New EU rules may hasten commodity liquidity flight

By Pratima Desai

LONDON (Reuters) - Planned EU regulations on position limits in commodities are fuelling intense debate about whether the move could prompt traders to flee to Asian markets, further hurting European liquidity and potentially hurting economic growth.

Restrictions on banks and capital requirements has already subdued enthusiasm for commodity trading.

The new rules aimed at stopping abuses of pricing power on commodity markets will encompass position limits, or curbs on how much one trading house can hold of a specific commodity, possibly on thousands of futures contracts.

Many commodity firms may also need to be authorised and be compelled to hold capital reserves in the same way as banks are required to do.

Commodity traders are currently exempt from the Markets in Financial Instruments Directive (MiFID).

That is set to change under MiFID II, which takes effect from January 2017. Regulators are working on details which are expected in September.

"If these changes are too punitive, what would happen very quickly is that liquidity will disappear from the LME (London Metal Exchange) and Matif (Euronext) and migrate to Shanghai and other exchanges," an executive at a major global commodity trader said.

The LME said it supports the underlying aims of MiFID II, but that there are situations when a participant could validly hold a large proportion of open interest on its market as a legitimately hedged trade.

"If a 'one-size-fits-all' approach is taken to EU position limits, such situations would need to be taken into account, or it could risk reducing liquidity in our market and the wider European market," an LME spokesman said.

Many forward contracts, such as those for gasoline or wheat, if agreed through an intermediary, are also likely to come under the directive.

"Liquidity can migrate to other regions without EU businesses relocating, though MiFID II and fears of being caught up in bank-style capital regulation may incentivise relocation," said Chris Borg, a partner at law firm Reed Smith.

"If liquidity suffers, increased price volatility and greater costs for consumers will follow. That would be an own goal for the EU Commission," Borg said.

Other options are consolidation via takeovers and mergers or the adoption of vertically integrated models, which would make it easier to absorb the costs of regulation.

But this would leave fewer, bigger players, lead to even less liquidity, transparency and competition and potentially explosive volatility during times of extreme stress.

A draft of possible exemptions for commodity firms is expected in September. But these too will be subject to negotiations which could take some time.

"Exemptions in the existing rules are being restricted. One for traders who deal only on their own account and whose main business is dealing with commodities or commodity derivatives has been deleted," said Robert Finney, a partner at Holman Fenwick Willan.

One way around for smaller firms is the ancillary activity exemption - based on the concept that instruments that come within the scope of MiFID II are ancillary to their business.

But the threshold to be based on 2016 accounts has not yet been defined.

A company that thinks it may be a borderline case and wants to trade in the EU from January 2017 may have to apply for a licence anyway and hold capital buffers.

One major worry is the idea that the EU will aggregate position limits on a global basis, further hampering firms' ability to operate efficiently.

Finney cites another concern about position limits. "If expressed in terms of current market size, how dynamic will they be to cope with growth?"

(Additional reporting by Silvia Antonioli and Gus Trompiz; editing by Veronica Brown and Jason Neely)