EU Position Limits: Born in the USA?
This is the second installment of Regulatory Guidance Expert Greg Hotaling’s blog on position limits, this time addressing EU-listed commodity derivatives and related products. As always, keep in mind that these limits can apply to asset managers, and other market participants, regardless of where they are based.
In 2009, the European Union’s first comprehensive position limit regime, for commodity derivatives, was indeed born in Steel City, USA. While obviously not part of Europe, the locale, otherwise known as Pittsburgh, Pennsylvania, was somewhat fitting. For so long, its reputation and prosperity rested on a dependable supply of specific raw materials – the very function that commodity position limits seek to protect.
Pittsburgh had arduously but successfully transitioned from its identity as a major steel manufacturing center for the better part of a century, to a more diversified economy, and then one of the few American cities to emerge from the 2008-09 global recession with continuing economic growth. It was for this stated reason that President Obama, as the official host of the 2009 G20 Summit, chose Pittsburgh as its site, taking place on 24-25 September. On a more practical note, New York City wasn’t available. But the storyline was nonetheless inspiring: the glitzy world summit typically hosted in global capitals, attended by the world’s most important heads of state, and tasked with addressing the largest economic crisis in recent memory, would take place in the Little Old Steel Town That Could.
It wasn’t easy. Roads were repaved. Schools and universities closed. Alternative summits were held in protest, flanking both political sides of the G20’s agenda with a “Peoples Summit” as well as a “Freedom Conference.” Police officers were brought in from other States and, for the first time in America, new “sonic weapons” used to disperse unruly crowds. Blackhawk helicopters patrolled the skies, Humvees the streets, Coast Guard gunboats the waterways.
Cloistered from the surreal atmosphere, G20 officials produced a “Leaders’ Statement” that called for strong regulatory measures in response to the financial crisis, including increased oversight of commodity futures markets. This would not only help set the tone for the American government to authorize stronger position limits on commodity derivatives a year later (through the Dodd-Frank Act), but would also drive the EU to establish its first position limit regime.
Pittsburgh survived the summit, which in fact elevated the importance of a G20 that pronounced itself as “the premier forum for our international economic cooperation.” And within a few short years, the European Parliament and Council would produce MiFID II, the EU’s largest piece of financial legislation since its origins, finding room in that text to acknowledge that “the G20 summit in Pittsburgh on 25 September 2009 agreed to improve the regulation, functioning and transparency of financial and commodity markets to address excessive commodity price volatility.” Hence the MiFID II position limit regime for commodity derivatives, which after some delays would ultimately take effect on 3 January 2018, arrived on the scene.
From a compliance perspective, one of the most significant aspects of MiFID II position limits is that they apply broadly, regardless of where the position holder may be based, and regardless of whether the position holder qualifies as a “MiFID firm” or “investment firm” as defined in MiFID parlance (these are mainly “sell-side” entities such as intermediaries). While in large part MiFID II requirements are restricted to such firms (see Article 2 of MiFID II), for the purpose of its position limits regime MiFID II extends to most types of entities (Article 1(6)). An important exception is commercial firms taking relevant positions to reduce the risks in their commercial activities. Such “non-financial” entities engaging in hedging practices are exempt (Article 57(1)).
The wide variety of commodity derivatives covered by MiFID II position limits is also noteworthy for investment managers who need to know if their holdings are affected. Unlike the American federal regime which covers derivatives related to an enumerated set of underlying commodities, MiFID II position limits apply to “commodity derivatives” generally, defined broadly to include futures, options, swaps, forwards, and both physically-settled and cash-settled contracts. Moreover, investors will be caught by the regime not just for their EU-listed commodity derivative holdings, but also for any OTC contracts that are deemed “economically equivalent” to these. Significantly, contracts trading on “third-country” (e.g. non-EU) venues are considered as OTC for this purpose (with the exception of certain exchanges deemed, by EU financial regulator ESMA, to have sufficient supervisory safeguards).
Investment managers also need to be aware that the limit levels can change. MiFID II does not set precise position limits but requires EU Member States to do so within certain parameters (based for example on a percentage range of deliverable supply of the underlying commodity). Thus, after an EU country sets position limits on a particular derivative (e.g. a maximum of 20,000 lots of wheat futures during its spot month period), possible factors that may cause an eventual change to the limit can include a change in the commodity’s deliverable supply, or a review by the Member State or ESMA of the limit’s appropriateness or adherence to MiFID II standards. Moreover, market participants should remain cognizant that EU exchanges may choose to impose their own position limits on other products that may not be “commodity derivatives” under MiFID II, such as financial and index derivatives.
For a compliance officer tasked with adhering to the limits, another critical aspect involves how to calculate holdings (which indeed is important for position limit regimes everywhere). Aggregating similar products held, remaining attentive to “contract” or “lot” sizes, and properly combining positions held by related corporate entities are essential, for knowing how much is considered to be held under MiFID II position limit standards. In addition, knowing precisely when the “spot” period goes into effect (during which the limits are often dramatically lower) is critical. In its review of each Member State position limit under MiFID II, ESMA has published Opinions which can offer some helpful insight into some of these nuances (see, for example, three such Opinions published by ESMA in September 2020). Note, too, that any Member State’s MiFID II position limit that is pending review by ESMA should still be adhered to (in other words, comply with the limit, rather than wait for ESMA to issue an Opinion that approves it).
Looking well ahead, investors can expect changes to MiFID II position limit rules. In April 2020, ESMA published its review and assessment of the regime’s effectiveness, suggesting these changes among others:
- Abandoning the limits on securitized derivatives that relate to commodities.
- Requiring limits only for commodity derivatives deemed to be important, based on open interest, number of market participants and the underlying commodity. (Alternatively, introducing an exemption for counterparties providing liquidity to the market.)
- Expanding the commercial hedging exemption, to include financial counterparties that are part of (and reducing risk for) a commercial group.
- Broadening the definition of the “same commodity derivative” trading on multiple venues (which requires the competent authority where the largest volume of trading occurs to set a single limit for all the relevant venues). Doing so would reduce the number of derivatives with the same underlying that are subject to different position limits in different Member States, hence reducing regulatory arbitrage.
Such changes require approval of the EU Commission, as part of a broad set of public consultations undertaken for much of MiFID II generally, which have been launched both by ESMA and by the Commission. The EU Parliament then needs to approve the resulting amendments. The takeaway for investors, therefore, is to periodically review developments (with the realization that such changes will not occur immediately).
As for Brexit, although the UK has officially left the EU, its financial regulator the FCA has stated that it will continue to impose its position limits that were mandated under MiFID II, even after the end of the Brexit transition period (slated for 31 December 2020). Moreover, in an October 2020 statement, ESMA acknowledged that commodity derivatives trading on some UK venues, from the moment these are considered to be “third-country trading venues” once the Brexit transition period ends, could be subject to MiFID II position limits if they are deemed to be “economically equivalent” OTC contracts. As referenced further above, any UK venue that ESMA determines has sufficient regulatory safeguards will not be considered to be hosting “OTC” products for this purpose, and hence would be out-of-scope for such MiFID II position limits. (ESMA stated that it will undertake such determinations about UK venues “before the end of the transition period”.)
A final note on two related frameworks, to avoid confusion. EU position limits are separate from “position reporting” and “position management controls,” which are not covered here. As they tend to be discussed in tandem (and sometimes confused) with position limits, be aware that position reporting requires daily reporting of commodity derivative holdings acquired OTC (MiFID II, Art. 58), while position management controls dictate that commodity derivative positions are subject to reduction by trading venues, who are tasked with monitoring open positions (MiFID II, Art. 57). Because these regimes don’t always cover the same types of entities as do position limits, it’s helpful to keep in mind the proper terminology in use when assessing the scope and impact of the EU’s commodity derivative initiatives.
To submit a question to our Regulatory Guidance experts on position limits, please email firstname.lastname@example.org.
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