On 4 December 2023, the Financial Conduct Authority (FCA) published a consultation paper (CP23/27) on reforming the UK commodity derivatives regulatory framework (Framework). CP23/27 sets out the FCA’s proposals regarding commodity derivatives, including position limits, the exemptions from those limits, position management controls, the reporting regime, and the ancillary activities test (AAT).
The Framework aims to mitigate the risk that large positions in commodity derivatives can result in disorderly pricing and/or settlement conditions. The FCA is concerned that such disorder can harm participants in financial markets, users of commodity markets and the economy itself.
CP23/27 forms part of the UK’s Wholesale Markets Review, a review of the UK’s secondary markets structure, that the FCA has been conducting with HM Treasury (HMT). With CP23/27, the FCA aims to ensure the UK’s commodity derivatives markets remain resilient under various market conditions by introducing new requirements to strengthen the supervision of such markets to make sure that they can continue to service users, in the UK and globally.
The FCA explains that the Framework seeks to take the learnings from periods of commodity market instability to deliver greater resiliency during times of market stress. The proposals in CP23/27 seek to improve the ability to identify risk through new requirements that involve additional data reporting (including of over-the-counter (OTC) commodity derivatives data) and ensure that the system of position limits is sufficiently agile to respond to swiftly changing market events.
Who CP23/27 applies to
The proposals in CP23/27 apply to:
- UK trading venues which admit to trading commodity derivatives; and
- persons, including commercial users and financial firms, who trade commodity derivatives in the UK.
The proposals will also be of interest to central counterparties dealing in commodity derivatives, trade associations and other persons, such as non-governmental organisations, that have participated in public policy debates on the Framework and those that manage infrastructure through which commodity futures contract deliveries are made.
The proposals in CP23/27 relate to the “key pillars” of the Framework. The proposals cover:
- Setting position limits by trading venues. Consistent with the Financial Services and Markets Act 2023, the principal responsibility for setting position limits for commodity derivatives is being transferred from the FCA to trading venues. While trading venues will be responsible for setting the specific level of position limits, the FCA’s proposals set out its expectations as to the factors they should have regard to. This differs from the EU approach, where position limits are set by the regulators based on the principles set out in legislation. CP23/27 notes that trading venues have the market proximity to set position limits effectively and to quickly change them if market conditions require. The FCA also proposes to retain the power to set position limits itself under certain circumstances.
- Applying position limits only to certain commodity derivatives contracts. The FCA proposes to narrow the application of position limits by identifying a set of “critical” contracts for which disorderly trading would have the greatest impact on commodity markets and their users. Under the proposals, trading venues will set position limits for critical contracts and also extend the application of such regime to contracts that are sufficiently related to the critical contracts. The FCA therefore proposes to apply more stringent requirements to a narrower set of critical contracts.
- Enhanced position management controls and reporting. The FCA proposes to enhance its expectations as to the oversight and surveillance arrangements trading venues must operate as part of their position management controls. The proposals require trading venues to establish accountability thresholds and to have access to additional information, including information on OTC commodity derivatives positions by members and their clients.
- Position limit exemptions. The FCA proposes new exemptions for liquidity providers and financial firms dealing with non-financial firms that are hedging risks arising from their commercial commodity activities. The FCA also proposes to strengthen its rules as to the arrangements that trading venues shall operate to satisfy themselves that the use of exemptions remains consistent with the operation of orderly markets.
- AAE. The ancillary activity exemption (AAE) provides an exemption from the regulated activity of dealing as principal in commodity derivatives, which non-financial firms (such as commercial producers) can benefit from under certain circumstances. The FCA proposes to provide guidance confirming that: (i) “ancillary” is something “related” or “subordinate” to the main business of the group; and (ii) firms can have regard to the trading and capital employed thresholds used in the EU delegated regulation to judge whether an activity is ancillary. At this stage, how the AAE will apply in its entirety is therefore unclear. We understand that the FCA does not intend to change the scope of the AAE – however, there is no reference to the de minimis test in the FCA’s proposals thus far (unlike the current AAE regime in the EU).
Appendix 1 to CP23/27 sets out a draft of the Commodity Derivatives (Position Limits, Position Management and Perimeter) Instrument 2024 that would make the proposed amendments to the FCA Handbook Glossary, Market Conduct sourcebook, Decision Procedure and Penalties manual, Recognised Investment Exchanges sourcebook, Enforcement Guide and Perimeter Guidance manual.
CP23/27 closes on 16 February 2024. After considering feedback, the FCA will make the necessary amendments to its rules and guidance.
CP 23/27 is available here.