*This blog was updated in July 2020.
What is the Hedging Exemption?
Under MiFID II, positions that are held by, or on behalf of, non-financial entities which are objectively measurable as reducing risk, must not be counted towards the limits and netted against positions which are not considered to reduce risk. It must be highlighted that positions should not qualify as reducing risk simply because they have been included as part of a risk-reducing portfolio.
However, this hedging exemption is subject to prior approval by the relevant competent authorities. Investors must apply for it before entering into a position. Non-financial entities from outside of the EU can apply for the same exemption in the same manner as EU firms.
Detailed information on the hedging exemption under the MIFiD II position limits framework can be found in the Regulatory Technical Standards (RTS 21), issued by the European Commission.
A nice hedge.
The European Securities and Markets Authority (ESMA) recently published a report concerning the position limits and position management in commodity derivatives. This followed a call for evidence in May 2019 and a consultation paper, where stakeholders were invited to share their experience with the applications of the MiFID II position limit and position management provisions.
Respondents commented on several provisions included within MiFID II, but notably a response in relation to the MiFID II hedging exemption arose and gained significant traction. In relation to the existing hedging exemption where
positions held by or on behalf of non-financial entities which are objectively measurable as reducing risk, must not be counted towards the limits, and netted against positions which are not considered to reduce risk.
One respondent highlighted a specific case where
a financial entity within a predominantly commercial group that acts as the market-facing entity for the risk reducing transactions of the commercial entities of the group. Because the decision had been made by the group prior to MiFID II to register that entity as an investment firm, the risk reducing transactions of the group are not eligible to the hedging exemption.
In response to the consultation paper, ESMA made it clear that they will not support a blanket hedging exemption for financial counterparties. However, ESMA was open to views on the possible introduction of a hedging exemption for a financial counterparty acting within a predominantly commercial group, where the positions meet the existing requirements of the hedging exemption.
ESMA received overwhelming support in response and as a result, proposes introducing within Level 1 a narrowly defined hedging exemption for financial counterparties. Specifically, this hedging exemption would apply to positions held by a financial counterparty, that are objectively measurable as reducing risk directly related to the commercial activities of the non-financial entities of the group where:
Within a predominantly commercial group, a person has been registered as an investment firm on a voluntary basis and acts as a market facing entity of the group.
EMSA further acknowledged that other financial counterparties may see benefits in a wider hedging exemption but is not prepared to support it as it would not be considered as consistent with the objective of limiting excessive speculation in commodity derivatives.
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