Regulation

Hedging plays an important part in determining the extent to which MiFID II and EMIR apply to firms trading commodity derivatives, for the reasons summarised below:

• MiFID II – ancillary activity exemption in article 2.1(j): commodity traders are required to exclude hedging transactions when calculating whether their derivatives trading activity is ancillary to their main business.
• MiFID II – position limits: position limits do not apply to positions held by non-financial entities, which are regarded as hedging transactions.
• EMIR – clearing threshold: commodity traders who are non-financial entities are required to exclude certain hedging transactions when determining if they exceed the clearing threshold.

Hedging is defined in a similar, although not identical, way in EMIR and Regulatory Technical Standards 2017/592 (RTS 20) and 2017/591 (RTS 21), which accompany MiFID II². The implementation of MiFID II and EMIR has brought increased scrutiny on those undertaking hedging activities. For those undertaking commodity trading, the key points to note are that:

a) under both EMIR and MiFID II, trades must be “objectively measurable” as risk reducing (i.e., the purpose of the trade must be to reduce the risk of price volatility in the underlying asset);

b) only risks relating to the “commercial activity” or, in relation to the exemption under Article 2(1)(j) MiFID II (i.e. the ancillary activity exemption), and EMIR, “treasury financing activity”, are eligible to be hedged;

c) the commercial risks eligible for hedging must arise “in the normal course” of business; and

d) under MiFID II, to establish that a trade (or series of trades) is “objectively measurable” as reducing risks, it is necessary to identify the underlying eligible risk, and establish a link between that risk and the hedge trades which demonstrates there is a risk-reducing effect arising from each such trade.

Based on the recitals to RTS 20, the following types of hedging strategy may be permissible from a regulatory point of view.

i. Anticipatory hedging is a tool used to lock in or secure a price to protect from price volatility; often this is a futures contract. Anticipatory hedging is regarded as risk reducing where the risks in question are “reasonably anticipated [as arising] in the normal course of business”.

ii. Proxy hedging is the use of a nonequivalent commodity derivative to hedge a specific risk arising from commercial activity where an identical commodity derivative is not available, or where a more closely correlated commodity derivative does not have sufficient liquidity. A proxy hedge for a commercial risk may be treated as risk reducing where it is in a “closely correlated instrument”, and the underlying is “very close … in terms of economic behaviour” to the commercial risk being hedged.

iii. Macro hedging is the hedging of a portfolio of assets and liabilities for the same type of risk. A macro hedge must relate to the underlying risks as reasonably anticipated in the normal course of business, though it may do so having regard to those risks on an “overall basis”.

iv. Portfolio hedging may be treated as risk reducing where each of the hedges within the portfolio is reducing a commercial or, as applicable, treasury risk. The risks being mitigated against do not have to be of the same type for each underlying asset in each portfolio. A portfolio reconciliation report should be maintained to demonstrate a sufficiently disaggregated view of the portfolio, and of the types of risk being hedged against.

While the above hedging policies may be compliant with the regulatory framework under MiFID II and EMIR, this is not necessarily the end of the story as far as the law and hedging are concerned. As can be seen from the case law below, the English courts’ criteria for what constitutes recoverable damages for hedging in a breach of contract claim may not align with what may be acceptable hedging strategy from a regulatory perspective. This is not so surprising given the divergent starting points of the English courts and the regulators, i.e., the difficulty of squaring the English law on damages with the desire for greater transparency and oversight of business. However, companies in the commodities sector need to be mindful of both.

Hedging before the English courts

In certain circumstances, hedging losses have for some time now been established as reasonably foreseeable losses for which a claimant may be compensated following a breach of contract³. However, as the English law on damages has evolved, so has the law relating to hedging.

At the heart of any damages claim are the principles of causation and foreseeability. In short:

a) a loss is not recoverable in circumstances where the loss claimed does not flow directly from the breach of contract (i.e., the loss was not caused by the breach); and

b) a loss is not recoverable if it is of a type that is too remote from the parties’ agreement (i.e., it was not reasonably foreseeable).

These principles are commonly cited by defendants as the underlying legal obstacles to the recoverability of hedging losses, as demonstrated by the following recent decision.

The case of Vitol v. Beta Renowable⁴ concerned, among other issues, Beta’s failure to deliver a cargo of biofuel to Vitol. Vitol’s primary claim was for the loss suffered due to its inability to complete a subsale and damages for the losses suffered in connection with the gasoil futures it had used to hedge the biofuel cargo purchased from Beta. In the alternative, Vitol claimed damages on a market value basis for the difference in the cost of a replacement cargo. In its defence, Beta sought to argue that the hedging losses were not caused by any breach on its part, and that causation did not exist at all because all of the postponements to the delivery were consensual. Beta also argued that the losses were not reasonably foreseeable, and were too remote; they were not of the type or kind of losses for which Beta could be treated as having assumed responsibility.

Beta’s argument was successful. The court rejected Vitol’s primary claim based on losses calculated by reference to its hedging activities, on the basis that it did not “represent a fair or proper basis of compensation". The court considered that the price of gasoil futures, sold in March 2016, and subsequently rolled over, could not be compared to the on-sale price of gasoil in July 2016. In essence, the court took the view that Vitol had compared “apples with pears” and had not based its claim on “the necessary “like for like” basis”. The court did, however, accept Vitol’s alternative claim for damages on a market value basis.

While the courts have been willing to accept that, between commodities traders, the practice of hedging to mitigate market risk is reasonably foreseeable, as the Vitol v. Beta Renowable case demonstrates, proving the causative link between a hedge and the underlying contract is still a fundamental and potentially problematic requirement. In particular, if the derivative is not clearly identifiable as relating to the physical commodity being traded, the risk is that a court, even with expert assistance, may not be able to find as a matter of fact the necessary link between the derivative hedge and the physical cargo.

The Vitol v. Beta Renowable judgment demonstrates that what is permitted from a regulatory perspective, may not necessarily be sufficient to meet the test for recoverable damages in a breach of contract situation. In particular, while proxy hedging and portfolio hedging are permissible from a regulatory perspective, in some circumstances, there is a risk that any losses sustained on such hedges would not be recoverable in a breach of contract scenario. The risk remains that the court may struggle to find that the necessary link between the particular physical trade and its corresponding hedge has been demonstrated to the court’s satisfaction. Such a link may appear concealed, particularly as traders commonly use consolidated books to record hedged positions.

Enhancing the prospect of recovery

The following may be of assistance to companies that use commodities derivatives as a means of hedging loss:

1. At the outset of contracting, consider your counterparty and whether they are likely to adopt similar hedging practices to yours. Not only may the court view a producer in a different way to a trader, but similarly, different traders may well have different views as to what is a ‘like for like basis’ and a comparable hedging instrument.
2. Ideally, employ an express term regulating recoverability of hedging losses, particularly in cases where the trader considers that they maybe be exposed to an exceptional risk. This will reduce the margin of any residual doubt as to what the express intention of the respective parties entering into the contract was.
3. Maintain accurate internal record-keeping to facilitate the proof of a link between the physical exposure and the derivative (e.g., maintenance of emails showing the progress of commercial and legal negotiations towards execution of the contract).
4. Once a breach of contract appears likely, it is important to consider what steps should be taken in relation to both the physical cargo and the hedging position. When a party ought to close out its hedging position is likely to be a tricky question, and will depend on a number of factual and legal issues.

1. MiFID II is a European Union directive which took effect on January 2018 and extended the existing MiFID requirements in a number of areas. MiFID II also introduced a harmonised commodity position limits regime, among others. MiFID II also enables the European Commission to make secondary legislation, such as the Regulatory Technical Standards (RTS). EMIR lays down rules relating to OTC derivatives, central counterparties and trade repositories.
2. EMIR was introduced to address the risks associated with counterparty credit risk. Importantly, the Regulation provides that: (1) all standardised OTC derivative contracts should be cleared through central counterparties; (2) OTC derivative contracts should be reported to trade repositories; and (3) contracts not centrally cleared should be subject to higher capital requirements. RTS 20 deals with activities considered to be ancillary to the main business (main business test), while RTS 21 provides the test for the position limits to commodity derivatives.
3. See, for example, Addax v. Arcadia Petroleum Ltd. [2000] 1 Lloyd’s Rep. 493 and Choil Trading SA v. Sahara Energy Resources [2010] EWHC 374 (Comm).
4. Vitol SA v. Beta Renowable SA [2017] EWHC 1734 (Comm).