Why fix something that isn't broken?

The key regulation that majority of the energy trading firms are concerned about is MiFID II and the accompanying Regulation on Markets in Financial Instruments and Amending Regulation (MiFIR)-often referred to without distinction simply as MiFID II. The regulation comes into effect in January 2017.

Many of the finer points of the regulations are yet to be finalized, with many energy trading firms using the European Securities and Markets Authority's (ESMA's) ancillary exemptions threshold value publication in September 2015 as a key date to mobilize resources to address the challenges the regulations pose. If they are within the threshold, then this gives the energy firms 15 months to prepare for the start of the regime.

What is MiFID II? Which of the energy traders are affected by this extended MiFID regime? And how are they preparing themselves for this challenge?

In essence, MiFID II in its wider definition focuses on the framework of venues and structures in which financial instruments are traded and on regulating the operations of these trading venues and structures. It looks at processes, systems, and governance measures for these venues, as well as their future supervision. It extends the governance that the first MiFID iteration bought to equity markets to a wider range of asset class, covering (but not limited to) physically settled over-the-counter (OTC) commodity derivatives. The legislation has four main objectives:

• Increase investor protection
• Align regulations across the European Union (EU)
• Increase competition across the financial markets
• Introduce reinforced supervisory powers

In layman's terms, this means energy trading firms involved in the distribution and trading of financial instruments in the EU-in other words, operating OTC trades and within a notional threshold (ancillary exemption) based on their main businesses relative to the size of trading activity and capital employed-are likely to be affected across a number of areas. These areas are summarized in Table 1.

Navigant spoke with a large cross section of energy and commodity trading firms and energy exchanges across Europe to gauge how each group of firms are preparing themselves and to share learning from the United States on implementing the transparency rule contained in the Dodd-Frank Act. A common thread throughout these conversations was that planning for compliance was a difficult process, as there is still uncertainty on how MiFID II will be translated into practically applicable rules and regulations. In general, the contributors can be split into four groups, as shown in Figure 1.

Firms unlikely to be impacted: A small population of the energy traders we spoke to believe their activity is predominantly focused on hedging and does not involve significant distribution and trading of financial instruments in the EU with speculative intent. Therefore, they expect be excluded under the ancillary exemption. The common trait amongst traders in this group is that they are closely monitoring the regulatory developments and plan to review the implication after the ancillary exemptions threshold publication in September to ensure they are indeed exempt.

A subset of this group is actively embracing the implications and have mobilized projects to take advantage of the unintended consequences of other firms leaving the OTC derivative market because of the costs of remaining compliant and competitive outweigh the benefits.

Firms very likely to be impacted and are fully embracing the regulations: As expected, some of the larger, more established energy traders with multijurisdictional trading activity and established presence in the United States who have abided by the Dodd-Frank regulations are in this group. What was unexpected was the number of mid-tier commodity trading firms that have used this as the trigger to carry out an enterprise-wide review of their approaches to risk and regulation.

The key characteristic of this group is the mindset of the CRO, the leadership to the current set of regulations, and the expectation that the current tranche is just the tip of the iceberg. Firms in this group see these regulatory challenges as an opportunity to get ahead of the regulatory curve and create an environment where bad behavior is not tolerated. As one CRO we spoke to in the United Kingdom said, "We're using this as an opportunity to clean house and get ourselves into a place where we don't have to spend more time and money each time a new regulations comes our way."

This group has created cross-disciplinary teams that include the Finance, Risk, Technology, and Treasury to look at MiFID II in context of an overall regulatory plan, with the CEO acting as the overall sponsor. They have engaged specialist advisors, analyzed their portfolio of trading activities, carried out impact analyses on their corporate strategy and operations, engaged their national regulators, and mobilized project teams to identify options for responding.

Firms very likely to be impacted and looking for ways to minimize or remove the impact and cost of adherence: This group of firms sees the regulations as a challenge and maintain that their impact should be minimized. They see the cost of full adherence outweighing the commercial benefits to the organization. This group of firms, while not large, does share a common characteristic; they tended to hold OTC portfolios that were on the brink of the current understanding of the notional threshold for ancillary activity exemption.

This group also tended to have proactive CROs who had taken an enterprise-wide view to regulatory challenges. However, the key difference between this group and the previous group that had actively embraced the pending regulations was the timespan they were looking at. The focus was on minimizing or removing the impact of the regulations on the business in the short term and reassessing the plan once the requirements were clearer or when the organization's strategy changed.

Some of the ideas that were considered by this group, taking learning from the financial institutions, include optimizing activities and organization to minimize impact without changing the commercial benefits; removing (winding down or disposing) activities that expose the business to additional regulatory requirements; taking advantage of possible geographical arbitrage by relocating activities to geographies outside of the EU; and modeling the impact of non-compliance or partial compliance.

Firms likely to be impacted but are sitting back and waiting for confirmation of the September ancillary activity exemptions: A large portion of the energy trading firms we spoke to revealed MiFID II was on their radar and they were closely monitoring progress. They also admitted that their level of readiness was poor. In general, this group tends to address each regulation in a piecemeal way and exhibited a silo mentality to regulation. One CRO based in Europe that we spoke to said, "I see REMIT [Regulation on Wholesale Energy Market Integrity and Transparency] as my CIO's problem; MiFID is my problem."

In the majority of the cases, the compliance mindset was one of how to practically apply the regulation without disrupting the business rhythm and to leverage existing systems and processes for adherence. We found that basic levels of impact analysis had been carried out at strategic level, but the cultural, operational, or cross-functional considerations, which are crucial in ensuring adherence in sprit (perhaps not in the word of the text), were not considered important until further clarity was provided. Firms in this group were particularly interested in understanding how their peers were preparing for the MiFID II challenge and in benchmarking themselves against their peers.

Another common trait with this set of firms was the lack of sponsorship or engagement from organizational leadership on the regulatory challenges. This set of firms was eager to engage specialist advice as soon as the exact value of ancillary activity exemption becomes clearer in the draft regulatory technical standards set to be published in September 2015.

WHAT SHOULD FIRMS BE DOING NOW?

While the go-live date of January 2017 might seem a long way off, the September 2015 date- which is anticipated to provide clarity on ancillary activity exemption-is a milestone in understanding the magnitude of the impact of MiFID II on energy trading firms. It is vital that firms scrutinize these developments closely and interpret the regulations and understand the strategic and operational the impacts on their businesses. Even if these firms avoid full regulation under MiFID II, a number of requirements will apply to those that trade commodity instruments in-scope. This includes adherence to regulatory position limits, as well as the reporting of positions in such commodities.

There is no one-size-fits-all solution or approach to addressing this challenge; where firms are placed in the four groups identified above and how far along they are in the regulatory readiness journey will inform your actions. In general, compliance teams should be engaging with the wider organization, including finance, tax, and treasury functions at a strategic level in order to assess the following:

• Realigning a firm's legal entity structure to drive compliance efficiencies or arbitrate opportunities in respect to the MiFID II requirements.
• The extent and purpose of the group's trading function (own-use vs. speculative trading) and how these activities influence the firm's approach under MiFID II requirements.
• The regulatory capital requirement impact operating costs and revenues in the context of a firm's corporate strategy.
• The optimal mix of trading venues on which to execute trades.

At an operational level, these firms should assess:

• Their ability to calculate and report on their position to the regulatory authorities in a timely manner. This would typically mean carrying out a gap analysis across all the components of their operations, including technology, data, documentation, and capability.
• The impacts on credit risk policies in line with the new position limit that MiFID II will set.
• Their existing control framework and how it can be used to evidence MiFID II compliance.
• Engage with the front and middle office functions to assess their ability to segregate own-use trading from speculative trading from an intent, technology, data, and process prospective.

Energy trading firms should, if they have not already, engage their national regulators to understand expectations and discuss their readiness. Not all national regulators have the same level of experience and maturity in dealing with regulations of this nature, and while some regulators like the Financial Conduct Authority (FCA) will have a clearer view of requirement, other less mature regulators may prefer a more consultative approach, especially in the build-up to the go-live date.

The key to successfully addressing the MiFID II challenge is to start preparing for it now. The reality for most energy trading organizations is that the changes are likely to extend beyond simple operational tweaks and affect more of a firm's strategy and structure in the long term.

ABOUT THE AUTHOR

Gajan Sritharan is a director in Navigant's global energy practice based in London. He has more than 16 years of experience in the oil and gas sector. Sritharan attended Cardiff University in Wales and holds a BSci degree with honors in mathematics and economics and a masters in business administration. He also is a Chartered Institute Management Accountant.