EMSA has recently published Guidelines on which commodity derivatives fall within the definition of "financial instrument" for the purposes of MiFID I. The Guidelines give clarity on the status of forwards, and guidance on the meaning of "physically settled". This article analyses the Guidelines, drawing out implications and highlighting significant areas of remaining ambiguity.

On 6 May 2015, the European Securities and Markets Authority (ESMA) published Guidelines on the application of the definitions of commodity derivatives in Sections C6 and C7 of Annex I to Directive 2004/39/EC (MiFID I). Those sections say:

Section C

(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 contracts 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.

The Guidelines follow a consultation process which started on 29 September 2015 and ended on 5 January 2015. They are aimed at the national supervisory authorities - the FCA in the case of the UK - which should incorporate the Guidelines in their supervisory practices.

Why are the Guidelines important?

The Guidelines seek to harmonise interpretation of MiFID I across the EEA until MiFID II comes into force on 3 January 2017.  They also set out ESMA's stance on some open issues on the interpretation of equivalent provisions in MiFID II.

The Guidelines indirectly define the scope of Regulation (EU) No. 648/2012 (EMIR). EMIR applies to over the counter (OTC) derivatives, as defined in Annex I to MiFID I. So if an instrument is a commodity derivative as defined in Section C6 and C7, parties to it must consider EMIR's risk management, reporting and clearing obligations.

What were the main issues in the consultation?

Key issues raised by respondents include:

  • Whether "forwards" are included in C6. Some respondents argued that forward contracts - which are usually intended to be physically delivered, although not necessarily exclusively so - should always be out of scope.
  • The lack of clarity of the meaning of "physically settled" - used both in C6 and C7 - particularly because MiFID I does not expressly include delivery methods that go beyond the physical delivery of the commodity itself.
  • The lack of stringency of the expression "which have the characteristics of other derivative financial instruments" in C7.
  • The limited scope of the conclusive test for "commercial purposes" as defined in article 38 Regulation 1287/2006/EC (the MiFID I Regulation).

Does C6 include forwards?

The Guidelines confirm that C6 includes forwards even though C6 does not expressly mention them, unlike in C5, C7 and C10. ESMA clarifies that C6 includes forwards that must be physically settled. This means that forward contracts which necessarily entail a physical delivery (i.e. they do not contemplate cash settlement) can be derivatives if they are traded on market venue such as a regulated market (i.e. an exchange) or an MTF. This means that cash settlement - even only as a secondary or optional mode of settlement - is not a prerequisite feature of derivatives if traded on exchange or MTF. This goes against commonly accepted understandings of "derivatives", but is consistent with FCA's views on forwards traded on MTFs.

The implications of this extended interpretation are potentially significant, particularly in the light of MiFID II. MIFID II extends the concept of market venues for the purpose of C6 to Organised Trading Facilities (OTFs). Increasingly high volumes of commodity forwards are traded via broker-operated platforms, such as Trayport and Spectron. Although some have introduced non-MTF platforms, many are likely to qualify as OTFs post MiFID II.

The C6 equivalent in MiFID II expressly excludes transactions in wholesale gas and electricity but not transactions in other types of commodities, such as crude oil, coal and agricultural commodities.

What is "physical delivery"?

Consistent with it consultation Paper, ESMA's Guidelines defines "physically settled" as:

  • physical delivery of the relevant commodities themselves;

  • delivery of a document giving rights of an ownership nature to the relevant commodities or the relevant quantity of commodities concerned (such as a bill of lading or warehouse warrant); or

  • another method of bringing about the transfer of rights of an ownership nature in relation to the relevant quantity of commodities 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 or the commodities.

ESMA contends that the text of the final guidelines is wide enough to recognise current practices in the physical market and to permit developments. But it is not clear that ESMA's definition of physical delivery is indeed broad enough.

In particular, the references to "transfer of rights of an ownership nature" and entitlement to "the relevant quantity of  commodities", coupled with the remarks in the feedback that whether at least one of the parties is to make or take physical delivery of the commodity is relevant would in our view, exclude many commodity trades currently considered physical.


For example, much of the world's bullion - gold, silver and platinum group metals - trading takes place in the form of unallocated bullion trading. Here the holder of unallocated bullion acquires a right against a bank it has opened unallocated bullion account with. The buyer's "holding" of gold exists in the form of gold that is credited to the account. Such credit does not correspond to a specific quantity of gold that account holder owns. All the account holder has is a contractual right against the bank to have that quantity of gold delivered to it (or the cash value thereof paid to it), if he so requires. It is difficult to see these as "rights of an ownership nature", unless "ownership" of choses in action are included. Or perhaps ESMA's assertion that "book entries are encompassed" in the "other methods" category of physical settlement should be considered good enough.

Although the terms of the unallocated bullion account usually provide for the account holder's right to demand the physical delivery of gold, the reality of unallocated bullion trading is that buyers and sellers rarely intend for physical delivery to ever take place. Unallocated bullion is used as a means to have "synthetic" holdings of gold and so obtain exposure to the price of gold by reference to the London gold fixing. A typical trading pattern would be for the client to buy gold, hold it for a time in the expectation of an increase in price and then sell it back to the bank. If the trade works out as the client expected all that changes hands as between client and the bank is money in an amount equal to the price difference times the notional quantity of gold that was bought. The payment will in the opposite direction if the price moved against the client.

If physical settlement and cash settlement are two mutually exclusive concepts (as they are in our view) and if cash settlement entails a derivatives transaction it follows that, if physical settlement does not take place in connection with unallocated bullion, then unallocated bullion is a form of derivatives transaction. This means that unallocated bullion trading may fall within the definition of financial instrument as defined in Section C5 of Annex 1 to MiFID I (which covers, among other things, forward rate agreements and any other derivatives contracts relating to commodities that must be settled in cash or may be settled in cash at the option of one the parties).

In the UK (which is where most unallocated gold trading takes place) unallocated gold and silver deposits fall outside the scope of the Financial Services Markets Act 2000 and are instead subject exclusively to The Non-Investment Products Code. The Bank of England and the FSA produced this code conjunction with participants in the London foreign exchange, money and bullion markets. This status quo could not continue if unallocated gold is a financial instrument under MiFID.

Gas and power

The words "that entitles the recipient to the relevant quantity of the commodities" in the third limb of the "physically settled test", are difficult to reconcile with the reality of wholesale natural gas and electricity trading in liberalised markets. Participants in such markets typically "buy" and "sell" natural gas and electricity at a virtual delivery point on the transmission systems that are operated by a third party.

What buyers and seller acquire as a result of a trade is a bundle of rights against the system operator whereby the system operator records a party's entitlement to, say, a given quantity of gas that is present at a specific point in time in the transmission network the system operator runs. Such entitlement, rather than the gas itself, is the subject matter of the sale and purchase agreement. It seems difficult, if not impossible, to characterise such bundles of rights as "rights of an ownership nature". They cannot be stolen. As with unallocated bullion trading, these rights appear to fall squarely within the legal concept of choses in action rather than proprietary rights of an intangible nature.

In fact, the quantity of gas (i.e. the individual molecules of gas that make up such quantity) never ceases to belong to the system operator. Crucially, the buyer of gas may not have the capability to offtake gas from the network. In fact, liberalised wholesale energy markets are devised so as to allow the participation of pure "traders", namely entities that do not have the means to inject or offtake gas into the wider transmission system.


A further challenging area is that of "bookouts" in the context of international trading of commodities such as crude oil, steam coal and agricultural commodities. There is often a chain of sale and purchase agreements for a given cargo of the commodity. Apart from the original seller and the ultimate buyer at the top and at the bottom of the chain, all other participants in the chain are simultaneously a buyer and a seller. A bookout occurs where a buyer-seller appears twice in the chain, creating a loop. The
bookout consists of the parties in such loop agreeing to cancel the contracts which make up the loop. Physical delivery will not occur under any contract that have been cancelled. Instead, there will be only be financial settlements to account for the difference in purchase prices agreed in the contracts.

In effect, the parties do away with their rights/obligations for physical delivery (e.g. the passing down the chain of the bill of lading) in favour of a financial settlement.

On its face, a bookout falls short of the "physically settled" test. In particular, the second limb of the test which refers to delivery taking place by way of transfer of bills of lading or other documents of title or quasi documents of title.

Limited scope of "for commercial purposes"

Disappointing many participants, especially those in the agriculture sector, ESMA declined to adopt the suggestion to specify that certain trades are always for commercial purposes and, therefore, physical. The call for ESMA's intervention stems from article 38 of the MiFID I Regulation, which limits the conclusive test of trades for "for commercial purposes" to natural gas and electricity trades that are entered into with the grid operator for balancing purposes. Some proposed adopting criteria similar to the ones used in the UK to define the commercial purposes of transactions that are not "futures". These include, for instance, whether at least one party to the trade is a producer of the commodity or uses it in its business.

Concluding remarks

The ESMA guidance will disappoint market participants who were hoping for clear, bright line tests around commodity  derivatives to better manage their MiFID and EMIR risks. Unfortunately, detailed analysis by lawyers will remain necessary under MiFID I, and it seems, MiFID II.