The capital requirements of CRD IV and classification as a financial counterparty subject to the clearing obligation under EMIR are arduous.
Source: KPMG Corporate Treasury News, Edition 48, October 2015
All industrial enterprises with commodity derivatives in their portfolio will have to address this question, as they fall within the scope of MiFID II. In addition to elaborate licensing procedures, the capital requirements of CRD IV as well as immediate classification as a financial counterparty subject to the clearing obligation under EMIR are particularly arduous.
However, the regulator takes account of the fact that industrial enterprises use commodity derivatives to hedge the risks of normal business operations, and therefore provides for an exemption, which needs to be renewed every year with the responsible authorities, at the initiative of the enterprise, based on various documentary evidence. To exercise this option, two calculations have to be made and documented: the 'market size test' and the 'main business test'. MiFID II defines 'privileged transactions', which are excluded from calculation of the exemption threshold used to determine the company's exposure. This includes derivatives with documented hedging relationships, internal derivatives and derivatives held by financial institutions within the group.
Companies that exceed one of the market size test thresholds are categorised as investment firms. If they fall below all thresholds, the main business test needs to be carried out. If the result of this test is between 10% and 50%, the threshold for the market size test is reduced by 50%, and if it is above 50%, the threshold for the market size test is lowered to 80% (e.g. for metals, a 0.8% market share is permitted for non-hedging derivatives).
Tests conducted for the first time are based on data from July 2015 to June 2016. Subsequent calculations are made on an annual basis using a rolling approach until a period of three years can be taken into account on a rolling basis (using a one, two and three-year rolling average).
Use of the 'hedging exemption' is of central importance, once again. In line with the definition of EMIR (ESMA Q&A OTC 10), risks, systems and required documentation are defined that are permissible as evidence of a hedging relationship. It must be ensured in processes, and dependent on the overall system of portfolios, books, limits and quotas, that derivatives are identified without direct connection to an underlying transaction and treated as non-hedging derivatives. In so doing, it is not sufficient for a company to rely solely on evidence that has already been implemented because MIFIDII also applies to exchange-traded derivatives.
Compliance with the requirements for documentary evidence of hedging relationships is difficult to implement, especially for commodity trading firms and in cases of management on a portfolio basis, and has to be verified accordingly. For industrial enterprises that hedge expected purchases and sales directly, it should be a lot easier to compile the necessary arguments and documentation, which could be sufficient already for the purposes of EMIR in the case of OTC derivatives.
In view of the potentially huge importance of this exemption for companies, and the financial regulator's objective of more tightly regulating the commodities market, management should make sure that its arguments and documentation are reliable and able to withstand scrutiny.
In summary, companies will face the following challenges:
• Identifying commodity transactions falling within the scope of MIFID II that need to be included in calculation
• Expansion of existing hedging evidence under EMIR for OTC commodity derivatives and exchange-traded derivatives
• Analysis of processes, guidelines, risk management and IT structures with a view to separate treatment of derivatives without a hedging relationship
• Annual performance of the necessary tests and calculations, followed by notification of the relevant European authorities
• Should it become evident that the exemption cannot be availed of, appropriate measures need to be taken in due time to ensure that the obligations relating to classification as an investment firm can be implemented by January 2017 – implementation of investment firm status takes six months on average.
Author: Martin Thomas, Senior Manager, email@example.com
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