EU finance authority ESMA on Monday raised the thresholds for exempting carbon trading firms from MiFID regulations due from 2017, potentially making it easier for non-financial companies to avoid costly compliance and reducing the possibility that market liquidity could be hampered.

ESMA published its final technical standards for MiFID II, which updates rules designed to overhaul financial trading to curb the influence of speculation in commodities markets in response to the 2008 financial crisis.

The rules include all EU ETS and UN carbon derivatives, including physically-settled futures that make up the bulk of EU carbon trading, though they don’t regulate trade deemed to be purely for hedging purposes, spot and auction trading, or when firms trade using regulated third parties.

MiFID II establishes position limits on what proportion of the total number of outstanding financial instruments or futures contracts a trading firm can hold.  This can range between 5% and 35% of the total open interest or number of units in circulation, down from 10-40% in earlier drafts.

Less liquid instruments with open interest of, or the number in circulation amounting to, fewer than 10,000 lots will have a position limit of 2,500 lots, the document said.

While all firms dealing in commodity derivatives are subject to some regulation, depending on their size, companies face paying €100,000-€1.5 million upfront for a MiFID trading license, plus ongoing compliance and reporting costs.

The licence fees applies unless firms can show they occupy a small enough market share and that trading is not a sufficiently core part of their business, therefore exempting them from being treated as on par with a regulated financial firm.

Thus, many smaller industrial market participants or firms not likely to be able to afford a full MiFID licence had been eagerly awaiting details for exemptions before they assess whether they would need to alter the way they participate or even exit the market altogether.

The final proposal should be more favourable to members of carbon trading lobby group IETA, which in March responded to a consultation saying that the draft exemption threshold levels were too low and risked cutting market liquidity by forcing firms to exit the market or restrict trading.

Under the rules, a firm can be exempt if it falls below the thresholds of the following two tests:

1) ‘Market share’ – If it shows its speculative carbon trading activity is lower than 20% of overall EU carbon market activity.

This is the highest threshold of the eight commodity asset classes, with 3% for gas and oil, 6% for power, 10% for coal and 15% for freight. It is also substantially higher than the 0.5% threshold proposed for all asset classes that ESMA set out in its draft proposal last year.

“ESMA does consider it as disproportionate to potentially require non-financial firms to apply for an investment firm licence based on a relatively low absolute amount of trading in the small emission allowance market, especially if this trading is due to compliance activity. Therefore ESMA considers it is justified to impose a significantly higher threshold for emission allowances and their derivatives at 20%.”

2) ‘Main business’ – If it shows its speculative trading activity (of all asset classes) is a sufficiently low proportion of its overall trading activity.

Here, the total trading – including hedging activity in particular – is used as a proxy for the main business of the non-financial entity. But because hedging activity is not wholly accurate as a proxy for the firm’s main business, ESMA adds a backstop provision of market share to ensure the test captures bigger firms only:

• If speculative trading activity is less than 10% of total trading it is exempt
• If speculative trading activity is 10-50% of its total trading, it may be exempt providing its market share is less than 50% of each threshold in the market share test (ie. 10% for carbon)
• If speculative trading activity is above 50% of total trading, it may be exempt providing its market share is less than 20% of each threshold in the market share test (ie. 4% for carbon)

“Calibrating the main business test this way should ensure that only relevant and sizable participants in European commodity derivatives markets should be assessed as not conducting their activities as ancillary to their main business,” ESMA said.

This ‘main business’ test differs from ESMA’s initial proposal, which required a firm’s capital used for speculative trading to be lower than 5% of the capital used for all the company’s EU activities. It said this was to avoid regulatory burdens because many firms would have had to collect additional financial information.

NEXT STEPS

The European Commission has three months to approve ESMA’s final draft standards. Once endorsed, the EU Parliament and member states have an objection period.

If approved, the rules come into effect from January 2017.

By Ben Garside – ben@carbon-pulse.com