MiFID expands the concept of ‘investment business’ – Part I

This is the first of three parts that look into specific issues of trading in instruments that are in the list of MiFID and were not in the list of the ISD. Institutions dealing in those financial instruments face the need to implement MiFID and Basel 2 at the same time and therefore becoming compliant means a lot of work, with a lot of issues due to the specific nature of some of the businesses involved.

Annex I of the level 1 Directive published in 2004 lists all the ‘services and activities and financial instruments’ covered by MiFID. Underwriting or placing a financial instruments is clearly defined as one of the investment services and activities that defines an ‘investment business’. The list of financial instruments includes : (a) “Options, futures, swaps and any other derivative contracts relating to commodities that can be physically settled…” and (b) “Options, futures, swaps, forward rate agreements and any other derivative contracts relating to climate variables, freight rate, emission allowances or inflation rates or other official economic statistics that must be settled in cash or may be settled in cash at the option of one of the parties…. , as well as any other derivative contracts relating to assets rights, obligations, indices and measures not otherwise mentioned in this Section that have the characteristics of other derivative financial instruments, having regard to whether… they are traded on a regular market or an MTF, are cleared and settled through recognised clearing houses or are subject to regular margin calls.”. Therefore underwriting or placing a commodity future became an investment activity.

So, if you are reading this from your desk in a financial institution spare a thought for commodity dealers and brokers. Their headache is slightly bigger than yours.

The FSA currently does not have dedicated rules for commodities and commodity derivatives markets. Its regulation is derived from several different regimes and its overall approach combines these. The implementation of MiFID and of the re-case Capital Adequacy Directive (i.e. the Capital Requirements Directive otherwise known as Basel 2) will significantly affect how the FSA regulates commodity markets.

The European Commission will report in 2008 to the European Parliament on a range of issues associated with commodity and other non-financial derivatives business. The Commission must decide which relevant firms, activities and instruments should be covered by the scope of EU financial markets regulation in this areas and if the current regulations need to be adapted to take into account the specificities of the commodity and commodity derivatives markets.

This will happen in 2008, MiFID will be effective from November 1^st , 2007 and the CRD from January 1^st 2008. So what is going to happen in the meantime ?

The questions behind an implementation of MiFID and CRD before the review varies depending on the nature of the firm and the business transacted. Also, CRD creates many more issues (and headaches) than MiFID.

A broker in commodity based derivatives working mainly with financial counterparty (i.e. clients that use the instruments clearly as an investment) will have less issues implementing the directive. Their business is basically a financial investment business and some of the principles behind the details of MiFID and CRD clearly apply to them.

CRD becomes very difficult to implement when we move to large commodity house that trade in their own account (say an oil company), there are several issues mostly due to the fact that CRD was that for a financial company, not for commodities. The two markets have clear differences. For instance :

In some commodities buying forward is the norm, for instance a coffee company would arrange a delivery plan with future contracts both as a way to cover against the risk of price fluctuation and to arrange a supply plan. Marking to market becomes a problem when you compare futures quotes with spot prices. Also, payment thirty days post delivery is the norm, that would be considered as a long term settlement. The other question is how far a Letter of Credit can be considered ‘risk mitigation’ rather than presenting a different risk in itself.

Operational Risk Requirements could be particularly onerous for those ‘producing’ companies (e.g. an oil company) that do not have a separate legal entity for trading. The Basic Indicator Approach requires a contribution to the reserve capital of 15% of income (a lot of money for the likes of BP, Shell, Centrica, etc.) and some Standardised Approach presents difficulties, mostly due to the different nature of the business (in other words, there is an obvious difference between trading commodities and trading money).

MiFID and CRD start have a fundamentally valid set of principles behind them. This is the case where there is a herd of devils in the detail (not just one). So what will happen ?

This is hard to say. The FSA helpline mentions a review and the deadline for comments was 30 April 2007, but still November 1^st and January 1^st are only a few months away.

If no special provision are made, a large commodity group could be in the same position as a financial house with a very large proprietary trading unit. Although the two business model could not be further apart, at the moment the range of possibilities between the worst case and best case scenario (in terms of time and efforts to become complaints) is very wide and, as yet, there is no real indication where the pendulum will stop. So, please spare a thought for the poor oil traders and commodity brokers who have a bigger headache than yours.

These are the headaches, would MiFID present any advantages to them? Clarity in the regulation may lead to a larger markets for commodity based investment products which could be marketed throughout the whole MiFID area (the EU plus Iceland, Norway and Liechtenstein). A level playing field across Europe comes to mind, MiFID will regulate activities across jurisdiction. It will be easier to operate from one territory to another, but does it really matter ? Stay tuned for Part II where I will discuss a business sector where it does (spread betting).

Once again, there is the need for a strong statement from the FSA over the transition period. Hopefully this will come once the Commission and CESR have examined the evidence gathered and everything will happen early enough to allow the affected business to have a realistic plan to become compliant in time.