On 1 July 2021, Her Majesty’s Treasury (Treasury) launched a Consultation on proposals to reform the UK’s wholesale markets regulatory framework (Consultation).
The UK Government wishes to update this framework in the post-Brexit environment to enhance the UK’s openness and global competitiveness whilst still maintaining high regulatory standards.
The Treasury is reviewing the feedback to the Consultation which closed on 24 September 2021. The Consultation has raised a number of proposed significant changes to the commodity derivatives market in the UK including on position limits, reducing the scope of financial instruments caught in-scope of regulation and making exclusions from regulation easier to comply with.
Changes to the MiFID II Foundation
The UK wholesale markets regulatory framework is currently based on the Markets in Financial Instruments Directive 2014/65/EU, associated regulation and delegated EU legislation (MiFID II). The UK has made a number of minor amendments of its own MiFID II framework to reflect its departure from the EU. No significant changes have been made to date which would result in any significant divergence from EU rules.
Through the Consultation, the Treasury is seeking feedback on how the UK’s approach to regulating secondary markets should be updated in the post-Brexit environment. Whilst the Ministerial Forward to the Consultation states that this Treasury Review is “not about lowering standards for wholesale capital markets”, the Consultation does propose some significant departures from MiFID II rules – for example removing the double volume cap.
The Minister’s view is that these regulations do not protect market integrity or encourage competition. Removing certain regulatory requirements will “ensure effective targeting of risk and resource by firms and regulator and bring greater competition”.
We do not address all the Treasury proposals in the Consultation in this FinBrief but instead focus only on the proposals in the Consultation relating to the commodity derivative markets.
A return to the prior approach on position limits
The current position under the MiFID II framework is that the Financial Conduct Authority (FCA) is required to establish and apply position limits on the size of a net position in commodity derivates traded on trading venues and economically equivalent Over-The-Counter (OTC) contracts.
These limits apply to the size of a position that an entity can hold (including any other positions held on behalf of that entity, such as by group entities). Trading venues apply position management controls, including monitoring of open interest and obtaining information on, inter alia, positions entered into and their owners.
The EU has recently amended and simplified the position limit rules by the Directive on information requirements, product governance and position limits (2021/338/EU, Quick Fix Directive), which is to be transposed into national laws and applied from 28 February 2022. The UK has implemented the Quick Fix Directive via the Markets in Financial Instruments (Capital Markets) (Amendment) Regulations 2021 which has applied since July 2021.
In the Consultation, the Treasury is proposing more far-reaching changes to the rules on position limits. The Treasury proposes to revoke the requirement for position limits to be applied to all exchange traded contracts and transfer the setting of position controls from the FCA to trading venues. This was the case before the MiFID II regime became applicable.
Reducing the scope of MiFID II financial instruments
The Consultation also proposes to reduce the scope of the MiFID II regime by removing from the scope of MiFID II “financial instruments”:
- “commodity derivates” that are not based on physical commodities;
other types of financial instruments which refer to commodities as a pricing element but are securities in their legal form; and
OTC contracts that are economically equivalent to exchange traded commodity derivates.
- The scope of MiFID II would therefore be limited to agricultural contracts and physically settled contracts. By way of example, derivates based on climate variables would be removed from scope of UK MIFID II. The rationale behind the proposed reduction is to remove the legal risk and compliance costs arising from uncertainty about which contracts are in the scope and which are not.
- The EU MiFID II regime is likewise being reduced through the Quick Fix Directive, however not as significantly: the EU MiFID II financial instruments will still include agricultural commodity derivatives and critical or significant commodity derivatives traded on trading venues and their economically equivalent OTC contracts.
Ancillary activities exclusion update
The Consultation proposes amendments to the ancillary activities exclusion by reverting to the qualitative ancillary activities test, which was in place prior to the MiFID II regime.
The 'new' test:
- follows a principles-based approach, which considers the nature of an entity’s business more holistically according to criteria set by the FCA;
- is forward-looking and provides for a more proactive assessment of an entity’s expected activities; and
- removes the need to annually confirm to the FCA that the threshold has not been reached and that the exclusion is being relied upon.
The ancillary activities test under the current MiFID II regime is quantitative – and often requires entities to perform complex calculations and process substantial volumes of historical trading data. Since it was introduced in 2018, no firms have exceeded the threshold, which suggests that the test is not fully effective.
According to HM Treasury, the proposed ancillary activities test is more streamlined, proportionate and cost effective. The EU Quick Fix Directive also amended the ancillary activities test; however, it is a more limited change than that posed by HM Treasury. EU national regulators will be able to combine a quantitative and qualitative assessment, based on guidance to be issued by the European Commission.
Out-of-scope: Oil market participants and energy market participants
Finally, The Consultation proposes to delete the oil market participants (OMP) and energy market participants (EMP) regimes as set out in the FCA Handbook.
Originally the OMP and EMP regimes were designed to be temporary.
The Treasury now proposes that Entities subject to the OMP or EMP would become subject to the MiFID II requirements for commodity derivates – unless they fall out of the scope of the new ancillary activities test.
Next steps for participants in the commodity derivatives markets
The Consultation closed on 24 September 2021. The Treasury has not yet specified timeframes for when it will respond with next steps.
The Consultation is a significant step in the next phase of capital markets regulation in the UK.
Whilst the UK had hoped for a range of equivalency decisions from the European Commission following the conclusion of the Trade & Cooperation Agreement at the end of 2020, these decisions were not forthcoming. Accordingly, the Consultation demonstrates a new willingness by the UK to diverge from EU regulatory standards in order to tailor the UK regulatory regime more closely to the unique circumstances and markets of the UK.
For participants in the commodity derivatives markets, the proposals – if enacted – will result in a significant lessening of regulatory responsibility and associated compliance burden and cost.
For participants with operations across Europe, however, an added complexity will be complying with divergent regulatory regimes in the UK and EU going forward.