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Brow-mopping after Mifid II start

European companies have recast their risk-management and hedging systems in line with last-minute Mifid II preparations

Energy firms and regulators in the European Union have been dealing with the impacts of the second Markets in Financial Instruments Directive (Mifid II) since it started to take shape more than two years ago. The directive, which came into force on 3 January, had financial traders across the EU—and beyond—panicking about not only the changes to the shape of markets, but also the reporting requirements that the regulations demanded. For energy companies specifically, the position-limits regime, which dictates commodity instrument exposures, had many concerned that their ability to risk-manage using financial tools would have gross impacts on the shape of markets. Some even went as far as to say the regime would draw down on commodity derivative activity and could impact spot markets.

During 2017, as market participants counted down the days towards what was billed as the continent's single-largest overhaul of the financial sector, lobbyists, consultants, energy firms, traders, risk managers, legal professionals and industry bodies appealed to regulators. Many complained about the lack of information on building risk-management systems, while others raised concerns that systems wouldn't be in place in time for the go-live date. It seems now, though, much of that panic was unwarranted.

"A lot of the work was in getting the systems in place—calibrating everything to make sure we were going to be within the regulatory scope," says the head of commodities markets at a Europe-based investment bank. "Much of the work during 2017 was in building those systems and making sure there would be no cliff edge to fall off."

Mifid II brought about a raft of changes. Notably there are new obligations in executing and dealing orders and a new market structure for pre and post-trading transparency requirements. Overall, there's a drive to increase investor protection, improve both visibility into potentially volatile sectors and efficiency; and reduce systemic risks.

The rationale for position limits—that is, limits upon which firms can hedge against future prices and the segment of the directive most concerning energy market participants—was political in nature. The EU was concerned that food prices were rising too quickly at the turn of the past decade and pointed the finger at financial commodities markets. It designated the European Securities Markets and Authority (Esma) as the body responsible for constructing Mifid II's vast array of rules, aimed at taming markets that were considered to be growing out of control.

Mifid II was initially scheduled for launch at the beginning of January 2017, but was held back a year as Esma failed to create the rules that member states were to transpose. Even with the year's delay, the regulatory body rushed many instructions through to national competent authorities (NCAs)—those national bodies responsible for overseeing the directive for each member state—in December last year. Across financial markets, many commodities traders panicked, fearing they lacked sufficient information on the reporting requirements, or some of the calculations with which they would understand if they were in breach of the rules or not. Other issues arose, such as a lack of clarity on how companies formed as groups should report—whether at group level or at the individual entity level.

Further uncertainty tinged energy markets around the position limits themselves. Initially, NCAs were to file the limits to Esma, which was to rubberstamp the methodology the national authorities had used to set them. But as the Mifid II launch date approached and it became clear that Esma was running out of time to oversee the limits, the European body handed power to the NCAs. It instructed them to set limits on the commodity instruments they thought necessary, with Esma signing off the limits post-Mifid II's launch date. That suggested that Esma might change the limits, even though firms were building their systems around those the NCAs had published. Markets were also reminded that NCAs had the power to change the limits on an ongoing basis—which they are now capable of with Mifid II in force.

The reporting demands looked to be cumbersome, particularly to smaller energy trading firms. Those designated as financial entities by Mifid II needed to report open positions on a daily basis, following different rules across different European jurisdictions.

Calm after the storm

But as 3 January came and passed, most market participants settled into the swing of things. Regulated energy traders at major banks and the risk management divisions of major energy firms utilise energy trading and risk management (ETRM) systems. These are sophisticated data-processing packages, built in-house but more frequently purchased from a vendor, which have been programmed not only to monitor positions, but also to set off warning bells should the firm's traders sail too close to the limits. Larger organisations generally use upwards of a dozen ETRMS, such is the reliance on the position management they afford. Using these systems, many firms have ensured that they are well placed to avoid the regulatory gaze.

"It's really about having the correct systems in place," says the bank's commodities head.

But while the status quo remains calm following the storm of 2017, there are still niggling doubts about the shape of markets, and how regulators could change things overnight. Both at the European and national level, political winds could change and position limits across the continent's gas, crude or the other energy products could be lowered instantly. Aside from the fact that ETRMs would need to be fully recalibrated, ancillary and hedge exemptions would have to be reconsidered, while speculative traders wouldn't need to be asked twice to leave a market in which regulators had moved to tame activity. A further underlying concern is that Esma has been instructed to review Mifid II on an ongoing basis. That could mean tweaking large parts of the system, adding costs and workload to market participants.

Separately, another threat to the position-limit regime comes from across the Atlantic. The Commodity Futures Trading Commission—the body responsible for overseeing financial markets in the US—has made sounds over the past couple of years about bringing together its own position-limit regime. While that will concern US participants, a call to arms among industry bodies and regulators alike to enter a new phase of regulatory convergence could well impact the very definition of position limits. With the pain of the preparation process in the build-up to Mifid II still fresh with EU energy market participants, the very idea of a prolonged period of reconsidering and reframing financial market risk management could well send chills across the industry.

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