Contracts having the characteristics of other financial instruments (MiFID definitions)
European Union Electricity Market Glossary

 


 

Pursuant to the Section C7 of Annex I to the MiFID I Directive financial instruments are, among others, options, futures, swaps, forwards and any other derivative contracts relating to commodities, that can be physically settled not otherwise mentioned in Section 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.

 

Regulation (EC) No 1287/2006

 

of 10 August 2006 implementing Directive 2004/39/EC of the European Parliament and of the Council as regards record-keeping obligations for investment firms, transaction reporting, market transparency, admission of financial instruments to trading, and defined terms for the purposes of that Directive (OJ L 241, 2.9.2006, p.1)

 

Article 38

(Article 4(1)(2) of Directive 2004/39/EC)

 

Characteristics of other derivative financial instruments

 

1. For the purposes of Section C(7) of Annex I to Directive 2004/39/EC, a contract which is not a spot contract within the meaning of paragraph 2 of this Article and which is not covered by paragraph 4 shall be considered as having the characteristics of other derivative financial instruments and not being for commercial purposes if it satisfies the following conditions:

 

(a) it meets one of the following sets of criteria:

(i) it is traded on a third country trading facility that performs a similar function to a regulated market or an MTF;
(ii) it is expressly stated to be traded on, or is subject to the rules of, a regulated market, an MTF or such a third country trading facility;
(iii) it is expressly stated to be equivalent to a contract traded on a regulated market, MTF or such a third country trading facility;

 

(b) it is cleared by a clearing house or other entity carrying out the same functions as a central counterparty, or there are arrangements for the payment or provision of margin in relation to the contract;

 

(c) it is standardised so that, in particular, the price, the lot, the delivery date or other terms are determined principally by reference to regularly published prices, standard lots or standard delivery dates.

 

2. A spot contract for the purposes of paragraph 1 means a contract for the sale of a commodity, asset or right, under the terms of which delivery is scheduled to be made within the longer of the following periods:

(a) two trading days;

(b) the period generally accepted in the market for that commodity, asset or right as the standard delivery period.

 

However, a contract is not a spot contract if, irrespective of its explicit terms, there is an understanding between the parties to the contract that delivery of the underlying is to be postponed and not to be performed within the period mentioned in the first subparagraph.

 

3. For the purposes of Section C(10) of Annex I to Directive 2004/39/EC, a derivative contract relating to an underlying referred to in that Section or in Article 39 shall be considered to have the characteristics of other derivative financial instruments if one of the following conditions is satisfied:

(a) that contract is settled in cash or may be settled in cash at the option of one or more of the parties, otherwise than by reason of a default or other termination event;

(b) that contract is traded on a regulated market or an MTF;

(c) the conditions laid down in paragraph 1 are satisfied in relation to that contract.

 

4. A contract shall be considered to be for commercial purposes for the purposes of Section C(7) of Annex I to Directive 2004/39/EC, and as not having the characteristics of other derivative financial instruments for the purposes of Sections C(7) and (10) of that Annex, if it is entered into with or by an operator or administrator of an energy transmission grid, energy balancing mechanism or pipeline network, and it is necessary to keep in balance the supplies and uses of energy at a given time.

 

Article 39


(Article 4(1)(2) of Directive 2004/39/EC)


Derivatives within Section C(10) of Annex I to Directive 2004/39/EC

In addition to derivative contracts of a kind referred to in Section C(10) of Annex I to Directive 2004/39/EC, a derivative contract relating to any of the following shall fall within that Section if it meets the criteria set out in that Section and in Article 38(3):

(a) telecommunications bandwidth;

(b) commodity storage capacity;

(c) transmission or transportation capacity relating to commodities, whether cable, pipeline or other means;

(d) an allowance, credit, permit, right or similar asset which is directly linked to the supply, distribution or consumption of energy derived from renewable resources;

(e) a geological, environmental or other physical variable;

(f) any other asset or right of a fungible nature, other than a right to receive a service, that is capable of being transferred;

(g) an index or measure related to the price or value of, or volume of transactions in any asset, right, service or obligation.

 

 

Pursuant to Section C6 financial instruments are 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.

 

Note that both Sections C6 or C7 of the Annex I of the MiFID (MiFID I and II equally) relate to commodity derivatives and are inclusive of "contracts which must be physically settled", depending upon the respective place of execution.

 

Section C 7 is interpreted to be only applied to those contracts not caught by C 6 and not within the scope of the C 6 exemption (ESMA draft technical advice for MiFID II secondary legislation contains a statement to that effect).

 

Commodity derivatives' designation in Section C 7 as well as the explanation what is meant by the phrase "having the characteristics of other derivative financial instruments and not being for commercial purposes" under MiFID I are based on the set of specific trading, clearing, margining and standardisation criteria detailed in Articles 38 i 39 of the Regulation 1287/2006 - see box.

 

In summary, a contract qualifies as a financial instrument under Article 38 of the Regulation 1287/2006 if the conditions in paragraph 1 (i.e. trading criterion under the Letter a, clearing or margining criteriion under the Letter b, and the standarisation criterion under the Letter c) are fulfilled on a cumulative basis and the contract is neither a spot contract as defined in paragraph 2 nor for commercial purposes as defined in paragraph 4. 

Note, however, the conditions stipulated under (i), (ii), (iii) in Article 38(1)(a), overall representing the trading criterion, have an alternative character.

MiFID II secondary legislation brought some modifications as regards the metric for the differentiation of "contracts having the characteristics of other derivative financial instruments and not being for commercial purposes", in particular, criteria currently in Article 38(1)(b) with respect to clearing (due to the circularity it creates with EMIR) and margining have been removed (see Article 7 of the Commission Delegated Regulation (EU) 2017/565 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).

 

See below for the outline of the main facets of the contracts "having the characteristics of other financial instruments" distinguishing them from products beyond the scope of financial sector legislation.

 

 

Trading criterion

 

  

Trading criterion is currently stipulated in Article (38(1)(a) of the Regulation 1287/2006.

  

Final Report ESMA's Technical Advice to the Commission on MiFID II and MiFIR of 19 December 2014, ESMA/2014/1569 (p. 415-416) made the following comments on the interpretation of this provision:

 

1. The three alternatives listed in Article 38(1)(a)) of the Regulation No 1287/2006 are intended to cover situations where:

(i) a contract is traded on a third country facility,

(ii) is conducted bilaterally and is then brought on venue (negotiated trade) or

(iii) where a contract off-venue is expressly stated to be the equivalent of an on-venue contract.

2. Article 38(1) Letter a needs to be read in conjunction with Section C 6 of the MiFID II Annex which already classifies all contracts traded on one of the MiFID trading venues (except for certain OTF contracts) as financial instruments.

 

3. While the first two of the three above-mentioned alternatives of the trading criterion were proposed to be maintained for determining whether a contract qualifies as a financial instrument, the third limb of the trading criterion (where a contract has been expressly declared to be the equivalent of an on-venue contract) has been considered as lacking objectivity since depending on the choices of the two counterparties concerned. Therefore, in the ESMA's proposals for MiFID II secondary legislation this part of the financial instrument's definition has been redrafted.

 

The requirement for the contract to be "expressly stated" to be equivalent to the on-venue contract has been removed and now it will be sufficient that the contract "is" equivalent.

 

Hence, parties will have to compare their trading conditions not only to contracts traded on regulated markets, MTFs and OTFs, but also to contracts traded on third-country trading venues.

 

Items to be analysed are in particular the price, the lot, the delivery date, but this catalogue is not exhaustive.

 

Above proposals as regards the reformulation of the trading criterion have been subsequently incorporated into Article 7 of the the Commission Delegated Regulation (EU) 2017/565 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.

 

However, an important reservation has been made by the Recital 5 of the Regulation of 25.04.2016 that contracts can be considered equivalent 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).

 

Further, more detailed comments on the interpretation of the term: 'contracts equivalent to a contract traded on a regulated market, an MTF, an OTF contract or such a third country trading venue' are available here.

 

 

Standardisation criterion

 

 

Standardisation criterion is currently stipulated in Article 38(1)(c) of the Regulation No 1287/2006.

 

The said provision states that a contract must also be standardised to be considered as having the characteristics of other derivative financial instruments.


Standardisation requirement has been maintained as an indicator for classifying contracts as financial instruments (and derivatives) under the MiFID II (Article 7(1)(b) of the Commission Delegated Regulation (EU) 2017/565 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).

 

The fact that the criterion at issue (for example common legal documentation) represents an important measure of determining whether a specific class of OTC derivatives should be subject to the clearing obligation is not in conflict with Article 38(1)(c) of the Regulation No 1287/2006 (and the MiFID II relevant secondary legislation), since the former measure takes into account the level of standardisation of products, which already were considered financial instruments under the latter metric.

 

 


 

 

 

 

Exemption for power and gas balancing markets

 

 

When it comes to Article 38(4) of the Regulation, the definition of a contract being for commercial purposes is currently rather narrowly framed and limited to the energy sectors (energy balancing mechanism).

 

Other sectors like, for instance, the agricultural contracts and those aimed to cover insurance risks, are not explicitly mentioned.

 

In turn, in the course of development for the MiFID II Level 2 legislation respondents mostly recommended to expand the scope of the said Article 38(4) to other contracts. The opinions were voiced, there is a room for such an extension in the MiFID II secondary legislation, provided it is reasonable in the commercial practice context and the extensions' scope has been unequivocally designated.

 

The aforementioned Commission Delegated Regulation of 25.4.2016, however, has not made such extensions. 

 

The provision was only added that the said energy balancing mechanism includes the case when the reserve capacity contracted by an electricity transmission system operator is being transferred from one prequalified balancing service provider to another prequalified balancing service provider with the consent of the relevant transmission system operator. This can be assessed as a change of a relatively minor impact.

 

 

 

ESMA draft technical advice to the European Commission

on contracts having the characteristics of other derivative financial instruments 

 

(extract from the Final Report ESMA's Technical Advice to the Commission on MiFID II and MiFIR of 19 December 2014 ESMA/2014/1569, p. 416-417)

 

A contract should be considered as having the characteristics of other derivative financial instruments if it is standardised and if it trades in line with conditions outlined in the following paragraphs. The contract must neither be a spot contract nor a contract for commercial pur-poses only in line with the conditions outlined below. Contracts within the scope of the ex-emption in C 6 should not be tested again under C 7.


2. A contract should be considered as standardised if parameters such as the price, the lot, the delivery date or other terms are determined principally by reference to regularly published prices, standard lots or standard delivery dates.


3. A contract should be considered as traded in such a way as having the characteristics of other derivative financial instruments if:
i. it is traded on a third country trading venue that performs a similar function to a regulat-ed market, an MTF or an OTF;
ii. it is expressly stated to be traded on, or is subject to the rules of, a regulated market, an MTF, an OTF or such a third country trading venue; or

iii. it is equivalent to a contract traded on a regulated market, an MTF, an OTF contract or such a third country trading venue, with regards to the price, the lot, the delivery date or other terms.

 

4. A spot contract should be defined as a contract for the sale of a commodity, asset or right,
under the terms of which delivery is scheduled to be made within the longer of the following periods:
i. two trading days;
ii. the period generally accepted in the market for that commodity, asset or right as the standard delivery period.

 

5. A contract should not be classified as a spot contract if there is an understanding between the parties to the contract that delivery of the underlying is to be postponed and not to be performed within two trading days or the period generally accepted in the market. This rule should apply irrespective of the explicit terms contained in the contract.


6. A contract should be considered to be for commercial purposes and as not having the characteristics of other derivative financial instruments for the purposes of Sections C 7 and C 10 if it is entered into with or by an operator or administrator of an energy transmission grid, energy balancing mechanism or pipeline network and it is necessary to keep in balance the supplies and uses of energy at a given time.


 

 

 

Significance of the precise differentiation for contracts "having the characteristics of other financial instruments"

 

 

The exact delineation of the notion of contracts having the characteristics of other derivative financial instruments influences on multiple legal qualifications. 

 

For instance EMIR establishes a number of obligations applying to derivatives with derivatives being defined by reference to Sections C 4 to C 10 as implemented by Article 38 and 39 of Regulation No 1287/2006. Therefore any change to the scope of the wording or interpretation of definitions of derivatives in MiFID has a direct effect on the scope of EMIR, among others, on the concrete timelines for EMIR reporting

 

For comments on other elements of the financial instruments' definition see here.

 

 

 



Last Updated on Thursday, 20 April 2017 23:21
 

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