Typical types of transactions
Other than transactions between dealers, what are the most typical types of over-the-counter (OTC) equity derivatives transactions and what are the common uses of these transactions?
The market for OTC equity derivatives transactions can be divided into hedge and investment transactions. In respect of hedge transactions, the following types of transactions can predominantly be seen in the German market:
- call options, put options, collars, forwards and total return swaps to hedge any equity price risk;
- equity swaps entered into by companies to hedge their obligations in respect of the relevant company’s employee benefit plan, which entails shares or share price related benefits;
- call options entered into by a company to hedge its payment obligations in respect of cash-settled convertibles, known as ‘equity neutral convertible bond transactions’ (in contrast, the German market does not see any call spread overlays transactions to hedge the strike price of the convertible due to statutory limitations and usually limited authorisations by shareholder meetings);
- margin loans and margin bonds where shares are used as collateral for a leveraged loan bond, usually in the context of an acquisition;
- share loans and share repurchase transactions in the context of convertibles to facilitate hedging by convertible investors;
- gap risk guarantees or swaps hedging the price risk in relation to the settlement of equities; and
- derivative-based share buy-back transactions.
In the category of investments by way of equity derivatives transactions, the following transaction types are commonly seen in the German market:
- share basket, index-linked transactions entered into by insurance companies, pension funds, etc;
- equity funds, exchange-traded funds (ETFs) entering into equity derivatives to get a synthetic exposure to a basket of shares or equity index; and
- retail certificates providing investors with an equity derivative exposure (eg, share-linked certificates, bonus certificates, express certificates, knock-in and knock-out certificates, index and performance certificates and discount certificates) - the retail equity derivatives market in Germany is worth €60-80 billion.
Borrowing and selling shares
May market participants borrow shares and sell them short in the local market? If so, what rules govern short selling?
The rules on short selling are set out in Regulation (EU) No. 236/2012 of the European Parliament and of the Council of 14 March 2012 on short selling and certain aspects of credit default swaps. This Regulation is directly applied in all EU member states and a harmonised approach applies across Europe. The Regulation requires that all short sales of shares must be covered either by having borrowed the relevant stock or by arranging for such borrowing, or having an arrangement with a market participant as regards the location of the relevant stock. Naked short selling of shares is prohibited. In addition, the regulation requires reporting in respect of the holding of net short positions of a market participant. Significant net short positions in shares must be reported to the relevant competent authorities when they are equal to at least 0.2 per cent of company-issued share capital and every 0.1 per cent above that; and be disclosed to the public when they are equal to at least 0.5 per cent of company-issued share capital and every 0.1 per cent above that. Exemptions are available for market-making activities and authorised primary dealers.
Applicable laws and regulations for dealers
Describe the primary laws and regulations surrounding OTC equity derivatives transactions between dealers. What regulatory authorities are primarily responsible for administering those rules?
There is no single rule book for the regulation of OTC derivatives and, in particular, equity derivatives transactions in Germany. Various pieces of legislation regulate certain aspects of an equity derivatives transaction:
- German Securities Trading Act: this act applies to financial instruments, which includes derivatives. This German legislation has implemented, inter alia, Directive 2014/65/EU of 15 May 2014 on markets in financial instruments and amending Directive 2002/92/EC and Directive 2011/61/EU (MiFiD II). The Directive is complemented by Regulation (EU) No. 600/2014 of 15 May 2014 on markets in financial instruments and amending Regulation (EU) No. 648/2012 (MiFiR). The German Securities Trading Act deals with insider trading, market abuse (in addition to the European legislation on market abuse - see below), disclosure of voting rights, organisation, transparency and prudent behaviour in relation to advising, selling and dealing in financial instruments (including derivative transactions), supervision of the German financial regulator (BaFin) and sanctions;
- German Banking Act: this act regulates certain activities requiring a licence. In the context of derivatives transactions, financial services institutions are required to hold a licence for the following activities, to the extent that these activities are commercially organised on a large scale:
- the brokering of business involving the purchase and sale of financial instruments, which includes derivative transactions (investment broking);
- providing customers or their representatives with personal recommendations in respect of transactions relating to certain financial instruments where the recommendation is based on an evaluation of the investor’s personal circumstances or is presented as being suitable for the investor, and is not provided exclusively via information distribution channels or for the general public (investment advice);
- the placing of financial instruments without a firm commitment basis (placement business);
- the purchase and sale of financial instruments on behalf of and for the account of others (contract broking);
- the management of individual portfolios of financial instruments for others on a discretionary basis (portfolio management); and
- the purchase and sale of financial instruments for own account as a service for others or the purchase and sale of financial instruments for own account as a direct or indirect participant in a domestic organised market or multilateral trading facility (proprietary trading);
- European Market Infrastructure Regulation (EMIR): in the EU, the G20 commitment on the regulation of OTC derivatives was introduced as part of Regulation (EU) No. 648/2012 on OTC derivatives, central counterparties and trade repositories, which imposes obligations on all EU undertakings (including banks, corporates and special purpose vehicles) that enter into derivative contracts, such as interest rate, foreign currency, inflation swaps and equity derivatives. These obligations include mandatory clearing of certain OTC derivatives through central counterparties; the imposition of risk mitigation techniques for non-cleared OTC derivatives, such as the exchange of collateral between parties; and the reporting of derivatives to trade repositories. The overall objective of EMIR is to improve transparency and reduce some of the risks associated with the derivatives market, in particular the risk that the insolvency of one derivatives counterparty may spread through the derivatives market, triggering further insolvencies. Since early 2017, draft legislation to amend EMIR (the EMIR REFIT proposal) has been under consideration, with the aim of making some of its requirements simpler and more proportionate, particularly for non-financial counterparties. Following trilogue discussions among the European Commission, Council and Parliament, political agreement on the amending legislation was reached at the beginning of 2019. Although EMIR came into force on 16 August 2012, it is taking effect in phases. In respect of the clearing obligation for certain equity derivatives, please refer to the public register maintained by the European Securities and Markets Authority (ESMA) pursuant to article 6 EMIR (which is regularly updated);
- the Market Abuse Regulation (MAR): Regulation No. 596/2014 on market abuse came into effect on 3 July 2016. It aims to increase market integrity and investor protection, enhancing the attractiveness of securities markets for capital raising. Although the Market Abuse Directive (MAD) had already been adopted in 2013, the European Commission felt it was necessary to frame the legislative revision of MAD in a European regulation (rather than a directive, as before) as its direct applicability would reduce regulatory complexity and offer greater legal certainty for firms. MAR strengthens the previous German market abuse framework by extending its scope to new markets, new platforms and new behaviour. It contains prohibitions on insider dealing, unlawful disclosure of inside information and market manipulation, and provisions to prevent and detect these;
- Benchmarks Regulation: Regulation No. 2016/1011 on indices used as benchmarks in financial instruments and financial contracts or to measure the performance of investment funds is dated 8 June 2016. It introduces a regime for benchmark administrators that ensures the accuracy and integrity of benchmarks. In addition, a code of conduct for contributors of input data requires the use of robust methodologies and sufficient and reliable data. Finally, user of benchmarks need to establish robust fall-backs and regulated entities may only use registered benchmarks for certain financial products. This regime applies also to equity indices across Europe;
- Stock Corporation Act (AktG): in respect of share buy-backs and transactions with share issuers, certain restrictions on such share buy-backs (including a buy-back via derivative transactions) apply;
- Short Selling Regulation: as set out in question 2, naked short sales of European shares are prohibited by Regulation (EU) No. 236/2012;
- German Civil Code and German Commercial Code: these acts set out certain general principles of contract law, which also affect documentation and interpretation of equity derivatives transactions to the extent the governing law of the transaction is German law; and
- German Insolvency Act: in light of standard market documentation for OTC equity derivatives (German Master Agreement and ISDA Master Agreement) and the reliance on netting provisions, German insolvency law needs to be consulted when transactions are entered into with German counterparties.
The rules and regulations set out above are policed by BaFin and ESMA.
In addition to dealers, what types of entities may enter into OTC equity derivatives transactions?
The main users of equity derivatives are banks, credit institutions and financial services institutions. In addition, funds (regulated and unregulated), ETFs, alternative investment fundss, securitisation and repackaging vehicles, insurance companies, pension funds, professional pension schemes and corporates are frequent users in the market. Retail investors are also heavily investing in equity-linked structured products.
Applicable laws and regulations for eligible counterparties
Describe the primary laws and regulations surrounding OTC equity derivatives transactions between a dealer and an eligible counterparty that is not the issuer of the underlying shares or an affiliate of the issuer? What regulatory authorities are primarily responsible for administering those rules?
In addition to the rules and regulations set out in question 3, specific rules apply to counterparties that are themselves regulated in respect of their investments and transactions activities. This is particularly the case for other regulated counterparties, such as insurance companies and regulated funds:
- German Insurance Supervisory Act (VAG): this Act is the equivalent of the German Banking Act for insurance companies. It was completely renewed in 2016 to implement the Solvency II Directive 2009/138/EC. Insurance companies are restricted in the spectrum of potential investments. Pursuant to the general principles set out in section 124 of the VAG, an investment by an insurance company in an equity derivative needs to comply with the following: safe investment, quality investment, liquidity and an appropriate risk and return ratio. These principles are further set out in detailed guidelines. In addition, any investment needs to comply with the newly introduced capital requirement rules. Although the VAG only applies directly to insurance companies, it should be noted that German pension funds, pension schemes, etc, may also apply these rules and consequently be indirectly subject to the same or similar restrictions; and
- German Investment Act (KAGB): this piece of legislation combines the regulated and former unregulated fund industry. The KAGB is predominantly the implementation of European directives. Whereas the rules for regulated funds derive from Directive No. 2014/91/EU for undertakings for the collective investment in transferable securities (UCITS), the unregulated investment funds are subject to Directive No. 2011/61/EU of the European Parliament and of the Council of 8 June 2011 on Alternative Investment Fund Managers (AIFMD) and amending Directives Nos. 2003/41/EC and 2009/65/EC and Regulations (EC) No. 1060/2009 and (EU) No. 1095/2010. The AIFMD is a piece of European legislation enacted to regulate alternative investment funds. It is part of the legislative response to the global financial crisis of 2007-2008. In the immediate aftermath of the crisis, both the hedge fund industry and, to a lesser extent, the private equity industry attracted a lot of criticism from certain European politicians because, owing to relative lack of transparency and lack of regulatory oversight, the practices prevalent in these industries had been perceived as significant contributing factors to the breadth and depth of the crisis. The AIFMD is an attempt to subject, in relation to many industry players for the first time, the alternative fund industry to a set of rules providing minimum standards in areas such as governance, transparency and accountability. It is also the first attempt to harmonise local rules applicable to alternative investment funds and to introduce the concept of a pan-European passport into the alternative investment funds’ space. The KAGB provides for restrictions and limitations in respect of the use of derivatives investments by a fund. These rules and restrictions are different depending on what type of fund is created and to which investors it shall be distributed.
Again, these rules and regulations are policed by BaFin and ESMA.
Securities registration issues
Do securities registration issues arise if the issuer of the underlying shares or an affiliate of the issuer sells the issuer’s shares via an OTC equity derivative?
The issuer may sell either newly created shares or treasury shares. In the case of register shares (in contrast to bearer shares) being sold, the share register will be updated following notice by the relevant custodian bank of the issuer and the purchaser. As German shares are predominantly cleared through Clearstream Banking AG, the share register will be electronically updated and reconciled with the books of Clearstream Banking AG. In light of equity derivatives transactions, the obligation (or the right) to request a change to the share register only arises with the transfer of the legal ownership of the shares (see section 67 AktG). The registration is particularly relevant in respect of voting rights and dividend rights.
May issuers repurchase their shares directly or via a derivative?
The AktG is rather restrictive in respect of share buy-backs by companies. Section 71 of the AktG sets out the limited circumstances in which a company may buy back its own shares:
- if the acquisition is necessary to avoid severe and imminent damage to the company;(if the shares are to be offered for purchase to the employees or former employees of the company or an affiliated enterprise;
- if the acquisition is made to compensate shareholders;
- if the acquisition is made without consideration or made by a credit institution in execution of a purchase order;
- by universal succession;
- on the basis of a resolution of the shareholders’ meeting to redeem shares pursuant to the provisions governing a reduction of share capital;
- if it is a credit institution or financial institution on the basis of a resolution by the shareholders’ meeting for the purposes of trading in securities; or
- on the basis of an authorisation from the shareholders’ meeting lasting no more than five years that sets the lowest and highest price and may not exceed 10 per cent of the share capital.
In practice, the last point is the most relevant scenario, which requires careful drafting of the shareholders’ resolution to allow for a share buy-back via derivatives (eg, put and call options, forwards). The shareholders’ authorisation must indicate the highest and lowest purchase price. The price range may also be determined as a percentage of a future market price. If the purchase price deviates from the fair market value, tax consequences need to be considered. The authorisation for a share buy-back is valid for 18 months.
The company itself can hold shares as treasury shares. The nominal value of the treasury shares held by the company cannot exceed 10 per cent of the nominal share capital. The company does not have rights arising from these shares, such as dividend or voting rights.
A third party acting in its own name but on behalf of the company (ie, a dealer) may acquire or hold shares in the company only if the company is permitted to make such an acquisition in accordance with the provisions set out above. Share buy-backs do not constitute an unlawful repayment of stated share capital if the buy-back is made in compliance with these provisions. Any share buy-backs are disclosed in the notes to the annual accounts and there is further disclosure in the company’s balance sheet where the buy-back is booked accordingly. Although not specific to share buy-backs via equity derivatives transactions, both parties need to comply with the insider dealing and market abuse provisions set out in the German Securities Trading Act and MAR, respectively.
The management board must inform the shareholders following a share buy-back of the purpose, the number of shares and the share capital purchased by the company. This information must be included in the notes to the annual report. The decision itself to buy back shares may - depending on the circumstances - be considered as price-sensitive. It may therefore be published in accordance with the regulations on ad hoc publicity. The company must inform BaFin if shareholders have authorised the company to repurchase shares to hold the shares in treasury.
What types of risks do dealers face in the event of a bankruptcy or insolvency of the counterparty? Do any special bankruptcy or insolvency rules apply if the counterparty is the issuer or an affiliate of the issuer?
As with any derivative the main risk is credit risk. The equity derivative transaction usually terminates or may be terminated following the occurrence of an insolvency of the counterparty. Since the provisions of EMIR are in effect, counterparties are now obliged to provide collateral to cover the credit risk as well as any operational or settlement risk. As the value of an equity derivative transaction is likely to fluctuate, the margining provisions needed to address this are by way of an initial margin to mitigate any collateral shortfall. Under German insolvency law, the general principle applies that the insolvency administrator may elect whether to continue the contract or to terminate it. This right usually does not apply in respect of equity derivatives transactions to the extent that these are documented under a master agreement (eg, ISDA or DRV). In these circumstances, all transactions under the master agreement will be terminated and the exposures against each other will be netted. German insolvency law provides for a statutory netting. Following a German Federal Court decision in June 2016, a new statutory netting regime came into force on 1 January 2017 that reconciles the law with the current market documentation. For the contractual netting to apply, the counterparties usually elect automatic early termination before the opening of any insolvency procedures in the relevant master agreement. There are no special insolvency regimes where the counterparty is the issuer of the underlying shares. However, it should be noted that depending on the economics of the transactions, the insolvency of the counterparty (which is also the issuer of the underlying shares) is likely to have a material impact on the value of the transaction. Finally, it should be noted that special regimes as regards reorganisation, moratorium, restructuring and resolution apply in respect of an insolvency of credit institutions.
What types of reporting obligations does an issuer or a shareholder face when entering into an OTC equity derivatives transaction on the issuer’s shares?
The usual trade reporting obligations under EMIR apply. In addition, depending on the precise structure of the transaction and whether the dealer will be treated as a holder of the shares for the purpose of reporting any share holdings, the dealer may be required to report its holdings. The thresholds for these purposes are 3 per cent, 5 per cent, 10 per cent, 15 per cent, 20 per cent, 25 per cent, 30 per cent, 50 per cent and 75 per cent. Further, reporting requirements may be triggered in respect of shares listed on an exchange. This depends on the applicable rules of the exchange. Moreover, insider and market abuse regulation applies, which may require adequate publication or reporting.
Are counterparties restricted from entering into OTC equity derivatives transactions during certain periods? What other rules apply to OTC equity derivatives transactions that address insider trading?
There are no specified periods in which counterparties are restricted from entering into equity derivative transactions. The usual insider trading provisions apply in respect of all equity derivatives transactions.
What additional legal issues arise if a counterparty to an OTC equity derivatives transaction is the issuer of the underlying shares or an affiliate of the issuer?
In addition to the summary of share buy-backs via equity derivatives set out in question 7, it should be noted that - in certain circumstances - the equity derivative transaction may be void if it is entered into in violation of the limitations to share buy-backs (section 71 AktG). Consequently, it is crucial for a derivatives dealer to ensure that the counterparty (being the issuer of the underlying) acts in compliance with these restrictions. Such compliance should not only be ensured via appropriate representations and warranties but also by sufficient due diligence in respect of the company’s authorisation.
What types of taxation issues arise in issuer OTC equity derivatives transactions and third-party OTC equity derivatives transactions?
There are no specific taxation issues in respect of equity derivatives transactions as such. However, the tax treatment of a share buy-back in issuer OTC equity derivatives transactions needs to be carefully considered. Purchased shares not subject to cancellation have to be reported as assets with the acquisition costs in the commercial balance sheet. The company has to build a reserve for the shares it has purchased in the same amount. The tax consequences depend on the precise structure of the transaction. Capital gains or losses realised on a subsequent disposal are exempt from corporate income tax, solidarity surcharge and trade tax. For credit institutions, financial services institutions and financial enterprises holding the shares in the trading book, the tax exemption will not apply and the normal corporate income tax regime applies.
Shares for cancellation may not be reported as assets in the commercial balance sheet. The purchase price is set off against the company’s capital.
Describe the liability regime related to OTC equity derivatives transactions. What transaction participants are subject to liability?
The general civil liability regime applies. This regime may already be applicable at a very early stage of a proposed transaction. If a party is providing financial advice that may not contractually be set out, but the circumstances suggest some financial advice (eg, structuring, assisting in modelling the transaction, tailored marketing), the relevant party needs to provide appropriate advice. Extensive case law exists in that area and the relevant party is obliged to explore the needs, the knowledge and the experience of the counterparty and suggest the appropriate derivative. Furthermore, the relevant party needs to disclose the risk and rewards associated with the relevant derivative.
In a series of judgments by the German Federal Court and various regional courts in relation to interest rate swaps (entered into between a credit institution and a corporate), the courts have further highlighted the conflict of interest for a party to a swap. If a credit institution is a party to a derivative transaction and at the same time a financial adviser (which is almost always the case in non-standard transactions that are outside the ‘execution only’ business), the credit institution is inevitably in a conflict. Any gain under the derivative is the counterparties’ loss and if the credit institution is structuring the derivative it may structure it in its favour. Consequently, in these scenarios credit institutions (which are also financial advisers) need to disclose to the counterparty any initial negative market value of a derivative transaction for the counterparty to fully evaluate the implicit costs of the transaction. This requirement does not need to be fulfilled if the derivative is a hedging transaction for a connected transaction (eg, a convertible or loan). Although these judgments have mainly been applied in respect of interest rate swaps, it is very likely that the same will apply to any other asset classes, including equity derivatives transactions.
If a party provides information about the underlying share issuer, it may be liable under the prospectus liability regime. Even if the information is drawn from publicly available sources, it needs to ensure that the information is comprehensive and no material information is missing that would render the information so provided as false.
Once the parties have entered into the transaction, the contractual arrangements apply and the liability is usually limited to breach of contract or violation of applicable rules and obligations.
This liability regime applies to all transaction participants. As a rule of thumb, it should be noted that the less experienced a counterparty is (particularly if it is a retail investor), the higher the requirement for disclosure and information.
Stock exchange filings
What stock exchange filings must be made in connection with OTC equity derivatives transactions?
There are no stock exchange filings in respect of OTC equity derivatives transactions, unless as a result of such transaction a counterparty becomes the shareholder. Depending on the rules of the exchange in relation to shares, notification may be required if the transaction affects the price, the liquidity or the company as such. As regards cleared equity derivatives, mandatory trading needs to be established in respect of these (see MiFiD2).
Typical document types
What types of documents are typical in an OTC equity derivatives transaction?
The OTC market predominantly uses the ISDA Master Agreement or the German Master Agreement (DRV). The equity derivatives transactions will then be documented by confirmations that set out the economic terms of the transactions. In addition, the confirmation refers to a standard set of definitions used with equity derivatives. Under the ISDA Master Agreement these are the 2002 ISDA Equity Derivatives Definitions. Although the 2002 ISDA Equity Derivatives Definitions were updated in 2014, these new definitions are rarely used in the market. Under the DRV a similar set of definitions is available: the equity derivatives addendum. These definitions deal with the mechanics of exercising an option, valuations, market disruptions, extraordinary events, and share and index adjustment events (eg, merger events and tender offers). Now EMIR is in effect, parties are required to use risk mitigation techniques, in particular collateral arrangements, to reduce their respective credit risk.
In the exchange-traded derivatives market, the terms and conditions of the relevant derivatives are set out in standardised terms and conditions applicable to the relevant derivative. The terms are very similar to the OTC market in order to mitigate the risk of legal gaps between the two markets. Trading in exchange-traded derivatives is usually made via electronic booking orders.
The retail equity derivatives market utilises a retail prospectus, which is approved by BaFin for public offers and listing purposes. The EU Prospectus Regulation (No. 2017/1129) entered into force on 20 July 2017. With few exceptions, the regulation will only apply from 21 July 2019. The regulation is aimed at ensuring that securities prospectuses are made simpler and more user-friendly to enable investors to make informed investment decisions, while at the same time making it easier for companies to access the capital market.
In addition, marketing material is produced, including a product information sheet. Since January 2018, product manufacturers need to produce a small prospectus, the so-called ‘key information document’ based on Regulation (EU) No. 1286/2014 of the European Parliament and of the Council on key information documents for packaged retail and insurance-based investment products.
For what types of OTC equity derivatives transactions are legal opinions typically given?
If transactions are entered into under an ISDA Master Agreement or a DRV, parties usually rely on the industry market opinion. However, these opinions mostly cover netting of transactions only and do not deal with any specific enforceability or capacity issues of a specific transaction. In the case of an equity derivatives transaction relating to a share buy-back, the counterparty (not being the issuer) usually requires a capacity and compliance opinion to ensure the validity of the transaction.
It was previously uncommon in the retail market to provide legal opinion in respect of the relevant transactions. However, this has changed and issuers increasingly require a legal opinion for their own internal compliance procedure and approvals.
May an issuer lend its shares or enter into a repurchase transaction with respect to its shares to support hedging activities by third parties in the issuer’s shares?
This is generally possible, subject to the share buy-back rules described in question 7. However, careful structuring is required in light of the relevant transaction. If an issuer enters into a repurchase transaction with a counterparty, the relevant treasury shares are subject to a ‘security arrangement’ under the repurchase transaction, in particular, the company will receive them back after maturity of the repo. Consequently, the company needs to comply with the 10 per cent restriction on holding of own shares (including the shares being subject to the repo).
The analysis may be slightly different if the documentation does not contain such ‘security arrangement’. If, for example, the shares are subject to a loan, the borrower is not bound by any security arrangement. Consequently, it can be argued that the borrower becomes the shareholder and upon maturity of the loan the return of the loaned shares is a share buy-back by the company. This would then require a shareholders’ resolution in compliance with the restrictions on share buy-backs.
What securities registration or other issues arise if a borrower pledges restricted or controlling shareholdings to secure a margin loan or a collar loan?
If the shares are freely transferable, there no specific securities registration requirements. It should be noted that the lender or the security agent or trustee holding the shares on behalf of the lenders is obliged to report its holding if the volume of shares is above the relevant thresholds. See question 9.
If a borrower in a margin loan files for bankruptcy protection, can the lender seize and sell the pledged shares without interference from the bankruptcy court or any other creditors of the borrower? If not, what techniques are used to reduce the lender’s risk that the borrower will file for bankruptcy or to prevent the bankruptcy court from staying enforcement of the lender’s remedies?
It depends on the characterisation of the security interest created over the shares. Usually, an account and securities pledge over the share account is given in favour of the margin lender. Such German law pledge agreement (assuming the account is located in Germany) is usually structured as a financial collateral arrangement within the meaning of the financial collateral directive. Under German law, an appropriation right applies to fungible securities falling under the financial collateral regime pursuant to paragraph 1259 of the German Civil Code. Consequently, the margin lender will be able to appropriate the shares without the involvement of the insolvency administrator (provided that the requirements of paragraph 1259 of the German Civil Court are fulfilled). In addition, a German pledge may be enforced by way of a private sale or a public auction.
What is the structure of the market for listed equity options?
The market for listed equity options is dominated by Eurex Exchange, the option exchange run by Deutsche Börse AG. The equity option market of Eurex covers options on over 500 stocks from 13 countries. Participants are able to access all the components of the Euro Stoxx 50 and Stoxx Europe 50 indices, as well as most components in the Stoxx Europe 600, Stoxx Europe Large 200, Stoxx Europe Mid 200, Stoxx Europe Small 200 indices and Dow Jones Global Titans 50 index.
In addition, most investment banks also offer options, warrants and certificates on various stock. However, these products are not as standardised as the Eurex offering and target mainly retail investors. The volume of options in this market is around €700 million.
Describe the rules governing the trading of listed equity options.
Trading of equity derivative options on Eurex range from one to 5,000 shares. Options are available in euros, Swiss francs, US dollars and pounds sterling. The contracts have a maturity of up to 12, 24 and 60 months. Eurex establishes a daily settlement price of all listed equity options. These prices are determined through a binomial model, which also takes into account, where necessary, dividend expectations, current interest rates or other considerations. The options may be offered American-style (ie, the option can be exercised on any trading day during the lifetime of the option). European-style options can only be exercised on the last trading day of the lifetime of the relevant option. The option premium is payable in full in the currency of the respective contract one business day after the trade day.
Types of transaction
What categories of equity derivatives transactions must be centrally cleared and what rules govern clearing?
All entities active in the EU derivatives market (whether banks, corporates, funds, SPVs, etc, and whether using derivatives for hedging or investment purposes) are impacted by EMIR, which imposes three main obligations on EU derivatives market participants (subject to limited exemptions) by staggered deadlines, with the latest having applied at the end of December 2018.
What categories of equity derivatives must be exchange-traded and what rules govern trading?
In Germany, no mandatory trading rules apply in respect of equity derivatives. Equity derivatives are not required to be traded on an exchange. If, however, equity derivatives are traded on an exchange, the rules governing the trading of these derivatives depend on the relevant market segment. On the regulated market, trading is governed by the Exchange Act, the Exchange Order and respective guidelines of the exchange. In respect of non-regulated markets, the exchanges have set up terms and conditions governing the trading on these markets.
Describe common collateral arrangements for listed, cleared and uncleared equity derivatives transactions.
Uncleared equity derivatives are subject to the bilateral collateral arrangements of the parties. Usually, parties collateralise their transactions under an ISDA collateral support annex or the equivalent DRV collateral addendum. Any transaction will be valued and a shortfall or excess will be determined on a net basis. The parties are required to provide relevant collateral to cover any shortfall or reduce any excess. The collateral is transferred by way of an outright collateral transfer allowing the collateral taker to reuse the collateral.
In this respect, a new European regulation has been introduced: Regulation (EU) No. 2015/2365 of 25 November 2015 on transparency of securities financing transactions and of reuse and amending Regulation (EU) No. 648/2012 (SFTR). It allows market participants to access secured funding (ie, to use their assets to finance themselves). This involves the temporary exchange of assets as a guarantee for a funding transaction. Examples include lending or borrowing of securities, repurchase or reverse repurchase transactions, buy-sell back or sell-buy back transactions, or margin lending transactions. The SFTR shall enhance transparency by introducing a reporting obligation for all securities financing transactions, disclosure obligation for investment funds on the use of SFTs and some minimum transparency conditions that should be met on the reuse of collateral, such as disclosure of the risks and the need to grant prior consent.
Apart from the clearing obligation (see question 21), article 11 of EMIR sets out certain risk mitigation techniques for OTC derivatives contracts not cleared by a central counterparty (CCP), including the timely, accurate and appropriately segregated exchange of collateral with respect to OTC derivatives contracts. This also affects equity derivatives. The implementing regulatory technical standards (RTS) on risk mitigation techniques for OTC derivatives contracts not cleared by a CCP under article 11(15) of EMIR were adopted on 4 January 2017. The new rules set out requirements for the collection of variation margin (VM) and initial margin (IM) in respect of OTC derivatives transactions not cleared by a CCP. VM is calculated by reference to the current market value of the OTC derivative and is to be collected from the party that is ‘out of the money’. Although the valuation used to calculate the VM requirement will be continually refreshed, there is always some risk that the market value of a particular contract will increase and a default occur before additional VM is delivered. The IM requirement creates an additional buffer that is intended to reduce the risk of a shortfall in that scenario. IM, where applicable, is posted by both parties and the amounts to be posted are not offset against each other. Non-financial counterparties (ie, corporates) are exempt from the collateralisation rules to a large extent and subject to certain conditions.
It should be noted that any equity derivatives that may become subject to mandatory clearing in the future will have to comply with the collateral requirements of cleared derivatives, which are more detailed and restrictive.
Must counterparties exchange collateral for some categories of equity derivatives transactions?
There are no specific rules for equity derivatives transactions. The general collateralisation rules of EMIR apply. See question 24.
Under the current final draft RTS for the margining of non-cleared derivatives, the provisions as regards eligible collateral require that the collateral-taker has access to the relevant markets and is able to liquidate such assets in a timely manner. Parties may agree to deliver the following eligible assets:
- cash (or similar, such as money-market deposits);
- gold (in the form of allocated bullion);
- sovereign securities;
- debt securities issued by credit institutions and investment firms;
- corporate bonds;
- the senior tranche of certain securitisations;
- equities included in a main index (or related convertible instruments); or
- shares or units in UCITS.
These broad classes are also subject to separate credit quality and wrong-way risk requirements and, in the case of IM, concentration limits. The RTS confirm that IM may be collected in cash, as long as it is held in accounts with a central bank or an EU credit institution that is not affiliated with the collateral provider or collateral taker.
Liability and enforcement
Territorial scope of regulations
What is the territorial scope of the laws and regulations governing listed, cleared and uncleared equity derivatives transactions?
All German legislation applies to counterparties acting within Germany. The scope of European legislation is, in general, also limited to the EU. However, third-country entities may also be affected by German and European legislation to the extent that they are conducting cross-border business (ie, entering into transactions with counterparties located in Germany or the EU, respectively). Some legislation (eg, EMIR) is addressing the direct, substantial and foreseeable effect in the EU or whether the purpose of the transaction is aimed at evading the obligations under EMIR. Consequently, the legislation may also have, although only limited, extraterritorial effect.
Registration and authorisation requirements
What registration or authorisation requirements apply to market participants that deal or invest in equity derivatives, and what are the implications of registration?
Market participants may require a banking licence, depending on their activities in the equities derivatives market (see question 3). Other types of registration now exist that are specific to the equity derivatives market.
What reporting requirements apply to market participants that deal or invest in equity derivatives?
See question 9.
What legal issues arise in the design and issuance of structured products linked to an unaffiliated third party’s shares or to a basket or index of third-party shares? What additional disclosure and other legal issues arise if the structured product is linked to a proprietary index?
There are not any specific issues with this type of product. However, whenever reference is made to an underlying third party, the issuer of the relevant structured product needs to ensure sufficient information (public or otherwise) is available. This is particularly the case where a disclosure document needs to be drawn up (eg retail prospectus). Furthermore, with the new Regulation (EU) 2016/1011 of 8 June 2016 on indices used as a benchmark for financial instruments and financial contracts or to measure the performance of investment funds, and amending Directives 2008/48/EC and 2014/17/EU and Regulation (EU) No. 596/2014 (Benchmark Regulation), specific rules on the use of indices may apply. In the case of proprietary indices, the Delegated Regulation (EU) No. 862/2012 of 4 June 2012 amending Regulation (EC) No. 809/2004 as regards information on the consent to use of the prospectus, information on underlying indexes and the requirement for a report prepared by independent accountants or auditors needs to be complied with. In particular, conflicts of interest need to be addressed and disclosed.
Describe the liability regime related to the issuance of structured products.
The liability regime may apply in respect of the structured product (ie, an error of the product or the covenants or representations provided by the issuer of the relevant product). This regime is based on the principles related to breach of contract.
A further liability regime exists in respect of wrong or insufficient disclosure as regards the underlying risk or the mechanism of the relevant structured product. This so-called ‘prospectus liability’ may be established on the basis of sections 21 and 22 of the German Securities Prospectus Act, if a prospectus under this regime has been drawn up. If no prospectus has been drawn up under this regime, an issuer may still be liable for any information provided to investors under the prospectus liability regime established by case law.
Finally, detailed and extensive case law exists in relation to the misselling of structured products in Germany. Sellers of structured products need to comply with the principles established by courts in respect of providing appropriate financial advice to investors. See question 13.
What registration, disclosure, tax and other legal issues arise when an issuer sells a security that is convertible for shares of the same issuer?
The principles set out in question 30 apply in respect of convertibles as well. Apart from specific rules applicable to convertible issuers under section 221 of the AktG requiring specific authorisation for the share capital underpinning the issuance of convertibles, convertibles are treated as a form of securitised equity derivative.
What registration, disclosure, tax and other legal issues arise when an issuer sells a security that is exchangeable for shares of a third party? Does it matter whether the third party is an affiliate of the issuer?
Exchangeable bonds are regarded as equity derivatives and no specific rules apply in that respect. If the third party is an affiliate of the issuer, the relevant corporate rules in relation to convertibles may apply.