EACT Letter for clarification for NFC on multilateral electronic trading platforms.
This article is by Simone Mecca. It appeared first in Bloomberg Brief | Corporate Treasury.
A common assumption among corporate treasury practitioners is that the European directive MiFID II will only have to be implemented by financial institutions, and corporates will escape the regulatory burden. This is only partially correct.
MiFID II extends the stricter collateralization and clearing requirements to OTC instruments and commodity derivatives commonly found in non-financial corporations’ books and has become more compelling following the recent financial markets turmoil. It follows the first set of regulation (MiFID I — Markets in Financial Instruments Directive) applicable since 2007, aiming at improving the competitiveness of the European financial space and insuring higher and harmonized protection for investors.
It’s now required that local governments pass domestic legislation to adopt the EU regulatory framework into state law. Adoption acts will be drafted on the basis of advice by the European Securities and Markets Authority (ESMA). Therefore they will tend to be very homogenous across the countries.
The directive should officially come into force in January 2018.
In spite of this possible delay, the fact that the U.K. Financial Conduct Authority (FCA) has already published its first consultation paper in December means it’s possible to make several considerations useful for corporate treasurers.
The assumption that corporate treasurers will not have to be involved with the implementation stems from the fact that the derivatives commonly used by corporate treasurers are meant to be used for hedging purposes only and therefore should not fall under the radar of MiFID.
This is a flawed assumption: companies are not automatically exempted from all obligations. Based on the FCA paper, the first obligation with the new directive is that entities conduct an assessment on their activities to prove that they shouldnot be subject to stricter MiFID II requirements. This assessment consists of two separate tests need to be passed cumulatively: firstly the so-called “market size test” and once this test is passed, the “main business test.”
The first test compares the size of the corporation’s trading volume of “derivatives not aimed at hedging” with the overall EU market.
The thresholds set by the ESMA guidelines span from 20 percent limits for emission allowances to 15 percent on derivatives on climatic variables, freight rates and other economic indexes. For derivatives on physical commodities, the levels are 4 percent on metals to 3 percent on oil and oil production derivatives. The ratio for derivatives on coal has been set to 10 percent, 3 percent on gas, 6 percent on power and 4 percent derivatives on agricultural products.
The derivatives should be defined usingthe reported data to trade repositories,the entities set up under another directive,EMIR, to track all the OTC activities.
If the trading entity falls below all the thresholds above, then the second test — the main business one — will also have to be conducted. This second test looks at the overall size of “non-for-hedging derivatives” in the books in comparison with the sum of one company’s derivatives transactions volumes.
Even if companies’ books are well below the thresholds mentioned for the first test, they will be required to document and submit it to the competent local authority.
For corporates that have used derivatives to hedge an exposure, the key takeaway here should be the concept of “non-hedging purpose derivatives” — as only those instruments will account for the tests.
Risk managers will want to make sure that they monitor with care the transactions falling within the “non-hedging scope” that need to be included in the “market size” threshold calculations.
Therefore the second impact of MiFID II on corporates would be a careful review of the hedging designation processes, and the design of internal procedures to make sure that the hedge documentation is consistent to identify and address separately the traded instruments falling under the “non-hedging category.”
A third and final point would be related to the IT process as the Treasury Management System should be in a position to separate those transactions that are not clearly used for hedging but are still exempted for being accounted for the tests, notably all the intercompany derivatives that do not qualify for the MiFID II tests.