Dealing on own account
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MiFID 2 Anatomy™
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Hoo boy.
Dealing on own account generally
The activity “dealing on own account” is vaguely defined in MiFID — always has been — as “'trading against proprietary capital resulting in the conclusion of transactions in one or more financial instruments” — but given MiFID’s purpose, generally has been understood as being restricted to brokerage and market-making activity; being continual prepared to fulfil third-party customer demand or provide market liquidity, but doing this as a principal not an agent, and therefore being permitted to hold “prop” inventory.
In other words, this is not about participants using their own capital to buy, and go on risk to, financial instruments. See, for example, this in the FCA’s Q&A to its perimeter guidance rules which, indeed, no longer represent European law but are all the same heavily influenced by it, to the point of being presently identical:
“Dealing on own account involves position-taking which includes proprietary trading and positions arising from market-making. It can also include positions arising from client servicing, for example where a firm acts as a systematic internaliser or executes an order by taking a market or ‘unmatched principal’ position on its books.
Dealing on own account may be relevant to firms with a dealing in investments as principal permission in relation to MiFID financial instruments, but only where they trade financial instruments on a regular basis for their own account, as part of their MiFID business. We do not think that this activity is likely to be relevant in cases where a person acquires a long term stake in a company for strategic purposes or for most venture capital or private equity activity. Where a person invests in a venture capital fund with a view to selling its interests in the medium to long term only, in our view he is not dealing on own account for the purposes of MiFID.”
Indeed, MiFID is meant to protect people like that, not regulate them.
So our starting point is this: whatever the regulations actually say — and God knows they are a mess, and we have met no-one with (or for that matter without) any expertise who is prepared to declare, hand on heart, what they actually say — it cannot be right that they are meant to to bring emissions investors — who are, by and large, acting through the agency of MiFID-regulated brokers and dealers — to themselves be regulated by MiFID. That would be a stupid outcome.
The curious case of commodity derivatives and emissions
We mention this only because there are some odd provisions of MiFID 2 which potentially put SPVs into scope should they look to securitise commodity derivatives or carbon emission allowances or EA derivatives (which for sanity’s sake we will call “commodity products” on this page, even though it isn’t a fantastically accurate description).
So, an odd thing. In MiFID 1, commodity derivatives and carbon emissions products were (largely) excluded from scope. To ensure participants on commodity derivatives markets appropriately regulated and supervised, MiFID 2 narrowed exemptions, especially as regards “dealing on own account”. The idea being, you would think, to make sure that commodity based financial products that in other ways resembled MiFID financial instruments — and commodity swaps to that, as do emissions allowances — should be regulated in the same way. You wouldn’t expect them to be regulated more heavily.
Anyway. When trying to bring commodity derivatives and EUAs into scope for MiFID, the regulations and technical standards do a curious job of them handling the usual exemptions, such as those under Art 2(1)(d) (see full text in panel on right), which, in a nutshell, exempts from MiFID:
2(1)(d) Persons dealing on own account other than in commodity products and who do not provide any other investment services or do any investment activities other than in commodity products unless they are market makers, participate on or have direct electronic access to a regulated market or MTF (excluding corporates who are hedging in an objectively measurable way), use high-frequency trading algorithms, or are executing client orders.
All very tedious, but what is going on here is exactly as presaged above: if you are just a regular joe, and you aren’t making markets, using algos, executing client orders, or directly accessing a regulated market beyond your normal funding and hedging activity, you don’t need to be authorised under MiFID 2 ... unless you’re transacting in commodity products.
Like, what? We have gone from all commodity activities being out of scope from MiFID 1 altogether, to some being in scope for MiFID 2, even when the same activities in other, “normal” MiFID instruments are not.
That cannot have been what the regulators intended. Can it?
To see, we have to continue down the laundry list of exemptions. The next one that might help is Article 2(1)(j) — again, set out in full in the panel for completists, but what it means in layperson’s terms is the following persons are exempt:
2(1)(j) Persons who “deal on own account” in commodity products, as long as they are not executing client orders or providing investment services in commodity products to their customers, and:
- Taken together this dealing activity is “ancillary” to their group’s “main business”,
- That main business is not providing banking or investment services or making markets in commodity derivatives
- They are not using high-frequency trading algorithms; and
- When asked, explain to their competent authority how consider their activity to be “ancillary to their main business”;
Ok we are getting somewhere, but — ah: there is this gnomic question of what counts as “ancillary to one’s main business”. Fear not: Article 2 also addresses that, but punts it off to ESMA to come up with some regulatory technical standards governing it. This has been recently updated and you can find the latest — as of June 2022 — here.
The “de minimis threshold” for ancillary activity
There are three alternative ancillary activity tests, of which two are a bit speculative and fiddly to calculate, but the third — the “de minimis threshold test” — gives a repackaging SPV room to work with.
Under the de minimis threshold test, a person’s activity is ancillary to its main business if its net outstanding notional exposure in EU-traded cash-settled commodity products, not counting those traded on a venue, is less than EUR 3 billion annually (calculated against an average over three-years on a rolling basis).
“Excluding those traded on a venue?” We suppose this exclusion is predicated on there being someone else — a broker — involved in an on-venue trade who has the appropriate permissioning (if there isn’t, the entity must be accessing the venue directly itself, so is out of scope for the exemption anyway) so these naturally should not count towards your limit — though query whether they should count towards offsetting OTC exposures you might have in other markets. It would be odd if an exposure to commodity derivatives hedged with futures gave you a different result to one hedged with a note or another swap.
“Net notional outstanding exposure”
In any case this is all good stuff, if you can monitor, and keep a lid on, your commodity product exposure, or — if you are some kind of securitisation vehicle — you may wonder what “net outstanding notional” exposure means.
Art 3(1) of the RTS addresses this. The punctuation in “commodity derivatives for cash settlement or emission allowances or derivatives thereof for cash settlement” leaves something to be desired — namely, some punctuation — but the only way we can read this is (i) cash-settled commodity derivatives; (ii) emission allowances; (iii) cash-settleable emission allowance derivatives — in that either party has an option to cash settle, that will be enough — but it leaves out purely physically-settled commodity derivatives and emission allowance derivatives.
This, we think, as something to do with MiFID’s fractalised coastline when it comes to commodities: physical commodities are out of scope; “synthetic” commodities — i.e., commodity derivatives — are in — unless they are physically-settled commodity derivatives, which are out — unless they are physically settled derivatives, but traded on a regulated market in the EU (i.e., a trading venue), in which case they’re in scope again. This is the kind of flip-flopping, concatenated series of multiple negatives that would get an ISDA tax ninja excited.
Cash-settled emissions derivatives?
The odd one out is physical emission allowances, which are sort of commodity-like — in that they’re inexorably tied to the commodities markets — but also financial instrument-like, in that they are abstract economic concepts represented and bounded by words, regulations, and legal title, and they can’t go off or be impounded in a warehouse in the Sudan, contaminated with sea-water or painted yellow and passed off as copper.[3] Thus, these are not in fact commodities, and are in scope in their physical format. Which is why this is such a tortured definition. In limiting “nettability” of emissions derivatives to cash-settled contracts, we think, is a drafting error — a mistaken read-across from commodities. Remember: physical commodities are out of scope for MiFID; physical emission allowances are not.
It shouldn’t have been this difficult, in any case: “MiFID eligibility” should trigger the de minimis exemption, but should not put a limit on the sorts of contracts that contribute to your exposure calculation. But the pragmatic reactions are: make sure your derivatives have a cash settlement option. That being economically neutral, it ought to do the trick. If it can’t — well, EUR3bn is a decent bit of headroom to play with.
That disjunctive “or”
Another puzzle is Article 3(3)’s reference to the netting methodology of Article 5(2). This comes from another test — the “capital employed” test — and this appears to bucket together different types of exposure, but then is not brilliantly clear what can be done between the buckets. The three buckets are:
- (A) Commodity derivatives (noting that physical commodities are not in scope for MiFID at all);
- (B) Emissions allowance contracts — and one might pause to wonder whether an emissions allowance itself is, properly called, a “contract”; it is rather a creature of a European regulatory regime (unlike, say, private financial instruments such as bonds and equities, which fundamentally are contracts; and commodities, which fundamentally are not creatures of the law at all); or
- (C) Emission allowance derivatives.
Note at once that bucket A cannot net with buckets B or C, seeing as the underliers are mutually exclusive. Even if you wanted to and were allowed as a matter of law to net these exposures you could not as a matter of fact. But can you net physical emissions allowances against derivatives of the same underlying allowance? Common sense would shriek, surely yes — the net exposure to EUAs comprising a long EUA and a short forward sale, for example ought to be nil — but a cautious literal reading leans towards no: you can net down just your EUA contracts, together, and your EUA derivatives, together, but you cannot net them down together.
The final rider poses more questions than it answers: “net positions in different types of contracts[4] with the same commodity as underlying or different types of derivative contracts with the same emission allowance as underlying can be netted against each other.”
If you are structured finance product and instead of hedging the asset risk you pass it on to the investor, what then? Would the debt certificates — undoubtedly cash-settled and with a return derived from the underlier — count as a cash-settled derivative? If you are genuinely interested in this question welcome to the MiFID/MIFIR/EMIR memeplex. Like the metaverse, it is over-engineered, makes you tired, dizzy and eventually will gives you a splitting headache.
In any case, we have a scenario where if you are trading on a regulated trading venue, the ancillary business exemption is off the table, so it stands to reason that the only regulated activity you can conceivably be doing and still qualify is emissions trading, or transacting cash-settled OTC commodity (or, sigh, emission allowances) derivatives.
See also
References
- ↑ https://www.esma.europa.eu/databases-library/interactive-single-rulebook/directive-201465eu-european/article-4-0
- ↑ Art 2(1)(a) of MiFID 2 RTS 20 at https://eur-lex.europa.eu/legal-content/en/TXT/?uri=CELEX%3A32021R1833
- ↑ https://www.mining.com/web/trader-buys-36m-of-copper-and-gets-painted-rocks-instead/
- ↑ The French text here says derivative contracts, so we think there is nothing momentous about the absence of that adjective here.