Getting Ready for MiFID II: Position Limit Monitoring A

ENERGY AND COMMODITIES

GETTING READY FOR MIFID II: POSITION LIMIT MONITORING

Getting Ready for MiFID II: Position Limit Monitoring 1

HOW IS “LARGEST VOLUME” QUANTIFIED?

For securitized derivatives, it is the venue with the highest daily average volume over a one-year period. With all other commodity derivatives, it is the venue with the largest daily average open interest over a one-year period.2

The new Directive, MiFID II, becomes effective on January 3, 2018. With a multitude of touch points and areas of impact, this recasting aims to ensure the ongoing integrity of the EU’s financial markets. Regulator’s inclusion of intraday position limit monitoring is designed to prevent market manipulation and excess speculation. In preparation of this considerable undertaking, regulating bodies have defined a harmonized approach which has cascading responsibilities for many market participants including previously unaffected commodity trading firms. The European Securities and Markets Authority (ESMA) has published Regulatory Technical Standards (RTSs) detailing requirements under MiFID II.

Compliance with position monitoring

RTS 21 of MiFID II addresses the methodology for calculating and aggregating positions. Firms are expected to aggregate positions at the MiFID defined group level across trading venues and including OTC contracts deemed economically equivalent. Position limits are applicable at all times of the day using regulator defined units and requirements. In the following text, we distill the published Directive for the benefit of commodity and derivative trading firms; most notably compliance, operations and trading units.

Regulatory structure and responsibilities

Incorporated in the European Commission’s recasting of the new Directive (MiFID II) are commodity derivative position limits. This includes positions traded on a regulated market, Multilateral Trading Facility (MTF), Organized Trading Facility (OTF) and Economically Equivalent OTC (EEOTC) contracts. With MiFID II, the scope of commodity derivative was broadened to include securitized contracts where the underlying is a commodity as well as physically settled derivatives which are traded on an OTF. Exempt from MiFID II requirements are those products traded on an OTF which must be physically settled since they are covered by Regulation on Wholesale Energy Market Integrity and Transparency (REMIT), otherwise known as REMIT carve-out.1

MiFID II requires a segregation of responsibilities. ESMA will serve as the coordinating body for all competent authorities

and publish public data to their website. In turn, each competent authority will set position limits and apply compliance measures. Those commodity derivatives traded on a single venue or single member state will have a position limit set by the competent authority of that member state. When an economically equivalent commodity derivative is traded on multiple member state venues, a competent authority of the member state venue with the “largest volume” of trading is deemed the competent authority and is responsible for setting the position limit. Competent authorities shall re-evaluate position limits regularly at a frequency not greater than a year.

MiFID II – economically equivalent

With MiFID II, position limits apply to a commodity derivative which can be traded on EU venues as either exchange-traded derivative (ETD) or EEOTC of ETD on an EU venue. An OTC derivative is deemed economically equivalent to an exchange traded contract provided all contractual specifications are identical; save differences in lots size, post trade risk management arrangements, and delivery dates within one calendar day. For the purpose of determining economic equivalence as well as position netting, it is critical to note cash settled contracts are not the same as physically settled contacts.

Position limit methodology

Position limits will be specified in lots where lot is equivalent to the unit of quantity per contract as defined on the venue with the “largest volume”. Those power and gas contracts without a standardized lot as a unit of trading will have a limit specified in terms of MWh. For the purpose of setting meaningful position limits which facilitate orderly settlement, position monitoring is subdivided into spot month and other months.

As contracts approach maturity, the supply of the underlying commodity can heavily influence trading. Therefore, competent authorities are to derive spot month position limits as a percentage of the deliverable supply. Other months position limits are calculated as percent of the total open interest since this is a better measure of liquidity. Two caveats apply:

1 CONSULTATION PAPER, MIFID II/MIFIR, 22 MAY 2014, ESMA/2014/549 (P. 278-281) 2 REGULATORY TECHNICAL AND IMPLEMENTING STANDARDS – ANNEX I, MIFID II/MIFIR, 28 SEPTEMBER 2015, ESMA/2015/1464 (P. 412-413)

GETTING READY FOR MIFID II: POSITION LIMIT MONITORING

Getting Ready for MiFID II: Position Limit Monitoring2

1. Spot month position limits are calculated as a percent of open interest for those commodity derivatives without underlying deliverable supply (as defined in Annex I, Section C10 e.g., weather).

2. Securitized derivatives to have a single position limit since they lack contract maturity dates. Limit calculated as a percentage of total issuance.

RTS 21 provides additional clarity regarding spot month contracts. The spot month is specific to each commodity and identified as the next commodity derivative contract to mature. Contracts which mature subsequently are aggregated separately from spot month and evaluated against the other months position limit. This logic applies to both ETD and EEOTC contracts.

Baseline limitFor contracts of “significant volume”, the baseline benchmark calculation for spot month and other months limits is 25 percent of deliverable supply or open interest respectively. Based upon the factors specific to a commodity derivative, competent authorities may adjust the limit to fall between 5 percent and 35 percent (or in the case of some agricultural commodity derivatives as low as 2.5 percent and as high as 50 percent). Factors considered when adjusting from the baseline 25 percent include market liquidity, number of market participants, volatility, and storage capacity.

De minimis levelThreshold for “significant volume” is a commodity underlying with open interest in excess of 10,000 lots or 10 million securities in issuance. Contracts below the de minimis level will have a fixed position limit of 2,500 lots or 2.5 million securities. Contracts with open interest below 2,500 lots could be held entirely by a single market participant without violation. However, once the significant volume threshold is exceeded, the standard methodology will be employed. This tiered approach was adopted to accommodate new and illiquid contracts which would be adversely impacted if position limits were set using the standard baseline methodology.

Position netting and aggregation To ensure compliance, firms must monitor positions intraday relative to the published position limit. Positions are calculated on a net basis where economically equivalent

long and short positions offset. Options are included in position netting on a delta equivalent basis. However, spot month positions are netted separately from positions in other months. Firms are required to aggregate their own position with subsidiary positions to determine a net position at the group level. Excluded from group level aggregation are those positions where the parent cannot control or influence management of said positons.

Enterprise-wide impact

ESMA estimates approximately 1,500 limits required for contracts traded across Europe. Under MiFID II, only those positions held by non-financial entities which can be evidenced as directly reducing risk of commercial activity may be exempt from position aggregation. On a practical level, the number of contracts included and ongoing maintenance required will bring significant pressures and additional costs to IT systems and department personnel. Risk, compliance, and operation teams responsible for monitoring positions in real-time require a robust solution capable of aggregating enterprise-wide positions, including subsidiary companies. Firms must monitor net positions relative to the limit. This necessitates ongoing maintenance of a position limit database, tracking new contract limits across the EU and ensuring existing limits are in sync with regulators. Integrity of referential contract data is also critical to differentiate between spot month and other months positions, especially at expiration of the spot month. Depending upon trade activity, calculation of net positions requires offsetting ETD, EEOTC, and option delta equivalent positions. Position monitoring logic should be incorporated in an accessible user interface which provides intraday monitoring and alerting as thresholds are approached.

Are you ready?

As implementation of MiFID II nears, firms are starting to evaluate solution options so they can ensure regulatory compliance. Market participants are looking for solutions to monitor position limits in accordance with MiFID II requirements as well as the proposed CFTC cross exchange level. An out-of-the-box solution for managing limits and alerting users as positions approach thresholds, such as FIS’ Kiodex, can ensure trading compliance in real time. Enterprise-wide management of intraday positions can empower compliance managers to act prior to consequence.

3 OPINION, DRAFT REGULATORY TECHNICAL STANDARDS ON METHODOLOGY FOR CALCULATION AND THE APPLICATION OF POSITION LIMITS FOR COMMODITY DERIVATIVES TRAD-ED ON TRADING VENUES AND ECONOMICALLY EQUIVALENT OTC CONTRACTS, 2MAY 2016, ESMA/2016/668 (P. 9)

Position limits will apply separately to securitized derivatives, economic equivalence is deemed true where securities on different venues are fungible.

About FIS Solutions for Energy and Commodities

FIS solutions for energy and commodities help utilities and retailers, pipeline and storage operators, marketers and traders as well as integrated energy companies compete efficiently in global markets by streamlining and integrating the trading, risk management and operations of physical commodities and their associated financial instruments. Through real-time data, connectivity and analysis, FIS solutions help you achieve t ransparency and regulatory compliance, optimize end-to-end transaction and operational lifecycles and meet time-to-market needs with flexible deployment options. As your technology partner, we can help take advantage of the latest innovation and explore new opportunities. For more information, email us at getinfo@fisglobal.com.

About FIS

FIS is a global leader in financial services technology, with a focus on retail and institutional banking, payments, asset and wealth management, risk and compliance, consulting and outsourcing solutions. Through the depth and breadth of our solutions portfolio, global capabilities and domain expertise, FIS serves more than 20,000 clients in over 130 countries. Headquartered in Jacksonville, Florida, FIS employs more than 55,000 people worldwide and holds leadership positions in payment processing, financial software and banking solutions. Providing software, services and outsourcing of the technology that empowers the financial world, FIS is a Fortune 500 company and is a member of Standard & Poor’s 500® Index. For more information about FIS, visit www.fisglobal.com

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“The supply of the underlying commodity actually available is what matters when the contracts are nearing maturity whereas it is much less relevant for maturities that can go years into the future where open interest as a reflection of liquidity is the much more readily

available and relevant metric”.3