Overview of key issues relating to the (lack of a harmonised) EU definition of the terms "derivative" and "derivative contract" in EMIR.
Despite their significance, it may come as a surprise that there is currently no harmonised EU definition of what actually amounts to a derivative. This is of particular concern in the context of the European Market Infrastructure Regulation (EMIR) and is causing confusion as to the extent to which certain financial instruments are caught by its provisions, in particular FX and physically-settled commodity forwards.
The lack of a consistent EU definition means that it falls to the domestic law of each EU member state to establish how to distinguish between derivative and non-derivative (or spot) transactions. The cross-border nature of the derivatives marketplace means that variations between EU member states in this context make EMIR scoping and implementation extremely challenging for market participants. Meanwhile, regulators are concerned about the potential for regulatory arbitrage between different member state regimes.
Given that EMIR is a Regulation with direct effect, rather than a Directive requiring transposition into the national laws of each member state, the lack of a consistent definition also undermines significantly its potential to create a level playing field for the regulation of OTC derivatives and minimise variations between member states as to the way in which its provisions are interpreted and applied.
These concerns led the European Securities and Markets Authority (ESMA) to write to the EU Commission on 14 February 2014 requesting that the Commission clarify the definition of a "derivative" or "derivative contract" under EMIR. This was followed by a reply from the Commission on 26 February 2014 acknowledging the lack of clarity in this area and agreeing that there is work to be done.
What are the core legal issues?
The provisions of EMIR apply to "derivatives" or "derivative contracts" which are defined in Article 2(5) of EMIR as "financial instrument[s] as set out in points (4) to (10) of Section C of Annex I to [MiFID] as implemented by Article 38 and 39 of [the MiFID Regulation]". The financial instruments set out in Sections C(4) to (10) of Annex I of MiFID include certain options, futures, swaps, forwards, derivative instruments for the transfer of credit risk, contracts for differences, commodity derivatives and exotic derivatives.
Although, as a result, EMIR contains a comprehensive list of the types of financial instruments to which its provisions apply, MiFID stops short of providing precise definitions of the terms used in Sections C(4) to (10) of Annex I and, in particular, of what amounts to a “derivative”. This means that it is currently necessary to consider how each EU member state has interpreted the MiFID language in order to construct a useable definition of each category of derivative caught by EMIR. As a result, EMIR has a different applicability "footprint" in each EU member state.
Differences as to how to distinguish between a derivative and a spot/non-derivative transaction are causing issues in the context of FX transactions, in particular FX forwards. Where the length of the settlement period is relevant, although most agree that a contract settling within 2 trading days will be a spot/non-derivative and that one settling after 7 trading days will be a derivative, there remains considerable variation regarding the treatment of contracts with settlement periods between 3 and 7 trading days. Other differences arise between those member states which focus on whether a contract is made for commercial, rather than investment, purposes when drawing this distinction and those which do not.
Physically settled commodity forwards
As far as physically settled commodity forwards are concerned, issues arise as a result of divergent interpretation and application of Sections C(6) and (7) of Annex I of MiFID.
- Section C(7) explicitly applies to “futures” and “forwards” whereas Section C(6) omits any reference to forwards. Consequently, there are divergent views as to whether or not physical forwards traded on a regulated market or a MTF are covered by MiFID (and consequently by EMIR).
- Sections C(6) and C(7) apply to instruments which can be “physically settled”. However MiFID does not define the term “physically settled”. Furthermore, Section C(5) refers to instruments that “must be settled in cash or may be settled in cash at the option of one of the parties” whereas Sections C(6) and C(7) refer to instruments that “can be physically settled”. This has led to divergence between member states as to the meaning of the term “physically settled” as well as the extent to which “physically settled” contracts are actually caught by Sections C(6) and C(7) (and consequently by EMIR).
What are ESMA and the EU Commission doing about this?
On 10 April 2014 the EU Commission published a consultation paper addressing the concerns outlined above in the context of FX transactions relating to how to distinguish between spot/non-derivative and derivative contracts. The deadline for responses was 09 May 2014. Although the Commission initally intended to use the power contained in Article 4(2) of MiFID to issue implementing regulations to clarify the position so as to remove the discrepancies identified, the Commission wrote to ESMA on 23 July 2014 stating that, on reflection, it would not be possible to address the issues raised in this way. Instead, the Commission suggests that the issues should be addressed in the long term via the Level 2 measures to be produced under MIFID 2. In the short term (before MiFID 2 starts to apply on 03 January 2017), the Commission suggests that the issues could be addressed, if ESMA considers this to be necessary and proportionate, via further measures such as ESMA guidelines.
On 29 September 2014 ESMA published a consultation paper on proposed guidance intended to clarify the application of Sections C(6) and C(7) of Annex I of MiFID. In this context, it is important to note that the intention is to resolve the ambiguities through guidance rather than any change to the wording of the sections themselves. The deadline for responses is 05 January 2015.
Whilst the motivating factor for the proposed clarification is consistent EMIR implementation across the EU, any changes to Annex I of MiFID or how it is understood to apply, will have wider ramifications affecting the range of financial instruments in respect of which certain activities will require authorisation as a MiFID investment firm, as well as the scope of the MiFID passport.
This document (and any information accessed through links in this document) is provided for information purposes only and does not constitute legal advice. Professional legal advice should be obtained before taking or refraining from any action as a result of the contents of this document.