2.1.6 Commodity derivative dealers

122. Although commodity derivative dealers1 require a separate discussion, due to the various exemptions and tailored requirements in both MiFID and the CRD 2013 and CRR regime, the actual investment services and activities performed by these commodity derivative dealers and the inherent risks associated with these investment services and activities are similar to those ‘regular’ investment firms face when performing the investment services and activities. The operational and financial risks for investment firms, as discussed in Section 2.1.2, should thus similarly apply to these commodity derivative dealers. Due to the specific types of financial instruments these commodity derivative dealers trade in and the specific types of venues on which they execute their transactions, however, certain risks relating to the transactions in these specific financial instruments or on these specific venues will result in a different (and even enhanced) risk profile compared to that of a ‘regular’ investment firm.2 The starting point for analysing the prudential risk profile of a commodity derivative dealer is the same as that of other investment firms and is based on the investment services or activities provided or performed by that commodity derivative dealer. The specific activities and services which result in an investment firm being a commodity derivative dealer will, however, lead to different or additional risks for the commodity derivative dealer as compared to the risk described in Section 2.1.2. This section will highlight the differences in risk profiles between ‘regular’ investment firms and commodity derivative dealers.

123. Commodity derivative dealers3 have been excluded4 from regulation in the European Union ever since the introduction of MiFID I in 2004. ESMA stated that the exemptions in MiFID I “are intended to cover commercial users and producers of commodities, under the assumption that commercial firms and specialist commodity firms neither pose systemic risks comparable to traditional financial institutions nor interact with investors, who may be put at risk”.5 Although no clear justification for the exemption of commodity derivative dealers is included in the recitals of MiFID I, the recitals of the CAD 2006 provide some insight into the reasoning of the European legislators by stating that “the goal of liberalisation of gas and electricity markets is both economically and politically important for the Community. With this in mind, the capital requirements and other prudential rules to be applied to firms active in those markets should be proportionate and should not unduly interfere with achievement of the goal of liberalisation”.6 One may question, however, whether the remark in the ESMA report that these commodity derivative dealers do not pose systemic risk comparable to traditional financial institutions is appropriate. As discussed in Section 2.1.4, systemic risk as such should not be a determining factor for assessing the risk profile of an investment firm. The risk profile of commodity derivative dealers should be assessed along the lines of operational risk and financial risk. And when we compare these to other (or ‘regular’) investment firms, the risk profile of a commodity derivative dealer is indeed similar to that of an investment firm dealing in derivatives which are not related to commodities. The decision by the European legislator to generally exempt commodity dealers is therefore highly questionable, from a theoretical but also from a risk perspective. Investment services related to commodity derivatives are services related to financial instruments and the regulatory response should, therefore, be similar to the regulatory response for those investment firms that do not qualify as commodity derivatives dealers.

124. Furthermore, one could argue that, because of the specific types of financial instruments these commodity derivative dealers trade in, namely financial instruments based on commodities – such as oil, gas, emission allowances, agricultural products – the limited liquidity in these products as compared to shares and bonds and the limited number of venues on which these products can be traded,7 the operational risk for a commodity derivative dealer is greater than for an investment firm performing the same investment services for shares or bonds.

125. In Section 2.1.2, under ‘execution of orders’, the differences from a risk perspective of the investment firm, between transaction executed through an exchange and OTC transactions were discussed. As discussed, EMIR requires certain OTC transaction to be centrally cleared, whereby ESMA “shall develop and submit to the EC for endorsement draft regulatory technical standards specifying the class of OTC derivatives that should be subject to the clearing obligation”.8 The types of OTC contracts for which the EC, based on advice of ESMA, has required central clearing do not contain commodity derivatives, meaning that there is no legal central clearing requirement9 for commodity derivatives. As such the markets for commodity derivatives and the settlement processes on these markets can be less sophisticated then the markets for bonds or shares. This will increase the operational risk of the commodity derivative dealer as he is faced with a greater risk of settlement errors when dealing on these less sophisticated commodity markets.

126. Despite this, commodity derivative dealers have obtained a special niche within prudential regulation in the European Union, as they have been exempted from prudential supervision within the CRR framework, see Section 7.2.5. This special position had been preserved10 in the proposals for a new supervisory regime for investment firms, which will be discussed in Chapter 9.11 As will be elaborated in that Chapter, the final text of the IFR that applies from 26 June 2021 abolished this generic exemption from capital requirements, and this particular sector will become subject to stricter requirements in the future.