In February 2014, the European Securities and Markets Authority (ESMA) submitted a request to the European Commission for clarity on the definition of “derivative” or “derivative contract” in Regulation (EU) No 648/2012 on OTC derivatives, central counterparties and trade repositories (EMIR) in order to ensure a uniform application of the definition and therefore also EMIR across the European Union (see our previous briefing: EMIR - ESMA requests clarity on the definition of derivative).

In response, the European Commission invited ESMA to consider issuing guidelines on the application of the definitions of commodity derivative contracts under points (6) and (7) of Section C of Annex I to Directive 2004/39/EC on markets in financial instruments (MiFID) which relate to physically settled commodity forwards.

ESMA published a consultation paper (ESMA/2014/1189) - Guidelines on the application of C6 and C7 of Annex I of MiFID on 29 September 2014 (the Consultation Paper). We have commented on the most material parts of the Consultation Paper below.

MiFID

Annex 1, Section C of MiFID provides the following definitions for points (6) and (7) (C6 and C7 respectively):

(6) Options, futures, swaps and any other derivative contract relating to commodities that can be physically settled provided that they are traded on a regulated market and/or an MTF.

(7) Options, futures, swaps, forwards and any other derivative contract relating to commodities that can be physically settled not otherwise mentioned in C.6 and not being for commercial purposes, which have the characteristics of other derivative financial instruments, having regard to whether, inter alia, they are cleared and settled through recognised clearing houses or are subject to regular margin calls.

There is not a common interpretation of C6 and C7 in respect of physically settled forwards across Member States. In particular, there is disagreement about whether forwards are included within C6 and what is meant by “physically settled” in both C6 and C7.

Forwards

ESMA believes that forwards are included in the definition of C6 as they fall within the wording “any other derivative contract”. This assumes that it is a commodity forward that can be physically settled and is traded on a regulated market and/or an MTF. Such commodity forwards are therefore financial instruments under MiFID and within the scope of EMIR.

“Physically settled”

The term “physically settled” is not defined in MiFID. However, ESMA has effectively re-issued the 2005 advice from its predecessor (The Committee of European Securities Regulators) on this subject.

ESMA’s view is that the term “physically settled” in respect of both C6 and C7 incorporates a broad range of delivery methods including:

  • physical delivery of the relevant goods
  • delivery of a document giving rights of an ownership nature to the relevant goods or the relevant quantity of the goods concerned (such as a bill of lading or a warehouse warrant)
  • the amendment, assignment or other form of alteration of the records of rights of ownership in a central registry or other dematerialised system recording entitlement to establish a change in beneficial ownership of a physical commodity
  • another method of bringing about the transfer of rights of an ownership nature in relation to the relevant quantity of goods without physically delivering them (including notification, scheduling or nomination to the operator of an energy supply network) that entitles the recipient to the relevant quantity of the goods.

Relationship between C5, C6 and C7

ESMA believes that there is no conflict in the overlap of definitions between commodity derivatives under point (5) of Annex 1, Section C of MiFID (C5) which “may be settled in cash at the option of one of the parties”, and commodity derivatives under C6 and C7 because:

  • transactions which must be settled in cash fall under C5
  • transactions which may be settled in cash at the option of one of the parties fall under C5. This means that a C5 transaction may be physically settled if the party with the option to settle in cash does not exercise this option
  • transactions which must be physically settled fall initially under either C6 or C7, depending upon the place of execution and, in the case of C7, whether they are for commercial purposes
  • transactions that can be physically settled in all cases fall initially under C6 or C7, depending on the place of execution, except for where there is an option, available to one of the parties, to cash settle in which case the transaction will fall under C5.

The points that we have highlighted above are the main issues that are preventing a uniform application of MiFID and, therefore, EMIR. However, the Consultation Paper also covers other issues such as how the words “not being for commercial purposes, which have the characteristics of other derivative financial instruments, having regard to whether, inter alia, they are cleared and settled through recognised clearing houses or are subject to regular margin calls” in respect of C7 should be interpreted.

Next steps

The Consultation Paper is open for comments until 5 January 2015.

ESMA’s final guidelines on this subject will only apply to the current MiFID requirements. The impact of MiFID II falls outside the scope of the Consultation Paper.