4.01  Derivatives trading in financial instruments has many antecedents outside the US, but Chicago claims primacy in developing centralized markets for trading financial derivatives.¹ This intrusion into the financial markets began with the opening of the Chicago Board Options Exchange, Inc. (CBOE) in 1973. The CBOE traded options on stocks and was soon joined by some of the stock exchanges. Interestingly, the New York Stock Exchange, the largest of the US stock exchanges was not a serious competitor in trading stock options.

(p. 170) 4.02  The creation of the CBOE threatened the existing jurisdictional lines between the regulation of stock exchanges by the Securities and Exchange Commission (SEC) under the federal securities laws and that of the commodity futures exchanges under the Commodity Exchange Act of 1936 (CEA) by the Department of Agriculture. This concern arose because the CBOE was the product of an effort by the Chicago Board of Trade (CBOT), the-then largest futures exchange, to apply commodity futures trading principles to stock. Moreover, the CBOT was planning to list futures on its trading floor where the underlying commodity would be a financial instrument.

4.03  A dispute also arose before the creation of the Commodity Futures Trading Commission (CFTC) as to whether the Securities Exchange Commission (SEC) could regulate options on ‘hard’ commodities like gold or silver. That issue was being tested in the courts before the creation of the CFTC by the Commodity Futures Trading Commission Act of 1974 (CFTC Act).² The CFTC Act intervened in resolving that issue. It gave the CFTC exclusive jurisdiction over options on all commodities, except the SEC retained its jurisdiction over options on stocks.³ This effectively meant that commodity options were unregulated because the CFTC did not immediately adopt any rules governing their sale to the public.

4.04  As a result, widespread abuses occurred from fly-by-night operators selling options to unsophisticated customers through unwarranted profit claims. Customers were also told that their losses were limited to the premium they paid for the option, but were not cautioned that such a loss constituted 100 per cent of their investment. The CFTC did not have the resources to effectively prosecute the options fraudsters, and it suspended trading in those instruments. Later, the CFTC allowed trading in options on regulated commodity futures exchanges, and it permitted options in which the participants were commercial entities, trading for commercial purposes.⁴

4.05  The arbitrary allocation of jurisdiction over futures and options between the SEC and CFTC by the CFTC Act also led to many disputes in the courts. In the end, the result was two markets in derivative financial instruments, i.e. the stock markets and the futures exchanges, that are governed by separate and, in many respects, different regulatory schemes. The complexities of this regulatory bifurcation was further compounded by the development of the massive swaps markets that began in the 1980s. The market was initially unregulated, but Congress broadly regulated swaps under the Dodd-Frank Act of 2010 (Dodd-Frank), which divided jurisdiction over swaps and other over -the-counter (OTC) derivatives between the SEC and the CFTC.⁵

4.06  Derivative trading in financial instruments on organized exchanges consists largely of the following instruments: futures, options, options on futures, and swaps. Those transactions are differentiated from ‘cash’ (sometimes called ‘actual’) transactions and ‘forward’ contracts. A cash contract requires actual and immediate, or near immediate, delivery of a financial instrument or other commodity. In contrast, a forward contract defers delivery until some agreed upon date in the future. The terms of forward and cash contracts are not generally standardized and delivery is almost always undertaken.⁶

4.07  The actual delivery element and the lack of standardization of terms make it more difficult to trade cash and forward contracts on an exchange. The futures contract corrected that problem by standardizing the terms of contracts calling for the future delivery of commodities. All terms of futures contracts are standardized, except the price of the commodity, which was initially negotiated on exchange trading floors, but is now generally conducted through electronic trading platforms.⁷ Although delivery may be required on some of these contracts, delivery is almost always avoided by offsetting one standardized contract against another. Some futures contracts do not even permit delivery. Instead, those contracts are settled by cash payments based on price changes in the underlying commodity.

4.08  Forward and cash contracts are traded in OTC markets, which are generally subject to the day-to-day oversight of a government financial services regulator.⁸ Nevertheless, OTC cash and forward transactions may not entirely be free of governmental restrictions. For example, in the US, the anti-manipulation prohibitions in the CEA may be applied to trading in cash and forward contracts where they are effected in order to create artificial prices.⁹ Government regulators may also require reports of cash or forward OTC transactions by large traders. For example, the CFTC has a large trader reporting system for large traders dealing in OTC forward and cash transactions that may affect futures prices.¹⁰

(p. 172) 4.09  As will be shown later, particular OTC derivative transactions involving retail customers in foreign currency are also subject to regulation by US authorities, including the CFTC, the SEC, and banking regulators. The purpose of those regulations is to protect unsophisticated retail customers from fraudulent business conduct and dealer failures. Exempted from that regulation are cash and forward transactions in foreign currency, precious metals, and other commodities where delivery is made within twenty-eight days of purchase.¹¹

4.10  Before the creation of the CFTC in 1974 only futures on specified, ‘enumerated’ commodities were regulated under the CEA. Those enumerated contracts were required to be traded on ‘boards of trade’ registered with the US Department of Agriculture as designated contract markets (DCMs). A consequence of this ‘enumerated’ approach was that several exchange traded futures contracts were unregulated.

4.11  Because of abuses, the CEA barred options on commodities from trading on DCMs. Options and other derivative contracts on commodities traded in OTC markets were not barred or regulated. Otherwise, by statute, with a single exception, all futures trading, including futures on financial instruments, was required to be conducted on DCMs regulated by the CFTC. The exception to this requirement is that futures contracts on a single stock, e.g. Apple, Inc., may be conducted either on a securities exchange regulated by the SEC or a DCM regulated by the CFTC. Futures contracts traded on stock indexes must be traded on a DCM. Options on stock indexes are traded on securities exchanges, but options on futures on stock indexes are traded on DCMs. Options on single stocks are traded on securities exchanges.¹²

4.12  The division of regulatory responsibility between the CFTC and SEC has resulted in some notable differences in the trading of financial derivatives in those markets. For example, trading in financial derivatives is carried out through exchanges competing for market share in the same instruments. This was facilitated by common clearing arrangements and resulted in a complex regulatory environment regulating trading among those markets. For example, the SEC implemented a national market system (NMS) through its Regulation NMS.¹³ Among other things, Regulation NMS implemented a requirement that securities trade at the national best bid or offer (NBBO) on all markets. Regulation NMS also prohibits ‘trade throughs’ of the NBBO or other order book listings among the competing markets. In other words, a trade cannot be effected at a price above or below the NBBO among all markets.¹⁴

(p. 173) 4.13  Swap transactions must be conducted through swap dealers, major swap participants, security-based swap dealers, major swap participants, or major security-based swap participants. Swaps are executed through swap execution facilities and cleared through a derivatives clearing organization. In addition, reporting of swap transactions is conducted by Swap Data Repositories.¹⁵ Swaps legislation enacted in 2010 (the Dodd-Frank Act) was an effort to apply the futures trading model to swaps by requiring that swaps, like futures, be cleared through a central counterparty (CCP) clearinghouse. Europe has followed that model.

4.14  As an EU Member State, the UK is obliged to treat financial instruments as defined in MiFID II as regulated, at least to the extent they relate to investment activities and services as defined in MiFID II, and it can be assumed that the UK has done this. However, before MiFID and its predecessor EU legislation were introduced, the UK had its own set of regulated investments (technically referred to as specific investments) and these not only remain but have also been developed alongside the introduction of financial instruments from MiFID II and its predecessors and similar changes derived from other EU legislation. Where a financial instrument covers similar ground to an existing domestically regulated investment, the UK has generally not sought to re-define the regulated investment to accommodate the financial instrument, but rather to add the financial instrument as what looks like an extra layer of the description. In some cases, this extra layer is to be used as the description of regulated investment that applies only to firms that are carrying on MiFID investment activities and services only and the domestic base layer is to be used for all other purposes. When combined with a similar approach in respect of regulated activities and exclusions, this makes the perimeter of the UK regime quite complicated. However, this is all set out in the Regulated Activities Order and the FCA has attempted to explain some of the more confusing aspects in Chapters 2 and 13 of PERG in the FCA Rules.

4.15  The UK’s Regulated Activities Order divides commodities into three types: options, futures, and contracts for difference. Each of these is treated as a contractually based investment as opposed to a security. Between them, these three types accommodate all derivatives under MiFID II (i.e. paras 4–10, Section C, Annex 1, MiFID II) including commodity derivatives in the way described earlier. However, the underlying domestic layer of the definitions is in some cases slightly different in scope.

4.16  Options within the scope of paras 5, 6, 7, and 10 of Section C of Annex 1 of MiFID II are captured, as are options to acquire or dispose of such options, but only in relation to certain types of firms that are performing MiFID II investment activities or services. (p. 174) Otherwise, the domestic layer of the test is limited to options to acquire or dispose of securities or contractually based investments, currency, and precious metal. Therefore, a cash settled or exchange traded option on base metal is a regulated investment in the UK, but only in connection with certain types of activities undertaken by certain types of person.

4.17  The UK understanding of futures are rights under a contract for the sale of a commodity or property of any other description under which delivery is to be made at a future date and at a price agreed on when the contract is made. This is a very wide definition, but is then reduced by the carving out of rights under any contract which is made for commercial and not investment purposes. This commercial versus investment purpose distinction is a similar concept to that used in para. 7 of Section C of Annex 1 to MiFID II, but it works in a slightly different way. First, contracts made or traded on a recognized investment exchange or expressed to be as traded on such an exchange or on the same terms as those on which an equivalent contract would be traded on such an exchange are deemed to be made for investment purposes. If this is not the case but the parties genuinely intend to deliver the property to which the contract relates within seven days, they are deemed to be made for commercial purposes. For all other contracts, there are a series of indicative factors which point either to an investment or commercial purpose and these have to be weighed against one another. It is an indication that a contract is made for commercial purposes if one or more of the parties is a producer of the commodity or uses it in his business and if the seller delivers or intends to deliver or the purchaser takes or intends to take delivery. It is also an indication of commercial purpose if the price, lot, delivery date, or other terms of the contract are determined by the parties for the purposes of the particular contract and not by reference to regularly published prices, standard lots, delivery dates, or standard terms. On the other hand, the fact that a contract is expressed to be as traded on an investment exchange, performance of the contract is ensured by an investment exchange or clearing house or there are arrangements for the payment or provision of margin are each indications of an investment purpose. The intention-based test is not therefore easy to apply and requires some judgment and subjectivity. It is arguably both narrower and wider than the MiFID II tests: narrower because under MiFID II physically settled commodity derivatives are within scope if they are not for delivery within two trading days and are traded on any regulated market or multilateral trading facility (MTF) (and sometimes on an organized trading facility (OTF)), whereas the UK test provides a more generous seven days and only refers to recognized investment exchanges and similar; but wider because the financial characteristics are hard coded into MiFID II and cumulative so that derivatives need to satisfy both a condition that links them to an exchange or exchange contract and the standardization condition. The practical consequence of this is that there may be OTC or other physically settled contracts which fall within the UK futures definition but not within para. 7 or 10 of Section C of Annex 1 of MiFID II. That said, as noted earlier, futures and forwards within paras 5, 6, 7, and 10 of Section C of Annex 1 of (p. 175) MiFID II are regulated investments where certain types of firms perform MiFID II investment activities or services in relation to them

4.18  Contracts for difference also includes any other contract, the purpose, or pretended purpose of which is to secure a profit or avoid a loss by reference to fluctuations in the value or price of property of any description or an index of other factor designated for that purpose. Contracts where the parties intend that the profit is to be secured or the loss to be avoided by taking delivery of property to which the contract relates are excluded, along with a couple of other exceptions. It is therefore understood that this type of investment would include financial contracts for difference as listed in para. C7 and some cash settled swaps in paras C4 and 5 of Section C of Annex 1 of MiFID II. However, derivative instruments for the transfer of credit risk in para. 8 of Section C are also included for certain types of firms that are performing MiFID II investment activities or services in relation to them.

4.19  The CEA, as amended over the years, has sought to push most trading in standardized options, futures, and swaps onto regulated exchanges where transactions are cleared through a CCP. Those exchange trading requirements do not apply to ‘cash’ and ‘forward’ transactions. As described earlier, however, cash and forward contracts are not entirely free of CFTC regulation.¹⁶

4.20  The CFTC has brought numerous cases charging that particular contracts were futures contracts that should be traded on a regulated DCM, as opposed to permissible OTC cash or forward contracts. In distinguishing between futures and forward contracts, the CFTC will look for particular elements commonly associated with futures contracts. For example, it will seek to determine whether the contract at issue is a standardized contract calling for future delivery, whether it is offered to the public, secured by margin, is used to shift or assume the risk of price changes in the underlying commodity, and whether it is usually offset without delivery.¹⁷

4.21  Despite the general exchange trading requirement for futures contracts, the CFTC allowed trading in so-called leverage contracts in precious metals. Those contracts involved arrangements in which dealers in precious metals financed the purchase of precious metals by their customers.¹⁸ Dodd-Frank furthered that exemption by (p. 176) excluding precious metals and other OTC contracts from the exchange trading requirement where there was an actual delivery of metals for a customer’s accounts within twenty-eight days of purchase.¹⁹ The CFTC has, however, brought cases charging that precious metals dealers did not qualify for the Dodd-Frank exclusion because of their failure to deliver metal to customers within the twenty-eight day period.²⁰

4.22  A provision in the CFTC Act, called the ‘Treasury Amendment,’ exempted from CFTC regulation options and futures on currency.²¹ That loophole resulted in widespread fraud in marketing such instruments to retail customers. The Supreme Court rejected an effort by the CFTC to construe the Treasury Amendment narrowly to exclude non-inter-bank market currency transactions.²² Congress then tried to narrow the Treasury Amendment to subject retail OTC transactions to CFTC regulation, but that amendment was eviscerated by an opinion of the Seventh Circuit Court of Appeals that sits in Chicago.²³

4.23  Congress then passed more legislation, including provisions in Dodd-Frank, which now closely regulates the operations of Retail Foreign Exchange Dealers (RFEDs).²⁴ A RFED is a firm that markets OTC options on foreign currency to persons that are not eligible contract participants (ECPs), i.e. persons that do not have a high net worth or large income. Among other things, Dodd-Frank requires RFEDs to register with the CFTC, unless they are already registered with that agency as a futures commission merchant (FCM). Dealers in retail foreign currency transactions are subject to onerous capital requirements of a minimum of USD20 million.²⁵ The industry self-regulatory body, the National Futures Association, also broadly regulates the sales and other practices of RFEDs. The Dodd-Frank additionally granted jurisdiction to the SEC and the banking agencies over retail foreign exchange dealers where those entities were otherwise subject to the regulation of those agencies.²⁶

4.24  The nature of exchange trading in both the futures and stock markets has changed dramatically since the 1990s. The open outcry markets have been largely supplanted by electronic platforms. That transformation changed the manner of order entry and execution on both stock and futures exchanges and dramatically reduced order entry and execution times. Electronic trading also had substantial effects on the traditional (p. 177) market makers on stock exchanges, i.e. the specialists, who lost their time and place advantage on the trading floors to what are now called liquidity providers.

4.25  Historically, the SEC required specialists to commit their own capital in order to maintain a continuous two-sided orderly market. That obligation was imposed in exchange for the specialists’ time and place advantage on the floor over all other traders. In contrast, market makers on electronic platforms are opportunistic high-frequency traders (HFTs). While they may achieve time and place advantage through their algorithmic trading programmes and co-location of their computers, HFTs do not have specialists’ obligations. The specialists were granted a monopoly in their role as market maker. In contrast, HFTs do not enjoy a monopoly in their market-making role. Rather, HFTs compete with each other for time and place advantage in their ever increasingly rapid transmission abilities.

4.26  In order to attract HFTs to act as market makers, the exchanges have created various incentive programmes that seek to encourage the maintenance of a continuous two-sided market by HFTs. Those incentives include maker or taker payments or exchange fee concessions that are made to reward and encourage the lifting or maintenance of resting limit orders. These incentives have been criticized by some because they reward the speed advantage of HFT’s whose trading practices are sometimes criticized. For example, one popular HFT strategy is liquidity detection, which employs algorithms to take advantage of other traders by detecting and predicting their trading plans or practices based on prior activity.²⁷ The existence of such trading programmes require active traders to employ deceptive strategies in which they avoid trading in sizes, amounts, or frequencies that can be detected by HFTs.²⁸ One such evasive technique is order shredding in which large buy-side firms use their own algorithms to shred their large orders (called parent orders) into numerous small orders (child orders).²⁹

4.27  Electronic trading has also raised concerns with computer generated market crashes. This includes the ‘fat finger’ syndrome in which orders are erroneously entered with extra digits in such a magnitude as to cause sharp drops in market prices and large losses. Exchange computers also sometimes breakdown during periods of high volume trading, causing a market crash. For example, on 6 May 2010, a ‘Flash Crash’ occurred in which the prices of e-mini S&P 500 futures contracts, the S&P 500 SPDR, and other similar products fell in value by some USD600 billion before almost immediately recovering. The Dow Jones Industrial Average was also affected by this Flash Crash, dropping by some 1,000 points.³⁰ A study of the Flash Crash by SEC and CFTC largely (p. 178) blamed the event on a faulty order entered by Waddell & Reed, a large mutual fund complex. However, the CFTC later charged that a London trader was a cause of the Flash Crash as a result of illegal spoofing orders.³¹

4.28  The trading in OTC derivatives in the EU and the European Economic Area (EEA) is regulated under the European Market Infrastructure Regulation (EMIR) as amended by the EMIR Refit.³² EMIR lays down rules regarding OTC derivative contracts,³³ CCP, and trade repositories. EMIR’s provisions are based on the G-20 commitments made in Pittsburgh in September 2009. EMIR has applied since 16 August 2012. Certain of these obligations have, however, entered into force later. The key requirements under EMIR are the following obligations:

• •  clearing obligation;

• •  risk mitigation obligations;

• •  reporting obligation; and

• •  trading obligation.

4.29  OTC derivative contracts must be cleared if: (i) they have been declared subject to the clearing obligation by ESMA; (ii) they have been entered into between two parties that are subject to the clearing requirement; (iii) they have been entered into on or after the date from which the clearing obligation takes effect; and (iv) no exemption is applicable.³⁴ The OTC derivatives contracts subject to clearing are registered by ESMA in a public register. The public register is available on the public website of ESMA.³⁵ There are currently no commodities derivatives subject to clearing under EMIR. The following OTC derivatives are currently subject to clearing:³⁶(p. 179)

4.30  The counterparties that have entered into an OTC derivative transaction subject to clearing must either be:

• •  Two financial counterparties exceeding the clearing threshold, meaning a duly authorized investment firm, credit institution, insurance undertaking, assurance undertaking, reinsurance undertaking, Undertakings of Collective Investment for Transferable Securities (UCITS) or, where relevant, its management company, an institution for occupational retirement provisions, or an alternative investment (p. 180) fund managed by an authorized or registered Alternative Investment Fund Management Company.³⁷

• •  A financial counterparty or a non-financial counterparty both exceeding the clearing threshold,³⁸ either meaning an undertaking established in the EU not being a financial counterparty or an entity established in a third country that would be subject to the clearing obligation if it were established in the EU. The clearing obligation is thus one of the few obligations under EMIR that apply also to counterparties that are domiciled in third countries.

• •  Two non-financial counterparties exceeding the clearing threshold.

• •  Two entities established in one or more third countries that would be subject to the clearing obligation if they were established in the EU, provided that the OTC contract has a direct, substantial, and foreseeable effect within the EU or where such an obligation is necessary to prevent an evasion.

4.31  One of the key changes introduced by EMIR Refit is the fact that the clearing obligation will from 17 June 2019 on apply on a per category-basis, meaning that the clearing obligation will only apply to the OTC derivatives in the categories where the clearing threshold is exceeded.³⁹ One of the key exceptions applicable to the clearing obligation are intra-group transactions, which are OTC derivative contracts entered into with another counterparty which is part of the same group to the extent both counterparties are included in the same consolidation on a full basis, they are subject to an appropriate centralized risk evaluation, measurement, and control procedures and that the counterparty is located in the EU or a third country recognized as having an equivalent legislation to EMIR by the European Commission.⁴⁰ Counterparties are deemed to be included in the same consolidation in case they are either included in a consolidation according to International Financial Reporting Standards (IFRS) or covered by the same consolidated supervision.⁴¹ There is an exemption applicable to C6 energy derivative contracts. C6 energy derivatives contracts under MiFID II mean options, futures, swaps, and any other derivative contracts mentioned in Section C.6 of Annex I relating to coal or oil that are traded on an OTF and must be physically settled.⁴² Until 3 January 2021 the clearing obligation set out in Art. 4 EMIR does not apply to C6 energy derivative contracts entered into by non-financial counterparties that exceed the (p. 181) clearing threshold or by non-financial counterparties that shall be authorized for the first time as investment firms as from 3 January 2018. Such C6 energy derivative contracts shall not be considered to be OTC derivative contracts for the purposes of the clearing threshold.⁴³

4.32  EMIR Refit, the revision of EMIR that has entered into force on 17 May 2019, has introduced the obligation applicable to financial and non-financial counterparties taking positions in OTC derivative contracts to calculate every twelve months its aggregate month end average position for the previous twelve months.⁴⁴ Where they do not calculate its positions, or where the result of that calculation exceeds any of the clearing thresholds, the financial counterparty shall: (a) immediately notify European Securities and Markets Authority (ESMA) and the relevant competent authority thereof, and, where relevant, indicate the period used for the calculation; (b) establish clearing arrangements within four months after the notification referred to in point (a); and (c) become subject to the clearing obligation referred to in Art. 4 for all OTC derivative contracts pertaining to any class of OTC derivatives which is subject to the clearing obligation entered into or novated more than four months following the notification referred to in point (a).⁴⁵

4.33  CCPs play a key role in the new financial market infrastructure in particular related to the clearing of OTC derivatives. All OTC derivative contracts subject to the clearing obligation must be cleared in a CCP either authorized or in case of a third country domiciled CCP recognized by ESMA and listed in the register of authorized and recognized CCPs. Each counterparty must liaise with a CCP by either becoming a direct clearing member or a client of a clearing member and thus to indirectly clear the OTC derivative transactions in a CCP. There are typically only few direct clearing members to a CCP, because they are responsible for discharging the financial obligations arising from a direct participation in direct membership.⁴⁶ This operational issue was intended to be addressed at least in theory by the possibility to allow counterparties subject to the clearing obligation to clear their derivatives as clients of a direct clearing member. In practice, however, it is not very attractive for direct clearing members to offer indirect clearing services, because it requires additional regulatory capital and does not bring much benefit.⁴⁷

4.34  The clearing obligations enter into force depending upon the category to which the counterparties belong. There are four main categories depending upon the status of the (p. 182) counterparty. The clearing obligations will at different points in time enter into force for these categories of counterparties.⁴⁸

• •  Category 1 consists of the most sophisticated market participants. They are the clearing members for at least one of the classes of OTC derivative contracts subject to clearing. The clearing obligations for these market participants has already entered into force: for IRS related to G4 currencies on 21 June 2016, for European Index CDS on 9 February 2017, and for IRS on NOK, PLN, and SEK on 9 February 2017.

• •  Category 2 comprises financial counterparties or alternative investment funds being non-financial counterparties that do not belong to category 1, but belong to a group whose aggregate month end average of outstanding gross notional amount of non-centrally cleared derivatives for January, February, and March is above EUR8 billion. The entry into force of the clearing obligation for IRS related to G4 currencies was on 21 December 2016, for European Index CDS on 9 August 2017, and for IRS on NOK, PLN, and SEK on 9 July 2017.

• •  Category 3 includes financial counterparties and alternative investment funds being non-financial counterparties which are below the group-wide aggregate month end average of outstanding gross notional amount of non-centrally cleared derivatives of EUR8 billion. The entry into force of the clearing obligation for IRS related to G4 currencies, European Index CDS, and for IRS on NOK, PLN, and SEK was on 21 June 2019.

• •  Category 4 comprises all non-financial counterparties not covered by the preceding categories. The clearing obligation for IRS related to G4 currencies entered into force on 21 December 2018, for European Index CDS on 9 May 2019, and for IRS on NOK, PLN, and SEK on 9 July 2019.

4.35  One of the key cornerstones under EMIR is the obligation to report any derivative contract counterparties have concluded and any modification or termination of such a contract to a trade repository. The reporting must be done no later than one working day (T + 1) following the conclusion, modification, or termination of the derivative contract.⁴⁹ This tight reporting deadline is in practice quite a challenge to meet, especially for commodities firms trading houses concluding, modifying, or terminating hundreds of derivative contracts. Mark-to-market or mark-to-model valuations of contracts reported to a trade repository shall be done on a daily basis. Any other reporting elements shall be reported as they occur.⁵⁰

(p. 183) 4.36  Prior to EMIR-Refit, that has entered into force on 17 May 2019, the reporting obligation has affected both counterparties to a derivative transaction no matter whether financial, non-financial below or above the thresholds. The EU has thus pursued a system known as double-sided reporting (as opposed to the single sided reporting where only one party has to report as common in the US or Switzerland). EMIR Refit has also introduced the single-sided reporting system in the EU. Financial counterparties shall be solely responsible, and legally liable, for reporting on behalf of both counterparties, the details of OTC derivative contracts concluded with a non-financial counterparty, as well as for ensuring the correctness of the details reported. The non-financial counterparty has, however, to provide the details of the OTC derivative contracts concluded with the financial counterparty to ensure that the financial counterparty has all data. The non-financial counterparty shall be responsible for ensuring that those details are correct, unless the non-financial counterparty decides to report its side of the trade.⁵¹

4.37  Transactions intra-entity, meaning e.g. between two desks of the same firm, must not be reported, because they are not executed between two separate legal entities. The reporting obligation does, however, not apply to legal entities to a derivative transaction that are domiciled in a third country. In case one counterparty to a derivative transaction is domiciled in the EU and the other counterparty to a derivative transaction in a third country, the EU domiciled counterparty is solely obliged to report. This is, however, not the case if the counterparty domiciled in a third country reports to a trade repository of a jurisdiction that has been designated as equivalent to the EU and the trade repository is obliged to give ESMA direct access to the data.⁵² The EU domiciled counterparty must however identify the non-EU domiciled counterparty in the report. CCPs can also become subject to the reporting obligation in case an existing contract is subsequently cleared by a CCP. Such a contract should be reported as terminated and the new contract resulting from the clearing must be reported.⁵³ The reporting obligation can be delegated to third parties or the counterparty.⁵⁴ This is in practice often the case. Brokers and banks typically do report on behalf of their clients. The delegating party remains, however, responsible for the regulatory reporting obligation.

4.38  It is important to note that not just OTC derivatives, but also exchange traded contracts (ETD) are subject to the reporting obligation. Commodities trading houses are trading large amounts of ETDs on a daily basis and the related reporting obligation imposes a considerable burden on them. That is why the single-sided reporting (p. 184) regime implemented under EMIR Refit is very much welcomed by commodities trading houses. It is at least questionable whether ETDs should be reported at all, because the G-20 principles have never called for the reporting of ETDs and ETDs are overreported under the EU financial market regulation architecture. ETDs are subject to multiple reporting obligations under the MiFID II regime. Also, intragroup transactions are generally subject to the reporting obligation. Another key benefit under EMIR Refit for commodities trading houses is the exemption of the reporting of from, if at least one of the counterparties is a non-financial counterparty or would be qualified as a non-financial counterparty if it were established in the EU, provided that: (a) both counterparties are included in the same consolidation on a full basis; (b) subject to appropriate centralized risk evaluation, measurement and control procedures; and (c) the parent undertaking is not a financial counterparty.⁵⁵ The content of the reporting is rather extensive and encompasses up to eighty-five reporting fields.⁵⁶

4.39  The derivatives must be reported to a trade repository registered with ESMA or recognized by the Swiss Financial Market Supervisory Authority (FINMA). A trade repository domiciled in the EU must apply for registration and must fulfil on an ongoing basis the conditions for registration.⁵⁷ The application for registration must be filed with ESMA. Trade repositories domiciled in third countries can also be used for the fulfilment of the reporting obligation under EMIR if they are either recognized by ESMA or the European Commission has adopted an implementing act determining that the legal and supervisory arrangements of a third country ensure that the trade repositories in that third country comply with legally binding requirements that are equivalent to the ones under EMIR, there is an effective supervision and enforcement of trade repositories, and guarantees of professional secrecy exist regarding shared business secrets.⁵⁸ The recognition of a trade repository domiciled in a third country requires also the submission of an application for recognition together with all the required information to ESMA.⁵⁹

4.40  Any data related to the details of a derivative contract must be kept as records by the counterparties and the CCP for at least five years.⁶⁰ The legally prescribed reporting obligation ensures that the reporting of any details related to the derivatives transaction is not considered a breach of any restriction on disclosure or information imposed by a contract, or by any legislative, regulatory, or administrative provision.⁶¹ The reporting obligation serves in other words as legal justification for the disclosure of data, but only to the extent such disclosure is required under the circumstances.

4.41  Financial and non-financial counterparties that enter into an OTC derivative contract not cleared by a CCP have to address the operational risks that arise from the entering into OTC derivative contracts by means of risk mitigation obligations. The law assumes that the counterparties are exercising due diligence, putting in place appropriate procedures and arrangements, and are monitoring as well as mitigating operational risk by including at least:⁶²

• •  timely confirmation, where available by electronic means;

• •  formalized, robust, resilient, and auditable processes to reconcile portfolios;

• •  the obligation to ensure portfolio compression;

• •  management and identification of disputes;

• •  mark-to-market on a daily basis the value of outstanding contracts in case of financial and non-financial counterparties exceeding the clearing threshold; and

• •  timely, accurate, and appropriately segregated exchange of collateral in case of financial counterparties or non-financial counterparties exceeding the clearing threshold.

4.42  A special exemption applies to C6 derivative contracts. Until 3 January 2021 the risk mitigation techniques will not apply to C6 energy derivative contracts entered into by non-financial counterparties exceeding the clearing threshold or by non-financial counterparties that shall be authorized for the first time as investment firms as from 3 January 2018.⁶³

4.43  The obligation to confirm the terms and conditions of an OTC derivative transaction means the documentation of the agreement of the counterparties to all the terms of an OTC derivative contract.⁶⁴ The confirmation obligation allows for early identification of discrepancies in the terms of a non-centrally cleared OTC derivative transaction, thereby assisting in more prompt resolution of such discrepancies. The confirmation can be made by means of an electronically executed contract of a document signed by both parties.⁶⁵ OTC derivative contracts must be confirmed within T+1 in case of financial counterparties and non-financial counterparties exceeding the clearing threshold.⁶⁶ OTC derivative contracts concluded with a non-financial counterparty not exceeding the clearing threshold must be confirmed within T+2 following the date of the execution of the derivative contract.⁶⁷ These deadlines are extended by no more (p. 186) than one business day if the OTC derivative transactions are concluded after 4 pm local time or in another time zone which does not allow confirmation by the set deadline. Financial counterparties must report on a monthly basis OTC derivative transactions outstanding for more than five business days.⁶⁸ The confirmation should be made by electronic means where available, meaning where an electronic confirmation is available to the market (e.g. confirmation platform).⁶⁹ Confirmation can either be made by means of positive affirmation or even a negative affirmation where combined with an appropriate legal framework. In our view a confirmation should even be possible if made by performance, meaning that no further obligations remain to be met. The confirmation obligation applies only to EU domiciled counterparties and not to counterparties domiciled in a third country.⁷⁰ In such a case the EU domiciled counterparty has to ensure that the requirements are met. In case the counterparty domiciled in a third country is established in a jurisdiction for which the European Commission has adopted an implementing act in accordance with Art. 13 EMIR, the counterparty could comply with equivalent rules in the third country.

4.44  Portfolio compression is a risk reduction service in which two or more counterparties wholly or partially terminate some or all of the derivatives submitted by those counterparties for inclusion in the portfolio compression and replace the terminated derivatives with another derivative whose combined notional value is less than the combined notional value of the terminated derivatives. The economic rationale of the portfolio compression can be found in that it reduces notional outstanding by eliminating matched trades or trades that do not contribute risk to a dealer’s portfolio. The operation of compression services can create new replacement contracts, e.g. where a contract is replaced by a new, smaller contract to allow the removal or an offsetting exposure. A notional reduction forms a necessary element of the portfolio compression.⁷¹ Portfolio compression can be made bilaterally, meaning involving the two counterparties, or multilaterally, meaning by involving multiple counterparties. Multilateral compression is usually done by a service provider within a legal and regulatory framework that applies to all the participants in the compression.⁷²

4.45  Financial counterparties and non-financial counterparties with 500 or more OTC derivative contracts outstanding with a counterparty which are not centrally cleared shall have in place procedures to regularly, and at least twice a year, analyse the possibility to conduct a portfolio compression exercise in order to reduce their counterparty credit risk and engage in such a portfolio compression exercise.⁷³ Financial counterparties (p. 187) and non-financial counterparties must ensure that they are able to provide a reasonable and valid explanation to the relevant competent authority for concluding that a portfolio compression exercise is not appropriate. The portfolio compression obligation applies only to EU domiciled counterparties and not to counterparties domiciled in a third country. In such a case the EU domiciled counterparty has to ensure that the requirements are met. In case the counterparty domiciled in a third country is established in a jurisdiction for which the European Commission has adopted an implementing act in accordance with Art. 13 EMIR, the counterparty could comply with equivalent rules in the third country.

4.46  Financial and non-financial counterparties to an OTC derivative transaction must agree in writing or other equivalent electronic means with each of the counterparties on the arrangements under which portfolios will be reconciled.⁷⁴ The main purpose of the portfolio reconciliation is to identify at an early stage any material discrepancies of an OTC derivative contract. That is why the portfolio reconciliation must cover the key trade terms that identify each particular OTC derivative contract and must at least include the valuation derived from a mark-to-market valuation approach.⁷⁵

4.47  The frequency of the portfolio reconciliation depends on the status of the counterparty and the number of outstanding contracts between the counterparties. Non-financial counterparties below the clearing threshold must perform the portfolio reconciliation obligation once a quarter if there are more than 100 OTC derivative contracts outstanding at any time during the quarter and once a year when the counterparties have less than 100 OTC derivative contracts outstanding. Financial counterparties must reconcile each business day in case they have more than 500 OTC derivative contracts outstanding, once per week when the counterparties have between fifty-one and 499 OTC derivative contracts outstanding, and once per quarter when there are fifty or less OTC derivative contracts outstanding at any time during the quarter.⁷⁶ The performance of the reconciliation obligation can be outsourced to third parties.

4.48  EMIR requires that the counterparties to an OTC derivative contract agree on a dispute resolution mechanism, meaning the identification, recording, and monitoring of disputes relating to the recognition or valuation of the contract and to the exchange of collateral between counterparties. Those procedures must at least record the length of time for which the dispute remains outstanding, the counterparty and the amount which is disputed. The procedures must also determine the resolution of disputes in a timely manner with a specific process for those disputes that are not resolved within (p. 188) five business days.⁷⁷ The amount or value of outstanding disputes must be calculated on a trade by trade basis if possible. A portfolio view can be deployed if the disputed margin is calculated at the portfolio level. There is no legal de minimis rule applicable. Counterparties can, however, agree in advance that minor discrepancies would not count as disputes.⁷⁸ The dispute resolution obligations apply generally only to EU domiciled counterparties. An EU domiciled counterparty entering into an OTC derivative contract with a counterparty domiciled in a third country does thus have to ensure that the relevant obligations are fulfilled. In case the counterparty is established in a jurisdiction regarding which the European Commission has adopted and implementing act, said counterparty could comply with the equivalent rules in said third country.

4.49  EMIR requires financial counterparties to have risk management procedures in place that require the timely, accurate, and appropriately segregated exchange of collateral with respect to OTC derivative contracts. Non-financial counterparties must have similar procedures in place, if they are above the clearing threshold.⁷⁹ The obligation to exchange collateral (initial and variation margin) is the only risk mitigation obligation that applies directly also to counterparties that are domiciled in third countries.⁸⁰

4.50  The obligation to exchange collateral means the obligation to exchange variation margin and eventually also initial margins. Variation margin means the collateral collected by a counterparty to reflect the results of the daily marking-to-market or marking-to-model of outstanding contracts.⁸¹ It is the daily exchange of profit and loss incurred on an OTC derivative contract entered into between two counterparties. Variation margins prevent the build-up of uncollateralized exposures within the system. The initial margin is the collateral collected by the counterparty to cover its current and potential future exposure in the interval between the last collection of margin and the liquidation of positions or hedging of market risk following a default of the other counterparty.⁸² Counterparties might provide in their risk management procedures that initial margins are not collected for all new OTC derivative contracts entered into within a calendar year where one of the two counterparties has an aggregate month end average notional amount of non-centrally cleared OTC derivatives for the months March, April, and May of the preceding year of below EUR8 billion.⁸³ Initial margins cannot be netted and reflect the changes in both the risk positions and market conditions. They are subject to (p. 189) concentration limits.⁸⁴ Initial margins must be re-calculated at least every ten days. The obligation to exchange collateral requires a detailed collateral management and operational procedures⁸⁵ as well as an exchange of collateral agreement.⁸⁶ The counterparties to an OTC derivative contract can agree that initial margins must only be exchanged if they exceed a minimal threshold of CHF50 million⁸⁷ and in case of the variation margin if they exceed the minimal threshold of CHF500,000 (the minimum transfer amount).⁸⁸ The eligible collateral is for both the variation and initial margin the same.⁸⁹ The collecting counterparty is, however, not entitled to rehypothecate, repledge, or otherwise reuse the collateral collected as initial margin, except to cash held by a third party holder if used for reinvestment purposes.⁹⁰

4.51  The obligation to exchange variation margin has entered into force on 1 March 2017 and the obligation to exchange initial margin will entry into force on 4 February 2017 through to 1 September 2020 during a phase-in period, depending upon the group aggregate average notional amount of non-centrally cleared derivatives.

4.52  Financial counterparties and non-financial counterparties exceeding the clearing threshold shall conclude transactions which are not intragroup transactions with other such financial counterparties or other such non-financial counterparties in derivatives pertaining to a class of derivatives that has been declared subject to the trading obligation and listed in the register only on regulated markets, multilateral trading facilities, organized trading facilities, or third country trading venues that have been deemed to be equivalent to the EU regime.⁹¹ The trading obligation applies also to counterparties which enter into derivatives transactions pertaining to a class of derivatives that has been declared subject to the trading obligation with third country financial institutions or other third country entities that would be subject to the clearing obligation if they were established in the EU. The trading obligation shall also apply to third-country entities that would be subject to the clearing obligation if they were established in the EU, which enter into derivatives transactions pertaining to a class of derivatives that has been declared subject to the trading obligation, provided that the contract has a direct, substantial, and foreseeable effect within the EU or where such obligation is necessary or appropriate to prevent the evasion of any provision of this Regulation. Derivatives declared subject to the trading obligation must be eligible to be admitted to (p. 190) trading on a regulated market or to trade on any trading venue on a non-exclusive and non-discriminatory basis.⁹²

4.53  The EU has introduced the trading obligation for certain classes of derivatives. Commodities derivatives are, however, not planned to become subject to the trading obligation.⁹³ The following derivatives are becoming subject to the trading obligation.

4.54  Fixed-to-float single currency interest rate swaps—EUR EURIBOR three and six months

Fixed leg

Floating leg

4.55  Fixed-to-float single currency interest rate swaps—USD LIBOR three months

Fixed leg

(p. 191) Floating leg

4.56  Fixed-to-float currency interest rate swaps—GBP LIBOR three and six months

Fixed leg

(p. 192) Floating leg

4.57  The trading obligation for derivatives does currently not apply to non-par swaps. Non-par swaps, including swaps traded at market agreed coupon (MAC), are currently not subject to the trading obligation for derivatives.⁹⁴

4.58  The trading obligation for said derivatives will begin on the following dates:

4.59  As noted earlier, the clearing obligation in EMIR applies in respect of OTC derivatives, meaning those that are not executed on a regulated market or a third country market which is deemed to be equivalent. As explained in Chapter 3, there is also an obligation for derivatives concluded on regulated markets to be cleared through a CCP in MiFIR. MiFIR also requires CCPs, trading venues, and investment firms that act as (p. 193) clearing members to have in place effective systems, procedures, and arrangements to ensure that transactions in cleared derivatives are submitted and accepted for clearing as quickly as technologically practicable using automated systems. Cleared derivatives for these purposes means all of those that are subject to the clearing obligation in MiFIR, those that are subject to the clearing obligation in EMIR and those that the parties otherwise agree to clear.⁹⁵ There are also obligations in respect of indirect clearing of exchange traded derivatives as set out in more detail in Chapter 3.⁹⁶

4.60  There are a number of different reporting regimes that are relevant to European trading venues and/or persons that enter into commodity derivatives on them. These are described in Chapter 3 and include transaction reporting,⁹⁷ post-trade transparency⁹⁸ and position reporting under MiFIR,⁹⁹ and reporting obligations under EMIR¹⁰⁰ and REMIT.¹⁰¹

4.61  There are currently no UK specific rules on clearing commodity derivatives. EMIR and the technical standards that sit beneath it are regulations so do not need to be implemented in the UK and instead have direct effect. This is also true of the transaction reporting and post-trade transparency obligations under MiFIR and the reporting obligations under EMIR. However, the position reporting obligations are in MiFID II which, as a directive, does not have direct effect and needed to be transposed into English law. The position reporting rules are set out in Chapter 10 of the FCA’s Code of Market Conduct Handbook. The FCA also produced a useful document for trading venues and investment firms submitting position reports¹⁰². Again, the risk mitigation rules in EMIR have direct effect in the UK, as does the trading obligation under MIFIR.

4.62  In the event that the UK leaves the EU without a withdrawal agreement that provides for a transitional period during which the UK continues to apply European law, the government has made plans to onshore these obligations into English law. The obligations would apply in the same way but the details about where information needs to be reported would be change.

4.63  The Commodity Futures Trading Commission Act of 1974 created the CFTC and required it to review and approve most exchange rules and contract terms before their implementation.¹⁰³ In exercising that authority, the CFTC initially grandfathered all existing exchange rules as being approved and exempted from its review all operational and administrative exchange rules. The CFTC then began affirmatively reviewing and approving new futures contracts and new exchange rules and rule amendments. To the dismay of the futures exchanges, that review process resulted in long delays in introducing new contracts and new and amended rules.

4.64  The most troubling and extended part of that now discarded review process was the CFTC’s economic analysis of new futures contract applications. That review analysed the economic viability and benefits of new contracts before allowing them to trade. Among other things, that analysis considered ‘the economic effect of new contracts, their susceptibility to manipulation and, in early stages, the proliferation of identical contracts that could cause liquidity problems when volume is split up between several exchanges.’¹⁰⁴ The delays engendered by such reviews were lengthy. To illustrate, the CFTC took over two years to review treasury futures contracts proposed to be traded by the MidAmerica Exchange in Chicago exchanges.¹⁰⁵ These delays resulted in much criticism of the CFTC’s process, and the CFTC reacted by concluding that ‘the marketplace, not the CFTC, should judge the economic viability of futures contracts’.¹⁰⁶

4.65  Despite this change in approach, delays in contract and rule approvals at the CFTC continued. In an effort to alleviate these concerns, Congress enacted legislation in 1982 that limited required CFTC approval of only exchange rules relating to the terms and conditions of commodity futures contracts.¹⁰⁷ Time limitations were also placed on the CFTC in approving those rules, i.e. approval or an action to challenge a proposed rule change was required to be instituted by the CFTC within 180 days of submission.¹⁰⁸

4.66  This legislation also proved to be ineffective. The CFTC then switched from a rule-based regulatory regime to a principle-based structure. ‘Principles-based regulation (p. 195) seeks to regulate by broad directives rather than by micromanagement through a set of lengthy and complex regulations, the model employed by the SEC.’¹⁰⁹ Congress enacted the Commodity Futures Modernization Act of 2000 (CFMA) to codify the CFTC’s sea change in its regulatory role.¹¹⁰ The CFMA repealed the CFTC’s use of an ‘economic purpose’ test for new contracts.¹¹¹

4.67  The self-certification rules under the new CFMA regulations could be implemented by DCMs ten days after notification to the CFTC.¹¹² The CFMA thus effectively removed the CFTC from any affirmative requirements for DCM rules to be approved by it. The CFTC was permitted to review and stay the implementation of the proposed rules.¹¹³ However, any such review could not include any economic analysis to assess competition issues, because such a test had been eliminated by the CFMA. The CFTC rules adopted under the CFMA allow the ‘voluntary’ submission by exchanges of their rules for CFTC review and approval.¹¹⁴ This process of deference to exchange rules allowed US futures exchanges to self-certify futures trading on bitcoins in 2017, which was then an untested and controversial financial product.

4.68  The CFMA also created several ‘core’ principles that DCMs rules and operations must implement and enforce. They include compliance with CFTC rules; assurance that contracts traded on the DCM are not readily subject to manipulation; that the DCM will act to prevent market disruptions; creation of limits on position sizes of traders to prevent market threats; daily publication of trading information; prevention of conflicts of interest; and recordkeeping requirements.

4.69  The CFMA also required futures clearinghouses to be separately registered and regulated by the CFTC as derivatives clearing organizations (DCOs).¹¹⁵ Like DCMs, these entities were subject to principle-based regulation pursuant to which they must adopt and enforce several specified core principles. Those principles include appropriate risk management capabilities; ability to complete settlements on a timely basis; standards and procedures to protect member and participant funds; and efficient and fair default rules and procedures.

4.70  Electronic trading broadly restructured exchange trading operations. Among other things, it resulted in a demutualization of the member owned futures exchanges and a consolidation of their activities. The two largest futures exchanges, the CME Group and The Chicago Board of Trade demutualized and became public companies before merging with each other in 2007 and with another large futures exchange, (p. 196) NYMEX, in 2008. The Intercontinental Exchange (ICE) also became a centralized futures market.

4.71  The effects from the introduction of electronic trading were also felt abroad. In one high profile competition during the 1990s a then new German all-electronic futures exchange, the Deutsche Terminborse (DTB), now Eurex, successfully challenged the London International Financial Futures Exchange (LIFFE), a traditional open outcry exchange. That competition was for market share in the German Bund futures contract in which the DTB prevailed. LIFFE then dropped its open outcry trading system and became an all-electronic exchange.

4.72  The French futures market Matif was started in 1986 and grew rapidly. It utilized and open outcry-trading system conducted in pits on trading floor. In 1994, Matif opened a new trading floor to house its open outcry trading pits, but that did not stop the replacement of floor trading by electronic platforms. The introduction of electronic trading side by side with open outcry trading occurred on the Matif in 1998. Electronic trading then resulted in the elimination of the floor traders within a matter of weeks. Matif then became an all-electronic exchange.

4.73  These events signalled to US futures exchanges that electronic trading could effectively challenge open outcry systems. Initially, the US futures exchanges responded slowly to electronic competition. They extended their trading hours and spent hundreds of millions of dollars installing electronic trading devices on their floors. Those expenditures were intended to speed open outcry executions and order handling on the trading floors. The Chicago Board of Trade opened a new 60,000 square foot trading floor in 1997 that cost over USD180 million. It was obsolete by the time of its opening. The Chicago futures exchanges then adopted side by side electronic trading platforms to compete with their own floor trading operations. The electronic trading platforms prevailed and most floor trading operations have now been discontinued. ICE was an electronic market that acquired various open outcry markets that it also converted to electronic trading.

4.74  Stock exchanges must register with the SEC as a national securities exchange. The largest of the traditional stock exchanges was the New York Stock Exchange (NYSE). The OTC market on Nasdaq was administered by the National Association of Securities Dealers (NASD), but Nasdaq later registered as a national securities exchange. That registration requires exchanges to act as self-regulatory organizations (SROs). The NYSE and NASD consolidated their SRO responsibilities into one organization, the Financial Industry Regulation Authority (FINRA).

4.75  FINRA carries out its SROs responsibilities by adopting and enforcing rules that seek to ensure compliance with the federal securities laws, SEC rules, and with ‘just and equitable principles of trade’. In contrast to the regulation of futures exchanges, the federal securities laws still employ a rule-based system of regulation. This means that, unlike (p. 197) futures exchanges, every new substantive rule or rule change that is adopted by a national securities exchange must reviewed and approved by the SEC before implementation and must be published in the Federal Register for public comment. As a Treasury Department White Paper noted:

Pursuant to the CEA, the CFTC currently employs a ‘principles-based approach’ to regulation of exchanges, clearing organizations, and intermediaries, while pursuant to the securities laws; the SEC employs a ‘rules-based approach.’¹¹⁶

4.76  It was historically rare for stock exchanges to list and trade the same securities. NYSE Rule 390 prohibited NYSE members from trading NYSE-listed stocks anywhere other than through that exchange. This rule sought to assure that all orders were routed through the specialist desks on the NYSE trading floor, allowing the specialist to garner a spread on those orders and allowing floor brokers to earn commissions.

4.77  Broker-dealers that were not members of the NYSE, and therefore not subject to NYSE Rule 390, could make markets in NYSE listed stocks. The trading by those non-member broker-dealers was referred to as the ‘third market’. It was a relatively small market because most large broker-dealers were members of the NYSE and subject to the proscriptions of Rule 390. A ‘fourth market’ also appeared that was composed of institutions that were not members of the NYSE. Those institutions experienced accelerated growth after World War II and by the 1990s were trading in sufficient volumes to create a viable market. The fourth market laid the groundwork for the electronic markets that are now dominating securities trading. Block trades were allowed on the NYSE. These trades were put together ‘upstairs’ by broker-dealers and then reported to the floor.

4.78  The SEC required the NYSE to freeze Rule 390 in the 1970s so that it did not apply to any stocks listed after 26 April 1979. However, the NYSE could still require orders for most of its large volume blue chip stocks to be sent to the floor for execution. This allowed the NYSE to continue its monopoly in most of the trading volume in its listed shares, even in the face of electronic competition, until that restriction was dropped altogether in December 1999. In the meantime, electronic communication networks had become a popular trading mechanism in NASDAQ stocks and posed a direct competitive threat to the NYSE once Rule 390 was terminated.

4.79  The NYSE resisted electronic trading because it would undercut the specialists’ monopoly over order flow, require them to tighten their spreads and remove the time and place advantage that they had theretofore enjoyed. As pressure mounted for more rapid and efficient executions, however, the stock exchanges gradually allowed some automated executions for small orders (for which the specialist still captured (p. 198) the spread). The stock exchanges also tried to speed executions by computer assisted trading devices and by adding technology to their floors, spending hundreds of millions of dollars in the process, all to protect the floor members from fully electronic trading platforms.

4.80  Electronic trading platforms were developed at the end of the last century that did not require a trading floor or specialists to make markets. Those electronic markets were initially called electronic trading networks (ECNs). If ECNs had been required to register as national securities exchanges, they would not have been able to function. This is because it was impracticable for them to meet the SRO responsibilities imposed on registered exchanges. The SEC concluded that ECNs were not exchanges because they only matched orders of opposing traders and did not make a continuous two-sided market. The SEC, therefore, allowed the ECNs to register as broker-dealers, instead of as an exchange.

4.81  Electronic trading continued to grow and, in 1997, the SEC began rule-making proceedings to further regulate it. It later adopted a set of regulations governing the operations of ECNs, which the agency renamed the Alternative Trading Systems (ATS).¹¹⁷ The SEC concluded that ATS have characteristics of both traditional exchanges and broker-dealers, stating that:

An ATS is any . . . person . . . : (a) that constitutes, maintains, or provides a marketplace or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange . . . ; and (b) that does not: (i) set rules governing the conduct of subscribers other than the conduct of such subscribers trading on such . . . system, or (ii) discipline subscribers other than by exclusion from trading.¹¹⁸

4.82  ATS sought to further the SEC’s goal of creating a national market system. It required market makers and specialists to publicly post any order they placed on an ATS that was better than their publicly quoted prices.¹¹⁹

4.83  Competitive pressures from ATS led the NYSE to demutualize and merge with an electronic exchange, Archipelago Holdings, which was founded in 1997. Archipelago had previously merged with the Pacific Stock Exchange. The NYSE, thereafter, became a public company. Another merger followed between the NYSE and Euronext, a European network of electronic exchanges. Euronext is a Dutch public company that was formed in September 2000 from the merger of the Amsterdam, Brussels, and Paris stock exchanges. Euronext acquired LIFFE and the Portuguese stock exchange in 2002.

4.84  Switzerland has followed and implemented into national legislation many other key jurisdictions the G-20 principles decided on the G-20 summit in Pittsburgh in 2009 about the regulation of OTC derivatives.¹²⁰ Switzerland has legislated the trading in derivatives in the Swiss Financial Market Infrastructure Act and the related ordinances and circulars of FINMA.¹²¹

4.85  All derivatives, meaning financial contracts whose value depends on one or several underlying assets and which are not cash transactions, are generally subject to certain obligations under the Swiss Financial Market Infrastructure Act (FMIA/FinfraG).¹²² There are, however, certain exemptions applicable to commodities related derivatives, which exempt them from the application of certain obligations. The following financial instruments are not deemed to be derivatives:

• •  derivatives transactions relating to electricity and gas which

  • •  are traded on an organized trading facility,

  • •  must be physically delivered, and

  • •  cannot be settled in cash at a party’s discretion;¹²³ and

• •  derivatives transactions relating to climatic variables, freight rates, inflation rates, or other official economic statistics that are settled in cash only in the event of a default or other termination event.¹²⁴

4.86  The following derivatives are not ‘derivatives’ for the purposes of the regulatory obligations applicable to derivatives trading:

• •  derivatives transactions relating to goods that

  • •  must be physically delivered,

  • •  cannot be settled in cash at a party’s discretion, and

  • •  are not traded on a trading venue or an organised trading facility.¹²⁵

4.87  ETD related to commodities are derivatives in the sense of Art. 2 para. 2 FMIO.

4.88  Commodities trading houses domiciled in Switzerland which are entered into the commercial register fall generally within the scope of application of the FMIA if they are trading in derivatives subject to the FMIA. This applies generally also to non-Swiss (p. 200) domiciled counterparties trading in derivatives subject to the FMIA with a Swiss based counterparty. Commodities trading houses are in Switzerland typically non-regulated. All non-regulated entities are qualified as non-financial counterparties (NFC).¹²⁶ They are deemed to be large (NFC+) if they exceed one of the following thresholds: CHF3.3 billion annual notional turnover in foreign exchange (FX), interest rates, or commodities derivatives as well as CHF1.1 billion annual notional turnover in equity or debt derivatives. They are small NFC- if they do not exceed one of these thresholds.¹²⁷ NFC can in the calculation of the thresholds deduct transactions that have been entered for hedging purposes. The thresholds are calculated on a group-wide basis, meaning that all the positions of the group entities of which the commodities trading house is part of are being accumulated.¹²⁸ Commodities trading houses that are regulated are Financial Counterparties (FC).¹²⁹ They are large if the positions in derivatives subject to the FMIA exceed the threshold of the CHF8 billion notional amount.¹³⁰

4.89  The trading in derivatives is generally subject to the following obligations, which must depending upon the status of the counterparties be fulfilled either by both or just one counterparty. The Swiss law allows the fulfilment of the obligations under the FMIA under a non-Swiss regulation to the extent FINMA has acknowledged such legislation as equivalent and the obligations that must be fulfilled by means of a foreign financial infrastructure are being fulfilled through a duly licensed or recognized financial infrastructure (based on the principle of substituted compliance).¹³¹ Subject to further notice, the rules and regulations set forth under EMIR have been acknowledged as equivalent by FINMA.¹³² It is, however, currently due to a lacking memorandum of understanding (MoU) between FINMA and ESMA for Swiss-based commodities trading houses not possible to report under EMIR and to fulfil the reporting obligations under the FMIA.¹³³

4.90  All derivatives must be reported to a trade repository no later than the working day following the transaction (T+1). The reporting obligation is one-sided, meaning that by law the higher ranking entity will have to report (CCP > FC+ >FC- > NFC+ > NFC-).¹³⁴ The selling counterparty or, in the case of swaps, the alphabetically preceding counterparty must report in the case of two equivalent counterparties with equivalent status. The reporting obligation does not apply to transactions in derivatives entered into between two NFC-.¹³⁵ The reporting obligation can however (p. 201) by default boomerang back to the Swiss based counterparty if the foreign counterparty will not report although higher ranking (e.g. Swiss Company is trading derivatives OTC with an EU based licensed broker and the broker is not fulfilling its reporting obligation).¹³⁶ The reporting obligation can be outsourced to third parties. The Swiss based commodities trading house will have to sign up either to SIX TR or Regis TR both being trade repositories in case it will be affected by the reporting obligation. The reporting matrix is almost identical to the one set forth under EMIR.¹³⁷ The reporting obligation for NFC- will start in Switzerland on the 1 January 2024. It has already started for NFC+ on the 1 January 2018.¹³⁸

4.91  Derivatives that are not voluntarily cleared through a CCP are subject to risk mitigation obligations. The risk mitigation obligations can generally be outsourced to third parties. The risk mitigation obligations have generally—except to the initial and variation margins—entered into force on 1 January 2017 for FC+, NFC+, or FC- and on 1 July 2017 for NFC-.¹³⁹

4.92  The terms and conditions of the OTC-derivatives transactions must be confirmed within a period of T+2, or T+3 if entered into after 4 pm. The deadlines that apply for complex transactions and small counterparties shall be extended by one business day.¹⁴⁰ This obligation applies to all counterparties independent of their status. The law works on the assumption that both counterparties have to confirm their transaction. The parties might, however, agree on a deviating confirmation mechanism, such as a multilateral exchange of confirmations only in case of disagreement.¹⁴¹

4.93  Both counterparties being subject to the portfolio reconciliation obligation must reconcile the key terms and the valuation of the outstanding OTC derivatives on a periodic basis. It is important to note that this process must be set up (p. 202) prior to the entry into an OTC derivative. The frequency of the portfolio reconciliation depends upon the number of open and outstanding OTC derivatives between the two counterparties (which would generally require an aggregation of the positions entered into by the same counterparties held by multiple custodians). The reconciliation must be done on each business day in case there are more than 500 open OTC derivatives positions. It must be done once a week if at any time during the week there are between fifty-one to 499 open OTC derivatives positions. The reconciliation must only be done once a quarter if there are no more than 50 open OTC derivatives positions outstanding at one moment in that quarter.¹⁴²

4.94  The portfolio compression obligation does only apply if there are 500 or more open OTC derivatives that have not been centrally cleared. The portfolio compression obligation intends to net out offsettable OTC transactions (e.g. five FX options with the same maturity, strike, and currencies: Counterparty A is three time the buyer and twice the seller. The outstanding contracts will be netted out to one contract). The portfolio compression must regularly be done at least twice per year. No portfolio compression must, however, be performed if it would not lead to a meaningful reduction of counterparty risk if there are only few offsettable OTC derivatives or such activity would jeopardize the effectiveness of the internal risk processes and controls.¹⁴³

4.95  The place of jurisdiction and the applicable law must be agreed prior to entering into an OTC derivative. There must be special provisions in place to identify, record, and monitor disputes about the recognition and valuation of the transactions as well as the exchange of collateral. There must also be a special dispute resolution mechanism in place for the swift resolution of disputes outstanding for more than five business days. This dispute resolution mechanism can be addressed by means of the International Swaps and Derivatives Association (ISDA) protocol on dispute resolution, in specific contracts, or in the general terms and conditions.¹⁴⁴

4.96  The valuation obligation requires that the outstanding commodities derivatives must be valued. A valuation based on internal model prices is possible if market conditions do not permit the valuation. Market conditions that do not permit the valuation of OTC derivatives transactions are deemed to hold sway if the market in question is inactive or the range of plausible fair value estimates is significant and the probabilities of the various estimates cannot be reasonably assessed. The valuation obligation can according to the black letter of the law only be outsourced by NFCs to third parties.¹⁴⁵

4.97  OTC derivatives are generally subject to margin requirements in the form of initial or variation margin, unless one of the counterparties is a small NFC. The initial margin is suitable for protecting the transaction partners from the potential risk that there could be market price changes during the closing and replacement of the position in the event of default on the part of one counterparty.¹⁴⁶ The variation margin is suitable for protecting the transaction partners from the ongoing risk of market price changes following execution of the transaction. The variation margin obligation must be applied by anyone subject to margin requirements. The initial margin requirement applies only to entities if the aggregated month end average gross position of OTC derivatives not cleared through a CCP exceed CHF8 billion. The parties to such contracts might agree a minimum transfer amount not exceeding CHF500,000, meaning that only collateral will be exchanged if the initial and variation margins exceed this threshold.¹⁴⁷ The exchange of initial margin alone might be waived if it does not exceed CHF50 million. Variation margin must be calculated and exchanged daily.¹⁴⁸ The initial margin must be exchanged within T+1 for the first time and be calculated every ten days.¹⁴⁹ Collateral can be exchanged in the form of all typical securities, such as cash, high quality debt securities, but also shares and gold as well as money market funds.¹⁵⁰ A hair cut on the collateral will be taken depending upon the type of collateral and the derivative category.¹⁵¹ The variation margin obligation has entered into force on 1 September 2017 and the initial margin obligation will enter into force on a sliding scale depending upon the group’s aggregate outstanding gross position of OTC derivatives not cleared through a CCP. The initial margin obligation for the last category will enter into force in 2020.¹⁵²

4.98  The clearing obligation means that a derivative must be cleared by a CCP which becomes the buyer of the seller and the seller of the buyer of a derivative. CCPs clearing derivatives must either be licensed in Switzerland or be recognized in Switzerland if domiciled outside of Switzerland.¹⁵³ FINMA has introduced the clearing obligation for interest rate swaps (IRS) and certain CDS. The universe of derivatives that has become subject to the clearing obligation since 1 September 2018 is basically the same as under EMIR.

4.99  The following OTC-interest rate derivatives have become subject to the clearing obligation:(p. 204)

4.100  FMIA/FinfraG introduces also the potential obligation that FINMA could designate certain derivatives subject to the platform trading obligation similar to the Swap Execution Facility (SEF) in the US.¹⁵⁴ There is currently no indication that the platform trading obligation will be introduced in Switzerland any time soon.

4.101  Derivatives transactions are not subject to the clearing obligation, obligation to exchange collateral, or platform trading obligation if:¹⁵⁵

• •  both parties are fully consolidated;

• •  both counterparties are subject to adequate centralized risk evaluation, measurement, and control processes;

• (p. 205) •  in case of the obligation to exchange collateral, no legal or factual obstacles for the immediate transfer of own funds or the repayment of liabilities exist; and

• •  the transactions are not made with the intent to circumvent these obligations.

4.102  Group internal transactions are however subject to the reporting obligation, unless they are both NFC-. This exemption applies, however, also to non-group internal transactions between two NFC-.

4.103  Switzerland has in 2011 introduced a trading system for emission allowances similar to the one in the EU which is the CO2 Act and the related ordinances.¹⁵⁶ It has since the inception of the CO2-Act and the related ordinances always been the goal of the Swiss lawmaker to combine the Swiss emission allowance trading system with the European emission allowance trading system. Switzerland has thus introduced in Switzerland an emission allowance trading system based on the cap-and-trade principle. This system allocates to the Swiss enterprises participating in the trading system a certain quantity of emission allowances for free. An enterprise must purchase additional emission allowances if it pollutes the environment more than its emission allowances permit. An enterprise polluting less can sell its spare emission allowances in the market. The emission allowances available in the Swiss cap-and-trade system will be reduced each year. It has been announced at the beginning of 2016 by the Swiss Federal Administration for the Environment (BAFU) which manages the Swiss emission allowances trading system that Switzerland and the EU have finalized the negotiations about the combination of both trading systems on a technical level. The corresponding agreement has been signed in 2017, but has so far not been ratified.¹⁵⁷

4.104  Emission allowances are under the Swiss emission allowance trading systems issued on the primary market.¹⁵⁸ They are in addition also tradable on the secondary market. They qualify neither on the primary market nor on the secondary market as securities or financial instrument.¹⁵⁹

4.105  Emission allowances do not qualify as securities or financial instruments under Swiss law. That is why they are generally not subject to regulatory obligations or a licensing requirements in Switzerland. The trading in emission allowances is thus in Switzerland in particular not subject to the requirement to be licensed as securities dealer.

4.106  This part of the chapter will show how short sales are treated by regulators in the stock and derivative markets. The US SEC has defined a short sale in the following terms:

A short sale is the sale of a security that the seller does not own and any sale that is consummated by the delivery of a security borrowed by, or for the account of, the seller. In order to deliver the security to the purchaser, the short seller will borrow the security, usually from a broker-dealer or an institutional investor. Typically, the short seller later closes out the position by purchasing equivalent securities on the open market and returning the borrowed security to the lender. In general, short selling is used to profit from an expected downward price movement, to provide liquidity in response to unanticipated demand, or to hedge the risk of an economic long position in the same security or in a related security.¹⁶⁰

4.107  In other words, short selling in the securities markets involves selling stocks or other securities that a trader did not own in expectation that the price of the security being sold will decline. In such event, the seller will buy the security at the lower price and deliver it to the purchaser, allowing the seller to profit from the difference. Of course, if the price of the security increased between the time of the sale and buy-in for delivery, the seller will suffer a loss from the adverse difference in prices.

4.108  Short selling in futures markets is distinguishable from a short sale in the securities markets. Short selling in futures contracts is viewed differently in the futures markets than in the stock market. The sellers of futures contracts generally do not own the underlying commodity. In fact, delivery is rarely made on futures contracts. Indeed, many futures contracts are cash settled and do not even permit delivery. Consequently, short sellers of futures contracts are not expected to ‘cover’ their position by borrowing the underlying commodity. Instead, the risk of their performing on the futures contract by paying their losses in the event of adverse price moves is secured by initial and maintenance margin requirements.

4.109  Short selling in the stock markets has been traditionally been viewed to be speculation that can be destructive by placing untoward downward pressure on prices. Critics even claim that short sellers can crash markets. In contrast, short sales of futures are viewed to be beneficial in pricing commodities because markets go up and down to the equal benefit or detriment of market participants. For example, a farmer may suffer when agriculture prices decline, while consumers benefit from lower food prices.

4.110  The obligation of a short seller in the securities markets is generally to arrange in advance to borrow and deliver the securities that are the subject of the short sale. This is called a ‘covered’ short sale. A transaction in which the trader does not arrange to borrow the security before engaging in a short sale is called a ‘naked’ short sale. Naked shorts seek to take advantage of settlement delays.¹⁶¹

4.111  Stock lending for covered short sales totals nearly USD2 trillion per year worldwide.¹⁶² Large investment banks and institutional investors have business units that arrange for short sellers to borrow stocks for delivery on their short sales. In a stock lending programme, the lender secures sufficient collateral from the borrower to assure that it will be able to repurchase and return the stock in the event of adverse price movements. The lender is compensated by interest and fees for this service.

4.112  As the following description shows, stock lending for covered short sales are secured by other collateral and that collateral is marked-to-market. Where the lender loans a security the borrower pays cash collateral slightly exceeding the value of the stock that is sold short. If the price of the security increases the broker-dealer will pay the increase to the lender. Should the price of the security drop, the lender will reciprocate.

4.113  In contrast, a naked short seller seeks to avoid the costs of arranging for and borrowing securities for short sales by closing out the short sale through an offsetting purchase before the settlement date. The short seller will then experience a profit or loss based on the difference in the sale and purchase prices without incurring the borrowing costs of a covered sale.

4.114  The naked short seller seeks to take advantage of the delay between the execution date of a stock trade and its settlement date. Previously trades were required to be executed five days after their execution (T+5). That number was subsequently reduced to three days and now is being reduced to two. A naked short seller intends to close its short position before the settlement date by an offsetting purchase. This negates the need to borrow securities for delivery or at least shorten the borrow period and thereby reduce borrowing costs. The SEC has adopted a regulation that prohibits naked short sales.¹⁶³

4.115  As noted, the obligations of short sellers in the futures markets do not include any obligation to own or borrow the underlying commodity, since delivery is rarely made. Instead, the seller’s performance is secured through good faith down payments in the (p. 208) form of margin requirements. Margin in the futures industry should not be equated with margin in the securities industry because stock margins are intended to limit speculation, while futures margins seek to assure performance.

4.116  Margin for securities is regulated by the Federal Reserve Board under Regulation T. It generally limits the amount of loans that can be made to purchase a marginable stock to 50 per cent of the value of the stock being purchased.¹⁶⁴ Margin for commodities futures is not viewed to be an extension of credit, as in the case of securities. Rather, it is a good faith deposit of money, a type of performance bond.

4.117  In the first instance, ‘initial’ margin is required for each futures contract when it is executed. This amount may be expressed as a percentage of the notional value of the futures contract. Initial margin levels are based on an assessment of the potential amount that a commodity might change in price before a clearing firm is able to liquidate the account of a defaulting customer. The initial margin for a futures contract is usually only a small percentage of the notional amount of a futures contract, usually less than 5 per cent.

4.118  In addition to initial and maintenance margin, ‘variation’ margin payments are required to be paid by contract holders. This is an additional deposit of money required to reflect losses incurred by the trader from adverse price changes on their open commodity futures positions. Variation margin requirements are computed through a mark-to-market system in which the market value of the commodity is computed daily to determine if its value has changed. The purchaser or seller experiencing a loss is required to post an additional amount equivalent to that loss. The party experiencing a gain will be credited with an offsetting amount.

4.119  The obligations of short sellers of options and single stock futures is somewhat of a hybrid model. Options typically are subject to risk-based requirements but also may have a fixed margin component based on the amount of the premium paid by the purchaser. Equity options are margined somewhat differently from commodity exchange option margins. For example, the short trader is paid the premium from the equity option buyer and the margin requirement is valued based on the net option liquidating value. In a futures style commodity option, the premium is not paid immediately to the seller. ‘Unlike equity-style margin options, futures-style options have daily realized variation margins calculated.’¹⁶⁵

4.120  Single stock futures are another variation on margin requirements that differ from futures margins for short and long sellers. Single stock futures are generally subject to an initial margin requirement equal to a fixed 20 per cent of the notional value of the underlying commodity, plus variation margin requirements.

4.121  Short selling in securities has historically been viewed to be a suspect practice because short sellers place downward pressure on prices. The Dutch banned short sales over four centuries ago and the English Parliament enacted such a ban in 1733 when it approved the Sir John Barnard’s Act. That suspicion of short selling migrated to the US after the Revolution. Short sales accompanied the growth of stock markets in New York and elsewhere and was greeted with hostility by state governments. New York banned short sales of stock in 1812. Massachusetts passed such a ban in 1836. Those bans proved to be ineffective and were eventually dropped.

4.122  In times of market stress, when prices are dropping, the concern was raised that short sales exacerbated market volatility. This is because more short sellers will pile into the market in order to take advantage of the downturn, pushing prices ever downward until the market crashes. Critics of short selling presume that increases in stock values is a good thing and that declines are bad, because they decrease wealth. Supporters of short selling contest this view, contending that short sellers keep the market efficient. Short sellers do so by questioning whether prices are inflated and their trading anticipates market corrections as when a market ‘bubble’ has distorted security prices.

4.123  Short selling was blamed as one of the abuses that led to the Stock Market Crash of 1929. The SEC was tasked with the regulation of such trades when conducted on a national securities exchange.¹⁶⁶ The SEC tried to dampen the market effects of short selling through its so-called ‘tick test’ in its Rule 10a-1.¹⁶⁷ That rule was adopted after a market downturn in 1937 that was blamed on short selling. The SEC tick test prohibited short sales from being entered at decreasing prices i.e. on down ticks. This restriction was thought to be a means of preventing short sellers from collapsing a market through continuous short sells during a market decline. The SEC’s tick test was widely criticized because it favoured long traders over short sellers, i.e. there was no tick test for stock purchasers that prevented them buying unless there had been a prior down tick in the market.¹⁶⁸

4.124  The SEC finally responded to the critics of its tick test rule in June 2007 by repealing that rule and adopting a new short selling regulation—Regulation SHO.¹⁶⁹ That regulation was directed at preventing naked short sales. The SEC believes that naked short sales cause concerns with adverse market effects. This is because fails to deliver can increase as a result of the failure to arrange the borrowing of securities prior to a short sale. Among other things, the SEC was concerned that ‘sellers that fail to deliver securities (p. 210) on settlement date may attempt to use this additional freedom to engage in trading activities to improperly depress the price of a security.’¹⁷⁰

4.125  SEC Regulation SHO imposed ‘four general requirements with respect to short sales of equity securities: a marking requirement, a short sale price test circuit breaker, a locate requirement, and a close-out requirement.’¹⁷¹ The ‘marking’ requirement requires broker-dealers to mark sell orders to indicate whether they are short sales that are subject to Regulation SHO.¹⁷² The short sale ‘circuit breaker’ price test prohibits short sales in equity securities that have declined 10 per cent or more in one day. This is a modified form of a tick test, but is invoked only in the event of a large decline in the price of a security.¹⁷³ The ‘locate’ requirement prohibits broker-dealers from accepting a short sale unless the seller has arranged to borrow the security so that it can be delivered on the settlement date, thereby preventing naked short sales.¹⁷⁴ The ‘close-out’ requirement establishes timing requirements for the closeout by clearing members of short sales in which there has been a fail to deliver.¹⁷⁵

4.126  The replacement of the SEC’s tick test with Regulation SHO was a singular act of bad timing because that repeal occurred just as the Financial Crisis of 2008 was unfolding. That crisis renewed the debate over whether short selling should be prohibited or restricted. The SEC responded to those concerns by imposing bans on short selling the stocks of financial services firms. Those stocks were in a downward free fall as a result of the crisis. Germany also imposed such restrictions. Those short sale restrictions were later removed. They were much criticized and were claimed by some to have even worsened market conditions and to have caused further deterioration in market quality. Following the Financial Crisis of 2008, the SEC focused its attention on banning and punishing naked short sales.

4.127  As noted previously, the futures industry takes a much different approach to short sales, which are encouraged and necessary for the markets to function effectively. This was not always the case. The U S Congress passed a statute during the Civil War that prohibited futures on gold because of concerns that short selling of that metal was driving down the value of the ‘greenbacks’ that the EU government was using to fund the Civil War. Greenback values fluctuated against gold prices and would drop in value when EU battles were lost. That ban failed to stabilize the value of the greenback, however, and was repealed two weeks after its enactment.¹⁷⁶ Criticism of short sellers rose again while Congress was considering the legislation that became the Commodity Exchange (p. 211) Act of 1936. Several proposals in Congress that sought to restrict or prohibit short selling were ultimately rejected.¹⁷⁷

4.128  Today, the futures industry imposes no special restrictions on short selling because such trading is a zero sum game in which there is always an opposite buyer seller. As the US Treasury Department has noted:

A short sale in the securities context is usually depicted as a risky bet that stock prices will decline. Moreover, some observers contend that heavy short-selling deliberately to drive down the price of a stock may constitute manipulation. In contrast, short selling in the futures context is generally viewed as a necessary and critical component of liquidity in the futures markets. Although the risk profile of short selling is similar in both the futures and securities contexts (price declines mean profitability for the short, while price increases mean unlimited potential losses), the SEC imposes extensive restrictions on the practice while the CFTC imposes few.¹⁷⁸

4.129  Instead of singling out short sellers, the futures exchanges may declare trading halts in times of high volatility or may increase margin requirements. Generally, those restrictions are applied equally to long and short traders. One exception to that even-handed treatment occurred in 1979, when the commodity exchanges imposed ‘liquidation only’ restrictions on the trading of silver futures contracts. That prohibition was imposed because of a concern that speculators were driving the price of silver upward to unprecedented and unwarranted levels. That restriction acted to prevent new long-side trading, a turnaround from short selling concerns. The result, however, was a precipitous drop in silver prices that caused large losses to traders and threatened the viability of some large brokerage firms after those traders defaulted on their margin calls. Those defaults touched off the ‘Silver Crisis’ of 1980. The market was stabilized and the brokerage firms were saved after the head of the Federal Reserve Board blessed a syndicated loans that, allowing the largest of the affected traders, the Hunt family of Dallas Texas, to cure their defaults on their silver futures margins.¹⁷⁹

4.130  Short selling, meaning the sale of securities about which the short selling party is not in possession of at the time the party is selling short has for a long time not been regulated in Switzerland. In 2008, during the aftermath of the last financial crisis have short selling rules been introduced by FINMA and the Swiss Stock Exchange in Switzerland. Short selling has remained permissible with an exemption made to naked short sales, meaning transactions that are not covered by a corresponding hypothecation of securities (uncovered transactions). The prohibition have generally only applied to (p. 212) stocks, but not derivatives.¹⁸⁰ Commodities derivatives have thus not been affected. In October 2013, in consultation with FINMA, SIX Swiss Exchange and the former Scoach Switzerland (now SIX Structured Products) supplemented their regulations on short selling. These new provisions replace the provisions issued in 2008. Under the new rules, short selling is permitted if the selling party is able to settle the transaction within the deadline set for this, i.e. deliver the securities on time. According to the regulations of SIX Swiss Exchange and SIX Structured Products are short sales permitted, if the seller is in able to settle the sale within the period set forth, meaning if he is in the position to deliver the securities on time. Short selling is now regulated as part of the market behavioural rules of the SIX Swiss Exchange Rule Book.¹⁸¹ These provisions address illicit and market manipulative behaviour in general and allow in particular for the introduction of provisions on short selling. Short selling is also addressed in the Trading Directive 3 which stipulates that short selling is generally permitted if the transfer and payment of trades occurs two exchange days after the trade itself (T+2) (value date). Exceptions are potentially applicable and laid down in the ‘Trading Parameters’ Guideline.¹⁸²

4.131  These rules and principles would also apply to commodities derivatives that are securities. There are currently, however, hardly any commodities derivatives traded on Swiss based stock exchanges. The rules and principles on short selling apply thus currently factually not to commodities derivatives.

4.132  Short selling, the sale of securities that one does not own at the time of the sale allows market participants who hold negative views on a company’s share price to express their views by selling the company’s shares. Thus, short selling can enhance the price discovery process and maintain market discipline.

4.133  The role that short selling plays in the market is also recognized by the International Organisation of Securities Commissions (IOSCO), the international standard setting body for securities market. In line with IOSCO’s report on the ‘Regulation of Short Selling’, the Monetary Authority of Singapore (MAS) is introducing requirements to enhance transparency on the level of short selling in securities listed on Singapore’s approved exchanges.

4.134  As part of the Securities and Futures (Amendment) Bill 2016, market participants will be required to (i) specifically mark short sell orders to the relevant exchange; and (ii) report short positions above specified threshold to MAS. Aggregate information on short sell orders and short positions will be published.

4.135  MiFID II introduced into European regulation a mandatory position limit regime for the first time in 2018. This requires the competent authority in each Member State to establish and apply position limits on the size of a net position which a person can hold at any time in commodity derivatives traded on trading venues authorized in its Member State and in economically equivalent OTC (EEOTC) contracts, in each case both cash and physically settled. The limits apply to all positions held by a person and those held on its behalf at an aggregate group level. These obligations are very wide in scope and apply to a person regardless of whether or not they are regulated and wherever they are located, within or outside Europe. However, position limits do not apply to positions held by, or on behalf of, non-financial entities and which are objectively measurable as reducing risk directly related to the commercial activity of that non-financial entity where that non-financial entity has applied for an exemption from the relevant competent authority. Each competent authority publishes a list of the position limits it has set. It should be noted that this obligation does not prevent an exchange from imposing its own, stricter, position limits than those required by the competent authority.¹⁸³ Most trading venues have in practice set position limits that are lower than the ones set by ESMA and the NCA.

4.136  All venues which offer trading in commodity derivatives are also required to have in place appropriate position management controls, providing the necessary powers at least to monitor and access information about commodity derivative positions, to require the reduction or termination of such positions and to require that liquidity is provided back on the market to mitigate the effects of a large or dominant position.¹⁸⁴ The trading venue must explain its position management controls to its competent authority so that it can pass them onto ESMA, which publishes summaries of position management controls in force on its website. There are currently the following position management controls in place:

(p. 214) 4.137  Finally, and as mentioned in Chapter 3 and earlier in this chapter, there are obligations on the trading venues and their participants to report positions in commodity derivatives, as well as emission allowances and derivatives on emission allowances.¹⁸⁵ Trading venues must publish an aggregated weekly breakdown of the positions held by different categories of persons for the different contracts traded on their platforms. They must also provide a comprehensive and detailed breakdown of the positions held by all persons, including their members or participants and their clients, to their competent authority at least daily. In order to achieve this, members and participants of trading venues are required to report to the trading venue details of their own positions held through contracts traded on that trading venue, as well as those of their clients.¹⁸⁶

4.138  At the time of writing, ESMA has recently sought the views of industry participants on their experience with the position limit regime so far, in order that it can advise the Commission, which must report to the European Council and European Parliament on the impact of the new regime.¹⁸⁷ ESMA sought views and experience so far on how trading in commodity derivatives may have been impacted, either positively or negatively, and on the potential impact of position limits on liquidity, market abuse, and orderly pricing and settlement conditions in commodity derivatives markets. This is a common exercise with newly introduced provisions in European legislation and may or may not result in any changes, but it has given industry participants a chance to express concerns about the breadth of the European regime compared to that in other jurisdictions. Several market participants have responded that the regime would be better (p. 215) limited to a smaller set of critical commodity derivatives or that the regulators need more flexibility in setting the limits for new and illiquid contracts.¹⁸⁸

4.139  The position limits must be set so as to prevent market abuse and support orderly pricing and settlement conditions, including preventing market distorting positions, and ensuring, in particular, convergence between prices of derivatives in the delivery month and spot prices for the underlying commodity, without prejudice to price discovery on the market for the underlying commodity. The European Commission considered that it was important to have a harmonized regime across Europe and so they provided for a delegated regulation which sets out the methodology by which competent authorities must calculate position limits. This requires the competent authority to determine a baseline figure for each contract, which can then adjusted within certain parameters according to a series of factors.¹⁸⁹

• •  The baseline for the spot month position limit is 25 per cent of deliverable supply of the underlying commodity, although it is sometimes possible to decrease it to 20 per cent where the underlying is food intended for human consumption. Deliverable supply is determined by reference to the average monthly amount of the underlying commodity available for delivery over the one year period immediately preceding the determination, taking into account storage arrangements for the commodity and other factors that may affect its supply.

• •  The baseline for the other months position limit is 25 per cent of the open interest in that commodity derivative. This is calculated by aggregating the number of lots of that commodity derivative that are outstanding on trading venues.

4.140  The competent authority can then adjust the baseline limit to between 5 per cent (or 2.5 per cent for food intended for human consumption) and 35 per cent according to the potential impact of a series of factors on the integrity of the market for that derivative and for its underlying commodity. These factors allow the competent authority to take into account the maturity of the contracts, deliverable supply in the underlying, overall open interest, the characteristics of the underlying commodity market, and volatility of the relevant markets. There are also some derogations for new and illiquid contracts. This results in a position limit for each of the spot and other months contracts.¹⁹⁰ There are also certain derogations, particularly for new and illiquid contracts where it was felt that imposing position limits would stifle the development of their markets. For example, for commodity derivatives traded on a trading venue with a total combined (p. 216) open interest in spot and other months’ contracts not exceeding 10,000 lots over a consecutive three-month period, competent authorities must set the position limit at 2,500 lots. 2,500 lots has, therefore, become the de minimis position limit.

4.141  Once the competent authority has determined the position limit it intends to set for each contract, it notifies ESMA, except about those where the de minimis limit will be applied, and ESMA issues an opinion assessing the compatibility of the proposed limit against the objectives of the regime and the required methodology. The competent authority must either modify its position limit in accordance with ESMA’s opinion or justify why it considers that such a change is unnecessary. ESMA also plays a role in monitoring the implementation of the position limits and there are cooperation arrangements in place between the competent authorities that provide for the exchange of relevant data to enable the monitoring and enforcement of the limits, particularly where the same contract is traded on trading venues in more than one Member State. Competent authorities are not permitted to impose position limits that are more restrictive than those adopted in accordance with the required methodology save in exceptional cases where they are objectively justified and proportionate taking into account the liquidity of the specific market and the orderly functioning of the market. Even in this case, a competent authority can only impose more restrictive position limits for an initial period of six months, which can be extended for further periods of six months only if the applicable conditions continue to be satisfied. Any such limits need to be justified to ESMA.

4.142  Position limits are specified in lots which are the unit of trading used by the trading venue on which the commodity derivative trades representing a standardized quantity of the underlying commodity. The position limits currently in force are the following: