UK Government Publishes Draft Legislation Revising Application of the Ancillary Activities Test for Commodity Derivatives and Emission Allowances

The U.K. government has published a draft statutory instrument (and related explanatory memorandum), which will be known as the Financial Services and Markets Act 2000 (Commodity Derivatives and Emission Allowances) Order 2023. The draft SI will simplify the process for determining when a firm satisfies the “ancillary activities” test and reduce the burden on firms that apply the test. The changes were discussed under the Wholesale Markets Review and announced as part of the Edinburgh Reforms.
 
The ancillary activities test is an exemption (originally introduced in the revised EU Markets in Financial Services Directive) from investment firm authorization requirements for firms that trade commodity derivatives or emission allowances as an ancillary activity to their main business, such as energy and other commodity trading firms which are active in both physical trading and financial instrument trading. These firms may avoid regulation if they can demonstrate that their financial activity is ancillary to the physical activity. As part of MiFID II, an attempt was made to capture more proprietary trading activities, especially for specialist firms speculating in the financial markets.  A corollary of this was to introduce an exemption for commercial firms, where their physical or real-world activities exceed those in financial markets.  However, this test was fraught with difficulty, especially for energy companies, which need to buy and sell energy not just on the spot markets for immediate settlement, but also via longer-dated futures contracts and those who hedge their risks in the financial markets. The ancillary activities test was often difficult to apply and became subject to many exemptions and interpretations designed to avoid its application and related unintended consequences. To qualify for the exemption, firms are not permitted to employ high-frequency algorithmic trading and must notify the Financial Conduct Regulator annually that they have employed the exemption. Therefore, applying the ancillary activity test can be burdensome and expensive for firms.
 
The draft SI removes references to the ancillary activities test from the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 and the Financial Services and Markets Act 2000 (Markets in Financial Instruments) Regulations 2017, so that firms will no longer be required to notify the FCA. The FCA will be responsible for establishing a simpler regime to determine which firms need to be authorized as investment firms as a result of their commodities and emission allowances trading business.
 
The draft SI is intended to come into force on January 1, 2025, allowing time for the FCA to consult on and finalize its new regime.

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