The limited hedging exemptions for commodity derivatives users contained within the Markets in Financial Instruments Directive II (MiFID II) could result in financial institutions incurring more un-hedged risk or hedging contracts outside of the European Union (EU), it has been warned.
MiFID II introduces position limits on commodity derivatives transactions in excess of 25% of deliverable supply although national regulators have the flexibility to amend this threshold to between 5% and 35% of deliverable supply. While EU regulators have said legitimate commercial hedging is permissible, little clarity has been issued on the finer details.
“The uncertainty could result in firms taking on more un-hedged risk or simply hedging commodity derivatives in non-EU countries. There is a fear this could impact non-financials hedging commodity derivatives,” said Katy Hyams, regulatory counsel at the London Metal Exchange (LME), speaking at the LME Metals Seminar in London.
A paper by the LME – “European Regulatory Change” – warned an exodus of commodity derivative hedging activity could result in a loss of liquidity at EU trading venues, or lead to firms being exposed to market volatility if they simply do not hedge in the first place.
MiFID II also scraps exemptions for a number of firms that had originally been enshrined in the first MiFID iteration, and commodity proprietary traders will likely be ensnared by this expanded scope. MiFID regulated firms will be subjected to the Capital Requirements Directive IV (CRD IV) and the Capital Requirements Regulation (CRR), a point made by Hyams. Compliance with CRD IV and CRR will force affected firms to maintain regulatory capital and impose remuneration restrictions on any employee within a firm who has a material impact on its risk profile, or who earns in excess of €500,000.
MiFID II provisions around Open Access, a regulatory initiative to bring about increased interconnectedness at market infrastructures, has also raised concerns. Open Access will enable EU Central Counterparty Clearing Houses (CCPs) to access EU trading venues and their data, while EU trading venues will be allowed to clear trades through any EU CCP with limited grounds for denial.
The LME paper warned this could result in market fragmentation and “may not be conducive to market stability or the reduction of systemic risk in financial markets.” Increased interconnectedness of market infrastructures could result in greater systemic risk as a failing CCP could bring about contagion at other CCPs to which it is connected. It could also facilitate cyclical margin call activities, warned the LME paper. “We are cautious about the benefits of Open Access. One issue that needs to be addressed surrounds the conflicting insolvency laws in EU member states. This could be an issue when CCPs and trading venues are located in different EU member states,” said Hyams.
Meanwhile, there were warnings about the EU Benchmark Regulation currently being discussed by policymakers. The rules, expected to be implemented in 2018, seek to bolster governance and operations at industry benchmarks in light of the recent LIBOR and EURIBOR scandals. The rules – should they come into fruition – could restrict the ability of EU financial institutions from using benchmarks derived from non-EU jurisdictions. While the LME paper acknowledged that regulators do intend to allow benchmark equivalence, it warned non-EU countries adopt wildly different rules towards benchmarks thereby making equivalence a difficult proposition.
“The EU Benchmark Regulation is currently being negotiated. The proposals could restrict non-EU benchmarks from being used by EU firms. This could impact the commodities and metals market in particular as EU firms would only be permitted to hedge price risk using EU indices. This is irrespective of whether there is a more correlated index available in a non-EU country. This could put EU firms at a commercial disadvantage and lead to a loss of liquidity and market fragmentation,” said Hyams.
LME warns on commodity derivative position limits
The limited hedging exemptions for commodity derivatives users contained within the Markets in Financial Instruments Directive II could result in financial institutions incurring more un-hedged risk or hedging contracts outside of the European Union, it has been warned.