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					EUROPEAN COMMISSION
Internal Market and Services DG FINANCIAL SERVICES POLICY AND FINANCIAL MARKETS Securities markets

CALL FOR EVIDENCE REVIEW OF COMMODITY AND EXOTIC DERIVATIVES AND RELATED BUSINESS AS REQUIRED BY MIFID AND RECAST CAD

1ST DECEMBER 2006

Commission européenne, B-1049 Bruxelles / Europese Commissie, B-1049 Brussel - Belgium. Telephone: (32-2) 299 11 11. Office: C107 04/004. Telephone: direct line (32-2) 298 48 02. Fax: (32-2) 295 56 06. http://ec.europa.eu/internal_market/

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INTRODUCTION....................................................................................................... 3 BACKGROUND AND LEGAL FRAMEWORK ...................................................... 3 OVERVIEW................................................................................................................ 4 METHODOLOGY ...................................................................................................... 6 4.1. Single report ...................................................................................................... 6 4.2. Consultation and sources of advice ................................................................... 6

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PROPOSED PROJECT DESIGN ............................................................................... 7 5.1. Problem identification ....................................................................................... 7 5.2. Guiding principles ............................................................................................. 7 5.3. Scope of the Report in relation to the underlying markets................................ 8 5.4. Scope of regulation in relation to persons and activities................................. 10 5.4.1. 5.4.2. The current scope under MiFID ........................................................ 10 Reasons for the existence and review of the exemptions .................. 11

5.5. Scope and nature of prudential regulation....................................................... 12 5.6. Scope and nature of conduct of business regulation ....................................... 13 5.7. Instruments ...................................................................................................... 14 5.8. Market regulation ............................................................................................ 14 5.8.1. 5.8.2. 6. Market transparency .......................................................................... 14 Market integrity ................................................................................. 15

NEXT STEPS............................................................................................................ 16 6.1. Stocktaking and data gathering ....................................................................... 16 6.2. Timing ........................................................................................................... 18

ANNEX I: SUMMARY OF QUESTIONS....................................................................... 19 ANNEX II: RELEVANT LEGAL PROVISIONS............................................................ 22 ANNEX III: INDICATIVE TIMELINE FOR THE REPORT ........................................ 25 ANNEX IV: COMMISSION DECLARATION............................................................... 26

Commission européenne, B-1049 Bruxelles / Europese Commissie, B-1049 Brussel - Belgium. Telephone: (32-2) 299 11 11. Office: C107 04/004. Telephone: direct line (32-2) 298 48 02. Fax: (32-2) 295 56 06. http://ec.europa.eu/internal_market/

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INTRODUCTION The European Parliament and the Council have asked the Commission to report on a broad range of regulatory issues associated with the commodity and exotic derivatives business. The present document constitutes a call for evidence to be submitted to the European Commission services in relation to this report (the Report). The purpose of this call for evidence is to present, and seek feedback on, the Commission’s preliminary orientation towards the Report in terms of the methodology and scope, the sources of data, and the other modalities of the Report. A list of questions is annexed to this call for evidence (Annex I). Evidence, preferably in the form of general remarks followed by answers to the questions listed in Annex 1, can be submitted by email to the following email address: markt-g3@ec.europa.eu. The Commission will publish a feedback statement as well all responses received on its website unless confidentiality is specifically requested. The call for evidence will be open for comment until 30 April 2007.

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BACKGROUND AND LEGAL FRAMEWORK The legal requirements concerning the report come from three different sources: (1) (2) (3) Article 65(3) of Directive 2004/39/EC on markets in financial instruments (MiFID)1; Article 40(2) of Commission Regulation 1287/2006 (MiFID implementing Regulation)2; Article 48 of Directive 2006/49/EC on the capital adequacy of investment firms and credit institutions (recast CAD)3.

The review under Article 65(3) of MiFID is concerned with questions of scope as well as of content of financial regulation in relation to persons active in commodity derivatives and 'exotic' derivatives4 markets. Some of the persons active in those markets are currently exempted from the scope of MiFID and the review should determine whether this exemption remains valid and if not, whether further changes to the MiFID framework should come about as a result of any change in scope.

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OJ L 145, 30.4.2004, p. 1. Directive as amended by Directive 2006/31/EC (OJ L 114, 27.4.2006, p. 60). OJ L 241, 2.9.2006, p. 1. 3 OJ L 177, 30.6.2006, p. 201. 4 'Exotic' derivatives are financial instruments listed in Annex I, Section C(10) of MiFID
Commission européenne, B-1049 Bruxelles / Europese Commissie, B-1049 Brussel - Belgium. Telephone: (32-2) 299 11 11. Office: C107 04/004. Telephone: direct line (32-2) 298 48 02. Fax: (32-2) 295 56 06. http://ec.europa.eu/internal_market/

Under Article 40 (2) of the MiFID implementing Regulation the Commission is obliged to re-examine the provisions relating to criteria for determining which overthe-counter (OTC) derivative contracts relating to commodities and 'exotic derivatives' are to be treated as financial instruments for the purposes of MiFID. Article 48 of the recast CAD introduces a transitional provision which exempts a number of investment firms who carry out commodities business from the capital requirements established in that Directive.5 This Article also states that the Commission should report on an appropriate regime for the prudential supervision of investment firms whose main business consists exclusively of the provision of investment services or activities in relation to commodity derivatives or derivatives contracts. Finally, Article 48 of the recast CAD also requires the Commission to report on the desirability of amending MiFID to create a further category of investment firm whose main business consists exclusively of the provision of investment services or activities in relation to derivatives relating to energy supplies (including electricity, coal, gas and oil). The complete text of the legal provisions associated with the Report can be found in Annex II. 3. OVERVIEW In broad terms, the various reports require the Commission to answer two important questions: • Which relevant entities, activities and instruments should be covered by the scope of EU financial markets regulation in these areas? • Whether current regulation needs be adapted to take into account the specificities of the commodities and commodity derivatives markets? The current regulatory landscape is complex. A number of exemptions exclude certain persons, activities and instruments from parts or the entirety of EU financial markets regulation but still allow Member States to impose regulation at the national level. Potentially, this could cause problems in terms of lack of a true single market in commodity derivatives trading, distortion of competition between regulated and exempted entities, uneven investor protection or greater systemic risk. It could be argued that extending the scope of the existing financial markets regulation could contribute to the completion of the single market in the area of financial services and energy by providing those active in these markets with an effective EU passport for the provision of investment services. It could also level the field in terms of competition and investor protection while addressing potential systemic risks arising from the activities of the currently unregulated entities.

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This exemption is available until 31 December 2010 or the date of entry into force of any modifications pursuant to the review under Article 65(3) of MiFID, whichever is the earlier.
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However, it has also been claimed that current financial markets regulation may not take fully into account the particularities of the commodity markets and commodity and exotic derivatives trading. A simple extension of the scope of financial regulation could prove unpredictable, inappropriate or harmful. In this sense, three basic choices present themselves: (1) Status quo, i.e. leave the MiFID and the CAD regime as it is (this would entail maintaining current MiFID exemptions and letting any temporary exemptions from the capital adequacy requirements expire) Extend the MiFID and CAD regime (this means abolishing exemptions under Articles 2(1)(i) and 2(1)(k) of MiFID while letting expire the temporary exemptions from the capital adequacy requirements) Create a special commodity derivatives regime tailored to the sectors' specificities (this would mean a thorough review of the scope and applicability to the sector of the particular MiFID and CAD provisions)

(2)

(3)

It is important that these three options be thought of only as preliminary concepts. Policy alternatives are expected be developed further once the Commission has gathered sufficient evidence. This document identifies and enquires about a range of regulatory issues related to the applicability of various parts of EU financial services and markets regulation to the commodity derivatives business. The fact that the scope of the call for evidence is broad should be interpreted as the Commission's intention to obtain a global perspective on the subject matter. The Commission has no pre-conceived ideas whatsoever and is only gathering views and evidence. 1. Do you believe that the current EU legislative framework gives rise to problems in the functioning of the commodity and exotic derivatives markets? If yes, please indicate the nature of the problems. 2. If there are significant problems, do you believe the three broad approaches outlined above are an appropriate starting point for a formulation of more detailed policy alternatives or is there another option that should be considered? 3. Do you have a preference for one of the approaches outlined above? Please answer the previous three questions as briefly as possible. More detailed questions related to specific MiFID and recast CAD provisions to the commodity derivatives business are posed below.

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4.

METHODOLOGY 4.1. Single report The Report will be prepared in accordance with Commission’s initiative on better regulation6 and its guidelines on impact assessment.7 The reviews mandated by the three different legal instruments concern different aspects of the commodity derivatives business. Nevertheless, they are clearly interrelated and, taken together, provide the need for a comprehensive overview of the regulatory framework of the commodity and exotic derivatives sector. It is for this reason that the Commission intends to integrate the separate reviews into a single report. 4.2. Consultation and sources of advice The relevant MiFID and recast CAD articles quoted above require the Commission to report on the basis of public consultation and in the light of discussions with competent authorities as well as after consulting the Committee of European Securities Regulators. The Commission’s White Paper on Financial Services Policy 2005-20108 set out our commitment to open and transparent consultation:9
Open consultations (including with stakeholder groups) will continue to play a central role and will be required before any legislation is deemed necessary. The Commission will continue to publish responses received to its consultations, practical summaries and feedback statements.

We will consult publicly twice during the preparation of the Report: firstly, by way of this call for evidence; and secondly, by way of a public consultation on a draft of the Report. We will seek, wherever possible, to include investor input in this public consultation. We will also ask the Committee of European Securities Regulators (CESR) and the Committee of European Banking Supervisors (CEBS) to provide expert and focused advice on factual and regulatory questions. The involvement of those committees is intended to fulfil our obligation to hold discussions with competent authorities. We will also use our recently-formed European Securities Markets Expert Group (ESME)10 to provide input into the report at an appropriate stage. Further, we might consider engaging specialist consultants if there is significant quantitative or qualitative work to be done requiring specialist expertise.

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See Press Release number MEMO/05/340, Brussels, 27 September 2005 for a succinct summary. Impact Assessment Guidelines (SEC(2005) 791. See http://europa.eu.int/comm/secretariat_general/impact/docs/SEC2005_791_IA%20guidelines_annexes. pdf. Available at http://ec.europa.eu/internal_market/finances/docs/white_paper/white_paper_en.pdf at paragraph 2.1 See Decision 2006/288/EC, OJ L 106, 19.4.2006, p. 14.
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5.

PROPOSED PROJECT DESIGN 5.1. Problem identification The first step is to analyse whether there are problems in the commodity and exotic derivatives markets that could be remedied by public policy and if so, what causes it, who it affects, and whether the EU level is the appropriate level to deal with it in view of the principle of subsidiarity. As well as seeking to collect anecdotal evidence of existing problems, we will also seek to establish whether there is research or data available tending to show, in a rigorous way, that present regulatory arrangements are suboptimal, in the sense that a different legal framework would have significantly beneficial impacts in terms of any of the possible policy objectives identified below. 5.2. Guiding principles The Report will analyse commodity and commodity derivatives markets in a comprehensive manner with the objective of developing recommendations aimed at addressing any identified problems which may hinder their soundness, competitiveness, efficiency and liquidity. Particular attention will be paid to the particularities of the commodity, commodity derivatives and exotic derivatives markets. Those markets are not homogeneous. Care will need to be exercised in order to make sure that, to the extent possible, significant structural differences are accounted for in any recommendations of the Report. Any policy recommendations will be mindful of developments in other Commission policy areas such as liberalisation of energy markets and competition. Furthermore, if there is strong evidence of problems, recommendations should be guided by clear principles and objectives which should be defined ex ante. The following are the main objectives proposed to guide any potential future policy action: (1) Market integration The general policy objective in the field of financial services is to achieve a greater integration and efficiency of financial markets and thus to contribute to the goals of the Lisbon Agenda of higher growth, increasing competitiveness and employment creation. An integrated and efficient financial market allows investors to benefit from higher returns on savings, through enhanced opportunities for portfolio diversification and more liquid and competitive capital markets. Furthermore, a well-functioning single market in financial services related to commodity derivatives is imperative in achieving a well integrated market in the underlying commodity sector itself. (2) Market stability and efficiency The globalisation of financial markets and the substantial increase in crossborder capital flows have created a more complex financial environment. Market transparency, comprehensive and effective risk-based financial regulation, market-reinforced prudential supervision and enhanced
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cooperation among competent authorities are the keystones for maintaining stability and efficiency of the financial system. (3) Enhancing global competitiveness of EU firms Trading and the provision of services in relation to commodities and commodity derivatives is often a global business. So potential policy effects on the global competitiveness of EU entities engaging in commodity trading as well as commodity derivatives business need to be taken into account. (4) Market integrity and investor protection A proper regulatory system needs to ensure that markets operate fairly and safely in order to encourage the widest possible confidence. An important goal is to ensure adequate price formation and prevents manipulative behaviour while providing a sound legal basis for the provision of investment services. Investor protection is another crucial pillar supporting public confidence and investment in capital markets. Investors must be able to rely on the professional conduct of market intermediaries. (5) Level playing field Regulation, apart from providing an effective legal and enforcement infrastructure which fosters market development, also imposes cost on individual market participants. Currently, some entities and activities in the commodity derivatives sector are regulated while others are not. It may not be sustainable to continue imposing different levels of regulation on market players involved in the same activities. Similarly, harmonisation should ensure that no 'superequivalent' national regulation imposes significant inequalities of treatment. (6) Security of supply Well functioning commodity and commodity derivatives markets contribute to the security of supply by ensuring market actors make informed investment decisions and business choices based on the price signals only efficient markets can provide. 4. Do you agree the Report should be drafted in light of the above principles/objectives? 5. Are there any principles/objectives we have not listed which you consider important? 6. Is there a hierarchy between these objectives/principles? If yes, please provide a ranking.

5.3.

Scope of the Report in relation to the underlying markets As explained above, the aim of the Report is to assess the current scope of financial regulation in relation to the commodity derivatives business as well
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as to explore any changes of this scope as regards the type of activities, entities, instruments or contracts if there is evidence of problems. The Report would thus be of broad 'horizontal scope'. Furthermore, although the various reviews are mandated in relation to commodity derivatives, the interrelation between the underlying and derivatives markets may also require a closer scrutiny of the underlying markets' structure and regulation and thus a widening of the inquiry to cover this relationship. Commodity markets have undergone significant changes. Deregulation of the energy markets, major shifts in demand due to the rapid expansion of emerging economies as well as changes in supply patterns with new actors entering the stage in the agricultural sector are but a few examples. The developments in the physical trading of commodities have been accompanied by the expansion of the commodity derivatives markets. Exchange-traded and OTC traded contracts have experienced significant growth in trading volumes and have provided market actors with more effective ways of hedging against risk, as well as opportunities for speculative exposure. Commodities and their derivatives are becoming an increasingly popular investment class. Because the fluctuation in their prices is generally uncorrelated or negatively correlated with fluctuation of prices of purely financial assets, they provide an important diversification opportunity. In practice, the underlying and the derivatives markets are very closely intertwined. However, the regulation of those underlying markets differs markedly (at least at a European level) from financial markets regulation. This will be especially the case after the entry into force of MiFID (from 1 November 2007). MiFID will harmonise the provision of investment services in relation to most commodity derivatives while the trading and other activities in relation to the underlying commodities will remain under the domain of national regulation even when this trading is undertaken by firms licensed under MiFID. Because of the close relation between the underlying and commodity derivatives markets, the question arises whether the Report should also examine the nature of the interaction between those markets and also whether the regulatory separation between the underlying and derivatives markets should be maintained in all areas. More concretely, it could be considered whether certain elements of EU financial market regulation (e.g. service passport) are potentially applicable to the underlying markets. However, it should be made clear that if the Report will seek a deep understanding of the underlying markets, it would not enter into the discussion concerning policies related to the regulation of the 'hard' structure of the underlying markets. This means that if it is desirable that the Report focuses in some way on the underlying markets, the focus should be on the commodity wholesale trading and not on commodity production/generation or, in the case of energy commodities, the regulation of distribution infrastructure, security of supply or regulation of transmission networks, etc.
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In this sense DG Internal Market and Services would work closely with other responsible DGs during the preparation of the report in order to properly address any of the issues outlined above. 7. Do you think that the close relationship between the underlying and derivatives markets warrants an investigation of the underlying markets as part of the Report? 8. Which features of EU financial markets regulation, if any, do you think could be potentially of interest or application in the commodity wholesale trading ? 5.4. Scope of regulation in relation to persons and activities 5.4.1. The current scope under MiFID

MiFID establishes a regulatory regime for those persons that provide investment services or activities on a professional basis. An investment service or activity listed in Annex I of the Directive can only be provided on a regular basis by those persons who are duly authorised in accordance with the provisions of Title II of the directive. However, Article 2 of MiFID also provides for some exemptions to this general regime. These exemptions are designed in order to exclude those persons who, because of the type of the business they engage in or because they are regulated in another manner should not be within the scope of the directive. In the area of commodity derivatives there are several relevant exemptions: • Article 2(1)(b) exempts persons which provide investment services exclusively for their parent undertakings, for their subsidiaries or for other subsidiaries of their parent undertakings; • Article 2(1)(d) exempts persons who do not provide any investment services or activities other than dealing on own account unless they are market makers or deal on own account outside a regulated market or an MTF11 on an organised, frequent and systematic basis by providing a system accessible to third parties in order to engage in dealings with them; • Article 2(1)(i) exempts persons dealing on own account in financial instruments, or providing investment services in commodity derivatives or derivative contracts included in Annex I, Section C 10 to the clients of their main business, provided this is an ancillary activity to their main business, when considered on a group basis, and that main business is not the provision of investment services within the meaning of this Directive or banking services under Directive 2000/12/EC;

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MTF means Multilateral Trading Facility and is defined in Article 4(1)(15) of MiFID.
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• Article 2(1)(k) exempts persons whose main business consists of dealing on own account in commodities and/or commodity derivatives. This exception shall not apply where the persons that deal on own account in commodities and/or commodity derivatives are part of a group the main business of which is the provision of other investment services within the meaning of this Directive or banking services under Directive 2000/12/EC. The Report should examine to what extent the different legal or regulatory status (e.g. bank vs. commodity dealer) of a person active in a particular market gives rise to different regulatory consequences and to what extent such differences are warranted in light of the activities those persons undertake. 5.4.2. Reasons for the existence and review of the exemptions

Only the exemptions in Articles 2(1)(i) and 2(1)(k) are subject to the review. At the time of MiFID negotiation, these exemptions were considered to be temporary pending the revision of the capital requirements regime for the exempted firms. Another reason to review the maintenance of these exemptions relates to the establishment of a level playing field with other regulated firms dealing in commodity derivatives in order to establish a coherent regulatory framework for the provision of investment services. An important feature of the MiFID exemptions is that they do not prohibit Member States from imposing a specific regulatory regime on the exempted entities. This presents the possibility of a patchwork of regulatory regimes erecting new barriers to provision of services. Thus, apart from investigating how to deal with the exemptions, it is also important to have a clear view of how Member States intend to regulate persons currently exempted under MiFID. 9. Do you consider that the rationales for maintaining or removing the exemptions under MiFID Article 2(1)(i) and 2(1)(k) are essentially the same for both exemptions, i.e. related to issues of capital adequacy? If not, why not? 10. Do you consider that the exemptions under MiFID Article 2(1)(i) and 2(1)(k) and under Article 48 of the recast CAD create a competitive distortion which could be of significant policy concern? If yes, what would be the most appropriate way of mitigating the distortion? 11. If there are competitive distortions between persons active in the commodity derivative space and those distortions would be removed, would there still remain a significant distortion between commodity derivatives trading and spot trading? If yes, what would be the most appropriate way of mitigating the distortion? 12. Do you consider it appropriate that Member States regulate the entities excluded from the scope of the MiFID and recast CAD a) pending the review of those exemptions;
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b) if the exemptions are maintained after the review? 5.5. Scope and nature of prudential regulation MiFID and the recast CAD establish a framework for prudential regulation of investment firms and credit institutions providing investment services. The goal of this framework is to foster the soundness of these institutions and their operations and thereby contribute to the overall stability of the financial system. MiFID establishes a comprehensive principles-based regime governing the organisational requirements which have to be met by all investment firms and credit institutions providing investment services irrespective of which activities they undertake. The recast CAD in turn imposes initial and ongoing regulatory capital requirements12, large exposure limits and complementary requirements for internal capital, internal governance arrangements13 and disclosures to enhance market discipline.14 The capital adequacy rules have come about mainly as a result of the specificity of banking institutions and the risks arising out of their operations. However, prudential regulation and, in particular, capital requirements are not imposed only on credit institutions but also on investment firms which do not accept deposits or grant credits other than those which are associated with the provision of investment services. This is because investment firms and banks carry on identical or similar activities and are exposed to identical or similar risks from these activities. Furthermore, the failure of investment firms on a large scale could have systemic consequences. Finally, investment firms and banks often act as direct competitors and so imposing similar or identical levels of regulation avoids distortion of competition Many commodity derivatives dealers which are not credit institutions would argue that their activities do not generate risks for depositors and only to a lesser extent, if at all, systemic risks as credit institutions do. One of the mandates of the report is to explore whether a different prudential regime which comprises of more tailored capital adequacy regime is a desirable policy.

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These include inter alia capital requirements for commodities risk calculated in accordance to Annex IV and counterparty credit risk according to Annex II of Directive 2006/49/EC; MiFID and the recast CAD overlap in the area of organisational requirements for investment firms and credit institutions providing investment services. The Commission addressed this problem during the negotiation of MiFID implementing measures where it secured a political agreement on the part of Member States and the European Parliament which attempts to provide an appropriate policy solution which was presented as a Declaration incorporated in the minutes of the European Securities Committee. The text of the declaration is set out in Annex IV. MiFID and the recast CAD overlap in the area of organisational requirements for investment firms and credit institutions providing investment services. The Commission addressed this problem during the negotiation of MiFID implementing measures where it secured a political agreement on the part of Member States and the European Parliament which attempts to provide an appropriate policy solution which was presented as a Declaration incorporated in the minutes of the European Securities Committee. The text of the declaration is set out in Annex IV.
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13. To what extent do you consider that the reasons for subjecting investment firms to prudential regulation hold equally for entities providing investment services and, in particular, the service of dealing on own account, exclusively in relation to commodity or exotic derivatives? Do you think that these reasons are (or are not) valid for all or only for some of these entities? 14. Do you think that parts of the current prudential regulation (organisational requirements, capital adequacy, internal capital, etc.) should not apply in their present form to the provision of investment services in relation to commodity and exotic derivatives? Would your opinion depend on whether the respective services are provided by a firm exclusively providing services in commodity or exotic derivatives? 15. If you consider some parts of the current prudential regulation should be adapted in order to be meaningfully applied to the provision of investment services in relation to commodity and exotic derivatives what are the reasons and what changes would you propose? Would the proposed changes depend on the type of entity providing the investment services or the underlying of the financial instrument? 5.6. Scope and nature of conduct of business regulation MiFID imposes important obligations on the activities of investment firms when dealing with their clients. These conduct of business rules are not only tailored to the type of client to whom investment services are provided, but also differentiated in relation to the types of services that an investment firm provides. However, commodity derivatives dealers exempt from MiFID are not subject to the same obligations in their client relations. This means that clients receiving the same service, e.g. investment advice, may be afforded different levels of protection depending on whether they deal with an investment firm authorised under MiFID or an entity that is exempt. The Report should examine whether it is desirable to maintain this regulatory difference and if not, whether conduct of business rules could be altered. 16. Do you think that activities giving rise to similar investor protection concerns should be, to the extent possible, subject to the same legal and supervisory framework? 17. Do you think that parts of the current conduct of business regulation (client classification, information disclosure, fiduciary duties, etc.) should not apply in their present form to the provision of investment services and, in particular, the service of dealing on own account, in relation to commodity or exotic derivatives? Would your opinion depend on whether the respective services are provided by a firm exclusively providing services in commodity or exotic derivatives? 18. If you consider some parts of the current conduct of business regulation must be adapted in order to be meaningfully applied to the provision of investment services in relation to commodity and exotic derivatives what are the reasons and what changes would you propose?
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Would the proposed changes depend on the type of entity providing the investment services or the underlying of the financial instrument? 5.7. Instruments The definitions of physically settled commodity derivatives present in Annex I Section C(7) of MiFID as well as exotic derivatives included in Section C(10) have been further specified in Articles 38 and 39 of the MiFID implementing Regulation. The review of the commodity derivatives business in relation to the instruments concerns the scope of the definitions as defined in the implementing Regulation. Those definitions depend closely on the Level 1 text. It could be desirable to obtain a comprehensive view by also examining the related Level 1 definition of commodity derivatives under Section C(7) of Annex I. 19. Do you consider the scope of the definition of financial instruments provided for in MiFID as well as its implementing Regulation to be adequate? 20. If there are changes in the scope of persons falling under MiFID, how would it affect the definition of financial instruments in Section C(7), Annex I of MiFID? In particular, would you find the commercial purpose of a contract a useful distinguishing factor of whether the contract should be considered a financial instrument? If not, why not? 5.8. Market regulation 5.8.1. Market transparency

The report will investigate market regulation as both MiFID and the CAD touch upon issues concerning market stability, integrity, efficiency and transparency of markets. One important feature of MiFID market regulation is the mandatory requirement of pre- and post- trade transparency for transactions in shares admitted to trading in regulated markets whether or not those transactions are carried out on a regulated market or an MTF15. Those requirements are part of a broader framework of rules designed to promote competition between trading venues for execution services so as to increase investor choice, encourage innovation, lower transaction costs, and increase the efficiency of the price formation process on a pan-Community basis. A separate Commission report is being prepared in relation to the desirability of extending transparency for transactions in financial instruments other than shares. The call for evidence issued in relation to that report proposed prioritising transparency review by placing mainly fixed-income financial instruments and their derivatives at the forefront of inquiry. This prioritisation

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Articles 22, 27, 28, 29, 30, 44 and 45 of MiFID and the Chapter IV of the MiFID implementing regulation establish common rules for the publication of details of completed transactions in shares and for the disclosure of details of current opportunities to trade in shares.
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was welcomed by most interested parties. However, any further comments on the transparency of commodity and exotic derivatives markets will be welcome. Transaction transparency is not the only type of transparency necessary for an orderly functioning of the market. It could be desirable to examine the different markets in order to determine which types of information are essential for an efficient price formation to occur, whether the information is sufficient and whether EU action may correct any potential deficiencies. This is especially the case in these markets where producers are particularly active in wholesale trading and where information asymmetries could affect the correct functioning of the market as well as the pricing of risk by nonproducers (i.e. higher spreads). 21. Which type of information (depending on the particular market) do you consider to be essential to efficient competition in the provision of investment services in relation to spot commodities and commodity derivatives? 22. In which commodity or commodity derivatives markets do you think there is scope for improvements regarding the availability of information which is essential for the orderly functioning of the market? 23. Other than publication of pre- and post-trade data in relation to transactions in commodity derivatives markets, are there any other types of information disclosures (e.g. publication of aggregate data by major market places) whose introduction might be desirable to enhance market efficiency and stability? 5.8.2. Market integrity

MiFID also provides competent authorities with the necessary rules which allow them to monitor market participants in order to promote the integrity of the market. The regulation of transaction reporting and the exchange of information between competent authorities under MiFID (in Article 25, and Articles 56 and 58 respectively) is a central element of the scheme for ensuring that competent authorities are in a position to carry out their obligations under the Directive as expeditiously and efficiently as possible16. To this extent it is necessary to ask whether the existing exemptions which result in certain firms not reporting the transactions they executed in relation to commodity derivatives are in accord with the need to ensure market integrity. Similarly, the Market Abuse Directive17 (MAD) and its implementing measures18 harmonise the rules related to insider dealing and market

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Article 25 of MiFD requires investment firms which execute transactions in any financial instruments admitted to trading on a regulated market to report details of such transactions to the competent authority as quickly as possible, and no later than the close of the following working day. This obligation applies whether or not such transactions were carried out on a regulated market. Directive 2003/6/EC on insider dealing and market manipulation, OJ L 96. 12.4.2003. p. 16.
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manipulation in relation to financial instruments admitted to trading on a regulated market and their issuers. Some of the most important commodity options and futures will therefore fall under the scope of the directive as the exchanges on which they are issued and traded will become regulated markets. This means that anyone who uses inside information related to these commodity derivatives to acquire or dispose of the instruments or performs market manipulative behaviour is covered by the prohibitions on insider trading and market manipulation19. However, not all of the current market abuse rules can be applied meaningfully to trading in commodity derivatives as many of those rules, e.g. disclosure of price-sensitive information apply mainly to issuers of financial instruments which, in the case of commodity derivatives business, means mainly exchanges. The producers or other actors in the commodity markets may also be in possession of important price-sensitive information but they may or may not be obliged to disclose it depending on market practice or other national rules. Furthermore, market abuse regulation in relation to the spot commodity trading itself has not been harmonised at an EU level. The Report could provide a good opportunity to review the functioning of MAD in relation to commodity derivatives as well as to explore the applicability of market abuse regulation to the commodity trading itself. 24. Do you consider it appropriate and consistent with the need to uphold the integrity of the markets to ensure that all transactions in relation to commodity and exotic derivatives admitted to trading regulated markets are reported to competent authorities? 25. Do you consider the current market abuse regime in relation to commodity and exotic derivatives is satisfactory? If not, how would you propose to improve the current regulatory framework? In particular, to what extent would you consider it desirable to investigate the applicability of market abuse regulation in relation to trading of spot commodities? 6. NEXT STEPS 6.1. Stocktaking and data gathering As a first step, the Commission will carry out a stock-taking exercise which should produce a comprehensive picture of the commodity and commodity derivatives markets, including their main structural and economic characteristics, regulation and interaction. The stock-taking exercise will be composed of a regulatory and a market review.

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Commission Directive 2003/124/EC, OJ L 339, 24.12.2003, p. 70; Commission Directive 2003/125/EC, OJ L 339, 24.12.2003, p. 73; Commission Regulation (EC) 2273/2003, L 336, 23.12.2003, p. 33. 19 See Articles 1(1) 2(1), 4 and 5 of Directive 2003/6/EC.
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The regulatory review will include an analysis of the national regulatory regimes currently in place in EU Member States in relation to commodity as well as commodity derivatives business. Part of the review concerning the prudential supervision of commodity firms is already under way20 and intends to find out how the national regimes address the risks arising from commodities business in terms of: – scope of the regime; i.e., which types of entities are covered; – coverage of risks: a description of the particular risks that the national regimes seek to address and the methodologies used to address such risks. – the analysis of the way in which national supervisory regimes deal with firms and commodities business carried out within financial or nonfinancial groups. – an assessment of the prudential supervisory regimes (if any) in place in major third country financial services markets, assessing the methods by which those regimes seek to address the relevant risks. The market review should seek to identify the size and the structure of the markets in question. This would include identification and the importance of the major market participants, institutional context of trading and the most commonly used instruments. For the purposes of the report, we intend to categorise the commodity and the derivatives markets in the following fashion. Agricultural o Grains and livestock o Foodstuffs o Textiles o Forest products Metals o Precious metals o Base metals Energy o Oil o Gas o Electricity o Coal Exotic derivatives
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The commission has issued a call for advice from CEBS concerning the review under Article 48 of the recast CAD. The call for advice is available at http://ec.europa.eu/internal_market/bank/docs/calls/1608-2006-call-commodities_en.pdf . To gather evidence in support of its advice to the Commission, CEBS published a questionnaire on current industry practices and thinking in relation to the measurement and management of commodity risk. Available http://www.c-ebs.org/Advice/advice.htm
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o Emission allowances o Weather o Other

26. Do you consider this classification scheme sufficient for the purposes of the review? 27. What information and data sources do you consider relevant to the issues raised in this call for evidence? Would you or your organisation be prepared to produce any relevant information or data if necessary? 6.2. Timing We have worked back from the end-October 2008 deadline in light of the above remarks to set out a preliminary set of milestones. The key milestones and deadlines applicable are set out in Annex III.

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ANNEX I: SUMMARY OF QUESTIONS 1. Do you believe that the current EU legislative framework gives rise to problems in the functioning of the commodity and exotic derivatives markets? If yes, please indicate the nature of the problems. 2. If there are significant problems, do you believe the three broad approaches outlined above are an appropriate starting point for a formulation of more detailed policy alternatives or is there another option that should be considered? 3. Do you have a preference for one of the approaches outlined above? Please answer the previous three questions as briefly as possible. More detailed questions related to specific MiFID and recast CAD provisions to the commodity derivatives business are posed below. 4. Do you agree the Report should be drafted in light of the above principles/objectives? 5. Are there any principles/objectives we have not listed which you consider important? 6. Is there a hierarchy between these objectives/principles? If yes, please provide a ranking. 7. Do you think that the close relationship between the underlying and derivatives markets warrants an investigation of the underlying markets as part of the Report? 8. Which features of EU financial markets regulation, if any, do you think could be potentially of interest or application in the commodity wholesale trading ? 9. Do you consider that the rationales for maintaining or removing the exemptions under MiFID Article 2(1)(i) and 2(1)(k) are essentially the same for both exemptions, i.e. related to issues of capital adequacy? If not, why not? 10. Do you consider that the exemptions under MiFID Article 2(1)(i) and 2(1)(k) and under Article 48 of the recast CAD create a competitive distortion which could be of significant policy concern? If yes, what would be the most appropriate way of mitigating the distortion? 11. If there are competitive distortions between persons active in the commodity derivative space and those distortions would be removed, would there still remain a significant distortion between commodity derivatives

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trading and spot trading? If yes, what would be the most appropriate way of mitigating the distortion? 12. Do you consider it appropriate that Member States regulate the entities excluded from the scope of the MiFID and recast CAD a) pending the review of those exemptions; b) if the exemptions are maintained after the review? 13. To what extent do you consider that the reasons for subjecting investment firms to prudential regulation hold equally for entities providing investment services and, in particular, the service of dealing on own account, exclusively in relation to commodity or exotic derivatives? Do you think that these reasons are (or are not) valid for all or only for some of these entities? 14. Do you think that parts of the current prudential regulation (organisational requirements, capital adequacy, internal capital, etc.) should not apply in their present form to the provision of investment services in relation to commodity and exotic derivatives? Would your opinion depend on whether the respective services are provided by a firm exclusively providing services in commodity or exotic derivatives? 15. If you consider some parts of the current prudential regulation should be adapted in order to be meaningfully applied to the provision of investment services in relation to commodity and exotic derivatives what are the reasons and what changes would you propose? Would the proposed changes depend on the type of entity providing the investment services or the underlying of the financial instrument? 16. Do you think that activities giving rise to similar investor protection concerns should be, to the extent possible, subject to the same legal and supervisory framework? 17. Do you think that parts of the current conduct of business regulation (client classification, information disclosure, fiduciary duties, etc.) should not apply in their present form to the provision of investment services and, in particular, the service of dealing on own account, in relation to commodity or exotic derivatives? Would your opinion depend on whether the respective services are provided by a firm exclusively providing services in commodity or exotic derivatives? 18. If you consider some parts of the current conduct of business regulation must be adapted in order to be meaningfully applied to the provision of investment services in relation to commodity and exotic derivatives what are the reasons and what changes would you propose? Would the proposed changes depend on the type of entity providing the investment services or the underlying of the financial instrument? 19. Do you consider the scope of the definition of financial instruments provided for in MiFID as well as its implementing Regulation to be adequate?

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20. If there are changes in the scope of persons falling under MiFID, how would it affect the definition of financial instruments in Section C(7), Annex I of MiFID? In particular, would you find the commercial purpose of a contract a useful distinguishing factor of whether the contract should be considered a financial instrument? If not, why not? 21. Which type of information (depending on the particular market) do you consider to be essential to efficient competition in the provision of investment services in relation to spot commodities and commodity derivatives? 22. In which commodity or commodity derivatives markets do you think there is scope for improvements regarding the availability of information which is essential for the orderly functioning of the market? 23. Other than publication of pre- and post-trade data in relation to transactions in commodity derivatives markets, are there any other types of information disclosures (e.g. publication of aggregate data by major market places) whose introduction might be desirable to enhance market efficiency and stability? 24. Do you consider it appropriate and consistent with the need to uphold the integrity of the markets to ensure that all transactions in relation to commodity and exotic derivatives admitted to trading regulated markets are reported to competent authorities? 25. Do you consider the current market abuse regime in relation to commodity and exotic derivatives is satisfactory? If not, how would you propose to improve the current regulatory framework? In particular, to what extent would you consider it desirable to investigate the applicability of market abuse regulation in relation to trading of spot commodities? 26. Do you consider this classification scheme sufficient for the purposes of the review? 27. What information and data sources do you consider relevant to the issues raised in this call for evidence? Would you or your organisation be prepared to produce any relevant information or data if necessary?

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ANNEX II: RELEVANT LEGAL PROVISIONS

Directive 2004/39/EC on markets in financial instruments Article 2 Exemptions 1. This Directive shall not apply to: (i) persons dealing on own account in financial instruments, or providing investment services in commodity derivatives or derivative contracts included in Annex I, Section C 10 to the clients of their main business, provided this is an ancillary activity to their main business, when considered on a group basis, and that main business is not the provision of investment services within the meaning of this Directive or banking services under Directive 2000/12/EC; (k) persons whose main business consists of dealing on own account in commodities and/or commodity derivatives. This exception shall not apply where the persons that deal on own account in commodities and/or commodity derivatives are part of a group the main business of which is the provision of other investment services within the meaning of this Directive or banking services under Directive 2000/12/EC; Article 65 Reports and review 3. Before 30 October 2006, the Commission shall, on the basis of public consultations and in the light of discussions with competent authorities, report to the European Parliament and Council on: (a) the continued appropriateness of the exemption under Article 2(1)(k) for undertakings whose main business is dealing on own account in commodity derivatives; (b) the content and form of proportionate requirements for the authorisation and supervision of such undertakings as investment firms within the meaning of this Directive; (d) the continued appropriateness of the exemption under of Article 2(1)(i).

Commission Regulation 1287/2006/EC implementing Directive 2004/39/EC of the European Parliament and of the Council as regards recordkeeping obligations for investment firms, transaction reporting, market transparency,
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admission of financial instruments to trading, and defined terms for the purposes of that Directive Article 40 Re-examinations 2. The Commission shall, after consulting the Committee of European Securities Regulators, re-examine the provisions of Articles 38 and 39 relating to criteria for determining which instruments are to be treated as having the characteristics of other derivative financial instruments, or as being for commercial purposes, or which fall within Section C(10) of Annex I to Directive 2004/39/EC if the other criteria set out in that Section are satisfied in relation to them. The Commission shall report to the European Parliament and to the Council at the same time that it makes its reports under Article 65(3)(a) and (d) of Directive 2004/39/EC.

Directive 2006/49/EC on the capital adequacy of investment firms and credit institutions (recast)

Article 48 1. The provisions on capital requirements as laid down in this Directive and Directive 2006/48/EC shall not apply to investment firms whose main business consists exclusively of the provision of investment services or activities in relation to the financial instruments set out in points 5, 6, 7, 9 and 10 of Section C of Annex I to Directive 2004/39/EC and to whom Directive 93/22/EEC (1) did not apply on 31 December 2006. This exemption is available until 31 December 2010 or the date of entry into force of any modifications pursuant to paragraphs 2 and 3, whichever is the earlier. 2. As part of the review required by Article 65(3) of Directive 2004/39/EC, the Commission shall, on the basis of public consultations and in the light of discussions with the competent authorities, report to the Parliament and the Council on: (a) an appropriate regime for the prudential supervision of investment firms whose main business consists exclusively of the provision of investment services or activities in relation to the commodity derivatives or derivatives contracts set out in points 5, 6, 7, 9 and 10 of Section C of Annex I to Directive 2004/39/EC; and (b) the desirability of amending Directive 2004/39/EC to create a further category of investment firm whose main business consists exclusively of the provision of investment services or activities in relation to the financial instruments set out in points 5, 6, 7, 9 and 10 of Section C of Annex I to Directive 2004/39/EC relating to energy supplies (including electricity, coal, gas and oil).
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3. On the basis of the report referred to in paragraph 2, the Commission may submit proposals for amendments to this Directive and to Directive 2006/48/EC.

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ANNEX III: INDICATIVE TIMELINE FOR THE REPORT
Milestone/process First part of CEBS advice Second part of CEBS advice End of consultation period on call for evidence First part of CESR advice (factual issues) ESME work schedule Publication of feedback statement Mandates and terms of reference CESR/CEBS further work (if necessary) Impact assessment (by COM or by Consultant) Draft report Consultation period Public hearing Final report Due date November 06 End April 07 End April 07 End April 07 End April 07 End September 07 End September 07 End March 08 End June 08 End June 08 Mid September 08 September 08 End October 08

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ANNEX IV: COMMISSION DECLARATION INSERTED IN THE MINUTES OF THE EUROPEAN SECURITIES COMMITTEE CONCERNING THE INTERACTION OF ORGANISATIONAL
REQUIREMENTS FOR INVESTMENT FIRMS DIRECTIVES 2004/39/EC AND 2006/48/EC AND CREDIT INSTITUTIONS UNDER

Directive 2006/48/EC, and Directive 2004/39/EC share a common approach to the regulation of the internal systems, resources and procedures of the investment firms and credit institutions which fall within their scope, even if the requirements relevant to that regulation which are imposed by each Directive are formulated in a different way. Taking into account that both Directives apply to investment firms and to credit institutions when carrying on investment services or activities and as both sets of rules have similar objectives, it would be disproportionate to require investment firms and credit institutions to distinguish between those internal systems, resources and procedures which they are required to maintain under the different Directives. In the interests of uniform, effective and proportionate regulation for investment firms and credit institutions, a common approach to the parallel requirements of Directiv 2000/48/EC, and Directive 2004/39/EC should be adopted to the extent that those requirements overlap. By virtue of Article 1(2) of the Directive 2004/39/EC organisational requirements under Article 13 of that Directive also apply to credit institutions authorised under Directive 2006/48/EC, when providing one or more investment services and/or performing investment activities Investment firms and credit institutions (when they carry on investment services or activities) which comply with the requirements of Directive 2004/39/EC and its implementing measures should be treated as having satisfied the requirements of Article 22 of Directive 2000/12/EC to which they are subject by virtue of Article 34 of Directive 2006/49/EC. No further organisational requirement in relation to Article 22 of Directive 2006/48/EC should be imposed on investment firms by Member States and competent authorities, for the purposes of Directive 2004/39/EC and Directive 2006/48/EC. However, in order to ensure prudent management of investment firms and in order to appropriately address the risks they are exposed to as a result of their specific risk profile and operating environment, investment firms and credit institutions when providing investment services shall comply with the provisions of Article 22 of Directive 2006/48/EC in respect of the risks set out in paragraphs 3 to 15 of Annex V of that Directive. Member States and competent authorities for the purposes of Directive 2004/39/EC and Directive 2006/48/EC, should not impose any organisational requirements on investment firms and credit institutions when providing investment services under Article 123 of Directive 2006/48/EC, other than those that deal with the strategies and processes to assess the amounts, types and distribution of internal capital that investment firms need to maintain on an ongoing basis in order to adequately cover the nature and level of risks to which they are or might be exposed. In particular, no further requirements should be imposed relating to the organisational structure of an
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investment firm, other than those regulated in this Directive, upon investment firms under that Article. Explanation The implementing measures adopted under Article 13 of the MiFID introduce an extensive and detailed legal framework regulating the organisational structure and processes of investment firms. These measures also apply to credit institutions when providing one or more investment services. The Directive 2006/49/EC on the capital adequacy of investment firms and credit institutions states in Article 34 that competent authorities must ensure that, as well as meeting the organisational requirements set out in MiFID, every investment firm must also comply with the organisational requirements set out in the Directive 2006/48/EC. The existence of two sets of parallel rules applying to the same activities risks both over-regulation and a system of inconsistent organisational requirements for regulated entities operating in the field of investment services. There is significant overlap between the scope of each Directive, in so far as both apply to investment firms and credit institutions when carrying on investment services or activities. Since both sets of rules have a similar objective, it would be disproportionate to require investment firms and such credit institutions to distinguish between those internal systems, resources and procedures which it is required to maintain for the purposes of each level 1 Directive. The draft Declaration addresses this problem and attempts to provide a policy solution. This solution is based on two principles. First, it is recognised that MiFID and the Directive 2006/48/EC share a common conceptual approach to the regulation of the internal systems, resources and procedures. Second, it recommends application of the rules of that Directive which provides for a more comprehensive and detailed regime in a particular area. Since MiFID and its implementing Directive contain a comprehensive, detailed and proportionate framework of requirements relating to organisational requirements for investment firms and credit institutions when carrying on investment services or activities, firms which comply with the relevant requirements of this Directive in the areas it covers should be deemed to comply with the relevant requirements of the re-cast Banking Consolidation Directive, and no further requirements should be imposed upon those firms in those areas. This solution gives best effect to the principles of better regulation. Nevertheless, there are some specific areas – for example risk management policies related to specified types of risk – that are either covered only by the Directive 2006/48/EC, or that are treated in greater detail in that Directive than under MiFID. In those cases, investment firms and credit institutions will have to comply with the requirements set out in the Directive 2006/48/EC.

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