Review of the financial regulatory framework for commodity and exotic derivatives

The European Commission (the Commission) is currently reviewing the financial regulatory framework for commodity and exotic derivatives (the Review). Due to report at the end of 2008, this Review could result in changes to the Capital Requirements Directive (CRD), the Markets in Financial Instruments Directive (MiFID) and potentially other directives. The Review is therefore complex in nature and could result in fundamental changes to the regulation of this business with associated risks and benefits for the UK commodity derivatives market. The purpose of this discussion paper is to ensure that the UK authorities – HM Treasury and Financial Services Authority (FSA) - are able to effectively reflect the

views of the UK markets to the Commission during the course of the Review.

Commodity and exotic derivatives are an important, growing and innovative market. HM Treasury and FSA are conscious of ensuring any new regime continues to encourage this and retains the global competitiveness of these markets. Adherence to the better regulation principles and thorough market consultation will help ensure that any proposals take full account of these issues. HM Treasury and FSA commend the Commission’s efforts to date in this regard and hope that this paper will further engage UK industry in the process.

A necessary justification for regulatory intervention is the existence of market failures. HM Treasury and FSA’s analysis suggests that some form of regulation of commodity derivative business may be necessary but not to the same extent as for financial firms. This conclusion is echoed in the existing UK approach to regulation of these firms. Alongside the need for a proportionate approach, HM Treasury and FSA also see a need to tailor the regime to the specificities of the commodity and exotic derivatives market.

There are broadly three key policy areas.

• the limited retail participation means there is currently less need for conduct of business rules but the MiFID regime should offer a graded approach tailored to the needs of different market participants providing the status of the smaller ‘professional’ clients is recognised. HM Treasury and FSA see a case for altering the available MiFID exemptions to bring some additional business within scope but only if an appropriate capital regime were agreed. HM Treasury and FSA seeno new evidence to justify altering the definition of MiFID instruments.
  
• HM Treasury and FSA suggest that an alternative regime is required to these firms’ capital requirements and that changes to the CRD calculations for financial firms’ activities in relation to commodity derivatives are also necessary. A bespoke regime may be merited for wholesale only players, in the energy markets and potentially more generally.
  
• HM Treasury and FSA see a particular need to adjust the transaction-reporting regime for commodity derivatives. However, no case has been made for new transparency requirements. Market abuse in the commodity derivatives market is already addressed by the Market Abuse Directive but HM Treasury and FSA see a case for considering whether more is necessary as part of the forthcoming EU Market Abuse Directive review.
  

The UK is a key centre for the trading of commodity derivatives both on-exchange and over-thecounter (OTC) accounting for some 14 per cent of worldwide OTC business. It is therefore particularly important for HM Treasury and FSA to draw on the experience of the UK regime and UK market participants as part of the engagement with the design of any new EU proposals. Responses are requested by March 2008. A summary of responses will be issued in Spring 2008.

Review_of_the_financial_regulatory_framework_for_commodity_and_exotic_derivatives_Dec.2007.pdf