ESMA Clarifies Application of Definition of Commodity Derivatives Under MiFID

Due to divergent approaches to the transposition of MiFID into national law, there has not, to date, been any single approach to the definition of a “derivative contract” under MiFID. As a result, derivatives-focussed legislation, such as EMIR, which relies on MiFID definitions has the potential to be significantly impacted.

To address this issue, ESMA has issued guidelines with a view to providing a common and uniform approach for derivatives falling within Annex I, C6 and C7 of MiFID until MiFID II comes into force in January 2017.

By way of background, ESMA wrote to the Commission in February 2014 drawing its attention to the divergent approach to the categorisation of foreign exchange forwards (FX forwards) and physically settled commodity forwards. In the context of FX forwards, for example, the difference in settlement dates (i.e. between 3 and 7 trading days) can result in the FX forward being categorised as a derivative in some Member States (i.e. Ireland), but not in others (i.e. the UK). Equally in the case of physically settled commodity forwards the manner in which certain terms have been defined (or have been used without definition – i.e. “physically settled”) in MiFID has resulted in a lack of clarity as to whether physically settled commodity forwards are to be identified as derivatives.

The absence of a consistent definition would have resulted in an inconsistent application of EMIR across Member States. For example, obligations under EMIR in relation to reporting of trades, the existence of clearing obligations and the calculation of clearing thresholds for non-financial counterparties all depend on the existence of an obligation in relation to a derivative contract. Where there is a divergence in the definition of a derivative contract the result would be an (unpalatable) inconsistent application of EMIR throughout Member States.

The ESMA guidelines address these issues and now provide that FX forwards traded on a regulated market or multilateral trading facility fall within the scope of MiFID and consequently also of EMIR. Furthermore, physical settlement is now to be determined at the point of execution and includes a broad range of delivery methods such as physical delivery of relevant commodities, transfer of title and risk to the commodity in question and other “[methods] of bringing about the transfer of rights of an ownership nature in relation to the commodities without physically delivering them”.

The guidelines will apply from 7 August 2015 and will in time be superseded by MiFID II delegated acts of the European Commission.

ESMA calls for modifications to the UCITS Directive

Following the introduction of EMIR, in late 2014 ESMA published a revised version of its Q&A on risk management which advised that UCITS should calculate counterparty risk for OTC financial derivative instruments (OTCs) which are subject to the clearing obligation in EMIR by looking at the clearing model used to determine the existence (and location) of counterparty risk.

The manner in which counterparty exposure should be calculated was then discussed in a follow-up paper of July 2014 on the calculation of counterparty risk by UCITS for these OTCs. This paper analysed the different clearing arrangements available and the consequence of a default of a clearing member (and its client) in the context of counterparty risk calculation.

Following this feedback, on 22 May 2015 ESMA issued an Opinion which called for amendments to be made to the UCITS Directive to take into account the clearing obligations of certain types of OTCs. Specifically, ESMA was of the opinion that:

  • The distinction between OTCs and exchange-traded derivatives (ETDs) should be removed and rather the distinction should focus on the cleared nature of the derivative transactions. This would result in:  - The type of segregation opted for (individual or omnibus client segregation) as well as the level of portability in the event of default of a clearing member to be taken into account when determining counterparty risk limits - ETDs and cleared OTCs with similar characteristics being treated in the same manner  - A change in the current counterparty risk requirements so that that UCITS will have to calculate counterparty risk for ETDs. As such, ESMA has undertaken to consult further to understand the impact of this approach
  • Counterparty risk limits will need to be considered at two (cumulative) levels. The first will depend on the type of CCP used. The second will depend on the type of segregation used. - For CCPs, the level of counterparty risk ascribed will depend on whether it is an EU CCP or a non-EU CCP recognised by ESMA on the one hand, or a non-EU CCP not recognised by ESMA on the other. These limits should be high for the former category of CCP but lower for the latter. - In the context of segregation, different counterparty risk limits will be set depending on the type of segregation applied by a clearing member. For example, there will be no counterparty risk limit to the clearing member where there is individual client segregation. Where there is omnibus client segregation then there will be counterparty risk to the clearing member.
  • Existing counterparty limits (5% / 10% limits) should remain in place for non-cleared OTCs and for non-EU CCPs not recognised by ESMA. This limit will be in addition to the counterparty risk limit for the non-EU CCP not recognised by ESMA.

As a closing remark, ESMA also noted the “conflict” between the operation of Article 50(1)(g)(iii) of the UCITS Directive and EMIR for OTCs subject to the clearing obligation. In essence, Article 50(1)(g)(iii) permits a UCITS to invest in OTCs provided they “can be sold, liquidated or closed by an offsetting transaction at any time at their fair value at the UCITS’ initiative”. To address this, ESMA noted that standard ISDA documentation has been amended to add a unilateral termination right. However, ESMA has recognised the practical reality that certain CCPs do not accept the unilateral termination clause. It has stopped short of calling for an amendment to the UCITS Directive in relation to this.

We would expect further consultation in due course with a view to ensuring that the scope and outcomes of any revised limits remain commercially viable for UCITS.