2.01  This chapter is about commodity trading houses, by which we mean companies that buy and sell physical commodities and commodity derivatives for their own account and/or on behalf of their customers. Commodity trading houses may be very specialist and deal in a few commodities only or they may have a wide-ranging business covering (p. 32) many different types of commodity. Examples of large and international commodity trading houses are Glencore, Trafigura, Vitol, and Cargill.

2.02  Commodity trading houses may form part of a wider group, where other parts of the group are in the business of producing commodities, whether that is by extracting them from the ground as a natural resource or manufacturing a usable product from one or more such resources. The commodity trading house may effectively be the marketing entity within the group—i.e. the entity whose function is to sell the product and sometimes also to buy any raw materials that are needed to produce it.

2.03  Sometimes that marketing entity will also enter into derivatives. Alternately, the derivatives trading business may be segregated into a separate legal entity. In particular, this can happen where a financial services authorization is needed for the derivatives trading activity, so as to isolate the regulatory obligations attached to the authorization from the rest of the business.

2.04  It is also common for groups that enter into derivatives to house that business in a single entity for practical and commercial reasons. For example, if that entity will trade on exchanges and other trading venues, it will need either to be a member directly or to have arrangements in place with one or more executing brokers, and there will be similar considerations in relation to clearing. The group may prefer such arrangements to be centralized in order to make efficient use of its resources. This may be particularly relevant in relation to capital, where a single entity will stand a better chance of being able to net exposures to counterparties and minimize margin requirements.

2.05  This chapter discusses the reasons why commodity trading houses might trade commodity derivatives and the different ways in which such trading can be undertaken. It then considers the regulatory regime applicable to commodity trading houses and the reasons why such companies may fall within the scope of financial services regulation in some countries. We then consider some of the main types of rules that might apply to a commodity trading house if it were to fall within the scope of regulation.

2.06  Hedging is probably the most obvious reason that a commodity trading house would want to buy and sell derivatives. Hedging is essentially about using derivatives to mitigate risk. There are several risks in the commodities world created by natural phenomena such as the finite supply of natural resources or the unpredictability of the weather, geographical considerations such as the market not being in the same location as production and the need to transport cargoes, and political factors which create restrictions on access to markets, such as sanctions. Some of these factors themselves and (p. 33) some of the derivatives that are entered into in order to hedge them may then create financial risks such changes in relative exchange rates.

2.07  To give a simple example of price risk, a farmer may be growing a crop of grain and may be concerned that the price of grain might fall between the time of sowing and harvest, meaning that he will not be able to sell the crop for as much money as he was hoping. To mitigate this risk, he might enter into a future to lock in a price at which to sell the grain. Of course, this will only work if there is another party that is willing to agree to buy the grain at the agreed price. This may be a bakery that is concerned that the price of grain will actually increase. However, it need not even be a party that has an interest in acquiring grain and, as we will see from some of the other motives, there may be market participants that are willing to take the opposite risk for a number of reasons.

2.08  Hedging has become quite an important concept in financial services regulation and is often used as means to differentiate those who should be subject to particular requirements from those that do not need to be. This has caused the law makers to have to define what hedging means and companies and regulators alike to have to interpret how narrow or broad these concepts are intended to be. This is not always straightforward and leads to differences of opinion and approach.

2.09  Speculation is the concept of entering into derivatives to make money from moves in the price of the underlying commodity, as opposed to insuring against that price move. Derivatives are a useful tool to achieve this because they give a party exposure to an asset without requiring them to hold that asset and that exposure can be many times the amount of money needed to enter into the derivative.

2.10  Hedging and speculation are often described as the two alternate reasons for buying and selling commodity derivatives and it is often assumed that commodity producers are hedging and that banks and hedge funds are speculating. While this might be a logical starting point, it is rarely as simple as that. This explains one of the reasons why commodity derivatives and those that enter into them have been brought within the scope of financial services regulation. It was felt that some commodity trading houses might not always be entering into derivatives to hedge their risk and that at some point their trades might become speculative and essentially be competing with the financial institutions. Some of the measures that have been taken in recent years are therefore about trying to create a more level playing field between those carrying on the same type of activity.

2.11  Speculation tends not to be defined by financial services legislation, because it is generally thought better not to define scope by reference to motive unless necessary because then analysis becomes somewhat subjective. In any event, if the scope of activities covered by a regulatory regime captures those undertaken by a participant that is (p. 34) speculating, there is no need to do so. The law makers have rather taken the approach of trying to carve out hedging where they have been convinced that this is appropriate.

2.12  Markets depend on liquidity or the availability of willing buyers and sellers. The idea of market making is to help create or support that liquidity and it is in fact sometimes referred to as liquidity provision. Therefore market makers are companies that participate in markets and hold themselves out as willing to enter into transactions, often on both the buy and sell side, at prices determined and usually published by them, on a regular, if not continuous, basis. Market making can be done both on and outside trading venues but is an activity more commonly associated with trading venues. In many jurisdictions, market makers need to be regulated to perform this activity although they are sometimes dispensated from the need to comply with certain rules on the basis that they are performing a form of service to the market.

2.13  Market making is such an important function for exchanges and other trading venues that they sometimes enter into agreements with participants which agree to act as market makers and incentivize them through discounts in fees or shares in the profit generated from the resulting transactions. In some jurisdictions, exchanges are required to treat market participants that act as market makers in practice as such and contractually oblige them to do so on an ongoing basis. In the EU, for example, trading venues must enter into agreements with market makers under which the firms must agree to post firm, simultaneous, two way quotes of comparable size and competitive prices for at least 50 per cent of daily trading hours during which continuous trading takes place, save in exceptional circumstances.

2.14  Regulators of the underlying commodities might also impose similar requirements, albeit for different reasons. For example, the UK’s energy regulator, the Gas and Electricity Markets Authority (OFGEM), requires large electricity suppliers to post prices at which they buy and sell wholesale electricity on power trading platforms up to two years in advance to trade at those prices.

2.15  Not all persons that want to enter into commodity derivatives can do so, especially where those commodity derivatives are traded on a trading venue. This is because trading venues usually have eligibility criteria about which types of person can become participants and use their trading facilities. Such criteria often relate to whether the person has appropriate regulatory status to enter into the transactions, whether they are appropriately set up in terms of IT connectivity and market abuse surveillance capability and whether they have sufficient capital and liquidity resources to support their (p. 35) activities. The way that other persons access the trading venue is therefore to ask a participant of the platform to execute a transaction on the trading venue for them. These people therefore become clients of the market participant.

2.16  The way in which this works depends on how the trading venue has set up its arrangements. In Europe, commodity derivative trading venues often require the participant to enter into transactions as principal, which means that the participant then has to enter into a separate derivative on the same, but opposite terms with its client. The alternative would be for a participant to enter into the derivative on the trading venue as agent for the client so that the client is the party to the derivative with the other participant in the market or, if it is a centrally cleared market, its central counterparty (CCP). This is explained in more detail in Chapter 3.

2.17  Many firms use computer algorithms to facilitate various different aspects of their trading.¹ This could be to determine which trading venue or venues to execute the transaction on; whether to break a large order down into smaller chunks; and whether to execute each ‘child’ order on different venues or at different times, or if trading conditions on different venues display certain characteristics, and to route those orders accordingly. In many cases, there is little or no human intervention in the way these algorithms operate once they are switched on.

2.18  Financial services regulators recognize that trading technology provides benefits to the market and market participants generally such as wider participation in markets, increased liquidity, narrower spreads, reduced short-term volatility, and the means to obtain better execution of orders for clients. However, they are alert to the risks that algorithms may pose including the overloading of the systems of trading venues due to large volumes of orders, risks of algorithmic trading generating duplicative or erroneous orders, or otherwise malfunctioning in a way that may create a disorderly market.

2.19  Modern regulatory requirements therefore seek to address these risks. For example, in EU legislation, there are now extensive and granular obligations on both firms and trading venues that use algorithms to ensure they have robust systems and internal controls around their design, procurement, testing, adoption, identification, use, ongoing monitoring, and ability to stop them in the event they appear to be causing disorderly or abusive trading. This responsibility is owned by senior management, but involves many other teams within the firm including Risk and Compliance as well as IT and Operations. Trading venues need to be able to identify orders that are generated by (p. 36) algorithms and between different algorithms so that they can determine which algorithm might be causing a problem and contact the persons responsible so that they can, if necessary, be shut down and re-tested or recalibrated. Both firms and trading venues also need to report transactions that are generated by an algorithm to the regulators so that they detect and investigate any potential market abuse the firm might be committing by using them.

2.20  High frequency trading is a sub-set of algorithmic trading where a trading system analyses data or signals from the market at high speed and then sends or updates large numbers of orders within a very short time period in response to that analysis.² In particular, high frequency algorithmic trading may contain elements such as order initiation, generating, routing, and execution which are determined by the system without human intervention for each individual trade or order, a short timeframe for establishing and liquidating positions, high daily portfolio turnover, a high order-to-trade ratio intraday, and ending the trading day at or close to a flat position. It is characterized by the use of infrastructure which is designed to minimize latency (i.e. the distance that the signal has to travel or the length of the physical cable that carries data from the trader’s computer to the intended trading venue). There are various ways that firms achieve low latency such as placing their servers in the data centre of the trading venue (known as co-location) or in the data centre of a third party located close to the trading venue (known as proximity hosting). A second and important characteristic is the sending of a high number of messages to the trading system constituting orders, quotes, and cancellations for transactions. High frequency trading is normally done by firms trading their own capital, as opposed to executing client orders.

2.21  While the regulators accept that high frequency traders are an important source of liquidity in many markets, they have raised concerns that the speed with which they can access information compared to the rest of the market creates an unfair dynamic which could give rise to potential conflicts of interest and market abuse, and may discourage other market participants from wanting to participate in the same markets. The regulators have sought to mitigate these risks by imposing greater requirements on firms undertaking a high frequency algorithmic trading technique.

2.22  Another form of access which is worth mentioning is direct electronic access. This is an arrangement where a member or participant of a trading venue permits another person (p. 37) (a user) to use its trading code so the user can electronically transmit orders directly to the trading venue.³ It includes arrangements that involve the use of the participant’s infrastructure or a connecting system provided by the participant to transmit the orders (known as direct market access), as well as arrangements where such infrastructure is not used by the user (sponsored access).

2.23  Direct electronic access is therefore a way to enable a non-participant to trade directly onto a market under the status of the participant. Although the markets need to know when an order has been submitted to their venues using direct electronic access, they treat such orders as those of the participant and require the participant to take responsibility for any transactions that are entered into as a result of its activity. The exchange may also set limits on the volume of transactions that a participant may permit its users to submit and participants may need to allocate such limits across a number of users and put in place controls to prevent such limits being exceeded.

2.24  Under some regulatory regimes, there are limits on who can grant direct electronic access and to whom it can be granted. For example, in the EU, a participant must be a bank or investment firm if they want to grant electronic access and they need to undertake appropriate due diligence on their users to ensure that they are suitable to trade on the market both at the outset of the arrangement and on an annual basis. Direct electronic access providers have an interest in such measures in any event as the exchanges usually require them to take wider responsibility for the behaviour of their users in the sense of monitoring for potentially abusive behaviour and contributing to disorderly trading on the market.

2.25  MiFID II is the EU’s Markets in Financial Instruments Directive and MiFIR is the Markets in Financial Instruments Regulation. These are level 1 or framework pieces of European legislation, which set out the framework which determines which activities and instruments are regulated in the EU, the requirements that authorized persons must comply with, the passporting regime and the basis for certain other structures such as regulated markets and data reporting service providers.

2.26  There are a number of further regulations that sit beneath MiFID II and MiFIR as the level 2 legislation and flesh out some of the detailed requirements described at level 1. These are a combination of regulatory technical standards and implementing technical standards, the former being more substantive and policy based and the latter being more procedural in nature. In addition, there are also level 3 materials, comprising (p. 38) guidelines and questions and answers published by ESMA which help to ensure that regulators and market participants interpret and implement the legislation consistently across Member States. These level 3 materials are not legally binding, but are of persuasive authority and of significance given their practical approach to achieving harmonization. The term MiFID II is sometimes used to describe the full set of arrangements or different parts of it.

2.27  MiFID II has been in place since January 2018. It replaced the previous regime which comprised the MiFID I, an implementing directive and an implementing regulation and various guidance that was published by the Commission and European Securities and Market Authority (ESMA), with a view to updating the regime and making it more comprehensive. Some of the key objectives were to further strengthen investor protection standards throughout the EU, to regulate the trading of commodity derivatives more tightly so as to create a level playing field and address issues with price volatility, to implement a G20 commitment to have standardized derivatives traded on organized platforms, and to reflect technological advancements and changes in market structure (such as high frequency trading) which were not adequately addressed in MiFID.

2.28  The adoption of both a directive and a regulation reflects a recent trend in European legislation which is intended to minimize the potential for national divergences across the EU. Under EU law, regulations are directly applicable law in each Member State, whereas directives are not and have to be implemented into national law. While directives like MiFID I worked on the basis of maximum harmonization, meaning that Member States are not permitted to impose additional requirements in the areas that are the subject of the directive, they still allow for differences in interpretation which undermine the aims of the single market. The idea is that anything that requires some degree of Member State flexibility is presented in the form of a directive, but anything where there can be no room for deviation is now included in a regulation.

2.29  The other important point to note is that, while MiFID II is EU legislation, it applies to other members of the EEA such as Iceland, Liechtenstein, and Norway where they have adopted it. Once the European Economic Area (EEA) State has adopted MiFID II, non-EU EEA firms are treated in the same manner as EU firms and are able to enjoy all the benefits of MiFID II such as passporting their services across Member States. At the time of writing, Iceland has not implemented MiFID II, and Liechtenstein and Norway have done so.

2.30  Under MiFID II, persons providing investment services or performing investment activities as a regular occupation or business on a professional basis are investment firms (p. 39) and are required to be authorized by the National Competent Authority of a Member State unless they are exempt.⁴

2.31  There are a number of investment services and activities but those that are most likely to be carried on by a commodity trading house are dealing on own account, executing orders on behalf of clients and reception and transmission of orders. Other investment services include investment advice, portfolio management, operating a multilateral trading facility (MTF), and operating a organized trading facility (OTF). There is no clear distinction between investment services and activities, although dealing on own account is generally thought to be the only activity as the others all involve providing a services to another person.

2.32  A person is only required to be authorized where they are providing an investment service or performing an investment activity in relation to a financial instrument. These include various types of commodity derivatives, exotic derivatives, and emission allowances and derivatives on emission allowances.

2.33  There are, however, a number of exemptions from the investment services and activities. If each part of a person’s business that would otherwise constitute an investment service or investment activity falls within an exemption, that person does not need to be authorized under MiFID II. It is important to note that, just because authorization is not required under MiFID II, it does not mean it is not required under another pieces of EU legislation or the domestic law of a Member State.

2.34  An investment firm can be any legal person. Member States may also authorize undertakings which are not legal persons provided that their legal status ensures an equivalent level of protection for third parties’ interests to that afforded by legal persons and such undertakings are subject to equivalent prudential supervision appropriate to their legal form.

2.35  If a person provides an investment service or performs an investment activity, and cannot rely on an exemption in respect of each part of that investment service or activity, it must apply to become authorized under MiFID II.⁵ Applications for authorization are submitted to the National Competent Authority of the Member State. Authorizations are granted in respect of specific investment services and activities in relation to specific financial instruments. Authorizations may also include permission to perform ancillary activities, for example, custody services⁶, but a person cannot be authorized to provide ancillary services only. Where an investment firm wishes to extend its business to additional investment services or activities or ancillary services or (p. 40) in respect of additional financial instruments not foreseen at the time of its initial authorization it is required to submit a request for extension of its authorization.

2.36  The competent authority will only grant authorization once it is fully satisfied that the applicant complies with all the applicable requirements set out in MiFID II. Authorization applications can take up to six months.

2.37  A competent authority may refuse an authorization request if it is not satisfied that the members of the management body are of sufficiently good repute, possess sufficient knowledge, skills, and experience and will commit sufficient time to perform their functions in relation to the investment firm. Additionally, if the competent authority believes there are objective and demonstrable grounds for believing that the management body of a firm may pose a threat to the firm’s effective, sound, and prudent management, to the adequate consideration of the interests of clients or to the integrity of the market, it may refuse authorization of the firm.

2.38  National Competent Authorities may withdraw an investment firm’s authorization in the following circumstances:⁷

• •  where the investment firm does not make use of its authorization within twelve months, it expressly renounces the authorization or has provided no investment activity for the preceding six months;

• •  where the investment firm obtains the authorization by making false statements, or by other irregular means;

• •  where the investment firm no longer meets the conditions under which the authorization was granted;

• •  where the investment firm has seriously and systemically infringed the provisions governing the operating conditions for investment firms; or

• •  where national law provides for withdrawal.

2.39  All Member States are required to maintain a register of all investment firms they have authorized and must ensure that investment firm’s authorization specifies the investment services or activities which the investment firm is authorized to perform. The register must be updated on a regular basis. National Competent Authorities must notify the ESMA of every authorization and withdrawal.

2.40  The G20 commitment to strengthen the financial markets including to regulate more tightly the trading of commodity derivatives resulted in a narrowing of the possible exemptions under MiFID II. Specifically, the commodity dealer exemption,⁸ which exempted companies trading in commodity derivatives on own account, was not included in MiFID II.⁹

(p. 41) 2.41  However, there are still a number of exemptions from authorization available under MiFID II, the most relevant of which to persons trading in commodity derivatives and emission allowances or derivatives on emission allowances are set out later. Each exemption is subject to a number of conditions. Persons relying on them must comply with conditions on a continuous basis. Where persons cease to satisfy the conditions they will no longer be able to rely on the exemption and must seek authorization as an investment firm unless they can rely on another exemption.

2.42  Entities providing investment services solely for their parent undertakings, for their subsidiaries or for other subsidiaries of their parent undertakings, are exempt from the authorization requirement under MiFID II.¹⁰ Under this exemption the only investment service that the entity can provide is to a group company. It is not permitted to provide any investment services to a third party. This is interpreted to apply to investment services as opposed to investment activities which means that firms can deal on own account on the markets provided they can rely on another exemption that applies to dealing on own account such as the ancillary activity exemption.

2.43  It is possible to combine exemptions under MiFID II. For example, the ability to combine reliance on the group exemption¹¹ with the own account dealing exemption¹² or the ancillary activity exemption¹³ is relevant to companies performing group treasury functions. This combination of exemptions is often used by commodity trading houses which have set themselves up such that they have a single market facing entity that enters into derivatives on trading venues to hedge risk arising from the activities of its affiliates, and then enters into back-to-back, intra-group derivatives with those affiliates.

2.44  A further exemption is available for firms which deal in commodity derivatives, emission allowances or derivatives thereof, where such trading activity is ancillary to their business on a group basis.¹⁴ It is important to note that this exemption cannot be used in respect of any other financial instruments such as transferable securities or foreign exchange (FX) derivatives.¹⁵ The exemption is subject to a series of conditions, but is particularly useful for entities which enter into derivatives in order to hedge their exposure to risks which arise as part of their commercial activity, such as commercial users or producers of commodities.

(p. 42) 2.45  The exemption can be used for two types of activity. First, it is available to persons dealing on own account, including market makers, but not where an entity deals on own account when executing client orders. Secondly, it can be used by persons providing investment services other than dealing on own account to the customers or suppliers of their main business. In each case, the exemption is conditional on the activity that would otherwise be within scope of MiFID II being ancillary to the person’s main business when considered on a group basis. However, that main business cannot include the provision of investment services or banking activities or market making in commodity derivatives. Further, the exemption is not available to entities which apply a high frequency algorithmic trading technique.

2.46  Persons wishing to rely on this exemption must notify their National Competent Authority on an annual basis and upon request report to the National Competent Authority how their trading activity is ancillary to their main business. Notification needs to be made by 1 April of the year for which the exemption applies. Each entity that is party to a commodity derivative and intending to rely on the exemption needs to make a notification. The notifications cannot be completed on a group basis.

2.47  There are strict quantitative parameters in place that establish which trades and volumes can be considered to be ‘ancillary’ to the main business of the group for these purposes. These are set out in a regulatory technical standard¹⁶ and comprise of two tests. Both tests need to be met in order to rely on the exemption.

2.48  The first test determines whether persons are large participants relative to the size of the financial market in that asset class and as a consequence should be required to obtain authorization. It looks at the trading activity of members of a group in each of eight asset classes being metals, oil and oil products, coal, gas, power, agricultural products, other commodities (including freight and exotics), and emission allowances or derivatives on them. For each asset class, this is calculated by comparing their trading activities in that class with the overall trading activity in the EEA for that class. For this test to be met, the trading activity of a person needs to be below the permitted threshold for each specific asset class.¹⁷ As commodity markets differ significantly, for example, in terms of size, number of participants, and liquidity, different thresholds apply for different asset classes. Depending on which of two versions of the second test is satisfied, the permitted threshold operates on a sliding scale so that the more important the person’s trading activity is to their group’s business, the lower the threshold on the size of their activity compared to the wider market.

(p. 43) 2.49  The second test determines whether the person’s trading activity is so extensive relative to the main business of the group that it cannot be considered to be ancillary at group level and that therefore the person should be required to obtain authorization. It provides two calculation methods in order to reflect the economic realities of the person intending to use the exemption and commodity trading houses can choose which one they want to use. The first method is the capital test, which measures the capital employed for carrying out the trading activity in the group against the capital employed at group level for carrying out the main business of the group. The second method measures the size of a person’s trading activity against the total trading activity of the group by references to derivatives it enters into. The person’s trading activity only needs to sit below the threshold of either method in order to meet this second test. The ESMA Questions and Answers (Q&A) on Commodity Derivatives¹⁸ that provides answers to many practical questions about these calculations should be understood and undertaken.

2.50  Certain transactions are considered to be ‘privileged’ and can be excluded from the calculations. These are:¹⁹

• •  intra-group transactions that serve group-wide liquidity or risk management purposes;

• •  transactions in derivatives that reduce risks directly relating to commercial activity or treasury financing activity; and

• •  transactions in commodity derivatives and emission allowances entered into to fulfil obligations to provide liquidity on a trading venue, where such obligations are required by regulatory authorities in accordance with EEA law; national laws, regulations, and administrative provisions, or by trading venues.

2.51  Additionally, transactions executed by a group member authorized under MiFID II or the Capital Requirements Directive²⁰ are also excluded from the tests.

2.52  It is therefore rather important for a commodity trading house to know which of its transactions are privileged. In order to ensure the scope of privileged transactions is not abused, several of the concepts are defined in the legislation or explained in the ESMA Q&A. For example, a derivative transaction can be considered objectively measurable as reducing risks when one or more of the following criteria is met:

• •  the transaction reduces the risks arising from the potential change in the value of assets, services, inputs, products, commodities, or liabilities that the person (p. 44) or its group owns, produces, manufactures, processes, provides, purchases, merchandises, leases, sells, or incurs, or reasonably anticipates owning, producing, manufacturing, processing, providing, purchasing, merchandising, leasing, selling, or incurring in the normal course of its business;

• •  the transaction covers the risks arising from the potential indirect impact on the value of assets, services, inputs, products, commodities, or liabilities referred to earlier, resulting from fluctuation of interest rates, inflation rates, foreign exchange rates, or credit risk;

• •  the transaction qualifies as a hedging contract pursuant to International Financial Reporting Standards.

2.53  A commodity trading house must have internal policies that describe the types of derivative used to reduce risks and their eligibility criteria, the link between the portfolio and the risks that it is mitigating, and the measures adopted to ensure that the transactions serve no other purpose than covering the risks directly related to the commercial activity or the treasury financing activity of the entity. It must, as a matter of practice, be able to identify any transaction serving a different purpose and provide a sufficiently disaggregate view of the portfolios in terms of class of derivative, underlying commodity, time horizon, and any other relevant factors.

2.54  MiFID II establishes two alternatives of liquidity provision programmes which can be excluded from the ancillary activity calculations: the first being transactions required by regulatory authorities and the second being based on requirements imposed by trading venues. An example of the first would be the market-making requirements established by OFGEM mentioned earlier. In order to qualify as the second type, requirements imposed by trading venues on liquidity providers have to be specified in advance by the trading venue and have to be subject to an enforceable agreement between the liquidity provider and the trading venue. The obligations of any liquidity provider have to go further than the activities of any normal market participant providing liquidity in a general sense. The agreement should contain provisions such as quoting requirements with maximum spread, minimum volume, minimum quote duration, and a maximum response time to provide quotes and a minimum participation rate²¹.

2.55  Where a person’s trading activity increases or alters so that it can no longer be considered to be ancillary to its main business and no other exemption is available, it will need to apply to its National Competent Authority for authorization.

2.56  In the March 2019 update to the ESMA Q&A, ESMA clarified that a third-country firm (including a third-country subsidiary of an EU firm) dealing on an EU trading venue in commodity derivatives or emission allowances or derivatives thereof is not in scope of the ancillary activity test. Consequently, such third-country firm does not have to (p. 45) notify any EU competent authority or ESMA that it makes use of the ancillary activity exemption.

2.57  A transmission system operator is a natural or legal person responsible for operating, ensuring the maintenance of and developing the transmission system in a given area and where applicable,²² its interconnections with other systems, and for ensuring the long-term ability of the system to meet reasonable demands for the transmission of electricity or gas.²³ Transmission system operators are excluded from the authorization requirement under MiFID II.

2.58  Transmission system operators are subject to specific certification and are supervised by sector-specific competent authorities. Further, they have specific obligations and responsibilities under their arrangements with the relevant competent authorities and are subject to network codes or guidelines. As a result, it is not considered necessary for such transmission system operators to be subject to the licensing requirement under MiFID II. In addition, service providers acting on behalf of transmission system operators to carry out their tasks required under legislation, network codes or guidelines, and any operator, administrator of an energy balancing mechanism, pipeline network, or system to keep in balance the supplies and uses of energy when carrying out such tasks, may also benefit from the exemption.

2.59  However, transmission system operators, their service providers and energy balancing mechanism, pipeline network, - system operators, or administrators are not able to benefit from this exemption where they are providing any other investment services or performing any other investment activities in financial instruments such as when operating a platform for secondary trading in financial transmission rights. The exemption is only available where they perform investment services or activities relating to commodity derivatives in order to carry out their tasks in these capacities.

2.60  Most requirements in MiFID II apply to investment firms, as will be evident in the following sections of this chapter. However, there are still certain requirements which will apply to entities that do not need to be authorized as investment firms. For example, the position limits regime applies to all ‘persons’ and not just investment firms. Similarly, the algorithmic trading requirements apply to members or participants of regulated markets and MTFs. Additionally the trading obligation, clearing obligation, (p. 46) and indirect clearing obligation applies to financial counterparties and non-financial counterparties that exceed the applicable clearing thresholds. These obligations are explained in other chapters.

2.61  Investment firms authorized under MiFID II are subject to a number of requirements that apply on an ongoing basis.²⁴ These can be broadly divided between prudential and conduct requirements. Prudential requirements relate to organization and capital resources, and conduct requirements are both investor protection related and market facing.²⁵

2.62  The organizational rules are designed to ensure a high level of integrity, competence, and soundness among investment firms. They relate to matters such as compliance, risk management, complaints handling, personal transactions, outsourcing, and the identification, management, and disclosure of conflicts of interest, some of which are described later. They tend to require investment firms to establish, implement, and maintain adequate systems and controls and policies and procedures to ensure compliance with the MiFID II. Some examples are provided later.

2.63  The overarching organizational requirements oblige investment firms to do the following, taking into account the nature, scale, and complexity of the business of the firm, and the nature and range of investment services and activities they undertake:

• •  maintain decision-making procedures and an organizational structure which specifies reporting lines and allocates functions and responsibilities;

• •  ensure that their relevant persons are aware of the procedures which must be followed;

• •  have internal control mechanisms designed to secure compliance with decisions and procedures at all levels;

• •  employ personnel with the skills, knowledge, and expertise necessary for the discharge of the responsibilities allocated to them;

• •  maintain effective internal reporting and communication of information at all relevant levels, maintain adequate and orderly records of their business; and

• •  ensure that the performance of multiple functions by relevant persons does not prevent those persons from discharging their functions soundly, honestly, and professionally.

2.64  Investment firms must maintain systems and procedures to safeguard the security, integrity, and confidentiality of information and an adequate business continuity policy aimed at ensuring, in the case of an interruption to their systems and (p. 47) procedures, the preservation of essential data and functions, and the maintenance of investment services and activities, or, where that is not possible, the timely recovery of such data and functions and the timely resumption of their investment services and activities. Investment firms must also maintain accounting policies and procedures that enable them to deliver to the competent authority on request financial reports which reflect a true and fair view of their financial position and which comply with all applicable accounting standards and rules. Investment firms must monitor and, on a regular basis, evaluate the adequacy and effectiveness of their systems and internal control mechanisms and arrangements, and take appropriate measures to address any deficiencies.

2.65  Most, if not all, investment firms are required to have a compliance function which is responsible for monitoring the adequacy and effectiveness of the measures, policies, and procedures and the actions taken to address any deficiencies in the firm’s compliance with its obligations, to advise and assist those carrying out investment services and activities to comply with the firm’s obligations, to report to the management body on the implementation and effectiveness of the overall control environment and the risks that have been identified, and to monitor the operations of the complaints-handling process.

2.66  Some investment firms will also have a risk management function although this may not be a dedicated person depending on proportionality. In any event, the firm must identify the risks to which it is subject, set the level of risk tolerated by the firm and ensure that the firms’ arrangements are designed and implemented in light of that level of risk tolerance.

2.67  Only the largest investment firms have their own internal audit teams and most rely instead on their group function to maintain an audit plan to examine and evaluate the adequacy and effectiveness of their systems and internal control mechanisms and arrangements.

2.68  Investment firms can outsource the performance of operational functions, including those which are critical for the provision of continuous and satisfactory service to clients or the performance of their activities provided they comply with a series of obligations. In particular, they must take reasonable steps to avoid undue additional operational risk and must not materially impair any internal controls or the ability of the supervisor to monitor the investment firm’s compliance with its obligations. It is also important to note that an investment firm cannot delegate responsibility for compliance with its regulatory obligations.

2.69  An investment firm’s organizational and administrative arrangements must take all reasonable steps to prevent conflicts of interest from adversely affecting the interests of the firm’s clients. Additionally, the policies and procedures an investment firm is required to implement must contain appropriate rules governing personal transactions by its managers, employees, and agents.

(p. 48) 2.70  Records of all services, activities, and transactions undertaken by the investment firm must be maintained in order to demonstrate that the investment firm has complied with all of its obligations. These records must be kept for a minimum period of five years. Where an investment firm has a branch in another EU Member State, the National Competent Authority of that Member State must be given direct access to the records.

2.71  Where an investment firm deals on own account or provides client order services which relate to the receipt, transmission, and execution of client orders, the records the investment firms is required to maintain includes telephone recordings, even where no transaction results from such telephone conversation. Therefore, investment firms must take all reasonable steps to record relevant telephone conversations and electronic communications and must notify new clients that it will record these communications. Clients may place orders with investment firms through durable mediums such as post, fax, email, or documentation of meetings, and records of these communications must also be maintained. Investment firms are prohibited from providing investment services and activities relating to the receipt and transmission or execution of client orders unless the clients have been notified in advance about the recording of their telephone communications or conversations.

2.72  A commodity trading house which holds financial instruments belonging to clients must make adequate arrangements in order to safeguard the ownership rights of the client. This is especially pertinent in the event of the investment firm’s insolvency. Further, the investment firm must ensure the use of a client’s financial instruments on the firm’s own account is prohibited except with the client’s express consent. Likewise, when holding client funds, commodity trading houses must make adequate arrangements to safeguard the rights of clients and prevent the use of client funds for its own account.

2.73  The management body of an investment firm must define, oversee, and be accountable for the implementation of the governance arrangements that ensure effective and prudent management of the investment firm including the segregation of duties in the investment firm and the prevention of conflicts of interest. The management body must carry out its duties in a manner which promotes integrity of the market and the interests of clients.

2.74  These arrangements must include:

• •  having overall responsibility for the institution and approving and overseeing the implementation of the institution’s strategic objectives, risk strategy, and internal governance;

• •  ensuring the integrity of the accounting and financial reporting systems, including financial and operational controls and compliance with the law and relevant standards;

• (p. 49) •  overseeing the process of disclosure and communications; and

• •  being responsible for providing effective oversight of senior management.

2.75  Further, a management body’s role involves defining, approving, and overseeing:

• •  the organization of the firm for the provision of investment services and activities and ancillary services including the attributes of the personnel, the resources, and the arrangements for the provision of these services and activities, taking into account the nature, scale, and complexity of its business and all the requirements with which the firm has to comply;

• •  a policy as to the services offered in accordance with the risk tolerance of the firm and the characteristics and needs of the clients of the firm. This should include carrying out stress testing where appropriate; and

• •  a remuneration policy of persons involved in the provision of services to clients to encourage responsible business conduct, fair treatment of clients as well as avoiding conflicts of interest in the relationships with clients.

2.76  The management body of an investment firm is required to monitor the adequacy and implementation of the firm’s strategic objectives, the effectiveness of the investment firm’s governance arrangements, and the adequacy of the policies relating to the provision of services to clients and take appropriate steps to remedy any deficiencies.

2.77  A chairman of the management body cannot, unless authorized by the National Competent Authority, simultaneously exercise the functions of a chief executive officer within the same investment firm. The management body of an investment firm must monitor the effectiveness of the institution’s governance arrangements and take appropriate steps to address any deficiencies²⁶.

2.78  Where the investment firm is significant in terms of its size, internal organization, and the nature, scope, and complexity of its activities, a member of the management body is not permitted to hold more than one executive directorship with two non-executive directorships, or four non-executive directorships, at the same time. National Competent Authorities may authorize members of the management body to hold one additional non-executive directorship. Where the investment firm is not significant, the number of directorships a member of the management body can hold at one time must take into account individual circumstances and the nature, scale, and complexity of the investment firm’s activities²⁷.

2.79  Members of the management body must be of sufficiently good repute and possess sufficient knowledge, skills, and experience to perform their roles. The composition of the management body must be adequately broad in range of (p. 50) experience. All members of the management body must commit sufficient time to perform their functions in the investment firm²⁸.

2.80  The management body of the investment firms must possess adequate collective knowledge, skill, and experience to be able to understand the firm’s activities including the main risks. Each member of the management body must act with honesty integrity and independence of mind. Their role includes to effectively assess and challenge the decisions of the senior management where necessary and to oversee and monitor management decision-making. The investment firm must devote adequate human and financial resources to the induction and training of members of the management body.

2.81  The investment firm and its nomination committee is required to engage a broad set of qualities and competences when recruiting members to the management body. They must ensure that a policy promoting diversity is in place.

2.82  The ESMA Guidelines²⁹ provide direction to investment firms in the assessment and appointment of their management body. They provide common criteria to assess the individual and collective knowledge, skills, and experience of members as well as the good repute, honesty, integrity, and independence of mind. The Guidelines provide a framework for assessing the time commitment expected of members of the management body and specify how the number of directorships should be counted. They also determine how diversity is to be taken into account in the process for selecting members of the management body.

2.83  Investment firms which are significant in terms of their size, internal organization, and the nature, scope, and complexity of their activities are required to establish a nomination committee composed of members of the management committee who do not perform any executive function. The nomination committee is required to identify and recommend candidates to fill management body vacancies and evaluate the balance of knowledge, skills, diversity, and experience of the management body. Further, the nomination committee is required to decide on a target for the representation of the underrepresented gender in the management body and prepare a policy on how to increase the number of underrepresented gender in the management body in order to meet that target.

2.84  Periodically the nomination committee is required to:

• •  assess and recommend any changes to the management body with respect to the structure, size, composition, and performance of the management body;

• (p. 51) •  assess and report to the management body on the knowledge, skills, and experience of individual members of the management body and the management body collectively; and

• •  review and recommend any changes regarding the policy of the management body for selection and appointment of senior management.

2.85  In performing its duties the nomination committee must take account the need for the management body’s decision-making to not be dominated by one individual or small group of individuals in a manner that is detrimental to the interests of the investment firm as a whole.

2.86  In order to ensure that investment firms have suitable shareholders or members, prior to the authorization of any firm, the National Competent Authority must be informed of the identities of the shareholders or members, whether direct or indirect, natural or legal persons that have qualifying holdings (being a holding of 10 per cent or more of the capital or voting rights) in the firm and the amounts of the holdings.³⁰ The National Competent Authority will then be able to make its assessment of the firm in the knowledge of the identities of its shareholders or members, to ensure its sound and prudent management. A ‘close link’ exists between two or more natural or legal persons where they are linked by participation in the form of ownership, direct or by way of control of 20 per cent or more of the voting rights or capital of an undertaking, one is a parent undertaking of the other or there is a permanent link of both of them to the same person by a control relationship. Where close links exist between the firm and any other legal or natural person, the National Competent Authority will only grant authorization if it believes the close link will not prevent the effective exercise of the supervisory function of the National Competent Authority, for example, where the laws, regulations, or administrative provisions of a third country governing the natural or legal close link might prevent the effective exercise of its supervisory functions.

2.87  Where influence exercised by persons is likely to be prejudicial to the sound and prudent management of an investment firm the competent authority may take appropriate measures to remedy the situation. These measures may include:

• •  applications for judicial orders or the imposition of sanctions against directors and those responsible for management; or

• •  the suspension of the voting rights attaching to the shares held by the shareholders or members in question.

2.88  Once authorized, an investment firm is required to continue to inform its National Competent Authority of its shareholders or members. Persons (natural or legal, or (p. 52) persons ‘acting in concert’) are required to notify in writing without delay and obtain the consent of the National Competent Authority prior to acquiring, directly or indirectly, a qualifying holding in an investment firm or to further increase its qualifying holding, as a result of which the proportion of the voting rights or of the capital held would reach or exceed 20, 30, or 50 per cent or so that the investment firm would become a subsidiary. The notification must include certain prescribed information concerning the proposed acquirers.

2.89  Persons wishing to dispose, directly or indirectly, of a qualifying holding in an investment firm, must notify in writing without delay the National Competent Authority indicating the size of the intended holding. Likewise, a person which has taken the decision to reduce his qualifying holding so that the proportion of the voting rights or of the capital held would fall below 20, 30, or 50 per cent or so that the investment firm would cease to be his subsidiary, must notify the Competent National Authority.

2.90  Where persons fail to notify and provide the required information to the National Competent Authority of a proposed acquisition or increase in qualifying holdings, the National Competent Authority may take similar appropriate measures as described above, such as making applications for judicial orders or the imposition of sanctions against directors and those responsible for management; or the suspension of the voting rights attaching to the shares held by the shareholders or members in question.

2.91  Where qualifying holdings are acquired or increased in opposition of the National Competent Authority, it may suspend the exercise of the corresponding voting rights or provide for the nullity or annulment of any votes cast.

2.92  The National Competent Authority will acknowledge receipt in writing of any notification regarding increasing or decreasing qualifying holdings in an investment firm within two working days.

2.93  Once notified of an intention to acquire or increase a qualifying holding in an investment firm, the National Competent Authority has a maximum of sixty working days from the date of its written acknowledgement of the notification and all documents required to carry out its assessment. During the assessment period the National Competent Authority may ‘stop the clock’ for a maximum of twenty working days where it needs to request further information from the proposed acquirer. If the proposed acquirer is located or regulated outside of the EU, this interruption may be extended to thirty working days.

2.94  National Competent Authorities must therefore appraise the suitability of any proposed acquirer and its financial soundness. In doing so the National Competent Authority uses the following criteria:

(p. 53)

• •  the reputation of the proposed acquirer;

• •  the reputation and experience of any person who will direct the business of the investment firm as a result of the proposed acquisition;

• •  the financial soundness of the proposed acquirer;

• •  whether the investment firm will be able to comply with any applicable prudential requirements and particularly whether the group of which it will become a part has a structure which makes it possible to exercise effective supervision; and

• •  whether there are reasonable grounds to suspect that money laundering or terrorist financing is being committed or attempted in connection with the proposed acquisition or there could be an increase in the risk thereof.

2.95  Upon completion of its assessment, the National Competent Authority must inform the proposed acquirer of its decision. Where the National Competent Authority has decided to oppose the acquisition it must inform the proposed acquirer within two working days and provide reasons for the decision. If the National Competent Authority does not oppose the proposed acquisition within the assessment period in writing it is deemed to be approved. The National Competent Authority may impose a maximum period for concluding the proposed acquisition and extend it where appropriate.

2.96  Investment firms subject to MiFID II are subject to the requirements of the Capital Requirements Directive (CRD)³¹ and the EU Capital Requirements Regulation (CRR).³² How the requirements around capital apply to an investment firm depends on the nature of the investment services or activities it undertakes and the consequential corresponding risk the investment firm might pose to the market. The CRR requires an investment firm to hold initial capital of EUR50,000, EUR125,000, or EUR730,000 on authorization depending on the activities it undertakes. Broadly, where an investment firm has permission to deal on own account it will be a ‘730k’ firm. Where a firm is not a 730k firm but has permission to hold client money or securities it will be a ‘125k’ firm. Finally, a commodity trading firm which receives and transmits orders and/or executes client orders but which is not able to hold client money or securities, will be a ‘50k’ firm.

2.97  Investment firms which are only permitted to undertake the MiFID II investment services and activities of reception and transmission of orders and/or investment advice and are not permitted to hold client money or undertake safeguarding and administration (p. 54) of investments, can be exempt CAD firms. Exempt CAD firms benefit from lower base capital requirements which comprise of the following options:

• •  base capital of EUR50,000; or

• •  professional indemnity insurance of EUR1,000,000 for any one claim and EUR1,500,000 in aggregate; or

• •  a combination of base capital and professional indemnity insurance resulting in an equivalent level of coverage to the options earlier.

2.98  In addition to the base initial capital requirement, investment firms are subject to ‘own funds’ requirements which require investment firms to hold further capital to protect against their exposure to various types of risk such as market, credit, and operational risk. The CRR³³ sets out certain exemptions from the CRD prudential requirements, including from the provisions on own funds, for investment firms whose main business consists exclusively of the provision of investment services or activities in relation to commodity derivatives³⁴ and to whom the Investment Services Directive³⁵ did not apply on 31 December 2006³⁶. The exemptions were included to allow regulators time to determine a prudential regime adapted to the risk profile of commodity dealers. Amendments to the CRR³⁷ extended the exemptions.

2.99  However, the European Commission has proposed that the legislative framework for prudential requirements for investment firms as set out in the CRR and CRD IV be replaced by a new Investment Firms Regulation and the Investment Firms Directive. The European Commission published its legislative proposals in December 2017. The Council of the EU and the European Parliament reached political agreement on the legislation in February 2019 and the Parliament adopted the legislation in April 2019.

2.100  The proposed requirements are intended to simplify the current complex prudential classification and to harmonize the approach taken to investment firm classification across the EU. It was put forward that the current regime does not appropriately reflect the nature, scale, and complexity of investment firm’s activities, which has led to situations where firms that conduct very similar activities and pose similar risks to the (p. 55) market are subject to varied prudential requirements. It is not intended that prudential requirements will increase significantly in practice.

2.101  The business conduct rules in MiFID II set out the way in which investment firms must carry on their business. Since many of these are client facing, they are also known as the investor protection provisions. According to the Commission:

they are designed to ensure a high level of investor protection to be applied in a uniform manner through the introduction of clear standards and requirements governing the relationship between an investment firm and its client. On the other hand, as regards investor protection, and in particular the provision of investors with information or the seeking of information from investors, the retail or professional nature of the client or potential client concerned should be taken into account.³⁸

2.102  There are actually three categories of client under the MiFID II framework: retail clients, professional clients, and eligible counterparties and the first task of an investment firm when facing a new client is to categorise the client accordingly. This determines which business conduct rules it must comply with when providing services or performing an activity for that client. The rules are designed such that retail clients get a higher level of protection than professional clients, which in turn get a higher level of protection than eligible counterparties. There is also a mechanism whereby firms can opt up clients from one category to another if they consider that they are sufficiently experienced and the firm follows the relevant procedural requirements, and clients can request to be opted down if they would prefer the protections afforded by a different category than that into which they naturally fall.

2.103  One of the key investor protection rules is that investment firms should act honestly, fairly, and professionally and in the best interests of their clients³⁹. While this is a rule, it can also be seen as a principle that informs many of the other, more detailed, rules, some of which are described later.

2.104  Providing information to clients is seen as an important way of protecting them as is reflected by the numerous rules that require firms to provide information to clients at all stages of their relationship. Investment firms must provide information about its status, the services it provides, the risks that are characteristic of the financial instruments and strategies involved in the services, and the execution venues it uses and all the costs and charges, in good time before it starts providing such services or the client is bound to receive them⁴⁰. This information, which is specified in further granularity in a delegated regulation⁴¹, can be provided in standardized form so (p. 56) many investment firms incorporate it into their standard terms of business. It must be provided in such a way that the client can easily understand it and in a durable medium so that the client can refer to it as needed in the future. All information must be clear, fair, and not misleading.

2.105  On an ongoing basis, investment firms must notify a client in good time about any material change to the information they have already provided. There are also various reporting requirements⁴². For example, an investment firm that executes client orders must provide a confirmation setting out the essential information concerning the execution of that order and the resulting transaction as soon as possible and no later than the first business day following execution. An investment firm must also provide information about the status of a client order at any time before it is executed if the client so requests. Portfolio managers must provide periodic statements setting out their activities and the content and value of the client’s portfolio at regular intervals which can be monthly, quarterly, or annually depending on their precise activities. Investment firms that hold client funds or financial instruments must provide a statement of those assets at least quarterly unless clients request something more frequent.

2.106  Information provision is an example of where some proportionality is demonstrated between different categories of clients with certain requirements only applicable to retail clients and certain provisions being dis-applied in relation to eligible counterparties, either with or without their consent.

2.107  There is a complicated set of rules that have developed in order to support obligations on firms to avoid potential conflicts of interests between the firm and the client⁴³. These essentially limit the circumstances in which an investment firm may pay or receive any fee, commission, or non-monetary benefit in connection with the provision of an investment service to or from a person other than the client. Investment firms that give independent investment advice or act as portfolio managers cannot accept and retain such benefits at all, unless they can be considered as minor non-monetary benefits.⁴⁴ Other investment firms can accept and retain them but only where they are designed to enhance the quality of service provided to the client and they do not impair compliance with the investment firm’s duty to act honestly, fairly, and professionally in accordance with the best interests of the client. Where an inducement is permitted, its existence, nature, and amount (or the means of calculating it) must be clearly disclosed to the client before the investment firms starts to provide its services. It should be noted that payments that are necessary for the provision of investment services, such as custody, exchange, and settlement fees, and which by their nature cannot give rise to conflicts of interest, are not treated as inducements.

(p. 57) 2.108  There are special provisions in relation to research, which mean that it need not be treated as an inducement where it is paid for by a firm using its own resources or a research payment account funded by a special charge levied on clients and in accordance with a research budget which is not linked to the volume or value of transactions executed on behalf of clients. Investment firms that provide both execution and research are therefore required to charge a separate amount for their research and any other services, which is not influenced by the level of payment received for execution services.⁴⁵

2.109  As the name suggests, these obligations are designed to ensure that clients make investments that are suitable and appropriate for their needs. The requirements are similar in concept but suitability applies to investment firms that perform portfolio management or give investment advice and appropriateness applies to investment firms that execute orders on an execution only basis.⁴⁶

2.110  Suitability requires the investment firm to obtain information from the client about their knowledge and experience of the type of financial instruments under consideration, their financial situation, including ability to bear losses and their investment objectives, including risk tolerance. The investment firm must undertake a suitability assessment on the basis of that information and only recommend investment services or financial instruments which are suitable for the client⁴⁷.

2.111  Appropriateness requires the investment firm to determine whether that client has the necessary experience and knowledge to understand the risks involved in relation to the product or investment service offered or demanded. If the investment firm believes this is not the case, it should warn the client that it is potentially inappropriate. The client may still insist on proceeding, in which case the investment firm will have to decide whether it can assist with the transaction⁴⁸.

2.112  Certain aspects of both obligations can be disapplied when dealing with professional clients so that they only apply to their fullest extent in relation to retail clients. It should be noted that a client cannot be categorised as an eligible counterparty for portfolio management or investment advice.

2.113  Best execution is one of the most trumpeted investor protection rules in MiFID II. It applies to investment firms when executing orders to take all sufficient steps to obtain the best possible result for the client taking into account price, costs speed, likelihood of execution and settlement, size, nature, and any other (p. 58) relevant consideration.⁴⁹ It also applies to investment firms that receive and transmit orders or act as portfolio managers where they place orders with other entities for execution⁵⁰.

2.114  Best execution is not therefore just about cost and these other execution factors can and should be taken into account where they are relevant, although where an investment firm executes an order for a retail client, the best possible result is determined in terms of total consideration, being the price of the financial instrument and costs relating to execution such as venue and clearing fees.

2.115  It is up to investment firms to determine how to achieve best execution and they must put in place arrangements for doing so and an order execution policy explaining those arrangements. Order execution policies should be sufficiently tailored to the type of financial instrument and order that needs to be executed, and they should also take into account the nature of the client and the execution venues available. Execution venues include not only trading venues such as regulated markets, MTFs, and OTFs but also systematic internalisers (SIs) and other liquidity providers.

2.116  Investment firms must provide appropriate and prescribed information to clients about their order execution policies which explain clearly how orders will be executed so that they can get their clients’ consent to the policy. Where an investment firm may execute orders outside a trading venue, it must make this possibility clear and get express consent to this. Investment firms must also be able to demonstrate to clients, at their request, that they have executed an order in accordance with the order execution policy. If a client wants its order to be executed in a specific way, the investment firm can agree to follow the client’s instructions, but the best execution policy will still apply to any aspects of the order that have not been so specified.

2.117  Investment firms must also publish information about how they have achieved best execution on an annual basis. This must include, for each class of financial instrument in which they execute orders, their top five execution venues by volume of trading and an analysis of the quality of execution obtained. In order to compile this information, investment firms can use information which trading venues are required to publish on a quarterly basis about the quality of execution they have provided.

2.118  Investment firms must monitor the effectiveness of their execution arrangements and correct any deficiencies. In particular, they must assess on a regular basis whether the execution venues they have chosen provide for the best possible result on a consistent basis. They must notify clients of any material changes they make.

2.119  Although it might be easier to apply the best execution requirements in relation to exchange traded and liquid commodity derivatives, they apply to all types of financial instrument. When executing orders over the counter (OTC), including bespoke (p. 59) products, the investment firm should check the fairness of the price proposed to the client by gathering market data used in the estimation of the price of such product and, where possible, by comparing with similar or comparable products.

2.120  An SI is an investment firm which, on an organized, frequent, systematic, and substantial basis deals on own account when executing client orders outside a regulated market,⁵¹ an MTF or an OTF without operating a multilateral system.⁵² An investment firm can be an SI in relation to any sub-asset class of derivatives, such as metal commodity swaps or energy commodity futures.

2.121  The key feature distinguishing an SI from a market place is that an SI is a counterparty rather than a trading venue. It operates a bilateral system and unlike a trading venue, does not bring together third party buying and selling interests. SIs should not consist of an internal matching system which results in matched principal trading on a regular basis, which indicates that SIs should enter into risk-facing transactions save on an occasional basis.

2.122  SIs are subject to various requirements under MiFIR.⁵³ In particular, they must notify their National Competent Authority. ESMA maintains a list of all SIs across the EU. It is therefore essential for investment firms to understand whether they fall within the definition in order to ensure they comply with the relevant obligations.

2.123  There are specific rules around when an investment firm is considered to be an SI as set out in Delegated Regulation⁵⁴ with the aim of including investment firms where their OTC trading is of such a size that it has a material effect on price formation, but excluding OTC trading of such a small size that it would be disproportionate to include such investment firms in the definition. In summary, an investment firm will be considered to be an SI in respect of all derivatives belonging to a class of derivatives where, in the last six months in relation to any such class of derivative:

• •  for which there is a liquid market, the number of OTC transactions carried out by it on own account when executing client orders is equal to or larger than 2.5 per cent of the total number of transactions in the relevant class of derivatives executed in the EU on any trading venue or OTC and the OTC transactions carried out by it take place on average once a week; or

• •  for which there is not a liquid market, the OTC transactions carried out by it take place on average once a week; and

• (p. 60) •  the OTC transactions carried out by it are equal to or larger than 25 per cent of the total turnover in that class of derivatives executed by the investment firm on own account or on behalf of clients and executed on a trading venue or OTC; or

• •  One per cent of the total turnover in that class of derivatives executed in the EU on a trading venue or OTC.

2.124  The calculations should be undertaken at legal entity level and should include the activity of EU investment firms operating branches in the EU. Where an SI undertakes matched principal trading, the two transactions are considered economically as one trade and would not be considered to be executed individually.

2.125  ESMA is tasked with publishing the total volume and number of transactions undertaken in the EU in each specific instrument or class/sub-class of instrument to enable entities to undertake the calculations. Currently, ESMA has only published data for equity and equity like instruments and bonds and the publication for all other asset classes has been delayed until 2020. Therefore, the SI assessment for entities entering into derivatives does not need to be performed until 2020.

2.126  However, an investment firm may choose to opt-in to the systematic internaliser regime and comply with the applicable rules. An investment firm which opts-in can decide in which specific instruments it wants to be a systematic internaliser. With respect to derivatives, an investment firm may choose the individual derivatives for which it opts-in and is not bound to opt-in for the entire sub-class of derivatives to which the individual derivative belongs.

2.127  One of the reasons some investment firms want to be SIs in relation to derivatives is that, where an SI enters into a derivative with an investment firm which is not an SI, the SI will be responsible for both counterparty’s post-trade transparency obligations⁵⁵, and many non-SI investment firms prefer to use SIs to execute trades outside a trading venue for this reason. Where both parties are SIs, the seller of the instrument is responsible for making the transaction public through an Approved Publication Arrangement.

2.128  The obligations of SIs most relevant to commodity trading houses are set out in MiFIR.⁵⁶ SIs are required to make public firm quotes in respect of derivatives traded on a trading venue for which they are a SI and for which there is a liquid market when they are prompted for a quote by a client of the SI or they agree to provide a quote.⁵⁷ Where there is not a liquid market, SIs must disclose quotes to their clients on request if they agree to provide a quote, unless the obligation has been waived in accordance with MiFIR.⁵⁸(p. 61) Any quotes published by an SI must be made available to the SIs other clients and SIs must enter into transactions under the published conditions with any other client to whom the quote is made available. However, SIs are able to protect themselves in a few ways. They are permitted to implement a commercial policy setting out the type of clients to whom they are prepared to give access to their quotes, provided this is done in an objective and non-discriminatory manner, and are permitted to establish non-discriminatory and transparent limits on the number of transactions they undertake to enter into with clients pursuant to any given quote. Therefore, SIs are required to have in place clear standards for governing access to their quotes. Further, SIs are permitted to refuse to enter into or terminate a business relationship with clients on the basis of commercial considerations, for example, client credit status or counterparty risk.

2.129  SIs may update their quotes at any time provided that the updated quotes are the consequence of, and consistent with, genuine intentions of the SI to trade with its clients in a non-discriminatory manner. SIs may only withdraw the quotes published under exceptional market conditions. This would include where the provision of firm quotes to clients would be contrary to prudent risk management and where the trading venue where the instrument was first admitted to trading or is the most relevant to market in terms of liquidity either halts trading of that instrument in accordance with MiFID II or allows market-making obligations to be suspended.

2.130  As the SI is entering into a transaction with a client, it is subject to the best execution rules under MiFID II. Therefore, it is required to ensure that the quoted price complies with these obligations and reflects prevailing market conditions in relation to prices at which transactions are concluded for the same or similar financial instruments on a trading venue. However, in justified cases, an SI may execute an order at a better price provided that the price falls within a public range close to market conditions.

2.131  SIs are not required to publish firm quotes when they deal in sizes above the size specific to the financial instrument. Further, National Competent Authorities are able to waive the obligation on SIs to make public the quotes where the orders are large in scale compared with normal market size, or where the derivative is illiquid.

2.132  An investment firm’s authorization is valid for the entire EU and allows an the investment firm to provide the services or perform the activities it is authorized to provide or perform throughout the EU either through the freedom to provide services or a right of establishment. This is known as ‘passporting’.⁵⁹

2.133  Investment firms are able to provide investment services and/or perform investment activities across the EU provided these services and activities are covered by its authorization in its home Member State.⁶⁰ An investment firm is also permitted to perform ancillary services provided it does so in conjunction with an investment service or activity. When providing investment services or performing investment activities, the ‘host’ Member State, the Member State in which the investment firm is ‘passporting’ into, is not permitted to impose any additional requirements on the investment firm.

2.134  When an investment firm wishes to begin providing investment services or performing investment activities in another Member State, or wishes to amend the range of services or activities it currently provides in a host Member State, it must communicate to its National Competent Authority its ‘programme of operations’ containing its name, address, and contact details in addition to the name of a specific contact persons at the investment firm;

• •  the host Member State in which it intends to operate; and

• •  the investment services and/or activities and any ancillary services which it intends to provide and the financial instruments it will provide.

2.135  The National Competent Authority will forward this information on to the National Competent Authority of the host Member State within one month of receipt at which point the investment firm may start to provide the relevant investment services and/or activities in the host Member State. Where an investment firm wishes to change its programme of operations, it must notify its National Competent Authority at least one month before implementing any changes. This includes information concerning any withdrawal or cancellation of authorization.

2.136  Another method of passporting services into another Member State is to establish a branch in that Member State through which the investment firm may provide investment services or activities, and ancillary services covered by its authorization in its home Member State.⁶¹ Alternatively, investment firms may use a tied agent established in another Member State to provide these investment services or activities, and ancillary services.

2.137  As is the case with investment firms providing cross-border services, where an investment firm establishes a branch in another Member State, the host Member State is not permitted to impose any additional requirements on the investment firm in respect of the organization or operation of the branch.

(p. 63) 2.138  Where an investment firm wishes to establish a branch in another Member State, it must notify its home Member State’s National Competent Authority of:

• •  its name, address, and contact details in its home Member State in addition to the name of a specific contact persons at the investment firm;

• •  name, address, and contact details in the host Member State of the branch or of the tied agent from which documents may be obtained;

• •  the name of the persons responsible for the management of the branch;

• •  reference to the location, electronic or otherwise, of the public register where the tied agent is registered (if relevant); and

• •  a programme of operations.

2.139  The programme of operations must include:

• •  a list of the investment services and activities, any ancillary services, and the financial instruments the investment firm will provide;

• •  an overview of how the branch or tied agent will contribute to the investment firm’s strategy;

• •  whether the investment firm is a member of a group and what the main functions of the branch or tied agent will be;

• •  a description of the type of client or counterparty and how the investment firm or tied agent will obtain and deal with those clients or counterparties;

• •  certain information regarding organizational structure;

• •  details of the individuals performing key functions in the branch or tied agent;

• •  details of any outsourcing arrangements critical to the operations of the branch or tied agent;

• •  details of the systems and controls that will be put in place; and

• •  forecast statements for profit and loss and cash flow over the first thirty-six-month period.

2.140  The National Competent Authority will forward this information and details of the accredited compensation scheme of which the investment firms is a member on to the National Competent Authority of the ‘host’ Member State within three months of receipt of all of the required information. On receipt of notification from the host Member State’s National Competent Authority the investment firm may establish the branch in the host Member State and commence business. If the host Member State’s National Competent Authority fails to notify the investment firm that it may establish a branch, the investment firm may do so after two months from the communication by the home National Competent Authority to the host National Competent Authority.

2.141  It should be noted that the requirements set out above are the regulatory requirements and are additional to any requirements that might exist as a matter of company, employment, tax, and administrative law in respect of setting up and registering branches in each Member State. These requirements should also be taken into account.

2.142  A tied agent is a person who, acting under the full responsibility of an investment firm, acts on behalf of only that investment firm to promote investment and ancillary services to clients, receives and transmits instructions or orders from the clients in respect of investment services or financial instruments, and places financial instruments or provides advice to clients in respect of those financial instruments or services. If an investment firms intends to use tied agents established in the ‘home’ Member State to provide the investment services and/or activities in the host Member State, the investment firm must communicate the identity of the tied agent to the home National Competent Authority in its programme of operations and it will communicate this to the host National Competent Authority within one month of receiving this information. The host National Competent Authority is obliged to publish this information.

2.143  In some cases it is clear when an investment firm will be undertaking investment services or activities in another Member State. However, there are circumstances where it is not clear in which Member State a service or activity is being undertaken. Member States use different tests to establish where an investment service or activity is undertaken. For example, some Member States use the ‘characteristic performance test’ which looks at where the ‘essential supply for which payment is due’ is undertaken, i.e. where the service is carried out in practice. However, other EEA States take a different view and instead apply a solicitation test which looks at whether it is the consumer or the provider that initiates the business relationship.

2.144  A Member State may give guidance as to whether an investment service or activity is undertaken in that Member State. For example, the UK is generally understood to apply a characteristic performance test so, a UK broker that receives orders by telephone from a customer in France for execution on a UK exchange may be deemed to be undertaking the investment service in the UK and it would be irrelevant that the customer was in France.⁶² In Belgium, not only is the actual performance of the investment services or activities considered but also the offering of those services. Therefore, if an investment firm advertises its services to investors in another Member State, whether by moving there, by means of distance selling technologies or through advertisements other than publicity, that investment firm will be considered to be performing investment services or activities in that Member State.^63,64

2.145  The National Competent Authority required to regulate and supervise a passporting investment firm depends on whether it is passporting on a branch or a services basis and which investment services and activities it is undertaking.

2.146  In general, an investment firm undertaking investment services on a cross-border basis will remain supervised by its home State National Competent Authority. Where an investment firm provides services in another EEA State by establishing a branch, the supervision of the investment firm is split between the home and host State National Competent Authorities. MiFID II specifies that the host State National Competent Authority is responsible for ensuring the investment firm’s compliance with certain organizational and operational conditions, including:

• •  conduct of business obligations;⁶⁵

• •  product governance;⁶⁶

• •  information provided to clients and potential clients;⁶⁷

• •  inducements;⁶⁸

• •  remuneration;⁶⁹

• •  cross-selling;⁷⁰

• •  suitability and appropriateness;⁷¹

• •  best execution;⁷²

• •  client order handling;⁷³

• •  transparency requirements;⁷⁴ and

• •  transaction reporting requirements.⁷⁵

2.147  All remaining obligations are to be enforced by the home State National Competent Authority. MiFID II also provides that host State National Competent Authorities have authority to examine branch arrangements and also to undertake on-site inspections in the branch.

2.148  A third country firm is a firm established outside of the EEA which would be an investment firm or credit institution if its head office or registered office were located (p. 66) within the EU. Prior to the implementation of MiFID II, the provision of services by third country firms in the EU was subject to the national law of the relevant Member State in which the services were provided. Further, there was no concept of a passport for third country firms. MiFID II aimed to harmonize this by providing a single set of rules which could be applicable across all Member States and to provide the ability for some investment firms to provide services across the EU. However, full harmonization has not yet been achieved because some of the provisions, namely those requiring establishment of a branch, are optional and therefore each Member State has the option of whether to apply them or not. Other rules, such as those relating to the provision of services without needing to establish a branch are set out in MiFIR and are therefore directly applicable in all Member States. However, they rely on the adoption of equivalence decisions which have not yet been made.

2.149  How a third country firm accesses the EU market will in part be determined by the types of clients it intends to provide its services to. This is because the rules set out in MiFID II and MiFIR apply to third country firms differently depending on the client type. Where a third country firm intends to provide services to larger and more sophisticated clients such as eligible counterparties and per se professional clients, it may do so to clients across the EU without having to establish a branch by registering with ESMA once the third country has been deemed equivalent to the EU regime for these purposes. However, where a third country firm wishes to provide services to less experienced clients such as retail and opted up professional clients, the national rules of each Member State will apply and it may be required to establish and authorize a branch, if not a subsidiary, in each Member State. Where a third country firm establishes a branch in a Member State under the MiFID II regime, that branch can provide services to eligible counterparties and per se professional clients in other Member States without having to establish further branches, and this creates something akin to a passporting regime for third country firms in these limited circumstances.

2.150  A third country firm may provide investment services and activities to per se professional clients and eligible counterparties without the need to establish a branch where it is registered with ESMA. ESMA may register a third country firm only where the following conditions are satisfied:

• •  the European Commission has adopted an equivalence decision with respect to the prudential and business conduct requirements in the firm’s third country;

• •  the Commission has concluded that the third country also has an effective equivalent system for the recognition of investment firms authorized under third-country legal regimes;

• •  the third country firm is authorized and under effective supervision and enforcement in the provision of the investment services or activities; and

• (p. 67) •  cooperation agreements exist between ESMA and the third country’s national competent authority relating to the exchange of information and the coordination of supervisory functions.

2.151  An equivalence decision requires the Commission to state, in relation to a third country, that its legal and supervisory arrangements ensure that firms authorized in that third country comply with legally binding prudential and business conduct requirements which have equivalent effect to the requirements set out in MiFID II, MiFIR, and CRD IV and their respective implementing measures, and that the legal framework of that third country provides for an effective equivalent system for the recognition of investment firms authorized under third country legal regimes. There are therefore two aspects to it: equivalence and reciprocity.

2.152  The prudential and business conduct framework of a third country may be considered to have equivalent effect where it fulfils all the following conditions:• firms providing investment services and activities in that third country are subject to authorization and to effective supervision and enforcement on an ongoing basis;

• •  firms providing investment services and activities in that third country are subject to sufficient capital requirements and appropriate requirements applicable to shareholders and members of their management body;

• •  firms providing investment services and activities are subject to adequate organizational requirements in the area of internal control functions;

• •  firms providing investment services and activities are subject to appropriate conduct of business rules; and

• •  it ensures market transparency and integrity by preventing market abuse in the form of insider dealing and market manipulation.

2.153  As is the case with the establishment of a branch set out later, the requirement for the third country firm to be authorized in its home third country will restrict the scope of services a regulated third country entity can provide to the extent that any such services are not regulated in the third country.

2.154  At the time of writing, the European Commission has not as yet adopted any equivalence decisions with respect to the prudential and business conduct requirements of a third country firm’s country and as such, this process cannot be used.

2.155  Once the European Commission has adopted the relevant equivalence decision, a third country firm will be able to submit its application to be on the ESMA register. Within thirty working days of receipt of all required information, ESMA is obliged to assess whether the application is complete, and if it concludes it is not, to set a deadline for submission of any further information. Once the completed application is submitted, ESMA has 180 working days in which to inform the applicant third country firm whether its application has been accepted of refused.

2.156  Once registered with ESMA, Member States are not permitted to impose any additional requirements on a third country firm in respect of matters covered by MiFID II (p. 68) or MiFIR and are also not permitted treat the third country firm more favourably than an investment firm established in the EU.

2.157  Third country firms providing services pursuant to this registration must inform clients before providing any investment services that they are not permitted to provide services to clients other than eligible counterparties and per se professional clients and that they are not subject to the supervision in the EU. Third country firms must also indicate the name and address of the Competent Authority responsible for their supervision in the third country. Additionally, the third country firm must offer to submit any disputes arising in relation to any services or activities it undertakes to the jurisdiction of a court or arbitral tribunal in a Member State.

2.158  ESMA may withdraw registration of a third country firm from the register where it has well-founded reasons based on documented evidence to believe that in the provision of investment services and activities in the EU, the third country firm is acting in a manner which is clearly prejudicial to the interests of investors or the orderly functioning of markets or the third country firm has seriously infringed the provisions applicable to it in the third country and on the basis of which ESMA has adopted any equivalence decision.

2.159  Until an equivalence decision is adopted in respect of a third country and for a further three years after that, third country firms from that third county are able to continue to provide investment services and perform investment activities to eligible counterparties and per se professional clients in a Member State in accordance with the national regime of that Member State⁷⁶. This means, for example, that third country firms are currently able to perform investment services and activities in the United Kingdom pursuant to the overseas persons exclusion set out in the UK’s Regulated Activities Order⁷⁷ and would, if the UK were to continue to be in the EU for that long, be able to do so for three years following an equivalence decision in relation to that third country.

2.160  Provisions set out in MiFID II permit Member States to require a third country firm intending to provide investment services or activities to retail clients or opted up professional clients in their territory through a branch authorized in that Member State.⁷⁸ This provision is optional and therefore not all Member States, including the UK, have implemented this Article and instead continue to impose their national regimes.

2.161  Where a Member State does permit third country firms to provide services to retail and opted up professional clients by establishing branches under the MiFID II regime, third (p. 69) country firms are only able to apply for authorization as a branch where they meet certain conditions. These conditions are:

• •  the services or activities which the third country firm wishes to provide in the Member State are subject to authorization and supervision in the jurisdiction where the third country firm is established and the third country firm is authorized in that jurisdiction to provide such services or undertake such activities;

• •  the third country jurisdiction pays due regard to the Financial Action Task Force recommendations relating to anti-money laundering and counter-terrorist financing;

• •  there exists cooperation arrangements between the Member State’s National Competent Authority and the third country regulator relating to the exchange of information for the purpose of preserving the integrity of the market and protecting investors;

• •  the third country branch has sufficient capital at its free disposal;

• •  one or more persons must be appointed to be responsible for the management of the branch and these persons comply with the governance requirements set out in MiFID II;

• •  there exist a tax information sharing agreement (complying with the standards set out in the OECD Model Tax Convention) between the Member State and the third country firm’s jurisdiction; and

• •  the third country firm belongs to an EU investor compensation scheme.

2.162  A number of issues arise as a result of this provision permitting Member States to require third country firms to establish an authorized branch in their Member State. Firstly, the conditions set out in MiFID II require that the services the third country firm wishes to offer be subject to authorization and supervision in its home third country. Further the third country firm must be authorized in its third country to provide these services. Therefore, a detailed mapping of the relevant investment services and activities between the third country jurisdiction and the EEA is required and problems arise given the range in definitional scope of services and activities in the EU and outside of the EU. Where a service is unregulated in the third country but is considered an investment service or activity under MiFID II, this will restrict the third country firm from being able to provide this service in the Member State. Further, a firm which is unregulated in the third country will be excluded from the possibility of establishing an authorized branch in the Member State.

2.163  A third country firm wishing to establish such a branch must provide the competent authority of the Member State with certain information including the name of the authority responsible for its supervision in the third country, all relevant details of the firm and a programme of operations setting out the investment services and/or activities to be provided and the organizational structure of the branch, including a description of (p. 70) any outsourcing of essential operating functions, the name of the persons responsible for the management of the branch and the relevant documents to demonstrate compliance with MiFID II requirements relating to its management body and information about the initial capital at free disposal of the branch.

2.164  The competent authority of the Member State where the third country firm intends to establish its branch can only grant authorization when it is satisfied that the conditions above are fulfilled and that the branch will be able to comply with the MiFID II provisions that will apply to it. The competent authority has six months from receipt of a complete application to decide whether to grant authorization. The applicable requirements are those relating to organization, conflicts of interest, and suitability, appropriateness, and best execution in MiFID II, and those on transparency and transaction reporting in MiFIR. The branch will be subject to the supervision of the competent authority in the Member State where the authorization is granted. Member States are not permitted to impose any additional requirements on the organization and operation of the branch in respect of the matters covered by MiFID II and must not treat any branch of third country firms more favourably than EU firms.

2.165  It should be noted that a branch that has been authorized in this way of a third country firm of a country in respect of which the Commission has made an equivalence decision may provide its services to eligible counterparties and per se professional clients in other Member States without having to establish branches in each of them. The branch remains subject to the supervision of the Member State in which it is established and must provide the same information to potential clients as those third country firms that are registered with ESMA to provide services on a cross-border basis. This provides much more flexibility than for third country firms dealing with retail and opted up professional clients because they must set up a branch in each Member State where they have clients, assuming of course that the Member State has adopted this regime. Otherwise they must comply with the national requirements of that Member State, which may require the third country firm to set up an authorized subsidiary.

2.166  The requirements for authorization by a National Competent Authority or, in the case of third country firms dealing with eligible counterparties and per se professional clients, registration with ESMA, do not apply where a client established or situated in the EU initiates at its own exclusive initiative the provision of an investment service or activity by the third country firm.

2.167  However, this ‘exclusion’ does not permit the third country firm (through its branch, where one is required) to market new categories of investment product or investment services to these individuals, i.e. once the relationship is established, any provision of a new service or provision of a service in relation to a new product must also be at the (p. 71) exclusive initiative of the client.⁷⁹ In other words, the exclusive initiative test applies on a service by service, rather than a relationship basis.

2.168  In practice this exclusion does not operate in the same manner across the European Union because different Member States have different interpretations of what reverse solicitation is.

2.169  In the aftermath of the Enron-situation in the US in which Enron has grown so large to be able to manipulate power prices in the US, the Europeans have introduced a law regulating wholesale energy markets. Regulation on the Wholesale Energy Market Integrity and Transparency (REMIT) intends to regulate the wholesale energy markets which are a key element for the functioning of the European society and to ensure the integrity and confidence in the electricity and gas markets. Prices in the wholesale markets should be set fairly and reflect a competitive interplay between supply and demand. No profits should be drawn from market abuse and consumers and other market participants.⁸⁰ REMIT is the centrepiece of the EU regulatory framework about market abuse. It contains provisions against insider trading (Art. 3) and market manipulation (Art. 5), but also requirements with which market participants have to comply with, such as the obligation publication of inside information (Art. 4), or the obligation to monitor trading activities (Art. 7). Market participants that are active in the European market must register themselves with the national regulatory authority (Art. 9 para. 1). Compliance with the provisions under REMIT is supervised and monitored by ACER located in Ljubljana and the responsible national competent authorities.

2.170  REMIT is complemented by a group of additional regulations which deal with establishment of ACER,⁸¹ but also specific energy wholesale products such as natural gas,⁸² or electricity,⁸³ as well as for the access to natural gas transmission networks⁸⁴ and networks for cross-border exchanges in electricity.⁸⁵ These regulations and provisions (p. 72) deal, however, primarily in physical trading activities in wholesale energy products. The provisions on the prohibition on insider dealing and market manipulation under REMIT do not apply to wholesale energy products that are financial instruments according to MiFID II.⁸⁶ Such financial instruments are subject to the insider dealing and market manipulation provisions under MAR. The insider dealing and market manipulation requirements related to physical wholesale energy products are due to the focus of this book on financial market regulatory topics only addressed briefly on the following pages.

2.171  Every market participant will have to register with the local competent authority. ‘Market participant’ means any person who enters into transactions, including the placing of orders to trade, in one or more wholesale energy markets.⁸⁷ A wholesale energy market means any market within the EU on which wholesale energy products are traded. Wholesale products are:

• •  contracts for the supply of electricity and natural gas where delivery is in the EU;

• •  derivatives relating to electricity or natural gas produced, traded or delivered in the EU;

• •  contracts relating to the transportation of electricity or natural gas in the EU; or

• •  derivatives relating to the transportation of electricity or natural gas in the EU.

2.172  The registration will consist of five sections. These are:⁸⁸

• •  Section 1: Data related to the market participant.

• •  Section 2: Data related to the natural persons linked to the market participant.

• •  Section 3: Data related to the ultimate controller or beneficiary of the market participant.

• •  Section 4: Data related to the corporate structure of the market participant.

• •  Section 5: Data related to the delegated parties for reporting on behalf of the market participant, meaning which registered reporting mechanism (RRM) will report the data for EGM.

2.173  The local competent authority must be informed immediately if there will be any change to the information provided.⁸⁹

2.174  Persons who possess inside information are subject to restrictions. Inside information means any information of a precise nature which has not been made public, which relates, directly or indirectly, to one or more wholesale energy products and which, if it were made public, would be likely to significantly affect the prices of those wholesale energy products. Wholesale energy products designates in particular any contract for the supply of energy and natural gas where delivered in the EU and contracts related to the transportation of electricity and natural gas in the EU.⁹⁰ Examples of inside information are in particular:⁹¹

information relating to the capacity and use of facilities for production, storage, consumption or transmission of electricity or natural gas or related to the capacity and use of LNG facilities, including planned or unplanned unavailability of these facilities, and; information which is required to be disclosed in accordance with other legal or regulatory provisions at Union or national level, insofar as this information is likely to have a significant effect on the prices of wholesale energy products. The prohibition applies to all persons being members of the administrative, management or supervisory bodies, or persons with holdings in the capital of an undertaking, or persons with access to the information through the exercise of their employment, profession or duties or persons who have acquired such information through criminal activity, or persons who know, or ought to know, that it is inside information. Such persons having inside information in relation to a wholesale energy product shall be prohibited from:⁹²

• •  using that information by acquiring or disposing of, or by trying to acquire or dispose of, for their own account or for the account of a third party, either directly or indirectly, wholesale energy products to which that information relates;

• •  disclosing that information to any other person unless such disclosure is made in the normal course of the exercise of their employment, profession or duties;

• •  recommending or inducing another person, on the basis of inside information, to acquire or dispose of wholesale energy products to which that information relates.

2.175  The following activities are not deemed to be an insider transaction:⁹³

• •  Transactions conducted in the discharge of an obligation that has become due to acquire or dispose of wholesale energy products where that obligation results from (p. 74) an agreement concluded, or an order to trade placed, before the person concerned came into possession of inside information.

• •  Transactions entered into with the sole purpose of which is to cover the immediate physical loss resulting from unplanned outages, where not to do so would result in the company not being able to meet existing contractual obligations or where such action is undertaken in agreement with the transmission system operator(s) concerned in order to ensure safe and secure operation of the system. In such a situation, the relevant information relating to the transactions shall be reported to ACER and the national regulatory authority.

• •  A market participant acting under national emergency rules, where national authorities have intervened in order to secure the supply of electricity or natural gas and market mechanisms have been suspended.

2.176  A market participant must publicly disclose in an effective and timely manner inside information which it possesses in respect of:

• •  the business or facilities which the market participant concerned; or

• •  its parent undertaking or related undertaking, owns or controls, or for whose operational matters that market participant or undertaking is responsible, either in whole or in part.

2.177  Such disclosure shall include information relevant to the capacity and use of facilities for production, storage, consumption, or transmission of electricity or natural gas, or related to the capacity and use of facilities, including planned or unplanned unavailability of these facilities. The publication can be done on the market participant’s website or on one of the platforms for the disclosure of inside information. Web feeds shall be provided in such a case to enable ACER to collect these data efficiently.⁹⁴ Please note that the disclosure of inside information in an incomplete or incorrect manner would be considered as a non-effective disclosure and thus be in breach of Art. 4(1) of REMIT.⁹⁵ Inside information should therefore normally be published as soon as possible, but at the latest within one hour if not otherwise specified in applicable rules and regulations. But in any case the inside information has to be published before trading in wholesale energy products to which that information relates or recommending another person to trade in wholesale energy markets to which that information relates.⁹⁶

2.178  The following minimum IT requirements shall be fulfilled in order to ensure an effective disclosure of inside information:⁹⁷

(p. 75)

• •  inside information shall be disclosed to the public on a non-discriminatory basis and free of charge;

• •  inside information shall be made available via an RSS feed specific for the disclosure of inside information, allowing easy and fast access by the public;

• •  inside information shall be kept available for the public for a period of at least two years;

• •  the information should be published in the official language(s) of the local competent authority and in English or in English only;

• •  minimal unavailability consistent with market expectations shall be ensured; and

• •  effective administrative arrangements designed to prevent conflicts of interests with market participants shall be ensured (applicable only for platforms).

2.179  The message disclosing insider information should—independent of whether it is being disclosed on the website or the platform—contain the following information:⁹⁸

• •  a subject heading that summarizes the main content of the publication;

• •  the time and date of the publication;

• •  the time and date of the relevant incident;

• •  if applicable, the name and location of the asset concerned;

• •  if applicable, the market area concerned;

• •  if applicable, the affected capacity of the asset concerned;

• •  if applicable, the available capacity of the asset concerned;

• •  if applicable, the fuel concerned;

• •  if applicable, the estimated time at which the assets concerned will be partly/or wholly available again;

• •  if applicable, the reasons for the unavailability of the asset concerned. If the reason(s) for the unavailability is/are not known, regular updates should be provided until the reason(s) is/are confirmed;

• •  if applicable, a history of prior publications regarding the same event, e.g. if a prognosis is updated or an unplanned outage becomes a planned outage; and

• •  any other information necessary for the reader to understand the relevant information.

2.180  A delay of the publication of the information is in the market participants own responsibility exceptionally possible if:⁹⁹

• •  there is no prejudice to its legitimate interests;

• •  such omission is not likely to mislead the public;

• •  the market participant is able to ensure the confidentiality of that information;

• •  does not make decisions relating to trading in wholesale energy products based upon that information; and

• (p. 76) •  ACER and the responsible Maltese Regulator for Energy and Water are immediately informed of the fact that a delay of the public disclosure is possible.

2.181  It is in market participants’ judgement whether to delay the disclosure of insider information. Whether a market participant rightly or falsely applied the delay of the inside information can only be determined ex-post. As soon as the legitimate interests cease to exist, the market participant must disclose the inside information in accordance with Art. 4(1).¹⁰⁰

2.182  Any engagement in, or attempt to engage in, market manipulation on wholesale energy markets shall be prohibited. Market manipulation can mean many things, but it means in particular:

• •  entering into any transaction or issuing any order to trade in gas or electricity which:

  • •  gives, or is likely to give, false or misleading signals as to the supply of, demand for, or price of the gas or electricity;

  • •  secures or attempts to secure, by a person, or persons acting in collaboration, the price of one or several gas or electricity products at an artificial level, unless the person who entered into the transaction or issued the order to trade establishes that his reasons for doing so are legitimate and that that transaction or order to trade conforms to accepted market practices on the gas or electricity market concerned;

  • •  employs or attempts to employ a fictitious device or any other form of deception or contrivance which gives, or is likely to give, false or misleading signals regarding the supply of, demand for, or gas or electricity products; or

• •  disseminating information through the media, including the internet, or by any other means, which gives, or is likely to give, false or misleading signals as to the supply of, demand for, or price of gas or electricity products, including the dissemination of rumours and false or misleading news, where the disseminating person knew, or ought to have known, that the information was false or misleading.

2.183  Examples of market manipulation are in particular:¹⁰¹

• •  Manipulation on wholesale energy markets involves actions undertaken by persons that artificially cause prices to be at a level not justified by market forces of supply and demand, including actual availability of production, storage, or transportation capacity, and demand.

• •  Deliberately making it appear that the availability of electricity generation capacity or natural gas availability, or the availability of transmission capacity is other than the capacity which is actually technically available where such information affects or is likely to affect the price of wholesale energy products.

(p. 77) 2.184  Layering and spoofing; layering consists of issuing multiple non-genuine orders to trade at different price levels (layers) on one side of the order book, in order to enter into one or multiple transactions on the other side of the order book. Spoofing consists of issuing a single large or multiple non-genuine orders at the same price level on one side of the order book, in order to enter into one or multiple transactions of the order book. ACER has elaborated in its Guidance Note 1/2019 in some detail about the difference between genuine transactions and non-genuine transactions, meaning layering and spoofing.¹⁰²

2.185  Art. 18 of REMIT establishes that the rules on penalties for breaches of Arts 3 and 5 of REMIT are established by the Member States. The implementation regime is therefore different across Member States and some breaches of REMIT may be sanctioned under national provisions.

2.186  The following sanctions have so far under REMIT been issued:

2.187  In the UK, entering into commodity derivatives that are financial instruments under MiFID II is a regulated activity for which authorization is required, as is providing investment services in relation to such commodity derivatives.

2.188  However, as well as implementing MiFID II, the UK also has what is essentially a base layer of domestic financial services legislation, which in some respects is wider than MiFID II. This largely follows the same structure as MiFID II in the sense that authorization is needed by a person who carries on a regulated activity (technically referred (p. 78) to as a specified activity) in relation to a regulated investment (a specified investment) and cannot rely on an exclusion. However, as can be seen, the terms used are not quite the same as those used in MiFID II, and the concepts do not match up precisely. We explained where the differences lie in relation to the scope of commodity derivatives themselves earlier. However, the UK regime is also wider in respect of some regulated activities and it has different exclusions.

2.189  The UK regulates a wider range of activities that require authorization than MiFID II and other EU legislation requires and, even where the UK regulated activities cover the same substantive activity as an activity described in EU legislation, the UK regulated activities are described by different names and do not always correspond precisely to MiFID investment activities and services. For example, the UK regulates activities known as dealing as principal and dealing as agent. Between them, these correspond to dealing on own account and executing orders on behalf of clients under MiFID II, but it is not as simple as to say that dealing as principal has the same scope as dealing on own account or that dealing as agent has the same scope as executing client orders as there are some overlaps on the boundaries of each. An example of a UK regulated activity being wider than its corresponding MiFID II activity is investment advice. In the UK, giving advice on the merits or otherwise of a regulated investment is regulated activity, whereas the MiFID II activity requires a personal recommendation to be made. It is true that the UK amended its concept of investment advice to align it to MiFID II for those firms that are already authorized, but the threshold test to determine whether authorization is needed for giving advice, is wider in the UK regime. In addition, there are some activities that are regulated in the UK that do not have a counterpart in EU law, such as making arrangements with a view to persons who use the arrangements, which is sometimes referred to as ‘limb 2’ arranging. This activity is very broad and persons who provide services that facilitate others entering into derivatives without necessarily causing a particular derivative to be entered into can be doing it. It tends to capture services like order routing and post-trade services.

2.190  In the UK, we also have an additional regulated activity of bidding in emissions auctions which means the reception, transmission, or submission of a bid at an auction of an emission allowance product on a recognized auction platform. An emission allowance product is, in summary, an emissions allowance offered for sale on an auction platform as a financial instrument or a two-day emissions spot. A two-day emissions spot is a contract where delivery is to be made at an agreed date no later than the second trading day from the day of an auction on an auction platform and is itself a financial instrument under MiFID II, but UK legislation still refers to it specifically because it was not regulated before MiFID II was implemented. As the FCA itself notes, the activity of bidding in an auction would involve various other regulated activities such as dealing as principal (if the bidder were bidding for itself) or dealing as agent (if it were bidding for a client). However, this bidding in emissions auctions activity has been specifically designed such that, if this is the only activity a person is doing that is regulated, this is the only permission it needs. We should clarify for completeness, that spot (p. 79) emission allowances and derivatives on emission allowances are also regulated in the UK as required by MiFID II. However, emission allowances are defined such that they are only regulated investments where a person is providing services under certain EU legislation in relation to them. This is similar to the way that some of the MiFID II derivatives definitions have been incorporated into UK law.

2.191  The UK also has a different set of exclusions than the exemptions set out in MiFID II and some exclusions are specific to a particular regulated activity. Many of the exclusions that apply to regulated activities that correspond to MiFID II investment activities and services can only be used if there is also an exemption in MiFID II that applies. However, it is not enough for an unauthorized person that is subject to the UK regime to rely on a MiFID II exemption, it also needs to be able to rely on a UK exclusion. The exclusions that are most often used by organizations that enter into commodity derivatives include the group exclusion, the with or through exclusion and the risk management exclusion. The UK group exclusion in the UK regime is a little more flexible than that in MiFID II as it applies to a regulated activity even if the person carries on another regulated activity with or for persons outside the group. The with or through exclusion is commonly used in relation to both dealing as agent and dealing as principal. In summary, it requires the person seeking to rely on it to enter into a derivative with a counterparty that is authorized or regulated by the FCA or using an agent or arranger that is authorized by the FCA. There is also an alternative option to the exclusion where overseas parties are involved. Last but not least, the risk management exclusion applies where the sole or main purpose of entering into a derivative as principal or agent is to limit the extent to which a person’s or its affiliate’s business will be affected by an identifiable risk arising otherwise than as a result of carrying on a regulated activity. This only applies where the business consists mainly of activities that are not regulated.

2.192  Given the exclusions in the domestic layer of the regime and the exemptions in the European layer, many commodities firms do not need to be authorized in the UK. It is then a question of ensuring they comply with those requirements that apply to both regulated and unregulated firms. These include the position limits regime in MiFID II, the prohibitions on market abuse and, for issuers, the other obligations in MAR, and the obligations applicable to non-financial counterparties in EMIR. Unregulated firms may also, of course, be impacted by requirements applicable to regulated firms which have to impose the obligations to which they are subject on their counterparties either contractually or as a matter of practice in order to comply with those obligations themselves.

2.193  Where commodities firms do fall within scope of the UK regime (including the parts that are derived from EU law), they are broadly treated in the same way as other regulated firms in different sectors, subject to a few exceptions. Although some UK firms are regulated for prudential purposes by the Prudential Regulatory Authority (PRA) (p. 80) and for conduct purposes by the Financial Conduct Authority (FCA), the types of activities which commodities firms carry on means they are more likely to be solely regulated for all purposes by just the FCA. Authorization has many consequences, but the one that might make the most economic difference to an organization is the need to hold capital that meets the financial resources requirements. The financial resources requirement that applies to any firm depends on the prudential categorization of that firm. There are numerous prudential requirements in the UK regime, some of which derive directly from EU law in the form of the Capital Requirements Regulation and Capital Requirements Directive IV (CRD IV), and some of which are special to the UK regime. What is already quite a complex regime is also subject to change pursuant to the European Commission’s review of the prudential regime for investment firms. This has resulted in a new Investment Firms Regulation and Investment Firms Directive. The Commission published a proposed regulation and directive in December 2017 and these are now under review by the European Council and Parliament.

2.194  To focus on the UK-specific aspects of the regime, there are two special categories of firm: energy market participants (EMPs) and oil market participants (OMPs). EMPs and OMPs are firms whose only investment business is energy market activity and oil market activity respectively and in each case, which do not fall within scope of various other types of firm. EMPs and OMPs include both commodity derivative firms that are outside MiFID scope, but within the FCA’s regulatory perimeter, and also those that are MiFID firms, but can use an exemption in CRD for firms whose main business consists exclusively of regulated activities relating to commodity derivatives. There are detailed definitions of energy market activity and oil market activity, but they are essentially any regulated activity in relation to an energy investment or energy on the one hand, or in relation to an oil investment or oil on the other, that is ancillary to activities related to energy investments or energy or oil investments or oil, as appropriate. However, they are each limited to executing own account transactions on certain types of exchange or other regulated activity that is performed in connection with persons who are not retail clients or individuals. For these purposes, energy is coal, electricity, natural gas (or any by-product or form of any of them), oil or biofuel, and oil is mineral oil of any description and petroleum gases, whether in liquid or vapour form, including products and derivatives of oil. The EMP and OMP categories are concessions to the full supervision regime and focus in particular on the prudential treatment of these firms. The capital requirements for such firms are set out in Chapter 3 of Interim Prudential Sourcebook (IPRU) (INV) although not all parts of that chapter apply to all EMPs and OMPs. The regime is conceptually similar to CRD although less developed as it reflects the capital regime prior to Basel 2 and the regime is in any event different in detail to reflect the operating models of the firms. Financial reporting rules apply to all EMPs. In addition, it is possible for the FCA to waive the capital requirements for EMPs whose main business consists of the generation, production, storage, distribution, and/or transmission of energy, but the FCA has rarely exercised its discretion (p. 81) to do so. The EMP capital concession was introduced to encourage authorization for energy firms with significant asset bases (such as power generators) to the market; these firms might otherwise be penalized by high liquidity charges on these assets. OMPs are only required to submit close links and controllers’ reports, but are exempt from other regulatory capital requirements’ apart from FCA’s Principle 4 (to maintain adequate financial resources), which is interpreted as meeting liabilities as they fall due. An OMP would only be required to meet the financial resources requirement if, as a member of a recognized investment exchange, it could trade with other exchange members under exchange rules. This last point dates back to the open outcry exchange model and has in recent years been interpreted pragmatically to reflect current market structures where members no longer access the market indirectly through the floor traders, but are direct participants.

2.195  The other types of requirements that apply to authorized firms relate to the way they are organised and their conduct when facing other market participants. MiFID II requires that the UK applies various requirements of this type to investment firms. In some cases, the UK has extended the MiFID II requirements to UK authorized firms that are not subject to MiFID II and, even where it has not done so, the UK’s pre-existing versions of these rules cover much the same ground. The main set of organizational requirements are set out in the Senior Management Arrangements, Systems and Controls part of the FCA Handbook (SYSC). They apply to most types of firm to some extent, including EMPs and OMPs and covers a range of issues from senior management suitability, requirements for compliance and risk functions, conflicts of interest, outsourcing, and record keeping. The main set of client-facing conduct rules are set out in the Conduct of Business Sourcebook in the FCA Handbook.¹⁰³ These apply to firms according to the regulated activities they carry on and, in some cases, there is a different set of rules for firms that do MiFID business versus those that do not. Certain rules do not apply, or are specified as being unlikely to apply, to EMPs and OMPs even if they do carry on MiFID business. More generally in relation to EMPs and OMPs, the FCA has published a handbook guide setting out which parts of its handbook apply to them.

2.196  The UK imposes some requirements on authorized firms that do not derive from EU legislation. The most obvious example is the approved person regime, which is in the process of being replaced by the senior managers regime. UK firms that are only regulated by the FCA at present are required to ensure that any member of their staff that performs a controlled function is approved by the FCA for that purpose. There are several types of controlled function, but they include governing functions such as directors, required functions such as the compliance oversight, money laundering reporting functions, and the significant management function which includes acting as a proprietary trader on the basis that their activities can have significant influence on a (p. 82) firm. The FCA assesses the fitness and propriety of such individuals and they are subject to a number of FCA rules in their own right including a series of statements of principle and a code of practice. The approved persons regime will be replaced by the senior managers and certification regime (SM&CR) on 9 December 2019. This regime already applies to banks and insurance companies but is being extended to most other types of firm. The aim of the new regime is to reduce harm to consumers and strengthen market integrity by making individuals more accountable for their conduct and competence. As part of this, the SM&CR aims to encourage a culture of staff at all levels taking personal responsibility for their actions and to make sure firms and staff clearly understand and can demonstrate where responsibility lies. There are three parts to the SM&CR: Conduct Rules that will apply to all financial services staff at FCA authorized firms. This simple set of rules means that individuals must act with integrity, due care, skill and diligence, be open and cooperative with regulators, pay due regard to customer interests and treat them fairly, and observe proper standards of market conduct. The responsibilities of Senior Managers will be clearly set out and, should something in their area of responsibility go wrong, they can be personally held to account. The Senior Managers will be approved by the FCA and appear on the FCA Register. Under the Certification Regime, firms will certify individuals for their fitness, skill, and propriety at least once a year, if they are not covered by the Senior Managers Regime, but their jobs significantly impact customers or firms. The SM&CR applies to different types of firms in different ways. Some EMPs and OMPs may be limited scope firms to which the lightest version of the rules apply.

2.197  Switzerland has introduced its version of reporting obligations related to electricity (but not gas unlike under REMIT) that relates directly to the obligations of Swiss domiciled entities under REMIT. Any Swiss domiciled entity that participates in the EU electricity wholesale markets and has to provide information to the European authorities according to Ordinance (EU) Nr. 1227/2011 (REMIT) must provide the same information in the same format to the Swiss ElCom.

2.198  It is noteworthy that the Swiss have their obligations very much aligned with the obligations under REMIT. The purpose was not to make market participants subject to an additional set of regulations. In accordance with REMIT, the Swiss obligations concern participants who conclude transactions or issue trading orders on wholesale electricity markets. A wholesale electricity market is under the Swiss rules any market on which wholesale electricity products are traded.¹⁰⁴ In addition to regulated markets under REMIT, also multilateral trading systems, over-the-counter transactions and bilateral (p. 83) contracts that are concluded directly or indirectly via brokers are covered.¹⁰⁵ Included are in particular also intra-group transactions.

2.199  ElCom must be provided in particular with the following information within T+1 for standardized energy wholesale transactions and T+30 for non-standardized energy wholesale transactions:¹⁰⁶

• •  transactions in wholesale electricity products, meaning contracts related to the transfer and delivery of electricity that are not directly used by the end consumer as well as derivatives related to the production, the trade, delivery, and transport of electricity;

• •  capacities in installations for the production and transmission of electricity, their availability and non-availability and the utilization of these facilities;

• •  insider information that has been published based on REMIT and potential delays of such publication;

• •  name, form of legal entity, and place of domicile (instead of the earlier data, the Centralized European Registry for Energy Market Participants (CEREMP) dataset may be uploaded in the ElCom registration process). This means in other words that affected market participants must register with ElCom. Such registration can be made online.¹⁰⁷

2.200  Market participants subject to the Swiss reporting obligations have to report news and insider information to existing platforms (e.g. European Energy Exchange (EEX)) or via registered reporting mechanisms (RMMs).¹⁰⁸ No direct reporting to the Swiss electricity market supervisory authority (ElCom) is possible. Market participants are at liberty to choose the RRM via which they report transaction data. If a market participant changes the RRM, ElCom must be notified about the change.¹⁰⁹ ElCom encourages market participants to use the existing EEX transparency platform for the reporting of insider information. In exceptional cases, market participants may publish the information on their own website and submit it to ElCom by e-mail. In any case, during the registration process market participants must indicate to ElCom (in the registration system) where they will publish their insider information.

2.201  ElCom collects wholesale electricity trading data with a view to improve its supervision of the functioning of the wholesale electricity market and Switzerland’s supply security. It evaluates the submitted data, contacts market participants if it detects any irregularities and informs them about these activities.

(p. 84) 2.202  The reporting obligations should help to increase transparency on wholesale electricity markets and to reduce the risk of market manipulation and distortion of price signals, and ensures that end consumers pay a fair price for their electricity. Any activities that are illicit market manipulation¹¹⁰ or insider dealing¹¹¹ under REMIT qualify correspondingly also as market manipulation and insider dealing under the Swiss obligations. ElCom reports regularly about the latest developments regarding trade surveillance in its period market surveillance reports and information events.

2.203  Firms that accept customer orders and funds for commodity futures and options must register under the Commodity Exchange Act (CEA) as a futures commission merchant (FCM).¹¹² Firms that only accept orders for futures and options for clearing by an FCM must register as introducing brokers (IBs).¹¹³ There were only sixty-three registered FCMs and some 1,200 IBs as 2018 began.¹¹⁴ The CEA further requires associate persons (APs) of FCMs and IBs to register. An AP is anyone who accepts customer orders on behalf of an IB, FCM or other registrant in other than a clerical capacity.¹¹⁵ There were some 50,000 registered APs in 2018.¹¹⁶ FCMs and IBs are required to supervise their APs. The CEA also contains a number of customer protection provisions, including custodial requirements for the segregation of customer funds, capital, and financial reporting requirements and recordkeeping provisions.¹¹⁷

2.204  FCMs and IBs are required by CFTC rules to maintain minimum amounts of net capital.¹¹⁸ This requirement seeks to assure that firms have an adequate capital commitment to their business and to guard against insolvency. FCMs must maintain minimum adjusted net (p. 85) capital in the amount of not less than USD1 million. Adjusted net capital is determined under a complex formula for computing the net worth of the FCM less deduction of illiquid assets, ‘haircuts’ to reflect the market risks of tradable assets and unsecured receivables and loans.¹¹⁹

2.205  FCMs must hold net capital in an amount equal to 8 per cent of the total margin requirements for outstanding customer positions when that amount exceeds USD1 million. Alternatively, firms that are also registered with the SEC as broker-dealers can meet CFTC requirements by complying with the SEC’s net capital rule.¹²⁰ IBs are required to maintain adjusted net capital of USD45,000 or, if the IB is registered with the SEC, it can comply by meeting SEC net capital requirements for IBs. An IB that is ‘guaranteed’ by an FCM is not required to comply with net capital requirements.¹²¹

2.206  FCMs and IBs are subject to a number of financial reporting requirements, including providing notice to the Commodity Futures Trading Commission (CFTC) when net capital falls below an ‘early warning’.¹²² FCMs and IBs must file monthly reports of their financial condition on CFTC Form 1-FR.¹²³ The annual report on this from must be certified by a CPA and must be attested to by the FCM’s chief executive officer or its chief financial officer. Monthly reports must also be filed that disclose the FCM’s leverage ratio of debt to capital. Firms dually registered with the SEC may alternatively report their financial condition on SEC FOCUS report forms.¹²⁴ FCMs must also file ‘large trader’ reports with the CFTC disclosing the size of particular customer positions when they reach a specified amount. These reports are used by the CFTC for market surveillance.¹²⁵

2.207  CFTC rules require FCMs and IBs to maintain complete copies of all records relating to their business. These records include all customer orders, including those that were cancelled, and confirmations and customer account statements, journals, ledgers, and marketing materials.¹²⁶ Daily computations of segregated fund requirements for customer funds and securities must be computed and retained.¹²⁷ Monthly customer account statements and point balances must be calculated and retained.¹²⁸ These records show the market price of customer open positions. Records showing investment of customer funds are also required.¹²⁹

(p. 86) 2.208  CFTC rules require mandated records to be kept for five years and must be in a readily available format for the first two years of that period. Books and records must be made available for inspection by the CFTC staff or the Department of Justice.¹³⁰

2.209  CFTC rules require registrants to have a system of procedures and controls that are reasonably designed to detect and prevent violations of CFTC rules; and registrants must diligently enforce those procedures and controls.¹³¹ The structure and nature of the supervisory procedures is left to the discretion of the registrant. However, FCM auditors must certify that the adequacy of the FCM’s control for the segregation of customer funds and protection of firm assets.¹³² CFTC rules further require that FCMs adopt risk management programmes that assess and manage the risks associated with the FCM’s business.¹³³

2.210  The supervision duty imposed by CFTC rules does not impose strict liability on supervisors when a violation has occurred. A breach of supervisory duties by FCM personnel are commonly found only when those who should have been supervised engaged in actual misconduct. Further, violations require a showing that the supervisor was aware of specific wrongdoing by an employee being supervised or that the supervisor failed to intervene where misconduct was apparent.

2.211  The CFTC and the courts have found that a number of sales practices may be fraudulent under the CEA’s anti-fraud prohibition. Such practices include ‘churning’, which involves a customer’s account that is controlled by a broker, and which is traded in a matter that generates commissions for the broker without regard to the customer’s best interests. The key elements of this offence is that the broker must be shown to have control over the customer’s account and used that control to trade the account excessively. Churning is also a problem in the securities industry, but the means for determining whether churning has occurred in a securities account is computed differently than the formula used to assess whether a futures account has been churned. This is because derivatives trading is inherently short term in nature and account turnover, historically, has been higher in the futures markets than on stock exchanges.¹³⁴ That difference, however, is being diminished by the growth of high frequency traders (HFTs) on electronic markets, which trade rapidly in both securities and futures.

2.212  Another customer abuse problem in the futures markets has been the unauthorized trading of customer accounts by brokers seeking to generate commissions.¹³⁵ This was (p. 87) historically a problem in the futures industry because most orders were transmitted by telephone from the customer to the broker, to the floor, to the pit, and back again. That process was inefficient and frequently resulted in errors. Manual order entry also allowed brokers to enter orders that were not authorized and allowed customers to claim that their instructions were not followed when losses occurred from trading. The growth of electronic trading in which customers directly enter their own orders has diminished these types of abuses.¹³⁶

2.213  The CEA also prohibits exaggerated profits claims by brokers in which they falsely represent the likelihood of large profits while downplaying trading risks. The use of hypothetical trading results is prohibited unless their hypothetical nature is disclosed.¹³⁷

2.214  A central part of the SEC’s sales practice regulatory effort is its suitability requirement. That is, a broker is prohibited from making an investment recommendation to a customer that is unsuitable for the customer. That determination is based on the individual circumstances of each customer, based on such facts as their age, number of dependents, income, net worth, and risk tolerance.¹³⁸

2.215  The CFTC declined to adopt a suitability requirement for futures trading. Instead, customers must be given a standardized risk disclosure statement that describes the risks associated with futures trading.¹³⁹ The customer is advised by this document to consider and make his or her own determination whether such trading is suitable for their investment objectives.

2.216  The CFTC has stated with respect to commodity options transactions that there is know-your-customer (KYC) obligation that extends beyond providing a standardized risk disclosure document. The NFA has also imposed a KYC obligation for FCMs and IBs for futures contracts. A suitability type obligation has also been imposed on the trading of single stock futures, which are jointly regulated by the CFTC and SEC.¹⁴⁰

2.217  Active trading began in swap contracts in the 1980s and it became a multi-trillion dollar market in notional terms within a decade.¹⁴¹ Swaps are derivative instruments that did not fit the classical definitions of a futures or options contract. The hybrid nature of swaps initially raised the issue of whether they were subject to CFTC regulation. Congress enacted legislation that allowed the CFTC to exempt swaps from regulation (p. 88) where the parties were ‘eligible swap participants’, i.e. wealthy individuals or institutional traders.¹⁴²

2.218  Swaps were then traded in the OTC market through swap dealers that acted as counterparties to the purchasers and sellers of swaps. These swap dealers were usually affiliates of commercial and investment banks. The swap dealers, which were usually triple-A rated affiliates of large banks, acted as clearinghouses in guaranteeing the performance of their swaps contracts. The terms of swap contracts were governed by standardized master contracts created by the International Swap and Derivatives Association (ISDA). The terms of individual swap contracts were ‘confirmed’ under the master agreement.¹⁴³

2.219  The swaps market was given a further boost by the Commodity Futures Modernization Act of 2000, which broadly excluded swaps trading from CFTC regulation. That exemption was available even when those instruments were traded on an organized exempt commercial market.¹⁴⁴ That exemption was lost after the Financial Crisis of 2008, which was blamed in some measure on unregulated swaps. The Dodd-Frank Act enacted in 2010 (Dodd-Frank), thereafter, broadly regulated swaps trading.¹⁴⁵

2.220  Dodd-Frank divided jurisdiction over swaps and other OTC derivatives between the SEC and the CFTC. Dodd-Frank regulated swaps by:

Providing for the registration and comprehensive regulation of swap dealers, security-based swap dealers, major swap participants, and major security-based swap participants; (ii) imposing clearing and trade execution requirements on swaps and security-based swaps, subject to certain exceptions; (iii) creating rigorous recordkeeping and real-time reporting regimes; and (iv) enhancing the rulemaking and enforcement authorities of the Commissions (SEC & CFTC) with respect to, among others, all registered entities and intermediaries subject to the Commissions’ oversight.¹⁴⁶

2.221  The CFTC and SEC jointly acted to adopt rules defining swaps that would be regulated under Dodd-Frank and they required the registration of swap entities, including swap dealers, and major swap participants.¹⁴⁷ The SEC and CFTC require most swap transactions to be conducted through a regulated ‘swap execution facility’ and cleared through a ‘derivatives clearing organization’. In addition, regulated ‘Swap Data Repositories’ must now register and are subjected to regulation by the SEC and CFTC.

2.222  Customer funds securing swap contracts must be held in segregated accounts. The SEC and CFTC are authorized to impose capital and margin requirements on swap (p. 89) dealers and major swap participants. Dodd-Frank requires a code of conduct for all registered swap dealers and major swap participants.¹⁴⁸ Swap market registrants are required to appoint a chief compliance officer for purposes of supervising swap trading activity. Extensive reporting requirements are imposed on swap market participants. CFTC rules require public dissemination of swap transaction and pricing and volume information. Swap dealers and major swap participants were also subjected to record keeping requirements and to the CFTC’s general record keeping rules for FCMs.¹⁴⁹

2.223  Under the current regime that will last until 31 December 2019, commodities trading houses need in Switzerland only a licence as securities dealer (investment firm) if they are trading financial instruments related to commodities which are securities. A ‘security’ in the sense of Art. 2 para. 1 lit. b FMIA/FMIA¹⁵⁰ is offered at uniform conditions to multiple parties.¹⁵¹ Securities are, in other words, standardized, certificated, and uncertificated financial instruments suitable for mass trading. They are thus either offered publicly in a similar structure and denomination or placed with more than twenty clients, unless they are being created specifically for individual counterparties.¹⁵² Bespoke OTC derivatives are typically not securities. Such OTC derivatives can however be a public deposit subject to regulation under the Banking Act.

2.224  Professional trading in securities related to commodities might require a licence as a securities dealer granted by the Swiss Financial Market Supervisory Authority (FINMA). The detailed requirements and licensing process depends heavily upon the place of domicile of the securities dealer and the type of business activity pursued. A Swiss-domiciled securities dealer is any legal entity or partnership that professionally¹⁵³ sells or buys securities related to commodities either:

• •  on its own account on the secondary market with the intent of reselling them within a short period of time (own account dealers and market makers); or

• •  for the account of third parties (client dealers); or

• (p. 90) •  publicly offers securities related to commodities to the public on the primary market (issuing houses).¹⁵⁴

2.225  Own account dealers and issuing houses have to be on an individual and group-consolidated level primarily active in the financial sector. This means that the main business activity of a group must be in the financial sector. Even sizeable securities trading activities of companies within a group that is pursuing a primary business purpose other than a financial activity are thus not subject to the licensing requirements of a securities dealer if the securities trading is closely related to the group’s business activity.¹⁵⁵ This does not, however, apply to market makers and client dealers that will have to apply for a licence even if the group’s main business activity is not a financial activity. According to established practice of the FINMA are typical commodities trading houses not active in the financial sector, because they are using commodities derivatives solely for hedging purposes, and their main business activity is trading in physical commodities. Commodities trading houses do thus typically not require a licence as securities dealer.

2.226  Securities dealers trading on own account in commodities derivatives will only have to apply for a licence if they pose a systematic risk to the financial system. That is why their gross annual turnover in securities must achieve at least CHF5 billion.¹⁵⁶ They typically do not have any clients. Securities dealers trading on their own account generally act in a professional capacity and on a short-term basis. Key aspects of trading on one’s own account include trading without instructions from third parties and taking on risk, which is primarily market risk. In the context of a clearing situation it can, however, lead to a counterparty risk if clients do not advance money to settle the securities.¹⁵⁷ Trading on a short-term basis means the active management of securities to achieve gains from short-term fluctuations in prices or interest rates within a short period of time. Long-term investments in securities are not deemed to be trading on own account.

2.227  Market makers trade in a professional capacity in securities in the form of derivatives publicly, on their own account and on a short-term basis. They trade publicly, because they offer the securities to anybody. They set a firm bid and ask for prices on an ongoing basis or on request (request for quote).¹⁵⁸ Trading on behalf of third parties (client trading) No licensing requirement is triggered if the entity deals only with clients who are Swiss or foreign banks or securities dealers, other enterprises under government (p. 91) supervision, shareholders or companies with significant holdings in the debtor and any parties affiliated or related to them, and institutional investors with professional treasury departments. Especially the latter exemption is key to the commodities trading industry, because most trader are legal entities that have at least one full-time employee managing the entities’ assets.¹⁵⁹

2.228  Securities dealers in the form of issuing houses underwrite derivatives related to commodities issued by third parties on a professional basis at a fixed price or for commission and offer them to the public on the primary market.¹⁶⁰ A key criteria for whether the underwriting and placement of derivatives related to commodities in the primary market is an activity of a securities dealer is thus whether it is ‘public’. An offering is public if it is addressed to an unlimited number of persons, in particular by means of advertisements in the media, prospectuses, or other electronic means. Offers of securities made exclusively to qualified investors such as domestic and foreign banks and securities dealers or other enterprises under government supervision, shareholders, and partners with a significant equity interest in the borrower and parties affiliated and related to them, and institutional investors with professional treasury departments are not considered.¹⁶¹ An offering is deemed to be ‘public’ even if securities have been placed with fewer than twenty people, but the offering has been addressed to an unlimited number of people which are not exclusively qualified investors.¹⁶²

2.229  Foreign securities dealers are entities that either possess an equivalent licence abroad, or apply the expression ‘securities dealer’ or an expression of similar meaning in their corporate name, business purpose, or documents, or conduct trading in securities as defined in Art. 2 lit. d SESTA.

2.230  Foreign securities dealers, meaning entities that are not domiciled in Switzerland, are generally subject to the same requirements as Swiss-domiciled securities dealers, unless the law sets forth different obligations.¹⁶³ Securities dealers that are factually managed in Switzerland and execute their transactions mainly out of Switzerland must incorporate in Switzerland and be organized according to Swiss regulations. They will be subject to the regulatory requirements of a Swiss securities dealer.¹⁶⁴ Securities dealers organized under Swiss law are deemed to be under foreign control if a foreign person indirectly or directly holds more than 50 per cent of the votes or has in any other way a material influence on the securities dealer.¹⁶⁵

(p. 92) 2.231  Foreign securities dealers will need to be licensed in Switzerland either as a branch or as a representation office if they employ staff in a professional capacity in Switzerland on an ongoing basis.

2.232  Foreign securities dealers will need to be licensed as a branch of a foreign securities dealer in Switzerland if they trade securities, have client accounts, or legally oblige the foreign securities dealer.¹⁶⁶

2.233  The securities dealer will need to be licensed as a representation office of a foreign securities dealer if it becomes active in any other way in Switzerland, namely by forwarding client orders or performing representational activities.¹⁶⁷ According to established FINMA practice, the following activities are typical of a foreign securities dealer:¹⁶⁸

• •  Employing persons in Switzerland that are fully integrated into the organization and brokering securities trades and forward orders.

• •  A corporation in Switzerland that is not licensed as a Swiss securities dealer, but carries the same or a similar name and brokers securities and forwards orders.

• •  Existence of exclusive contracts with natural persons and legal entities in Switzerland to broker securities. The Swiss representative acts in such a situation exclusively for the foreign securities dealer and gets reimbursed for each trade.

• •  Conclusion of non-exclusive contracts with natural persons and legal entities in Switzerland for the brokering of trades, but authorization to use its own corporate name. The representative is compensated for each trade.

2.234  Anyone falling within one of the categories of a securities dealer mentioned earlier has to apply for a licence with FINMA. The licence will be granted if certain key requirements are fulfilled at the time the licence is being granted and on an ongoing basis.

2.235  A securities dealer must have an adequate organization in place that allows for the execution of its activities. The securities dealer must have a board of directors and management. The members of the management will have to be fit and proper for the execution of their respective function. There must be an adequate separation between trading, asset management, and administration.¹⁶⁹ The securities dealer must also establish an internal control system consisting of compliance, risk management, and internal (p. 93) audit.¹⁷⁰ An external regulatory audit firm must also be appointed. It is possible to unify some of the control functions with a specific person.

2.236  Any securities dealer must have a fully paid-in minimal capital of at least CHF1.5 million. Any shareholder indirectly or directly holding more than 10 per cent of the capital or the voting rights of a securities dealer or that may in any other way influence the business activities of the securities dealer must pass the fit and proper test of FINMA.¹⁷¹ The provisions applicable to banks regarding own capital and accounting generally also apply to a securities dealer.¹⁷² Privileged deposits of clients are subject to enhanced protection.¹⁷³

2.237  Any securities dealer will have to comply with multiple reporting, information, and approval obligations on an ongoing basis. Any change to the preconditions for granting the licence, but in particular the articles of association, regulations, material change of business activity, management, board of directors, and external audit firm, as well as build ups, investments, and divestments of foreign operations must be pre-approved by FINMA.¹⁷⁴

2.238  Any indirect or direct acquisition or sale of a stake in a securities dealer reaching, exceeding, or falling below the thresholds of 20, 33, or 50 per cent of the capital or the votes must be reported to FINMA.¹⁷⁵

2.239  Securities dealers have to report any orders and transactions in securities as well as derivatives that are being derived from securities listed on a Swiss trading venue.¹⁷⁶ Such reporting must be made to the corresponding trading venue.¹⁷⁷

2.240  The new Swiss Financial Services Act (FINSA) will enter into force on 1 January 2020. It affects all financial service providers that purchase, sell, or distribute financial instruments, receive or transmit orders related to financial instruments, provide asset management or investment advice, and grant loans to finance transactions with financial instruments for clients in Switzerland no matter whether provided in Switzerland or on a cross-border basis from outside of Switzerland into Switzerland to existing, but also potential new clients.¹⁷⁸

(p. 94) 2.241  Commodities trading houses are typically not providing financial services in the sense of the FINSA if they are engaging in said activities on own account or for group companies. Swiss or non-Swiss commodities trading houses that provide in Switzerland or on a cross-border basis similarly like a financial service provider independently and on a professional basis (in general for more than twenty clients if no public advertisement for the services is made) one of the following activities can, however, fall within the scope of FINSA, unless these services have been explicitly requested by the client without prior solicitation efforts from the part of the affected commodities trading house:

• •  Hedging solutions no matter whether in the form of OTC derivatives or exchange traded derivative (ETD) to third parties that are not group companies and that are not directly linked to physical commodities trading. Such activity will be an execution of financial instruments in its purest form, but will in most cases be investment advice related to financial instruments (such as OTC derivatives an ETD), because the commodities trading house will advise the client on the structure and type of financial instrument best suited for the purpose;

• •  distribution of financial instruments (e.g. OTC derivatives or ETD having commodities as an underlying) to clients in Switzerland that have been issued by group companies or third parties;¹⁷⁹ and/or

• •  granting credit for the purchase of financial instruments (e.g. OTC derivatives or ETD having commodities as an underlying), although credit activities are generally out of scope of FINSA.

2.242  The universe of affected financial instruments, to which the financial services must relate to trigger the application of FINSA, are essentially the same as under MiFID II (shares, bonds, derivatives, structured products, funds, structured deposits).

2.243  In case commodities traders fall within the scope of FINSA, they will have to comply with multiple obligations. These obligations are segmented into behavioural rules and organizational obligations as well as the obligation to enter client advisers into the client adviser register and to affiliate with an ombudsman for financial services. Some of these obligations are similar to the ones under MiFID II. Other obligations differ from MiFID II materially. It has to be decided on a case-by-case basis whether the MiFID II standard is sufficient for compliance with the FINSA regime.

2.244  Commodities trading houses subject to FINSA will have to comply with the following behavioural rules:

(p. 95)

• •  Client segmentation obligation: Commodities trading houses in scope of FINSA must assign the persons to whom they provide financial services to the segments of either retail clients, professional clients, or institutional clients, based—in general—on the qualification of the client.¹⁸⁰ Clients of commodities trading houses will typically be professional or institutional clients. As under MiFID II, in FINSA the client has the opportunity to declare that he would like to change the segment. A professional client is a person who can credibly declare that on the basis of training, education, and professional experience or on the basis of comparable experience in the financial sector, she or he possesses the necessary knowledge to understand the risks associated with the investments and has at their disposal assets of at least CHF500,000. A professional investor can alternatively also have at his or her disposal assets of at least CHF2 million. No knowledge or experience is required in this case. Professional clients who are not institutional clients may declare that they wish to be treated as retail clients at the higher protection level (opting in). Institutional clients may declare that they wish to be treated only as professional clients (opting in). Institutional clients are licensed financial intermediaries, insurance companies, corresponding foreign institutions, or public companies having a person taking care of the management of assets on a full-time basis. Professional clients may waive from complying with the obligation to provide information, documentation, and rendering account and the appropriateness and suitability test must only be carried out if there are indications for doubts of a sufficient understanding of the business.¹⁸¹ The client segmentation obligation must be met within one year of the entry into force of FINSA and FINSO, likely by 1 January 2021.

• •  Obligation to provide information: The financial service provider is obliged to provide information about both his general activities and specific activities. The clients must be informed before the signing of the contract or provision of the service in order to have sufficient time to understand the information regarding the client relationship or the provision of the financial service.¹⁸² Financial service providers must satisfy this duty within one year of entry into force of the FINSO, likely by 1 January 2021.

• •  Obligation to conduct an appropriateness and suitability test: Assuming that most clients of commodities trading houses in scope of FINSA will be professional or institutional investors, the suitability, and appropriateness test obligations will generally not apply. If they, however, apply, and if financial service providers provide investment advice only for individual transactions without taking into (p. 96) account the entire client portfolio, a suitability assessment must be carried out.¹⁸³ The financial service providers must check whether financial instruments are appropriate for its clients before recommending them.¹⁸⁴ In case of investment advice taking into account the client portfolio or portfolio management, it must enquire about its clients’ financial situation and investment objectives as well as their knowledge and experience.¹⁸⁵ These duties must be met within one year of entry into force of the FINSO, likely by 1 January 2021.¹⁸⁶

• •  Obligation to document and render of account: Commodities trading houses falling within the scope of application of FINSA are subject to extensive documentation requirements relating to financial services agreed with clients, information about them, information about a missing, unsuccessfully conducted appropriateness, or suitability test, and the services provided to clients. In investment advice, they also document the needs of clients, as well as the reasons for each recommendation that leads to the purchase or sale of a financial instrument.¹⁸⁷ Both obligations must be met within one year of entry into force of the FINSA and FINSO, likely by 1 January 2021.¹⁸⁸

• •  Obligation to provide documents: The clients are entitled at any time to receive a copy of their dossier and all documents concerning them. Due to the regulatory nature of the claim, the client cannot waive it. The request must be made in writing or in another form demonstrable via text. One copy is sufficient.

• •  Handling of client orders: Financial service providers must uphold the principles of good faith and equal treatment when handling client orders.¹⁸⁹ The financial services provider must have systems and processes that are commensurate in size, complexity, and business, and that ensure equal treatment of client’s interests.¹⁹⁰

• •  Best execution of client orders: The best execution principle is mainly used by commodities trading houses within the scope of FINSA that either execute transactions themselves or forward orders to third parties. They have to ensure in the execution of their clients’ orders that the best possible outcome is achieved in terms of cost, timing, and quality. Both own and third-party costs have to be considered.¹⁹¹ Each affected commodities trading house establishes its own Best Execution Policy in the form of an internal policy based on the size and content of the affected transactions and the relevant client categories.

• (p. 97) •  Use of financial instruments of the client: Clients must agree, in a separate agreement to the terms and conditions, in writing or in another form demonstrable via text, that financial instruments from their holdings are being lent to counterparties by the commodities trading house in the scope of FINSA or that the financial service provider is brokering such transactions.

2.245  All commodities trading houses in scope of FINSA must comply with the following organizational obligation, regardless of whether they serve institutional, professional or retail clients. Financial services providers must have within one year of the entry into force of the FINSA and the Swiss Financial Market Ordinance (FinIO), likely until 1 January 2021, an appropriate organization.¹⁹²

2.246  Commodities trading houses which fall within the scope of FINSA must ensure compliance with the obligations under FINSA through an organization that is appropriate to their size, complexity, business activity, and risk profile, and through internal rules. Staff must be carefully selected, trained, and registered in the register of advisers. The remuneration policy must be designed in such a way that there are no incentives for the staff to disregard statutory duties or to conduct themselves in a manner detrimental to clients.¹⁹³

2.247  Commodities trading houses in scope of FINSA are responsible for representing the client’s interests when conducting financial services. Conflicts between different client interests must be avoided. The self-interest of the affected commodities trading house, their staff’s interests, and the interests of third parties must not conflict with the clients’ interests.¹⁹⁴ In organizational terms, the affected commodities trading house must have an internal directive that adequately addresses and regulates conflicts of interest.

2.248  A particularly common type of a potential conflict of interest are compensations from third parties, i.e. financial benefits, for example, in the form of ‘soft dollars’, brokerage fees, discounts, and commissions, which the affected commodities trading house receives in connection with the provision of financial services from third parties. Under supervisory law and contract law, commissions generally belong to the client in their entirety. If they cannot be passed on to the client, such as ‘soft dollars’, they must be disclosed to the client as a conflict of interest.¹⁹⁵

2.249  The FINSA also provides an explicit provision for a second conflict of interest constellation. These are frowned on staff transactions. This includes (p. 98) all natural and legal persons who work for the commodities trading house in scope of FINSA and their family members and other related persons.¹⁹⁶ Financial service providers must take adequate measures to prevent staff from misusing for own-account transactions any information made available to them only by virtue of their function.¹⁹⁷

2.250  Commodities trading houses in scope of FINSA are also subjected is the obligation to be affiliated with an ombudsman.

2.251  Client advisers of commodities trading houses in scope of FINSA must be entered in the client adviser register prior to the provision of any financial services in Switzerland or prior to the provision of financial services from outside Switzerland to Swiss-based clients.¹⁹⁸ The entry into the client adviser register is thus a non-negotiable requirement for the access to the Swiss market. The wording within the FINSA suggests that this obligation affects every client who (even temporarily) resides in Switzerland (e.g. a UK-domiciled client is on business trip in Geneva). The entry into the register of advisers must by law be finalized no later than 30 June 2020¹⁹⁹ (which can be found under www.regservices.ch).

2.252  The requirements for entry are sufficient knowledge of the behavioural rules under FINSA, required knowledge related to the activity, a professional liability insurance or equivalent security, the affiliation to an ombudsman, no entry in the criminal register regarding property under the Swiss Criminal Code, and no industry ban or prohibition issued by FINMA.²⁰⁰ The client adviser register has the discretion to decide whether a specific client adviser has sufficient knowledge about the behavioural rules under FINSA and for conducting the financial services. This knowledge will easily be provable by passing a test that can be accessed online on a 24/7 basis. Client advisers must have the necessary knowledge within one year of the entry into force of FINSA and FINSO, i.e. likely until 1 January 2021.²⁰¹ The client advisers must prove at the time of application, based on documents and eventually also by means of an oral interview, that he/she has the required knowledge and capabilities. The client adviser register contains as a minimum the following information about client advisers:²⁰²

• •  name and surname;

• •  name or firm and address of the financial service provider for which they are active;

• (p. 99) •  function and position of the client adviser within the organization;

• •  fields of activity;

• •  education and continuing professional education;

• •  the name of the ombudsman to whom the financial service providers are affiliated with; and

• •  date of entry.

2.253  Furthermore, client advisers must report the following developments to the register within fourteen days:²⁰³

• •  any change in their name or address and of the financial service provider for which they work;

• •  any change in their function and position within the organization and their areas of activity;

• •  completed basic training and continuing professional development;

• •  any change of the ombudsman;

• •  the complete or partial termination of the professional liability insurance;

• •  termination of the activity as client adviser;

• •  issued loss certificates (Verlustscheine) in their name;

• •  convictions for criminal offences under the Swiss financial market acts or for criminal offences against property or comparable convictions handed down by foreign authorities; and

• •  imposed Swiss and non-Swiss prohibitions on them from performing respective activities/ from practising.

2.254  It is important that affected non-Swiss financial service providers, non-Swiss client advisers, and producers of financial instruments comply with the new obligations. Deliberate non-registration with the client adviser register can be sanctioned with imprisonment of up to three years and non-diligent non-registration with a fine of up to CHF250,000 per case. FINMA may also open an investigation for the unlawful provision of financial services and to sanction the financial service providers and involved client advisers accordingly.

2.255  Under the new Swiss Financial Institutions Act (FINIA) that enters into force on 1 January 2020, the licensing and licensing requirements of financial institutions such as investment firms (the former securities dealer), fund management companies, asset managers of collective investment schemes, external asset managers, and trustees will be regulated. Commodities trading houses trading in securities,²⁰⁴ such as ETDs and (p. 100) non-bespoke OTC derivatives, can become subject to the obligation to get licensed as an investment firm under the FINIA if they are engaged in short-term trading activities in securities and is ‘mainly active in financial markets’. It is likely that the ‘mainly active in financial markets’ will be construed similarly like under the pre-FINSA-regime,²⁰⁵ meaning that there will a group consolidated view of the activity and that the activities of commodities trading houses/groups are mainly seen as commercial. This means in other words that the trading activities of single or some trading desks of a commodities trading house or a group company in commodities derivatives that are securities that are not directly linked to a transaction in physical commodities must be reviewed on a case-by-case basis whether they trigger the requirement to get licensed as investment firm.

2.256  As under the pre-FINIA regime currently in force, commodities trading houses engaging in proprietary trading activities regarding commodities derivatives on own account hedging their physical trading activities or the physical commodity exposure of one or their group companies are typically not engaging in activities that require a licence as investment firm. They can, however, engage in an activity that requires a licence as investment firm if they are mainly active on financial markets and (i) either engage in proprietary trading activities in commodities derivatives for speculative purposes and if their annual overall turnover in securities exceeds CHF5 billion. or (ii) they are participant to a trading venue. Market making in securities or client trading activities (in the name of the investment firm, but on behalf of their clients) in securities such as ETDs or other financial instruments can only be performed with an investment firm licence.²⁰⁶ Client trading activities require that the affected company holds directly or indirectly holds accounts or holds securities in custody for more than twenty clients. No clients are group companies, shareholders, licensed banks, and investment firms or other supervised entities and companies that have a person that manages on a full-time basis the assets of the company.²⁰⁷

2.257  Any commodity trading house that will have to get licensed as investment firm under the new FINIA-regime will have to notify FINMA about this fact no later than until 30 June 2020 and will have to submit its application no later than until 31 December 2023.