Brexit’s impact on natural resource-intensive industries and commodity trading
Brexit’s impact on commodity trading
Implications of the UK’s exit from the EU without a treaty relating to commodity trading
A hard Brexit and its consequences on trades taking place on British commodity markets
The immediate implications of the UK’s exit from the EU without a treaty or without specifying the status of UK marketplaces regarding the forex markets and the European monetary policy were discussed and analyzed (for instance, the end of the IBOR) at length in past newsletters. Commodities traders and natural resource-intensive industries that for the intents and purposes of EMIR1 are deemed as Non-Financial Counterparty Minus (NFC-) and that trade in commodity derivatives on different UK market venues will have to face further challenges in connection with applicable EMIR rules.
If the status of UK exchanges remains uncertain, all of the trades currently deemed as ICE2, LME3 and LCH4 (and others) will, as of 1 January 2021, be considered as OTC derivatives according to the Ordinance. What this means is that, as of this moment, they will have to be included in the calculation of the clearing threshold. This could cause companies so far categorized as NFC- to exceed the EMIR-defined clearing thresholds and thus become NFC+5 according to EMIR. This, in turn, will have specific repercussions on the notification, reporting, clearing and margining duties and will require more risk mitigation techniques, thus making it considerably more expensive to trade. It could even call forth a lower rating.
Market participants now hope that the EU Commission in cooperation with the ESMA6 will leave the status of UK trading venues unchanged, thus avoiding the reclassification of certain derivatives as OTC transactions. If and when this will happen is anything but certain.
Three options open to NFC- companies
Generally, companies who conclude financial derivatives and who are deemed to be NFC- according to EMIR calculate whether the notional value of concluded OTC derivatives that do not have a measurable risk-mitigating effect exceeds the pre-defined clearing threshold7 in an asset class. In the case of a hard Brexit, the calculation method should be reviewed to make sure it properly allocates OTC derivatives and to check whether any clearing thresholds have been exceeded.
Below, we would like to draw attention to three different options which could help avoid a potential exceedance of the clearing thresholds.
- Taking on the risk of exceeding a threshold
If it should be impossible to implement the following options because of regulatory reasons or because they are too expensive, the company will have to examine the additional EMIR requirements due to having been identified as an NFC+ and implement relevant measures. This will give rise to the duty of clearing and margining. These extra implementation costs and the resulting daily business of clearing fees, keeping aside liquidity and changing processes and IT systems could make trading significantly more expensive for the companies concerned.
- Reducing the number of OTC derivatives
Obviously the most “pragmatic” solution to avoid exceeding the clearing threshold is to reduce the number of commodity derivatives traded on UK trading venues or to examine to what extent an ICE, LME or LCH derivative is needed and if necessary, move the trade to a trading venue in the EU. Should other market participants also switch to other trading venues for hedging transactions, UK trading venues will have to deal with lower liquidity for commodity derivatives, which could also have a negative impact on the costs related to derivatives trading.
- Reduction of relevant derivative contracts with objectively measurable risk reduction
Other options may be found in the application guidance8 issued by the BDEW9. Derivatives used to hedge a company’s or group’s business, liquidity or financial management risks for a portfolio (cf. Commission delegated Regulation (EU) 149/2013 recital 18, 3rd sentence) may be excluded when calculating the clearing threshold. To demonstrate this “portfolio view”, a company will have to review whether derivatives traded at a venue meet the following criteria stated in Commission delegated Regulation (EU) 149/2013 Chapter VII, Article 10(1):
a) that risks of potentially changing the value of assets, services, inputs, products, commodities or commitments are covered.
b) that risks of a potential indirect impact of fluctuating interest rates, inflation rates, exchange rates or credit risk of the values mentioned in a) are covered.
c) that it is classified as a hedge.
If an OTC derivative contract does not fulfill any of these criteria, they may still be recognized as objectively measurable risk mitigation for the company’s or group’s business activities, liquidity or finance management if it hedges risks as part of a proxy hedge or a portfolio hedge (cf. Commission delegated Regulation (EU) 149/2013 recital 18, 2nd and 3rd sentences) or because they must be entered into as the original hedge has become redundant due to changed circumstances and must now be canceled (cf. Commission delegated Regulation (EU) 149/2013 recital 19). We generally recommend reviewing whether these criteria are fulfilled and to consult your year-end auditor or EMIR auditor.
Another drawback that should not remain unmentioned: In view of the calculation procedure stated in Article 10(1)(a) of Regulation 648/2012 (EMIR) which was amended with Regulation no. 2019/834 (EMIR-REFIT), the clearing threshold is determined through the aggregated average month’s end exposure of the NFCs to each derivative class for the past twelve months. Moreover, if there is a short-term exceedance of the clearing threshold, the company or group will have a four-month-long transition period to adjust the exposure. As such, a bit of time remains until the new threshold calculation takes effect, so that the new measures do not necessarily have to be implemented by 1.1.2021. To what degree the new OTC transactions affect the threshold calculation depends on the trading volume of each company or group and will have to be examined individually.
Source: KPMG Corporate Treasury News, Edition 107, December 2020
1 European Market Infrastructure Regulation
2 Intercontinental Exchange
3 London Metal Exchange
4 London Clearing House
5 Non-Financial Counterparty Plus (NFC+): companies that fall into this category will be subject to EMIR regulations
6 European Securities and Markets Authority
7 According to the Commission delegated Regulation (EU) 149/2013 Art. 11
8 BDEW application guidance for the implementation of the EU Ordinance “EMIR“ that regulates over-the-counter derivatives trading, BDEW, 10.02.2014.
9 Bundesverband der Energie- und Wasserwirtschaft (German business association for the energy and water industries)
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