The consultation paper aims to clarify the classifications of derivatives and provide a consistent approach for entities operating across the EU.
The European Securities and Markets Authority (ESMA) recently published a consultation paper on draft guidelines to clarify the application of the definition of “commodity derivatives” under the current Markets in Financial Instruments Directive (MiFID). Given that the definition of “derivatives” under the European Market Infrastructure Regulation (EMIR) cross-refers to the list of financial instruments enumerated in Annex 1 to MiFID, this initiative will help obviate significant problems that have arisen in the implementation of EMIR caused by the non‑harmonised classification of financial instruments as derivatives.
The source of the harmonisation problem is the use of a defined term in an EU regulation (which takes direct effect throughout the EU) that cross-refers to a definition set out in an EU directive (which relies on each member state of the EU to implement it in their local law as the state sees fit). The different transpositions of MiFID into local law across member states mean that there is no single, commonly adopted definition of “derivative” in the EU, thus preventing the convergent application of EMIR EU-wide (as well as other directives that rely on MiFID definitions of financial instruments). This runs contrary to the purpose behind the use of an EU regulation.
Earlier this year we reported on ESMA’s request to the European Commission to clarify the definition of “derivatives” under EMIR. On 29 September, ESMA published a consultation paper on guidelines they seek to issue to local regulators in each member state to clarify the application of the definition of “commodity derivatives” as financial instruments under points 6 and 7 (C6 and C7) of Section C of Annex I of MiFID.
The purpose of ESMA’s guidelines is to create a level playing field between EU market participants by ensuring the uniform application of the definitions and to clarify the classification of financial instruments. This will provide clear rules for stakeholders, mitigating legal risks and removing difficulties to a consistent approach for entities operating across borders.
In the context of EMIR, ESMA has identified the following areas as unlevel in the market due to the non-harmonised definition of “derivatives”:
- Reporting obligations regarding derivatives transactions across member states. Different classifications of what constitutes a derivative contract may lead to the reporting of certain transactions in one member state and not in others.
- The power to determine the classes of derivatives subject to the clearing obligation has been given to ESMA to ensure, amongst other things, one single uniform and consistent application of this obligation EU-wide. If competent authorities adopt different classifications of what constitutes a derivative contract, the clearing obligation would not apply in a uniform manner EU-wide.
- The calculation of the clearing threshold by nonfinancial counterparties is made on the basis of positions in over-the-counter (OTC) derivatives. Directly applicable obligations under EMIR for nonfinancial counterparties derive from the calculation of the clearing threshold. Different classifications of what constitutes a derivative contract would determine the inclusion of certain financial instruments in the calculation of the clearing threshold for financial counterparties established in some member states and the exclusion of those for nonfinancial counterparties established in other member states.
- Higher margin requirements apply to OTC derivatives than to other financial instruments. If EU regulators apply different classifications of what constitutes a derivative contract, a central counterparty (CCP) established in one member state may face higher margin requirements than a CCP established in a different member state.
- The relevant obligations for risk mitigation techniques for OTC derivatives contracts not cleared by a CCP apply to OTC derivatives contracts. Different classifications of what constitutes a derivative contract by different EU regulators would lead to an inconsistent application of EMIR.
The Definition of “Commodity Derivatives” under C6 and C7 of Annex I to MiFID
Annex 1, Section C, of MiFID provides the following definitions under C6 and C7:
- C6: 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 a multilateral trading facility (MTF)
- C7: Options, futures, swaps, forwards, and any other derivative contract relating to commodities that can be physically settled not otherwise mentioned in C6 and not being for commercial purposes, which have the characteristics of other derivative financial instruments, having regard to whether, amongst other things, they are cleared and settled through recognised clearing houses or are subject to regular margin calls
The interpretation of definitions C6 and C7 in relation to physically settled forwards is not convergent across the EU. In particular, there is not a common understanding of whether forwards are included within the definition of C6 and what is meant by “physically settled” for both C6 and C7.
ESMA considers that C6 should apply to all commodity derivatives contracts, including forwards, provided they can be physically settled and traded on a regulated market and/or an MTF.
ESMA considers that “physically settled” incorporates a range of delivery methods including the following:
- Physical delivery of the relevant goods
- Delivery of a document giving ownership rights to the goods
- Another method of transfer of ownership rights, without physically delivering the goods, that entitles the recipient to the relevant quantity of the goods
ESMA considers that C7 should apply as a distinct category from C6 in respect of a commodity derivative contract that can be physically settled, but that is not traded on a regulated market or an MTF, providing that it
- is not a spot contract, i.e., a contract under which delivery is to be made within the longer of (a) two trading days or (b) the acceptable market period, as long as delivery is not postponed beyond (a) or (b);
- is not made for commercial purposes in an energy-related context;
- meets one of the following three criteria:
- It is traded on a third-country trading facility similar to a regulated market or an MTF.
- It is expressly stated to be traded on, or is subject to the rules of, a regulated market, an MTF, or a similar third-country trading facility.
- It is expressly stated as equivalent to a contract traded on a regulated market, an MTF, or a similar third-country facility.
- is cleared by a clearing house or equivalent or there are arrangements for margin payment/provision; and
- is standardised so that the price, lot, and delivery date are determined mainly by regularly published prices, standard lots, or standard delivery dates.
The consultation period expires on 5 January 2015. ESMA is particularly interested in whether stakeholders believe there is a conflict between the definitions in C6 and C7 and whether the proposed boundaries could result in gaps into which some instruments might fall.
ESMA has made it clear that it is the responsibility of all investment firms to be aware of the boundaries of their activities that require authorisation under MiFID.