EUROPEAN UNION: ESMA Publish Q&A on MiFID II and MiFIR Commodity Derivatives Topics

Wednesday November 15 2017

On 14^th November 2017, the European Securities and Markets Authority (ESMA) published Q&A’s on MiFID II and MiFIR commodity derivatives topics.

Please see below updated Q&A’s:

Question 2

What is the definition of a lot for the application of Article 15(1)(a) and (b) (New and illiquid contracts) of RTS 21 to those commodity derivatives for which a lot, as defined in the contract specification by the trading venue, does not represent a standard quantity of the underlying across all maturities/delivery periods for that commodity derivative?

Answer 2

In some derivative markets (mainly related to power or gas), trading venues offer trading in derivative contracts that refer to an identical underlying but have a variety of delivery periods, e.g. annual (calendar), quarterly, monthly, weekly (whole week, working day week and weekend) or daily.

For these contracts a lot or unit of trading, as defined in the contract specification by the trading venue, does not necessarily represent a standard quantity of underlying across all maturities/delivery periods, i.e. the lot size for a daily contract is different from that for a monthly contract as the lot size usually depends on the number of relevant days and/or hours in the delivery period.

Since there is not an unambiguous equivalence between a lot and an absolute quantity of underlying commodity, it is necessary to define a reference period and use the associated lot size to determine the liquidity of a contract under Article 15(1)(a) and (b) of RTS 21 and to set position limits under Article 15(1)(a) of RTS 21.

As the trading activity in European power and gas derivative markets is generally concentrated in monthly contracts, the period of the monthly contract should be used as the reference period. The associated lot size should be calculated by using the relevant days and/or hours as specified by the trading venue for that particular contract type.

Question 9

Will there be a different position limit for options and futures? If so, how should options be converted into futures for the application of position limits?

Answer 9

No, there will be no separate limits for futures and options on the same commodity derivative. Futures and options are fungible in terms of their economic effect at expiry if an option expires in the money with the respective future expiring at the same time. During the life of an option contract, the probability of the option expiring in the money is reflected in its delta value.

Option positions should therefore be converted into positions in their respective future contracts on the basis of the current delta to arrive at a delta equivalent futures position. Long delta equivalent positions on calls and short delta equivalent positions on puts should be added to positions on futures. Short delta equivalent positions on calls and long delta equivalent positions on puts should be subtracted from positions on futures.

If available, position holders should use the delta value published by the trading venue or the CCP to report their positions in options. In the absence of a published delta value, position holders may use their own calculation. Position holders should be able to demonstrate, on demand, to the NCA responsible for the application of the position limit that their calculations correctly reflect the value of the option.

To determine which contracts are liquid under Article15 of RTS 21 and also to establish position limits based on the quantity of open interest, the open interest of futures plus the delta-adjusted open interest of options should be used, where there is a future and/or option traded on the commodity derivative and the relevant data are available. This is consistent with the reporting of positions made under Article 58 of RTS 21.

Question 10

How is the position limits regime applied to the various underlyings listed in Annex I, Section C(10) of MIFID II?

Answer 10

Section C(10) of Annex I of MIFID II covers a number of different types of commodity derivatives. For these instruments the following approaches should be taken:

Position limits should be applied to freight rate derivatives (wet and dry freight) based on the open interest both in the spot month and in the other months.

Position limits should be applied to derivative contracts relating to indices if the underlying index is materially based on commodity underlyings as defined in Article 2 No. 6 of Commission Delegated Regulation (EU) 2017/565 of 25 April 2016. ESMA considers that the underlying index is materially based on commodities if such commodities have a weighting of more than 50% in the composition of the underlying index. The spot and the other months’ limits should be based on open interest only, in accordance with Article 13(1) of RTS 21, as no single measurable deliverable supply can be determined for the commodities contained within the index.

A commodity derivative contract in the legal form of a “spread” or “diff” contract is a contract that is cash-settled and whose value is determined by the difference between two reference commodities which may vary in type, grade, location, time of delivery, or other features. Whilst having multiple commodity values underlying it, the commodity derivative is available on a trading venue as a single tradable financial instrument. A spread contract is different to a spread trading strategy, when two or more commodity derivative contracts may be traded together in order to achieve a certain economic effect. Such a strategy may be executed by a single action in a venue’s trading systems, but it remains composed of separate and legally distinct commodity derivatives which are executed as trades simultaneously.

As a spread contract has no single commodity at a specific place or time as the underlying, it is not possible to link it to a single physical deliverable supply against a contractual obligation to physically settle the trade. It is for this reason all spread contracts are cash-settled and not physically settled.

Therefore, spread contracts should be treated for the application of the ESMA methodology in the same manner as C10 commodity derivatives which do not have a physical underlying, such as weather derivatives. The open interest figure for the commodity derivative itself should be used as the baseline for both the Spot Month limit and the Other Months’ limit.

For other derivatives listed in Section C10 of Annex I of MiFID II and in Article 8 of Commission Delegated Regulation (EU) 2017/565 of 25 April 2016, ESMA is not expecting the setting of any position limits as the underlyings of such derivatives are not considered to be commodities as defined in Article 2 No. 6 of Commission Delegated Regulation (EU) 2017/565 of 25 April 2016.

Question 12

How shall transactions concluded on venues outside the EU be treated for the market size test computations under Article 2 of RTS 20?

Answer 12

Transactions concluded on non-EU venues should not be included in either numerator or denominator of the market size test, since those transactions do not constitute part of trading activity in the Union.

Question 13

How shall OTC transactions done by non-EU entities of an EU group with EU counterparties be counted for the market size test?

Answer 13

For the purpose of calculating the numerator, these transactions would be considered to take place in the EU and therefore should be included in the numerator of both the group that has an EU presence and the EU counterparty.

For the purpose of the denominator, these transactions would also be considered to take place in the EU.

Question 14

RTS 20 refers only to Article 360 of the CRR, while the ‘simplified approach for calculating regulatory capital requirements’ is contained in CRR Articles 357, 358 and 360. Is the text in RTS 20 self-contained or should firms refer to the whole of CRR?

Answer 14

Article 3(5)(6)(7) of RTS 20 replicates the content of Articles 360(1) and 357(3) of Regulation (EU) No 575/2013 of 26 June 2013 (CRR). RTS 20 contains the stand-alone test that needs to be performed without firms having to refer to the rest of the articles that relate to commodity derivatives in the CRR. However, firms may find it useful to refer to the EBA Q&A on clarification of the treatment of positions in commodities for the purposes of calculating net and gross positions according to Article 360(1) of CRR.

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