|Contracts having the characteristics of other financial instruments (MiFID definitions)|
|European Union Electricity Market Glossary|
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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.
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 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 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.
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.
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.
|Last Updated on Thursday, 20 April 2017 22:21|