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Summary of Consultation Paper on CESR's/CEBS's Technical Advice to the European Commission on the Review of Commodities Business

Introduction

This consultation paper is a response to the European Commission's Joint Call for Advice issued in December 2007, seeking technical input from CESR and CEBS on the regulatory treatment of firms involved in commodity derivatives and exotic derivatives. The paper builds on prior advice from 2006 and 2007, and incorporates findings from a Call for Evidence published by CESR and CEBS in January 2008. The consultation period runs until 1 August 2008, with the aim of gathering industry feedback on market and regulatory failure analyses, potential regulatory impacts, and specific issues.

Core Content and Key Findings

Part A: EU Commodity Derivatives Markets

• Products: The largest commodity derivatives markets are in oil and gas. Oil derivatives alone have a notional value of $5 trillion annually in the UK, while gas derivatives in the EU reached €400 billion yearly turnover. Electricity and soft commodities are also significant, with a large portion of trading occurring outside regulated markets.
• Trading Venues:
  • OTC Trading: Dominates EU commodity derivatives markets. The UK is a major hub, with an estimated 14% global market share for OTC commodity derivatives.
  • Regulated Markets: Exchange trading is growing, with the UK and Germany being the primary locations. Exchanges like LME, EEX, and LIFFE play key roles, with EEX representing 20% of Germany's electricity consumption.
• Participants: Producers and distributors historically dominated the market, but there has been a significant increase in private and institutional investors entering the market for financial returns.
• Investor Participation: Private and institutional investors are expected to continue to play a growing role in the market, indicating a long-term trend.

Part B: Market Failure Analysis

• Information Asymmetries:
  • Low transparency in OTC markets is a concern, potentially deterring participation.
  • Information asymmetries can lead to abusive market conduct.
• Negative Externalities:
  • Specialist commodity derivative firms may generate systemic risks, but these are generally lower compared to banks and ISD investment firms.
  • Energy-only investment firms do not appear to pose significantly different risks than other specialist firms.

Part C: Regulatory Failure Analysis

• Differential Treatment:
  • Differences in regulatory treatment across firms and Member States may lead to competitive distortions.
  • The paper examines whether the current regulatory framework adequately addresses market and prudential risks.
• Free Movement of Services:
  • Potential distortions in the free movement of services are discussed, including regulatory arbitrage.
• Regulatory Failures:
  • Market Transparency: OTC markets lack transparency, which may hinder market integrity.
  • Market Integrity: Issues with transaction reporting and market abuse are identified.
  • Client Categorisation: Concerns exist regarding how client categorisation rules apply to commodity derivatives.
  • Regulation Based on Main Business: The current approach may not be suitable for all types of firms.
  • Definition of Financial Instruments: The definition of commodity derivatives may not fully capture all relevant instruments.
  • Capital Requirements: The current capital requirements for commodity derivatives may be too high for specialist firms.
  • Large Exposures: The application of the large exposures regime to specialist firms could demand significantly higher capital than they currently hold.

Part D: MiFID Questions

• Transparency: The paper explores whether MiFID's pre-trade and post-trade transparency rules should be adapted for commodity derivatives.
• Market Integrity: The paper discusses transaction reporting and market abuse in the context of commodity derivatives.
• Organisational Requirements: These are considered relevant to the regulation of commodity derivatives.
• Client Categorisation: The consultation paper seeks further input on the perceived issues with applying MiFID’s client categorisation rules to commodity derivatives.
• Financial Instruments:
  • There is a need for clarity on the underlying assets of commodity derivatives.
  • Cash-settled exotic derivatives and physically-settled commodity derivatives are discussed.
• Entity Type Differences: The paper considers whether regulatory treatment should vary based on the type of entity providing investment services.
• Underlying Commodity Differences: The paper investigates whether regulatory treatment should differ based on the underlying commodity, asset, right, service, or obligation.
• MiFID Exemptions: The paper evaluates whether the exemptions in Articles 2(1)(i) and (k) of MiFID should be retained, modified, or eliminated.

Part E: CRD Questions

• Regulatory Treatment: The paper assesses whether the current treatment of commodity derivatives under MiFID and CAD supports the intended aims of prudential regulation.
• Large Exposures: Applying the large exposures regime to specialist commodity derivative firms would require significantly higher capital than they currently hold, which may be excessive.
• Maturity Ladder Approach: This method is unsuitable for non-storable commodities. Alternative approaches based on forward prices are suggested.
• Regulatory Options:
  • Option 1: No regulatory capital requirements, relying on qualitative risk management.
  • Option 2: Pillar 2-type approach, combining qualitative and quantitative risk management.
  • Option 3: Recalibrating the CRD to better fit specialist firms.
  • Option 4: Full application of the CRD with a tailored exemption regime.
  • Complementary Opt-In/Out Regime: Firms could choose between preferential treatment and less burdensome regulation.

Key Views and Recommendations

• The current regulatory framework may not be fully aligned with the evolving nature of commodity derivatives markets.
• There is a need to reassess the exemptions under MiFID and CAD to ensure they remain appropriate.
• The maturity ladder approach for capital requirements is questioned, with alternative methods proposed.
• The paper suggests a range of regulatory options, including a possible opt-in/opt-out regime for firms.
• Transparency and market integrity are key concerns in OTC markets, and there is a call for more detailed evidence and analysis.

Conclusion

The consultation paper outlines a comprehensive analysis of the EU commodity derivatives market, identifies key market and regulatory failures, and proposes several options for regulatory reform. The aim is to ensure that the regulatory treatment of these markets supports both market quality and prudential stability while allowing for the evolving role of private and institutional investors. The final recommendations will be delivered in autumn 2008 after considering industry feedback.