|Viability of the EU OTC commodity forward markets hinged on one word in the recital of the European Commission Regulation|
|Tuesday, 30 August 2016 06:30|
Physical forwards can still be used under MiFID II by commodity producers in bilateral contracts. Most of them will not be captured by the financial instruments' strict legal requirements.
What is more important in the EU regulation: the recitals or the body of the legislative text (articles, paragraphs, etc.)?
The general and unquestioned rule is that recitals are not legally binding, they only provide context and allow clearer interpretation of the Articles of both the Level 1 text and the implementing measures.
That's the theory, but I'll give you a blatant, practical example to the contrary.
In this case the meaning and core of the fundamental rule having colossal, practical impact on business is hidden not only in the recital, but also only one very short word.
So, could you answer simple "yes" or "no" to the question whether OTC commodity forwards are financial instruments under MiFID II?
I suppose you couldn't, it's natural, since the answer is more complex in that regard.
The issue revolves around the so-called 'C7 financial instruments' (awful legal jargon), which are defined in MiFID II as "Options, futures, swaps, forwards and any other derivative contracts relating to commodities, that can be physically settled not otherwise mentioned in point 6 and not being for commercial purposes, which have the characteristics of other derivative financial instruments".
C7 financial instruments are defined by specifying that they should be standardised, traded on an EU or third country venue and not be spot contracts.
Moreover, under MiFID I financial instruments were off-venue contracts expressly stated to be the equivalent of an on-venue contract.
MiFID II has modified the existing MIFID I implementing rules to take into account the new organised trading facility (OTF) category and to remove the reference to clearing.
As regards contracts to be "expressly stated" to be equivalent to the on-venue contract it will be sufficient under MiFID II that the contract "is" equivalent (objective criterion as opposed to the previous one, dependent on the parties' express statement in the contract).
This is clearly stipulated in Article 7(1)(a)(iii)) of the Commission Delegated Regulation (EU) of 25.4.2016 supplementing Directive 2014/65/EU of the European Parliament and of the Council as regards organisational requirements and operating conditions for investment firms and defined terms for the purposes of that Directive, pursuant to which financial instrument under MiFID II, will be, among others, the contract that "is equivalent to a contract traded on a regulated market, MTF, an OTF or such a third country trading venue, with regards to the price, the lot, the delivery date and other contractual terms".
Hence, analysis based on the literal wording of the said Article 7(1)(a)(iii)) of the Commission Delegated Regulation of 25.4.2016 that needs to be carried out in order to establish whether given physical forward is a financial instrument under MiFID II, requires a scrupulous inventory of trading conditions constituting all the aforementioned on-venue contracts.
This can be assessed as the Herculean task.
In comparison with MiFID II, the approach adopted in the Article 7(1)(a)(iii)) of the Commission Delegated Regulation of 25.4.2016 widens the scope of the equivalence test to over-the-counter contracts that share some of the features of exchange traded contracts.
Given that many commodity physical producers use forward contracts linked to exchange traded products to sell their production forward, and these physical forwards are linked to the settlement price of the exchange traded contracts, but are often adjusted for the specifics of the trade (delivery date or place), the consequences of approach adopted in the Article 7(1)(a)(iii)) of the Commission Delegated Regulation of 25.4.2016 could be severe and far-reaching:
- may lead to many smaller commercial entities being captured by MIFID authorisation requirements;
- stakeholders who rely on forwards which are linked to exchange traded contracts for their physical transactions would be disproportionately impacted.
Luckily, the recital 5 has appeared in the preamble of the said Commission Delegated Regulation of 25.4.2016, which reads:
"A derivative contract should only be considered to be a financial instrument under Section C(7) of Annex I to Directive 2014/65/EU if it relates to a commodity and meets a set of criteria for determining whether a contract should be considered as having the characteristics of other derivative financial instruments and as not being for commercial purposes. This should include contracts which are standardised and traded on venues, or contracts equivalent thereof where all the terms of such contracts are equivalent to contracts traded on venues. In this case, terms of these contracts should also be understood to include provisions such as quality of the commodity or place of delivery."
What's the most important? This sentence:
"This should include contracts which are standardised and traded on venues, or contracts equivalent thereof where all the terms of such contracts are equivalent to contracts traded on venues", and, particularly, the word: "all".
One word and three letters only, but what a difference!
The word "all" in the recital 5 of the Commission Delegated Regulation of 25.4.2016 narrows the equivalence tests - it unequivocally excludes over-the-counter contracts that are not exactly equivalent to exchange traded contracts.
In particular, only those over-the-counter contracts, which have all the same main features as exchange traded contracts (such as price and delivery and lot) will under MiFID II be considered C7 financial instruments.
In effect, the word: "all" in the aforementioned recital 5 will enable the 'physical forwards' to be used by commodity producers to sell their produce forward and not be captured by the financial instruments' strict legal requirements.
This small, but extremely important modification causes that the vast majority of OTC contracts used for physical delivery will not be captured by the modified financial instruments' definition.
In this way MIFID II provisions will focus on non-commercial entities.
I have one small question at the end of this thread. Why so important political and legal choices are determined at this stage of MiFID II implementation only? Shouldn't this be decided when the MiFID II itself was negotiated? Or, maybe, the MiFID II is so discretional that every political choice may be included? Is it good or bad?
And a one more doubt - is the recital (which, as was said above, by its nature is not legally binding) the right place for the rule of such an fundamental impact?