all, non-financial companies involved in trading FFAs will avoid needing to become regulated firms on the basis of their FFA activity.
Below is a summary of some of the key points we discussed with ESMA. Please bear in mind, however, that the RTS contain many more detailed rules than are described here.
One of the major positive changes in the final RTS is the broadening of the definition of what constitutes hedging for the purposes of MiFID II. The RTS set out two tests (see below) to assess whether a company’s speculative trading activity in commodity derivatives is of sufficient size to require the company to be regulated as a financial firm. For both tests hedging activity can be excluded from the calculations but under the original draft RTS it appeared that a very narrow hedging definition would apply so that only an exact match between an underlying commercial risk and a derivatives hedge would qualify. We explained to ESMA that this would mean that almost all FFA hedging activity would be excluded from the definition since FFA contracts are based on standardised ships and standardised maturities using standardised routes or a basket of routes which rarely match exactly a specific underlying commercial risk. It would therefore also have excluded the type of portfolio hedging used by most active FFA market participants, meaning that many firms using FFAs for bona fide hedging purposes might find themselves needing to be regulated.
By contrast, the final RTS state that “macro, portfolio or proxy hedging commodity derivative contracts may constitute hedging” and then describe in some detail how dynamic portfolio or macro hedging falls within the definition. This should mean that a firm need only consider true speculative activity when performing the calculations for the two ‘ancillary activity’ tests described below.
Commodity asset classes
MiFID II divides commodity derivatives into eight asset classes. These include Metals, Oil and Oil Products, Coal and five others. Freight is included in an asset class known as C10 which also includes weather derivatives, inflation derivatives and derivatives linked to official economic statistics. We did not consider that this grouping of freight with other totally unrelated derivatives which may not trade actively was appropriate and seemed to leave freight essentially in an asset class of its own or at best in one a fraction the size of the other asset classes. This could mean that a company could be captured by MiFID II for trading a moderate amount of FFAs but not for trading far larger volumes of other commodities. We proposed that instead freight should be integrated with the asset classes to which the specific freight contracts relate as freight is instrumental to trading in other commodity derivatives. This could have placed Dry FFAs with Metals or Coal and Wet FFAs with Oil and Oil Products. However, ESMA concluded that this was not possible as there was no legal ground for varying the asset classes set out in the MiFID II text. However, ESMA was willing and able to show more flexibility when it came to the ancillary activity tests.
Ancillary activity tests
MiFID II (Article 2(4)) instructs ESMA to set criteria based on two tests for establishing whether a company’s trading activity in commodity derivatives is to be considered as ancillary to its main business. If the company’s trading activity can be shown to be ancillary to its main business (at a group level) then it is not captured by MiFID II, otherwise it will need to become regulated as a financial firm.
The first test (the ‘trading activity’ test) considers the size of the company’s trading activity in each class of commodity derivatives compared to the size of the overall market in that asset class. The second test (the ‘main business’ test) considers the size of the company’s trading activity in a class of commodity derivatives relative to the size of the group’s overall activity. In the original draft RTS ESMA set a threshold of just 0.5% for the trading activity test meaning that if a company’s FFA trading activity gave it a market share above this threshold it would need to be regulated. We pointed out to ESMA that in the FFA market, which has relatively few participants, almost all active traders have a market share of more than 0.5% and would therefore be caught under MiFID II and we proposed that the threshold be raised significantly to avoid this unintended outcome. ESMA took note of this and in the final RTS the threshold for the trading activity test has been raised to 15% market share. Taken together with the wider hedging definition this should now mean that no FFA market participant is captured on the basis of this test.
ESMA has made an even more fundamental change to the rules for the main business test. In the original RTS a company would need to be regulated if it used more than 5% of its group’s capital to trade FFAs. Given the volatility of the freight market and the associated relatively high margin requirements for FFAs together with the need to hedge freight exposure over a period of years, we argued that this threshold was also set far too low and could cause even small shipping companies that use FFAs to be captured by MiFID II.
ESMA has now taken a different approach. The new assessment measures the size (notional value) of speculative trading activity across all asset classes engaged in by a company as a proportion of the total derivatives trading activity across the group. A company will not be caught by MiFID II if this proportion is less than 10%. In addition, where a company’s speculative trading is between 10% and 50% of its overall trading activity, the company will not need to be regulated on the basis of its speculative FFA trading activity as long as this constitutes less than 7.5% of overall FFA market activity. Finally, where the speculative proportion of trading activity exceeds 50%, the company will still not need to be regulated on the basis of its speculative FFA trading activity as long as this constitutes less than 3% of overall FFA market activity. These additional criteria mean that a small firm that engages in a relatively large amount of speculative FFA trading for its size can still avoid needing to be regulated if its FFA market share is not above these 7.5% or 3% thresholds. Overall this should now mean that FFA market participants are also unlikely to be captured by MiFID II on the basis of the main business test when it comes into effect on 3 January 2017.
MiFID II requires national competent authorities such as the FCA in the UK to set maximum position limits in commodity derivatives using rules set out in the RTS. Hedging activity is not included in calculating position limits though this may be defined slightly more narrowly here than for the ancillary activity tests above. The original RTS proposed that the base line position limit would be set at 25% of deliverable supply with competent authorities given discretion to increase this in the case of each commodity derivative to a maximum of 40% or decrease it to a minimum of 10%. In the final RTS ESMA has lowered the upper position limit that a competent authority may set for any commodity derivative to 35% and the lower limit to 5%. However, in the case of freight, following our discussion with ESMA, open interest rather than deliverable supply is to be used as the basis for the calculation. Position limits are calculated on two maturity buckets for any instrument – a position limit on the front month and a separate one for the remaining maturities. We intend to work with the FCA to ensure that the position limits for FFAs are set as close to the upper 35% level as possible.
The Baltic Exchange
 Market in Financial Instruments Regulation (EU) No 600/2014 of the European Parliament and of the Council of 15 May 2014
 Market in Financial Instruments Directive 2014/65/EU of the European Parliament and of the Council of 15 May 2014