Shell is understood to have made clear to EU policymakers that proposed rules under the new Markets in Financial Instruments Directive (MiFID 2) would create a clear case of regulatory arbitrage that could lead it to shift some EU-based activities abroad, especially hydrocarbons trading.
Proposed new rules on derivatives trading under MiFID 2 and the EU’s extension of the Capital Requirements Directive to commodity firms would have a severe impact on Shell’s activities, first and foremost its trading division, as well as on those of other similar companies. Companies may respond by moving these activities outside the EU.
MiFID 2 includes a broader definition of what is considered a financial instrument, which risks capturing a broader range of physically settled commodity contracts. In turn, this makes those contracts subject to rules on position limits and position reporting. It also triggers the extension to commodity firms of capital requirements and trading bonus caps under the Capital Requirements Directive from 31 December 2017.
“It is critical that the cumulative application of financial reforms be proportionate to the risk posed and enable non-financial organizations such as ourselves to manage risk in a sensible way,” Shell Trading and Supply executive vice-president Mike Conway said. In case those reforms are not proportionate he said the company may take “appropriate action to mitigate the impact to our trading business so we can operate in the most cost-effective way for Shell.”
“Shell strongly supports financial regulation that is intended and designed to make markets safe, resilient and efficient. We will of course comply with MiFID 2 and other regulations that apply to our business. We have welcomed the opportunity to engage constructively with the European Commission and regulators on this topic to inform a workable outcome,” Conway said.
Shell chief financial officer Simon Henry has previously stated that MiFID 2 and related legislation increases risk in the real economy. “Overall risk, volatility and potentially security of supply are not enhanced by these moves,” Henry said early last year.
Market participants expect the new EU rules to cause a rise in commodity price volatility, with knock-on effects for the real economy, while regulatory capital requirements would have a chilling effect on market liquidity.
Henry has previously stated that the Shell group would need to tie up as much as $30bn in regulatory capital to meet its obligations under the rules as drafted, a sum equivalent to its annual worldwide capital expenditure and three times total annual shareholders’ dividends. Lower commodity prices mean that the sum involved may now be $15bn, but the sum is still significant enough to make the company consider plans to move operations outside of the EU.
The new rules face Shell and other companies that trade commodities with a choice of changing their business structure or moving activities to other jurisdictions, or both. The rules will have an impact on liquidity because trading a derivative contract in the EU will be made difficult, and commodities will be exposed to more volatility, trading executives has said.
Companies still have a couple of years in which they can work with EU policymakers to mitigate the regulatory threat to commodity markets, up until the December 2017 trigger on the capital requirements rules. Shell is understood to be formulating options and plans to move activities overseas and will need these to be in place by 2017 so that they can be executed if the risk is not dealt with by EU policymakers.
Shell and other major energy firms already have offices in the US and Singapore that they could move trading operations to.
Key outstanding issues that will affect EU commodity trading are regulatory capital requirements, exemption rules for firms that trade commodities, position limits rules and the EU’s definition of “ancillary activity”. As things stand, market participants view the ancillary activity definition as ill-defined and say that it risks capturing activity well beyond strictly derivative trading, including all kinds or risk management and optionality in contracts.
EU financial regulator Esma is due to send its final proposals to EU institutions by 25 September. Once adopted by the commission, member states will have to fully transpose the new rules into national legislation by 3 July 2016, with full enforcement throughout the EU from 3 January 2017.
EU member states Germany, France and the UK sent a joint letter, dated 25 August, urging the European Commission and Esma to return to the original spirit of the MiFID 2 legislation when drafting so-called “level 2 implementing measures” that define the rules. They want the rules to acknowledge the difference the “real economy” of physical commodities and the world of purely financial markets, instruments and institutions.