Counting the cost of EU regulation for commodity firms

(Reuters) - European officials may back a one-year delay to January 2018 for introducing landmark reform of EU financial markets.

The European Commission said a delay is needed as regulators are not ready for an original January 2017 start for the Markets in Financial Instruments Directive (MiFID II).

MiFID II will significantly increase reporting requirements for banks and brokers but final rules have yet to be published, meaning time is too short to get computer systems ready.

But some of the challenges MiFID II poses for commodity firms and banks will still exist in 2018.

Industry sources say banks and traders have been lobbying exchanges to expand the commodity derivatives on offer in Asia and the United States.

More than 1,000 -- some cite a number closer to 3,000 -- EU commodity contracts will be subject to position limits compared with only around 30 in the United States under Dodd-Franks.

A large number of commodity firms will for the first time have to be licensed like banks. Sources say proposed regulation is based on flawed legislation -- the crux of the problem.

Below are summaries of conversations Reuters has had with commodity firms, lawyers, industry groups and regulators.

POSITION LIMITS

Position limits aim to curb speculation, but may limit bank lending and drive commodity trading away from the Europe towards Asia and the United States.

The definition of an economically equivalent over the counter (OTC) contract was published in September by the European Securities and Markets Authority (ESMA). The proposed definition is narrow; to enable position offsets, OTC contracts must have the exact specification as exchange traded contracts.

* Trade finance. Banks will have no hedging exemptions. The definition of economically equivalent OTC contracts means position limits could be reached more quickly, limiting ability to manage risk.

If banks cannot hedge, they may not lend, making it harder for the EU to import raw materials. It may also create working capital difficulties for small firms.

The U.S. regulator has an exemption where limits are unaffected if end-users have to hedge with alternatives because the equivalent exchange contract is illiquid.

The EU has an exemption for proxy hedging, but it cannot be used by banks and MiFID firms.

* Physical business. Large volumes give the impression of unduly large positions, but holdings are often physically backed. Traders too are likely to reach ceilings quickly, perhaps undermining their ability to hedge.

However, firms only using derivatives to hedge would not need a MiFID authorisation, and are unlikely to have problems with position limits.

Those heavily involved in speculative trading may have problems, but the intention is to curb excessive speculation.

"The point in debate is whether curbing excessive speculation means limiting any speculation to regulated firms – which is where some commentators think this is heading," said Chris Borg, partner at Reed Smith.

* Aggregation. Positions of subsidiaries of foreign companies (adding an extraterritorial element) or subsidiaries in the EU have to be aggregated at group level.

* Position limits have to be complied round the clock. Systems monitoring positions and tell you when it is in danger of breaching limits need large amounts of investment and time.

The problem is compounded by the aggregation requirement. A firm will need to monitor aggregated positions across the globe and net any economically equivalent positions in real time.

ANCILLARY ACTIVITY TESTS

The "market share" test assesses whether a company's speculative trading is high in relation to overall trading. A problem for this test is a lack of data.

The "main business" test measures speculative trading in commodity derivatives as a percentage of total derivatives trading. ESMA said the test will be done against "total trading in commodity derivatives".

Regulated by banks. Firms will have to be licensed and hold capital reserves, which may persuade some to relocate trading arms or clear contracts in other jurisdictions.

The requirements to hold large capital reserves will not kick in for commodity dealers until 2018 and sources say there are talks on whether this should be extended to end-2020.

Authorisation also means being regarded as financial counterparty under European Markets Infrastructure Regulation (EMIR), which mean risk mitigation and clearing obligations.

* EU or global. The regulator hasn't been specific about whether the market share test relates just to EU business. Some are interpreting this omission to mean global business, but ESMA said the test will relate just to EU business.

* The "main business" test doesn't look at commercial business, fixed assets or trade with end-consumers.

The European Federation of Energy Traders is calling for the reintroduction of the "capital employed test" to determine exemptions from MiFID II.

* Market size. The first reference period for the calculations runs from July 2015 to June 2016. A delay may mean companies will have more time prepare applications for licensing, but that relies on the regulator publishing numbers for the size of the market soon.

* "Big-bang". Implementation could be risky due to interdependencies. The United States used a phased approach, where a data collection period was used to calibrate pre- and post-trade transparency.

(Reporting by Pratima Desai; editing by David Evans)