Contracts equivalent to a contract traded on a regulated market, an MTF, an OTF contract or such a third country trading venue
European Union Electricity Market Glossary

 


 

 

"Contracts equivalent to a contract traded on a regulated market, an MTF, an OTF contract or such a third country trading venue" represent a third limb of the so-called "trading criterion" of the financial instrument's definition under the EU financial legislation (MiFID).

 

At the same time these contracts are also an integral constituent of the wider category of  "contracts having the characteristics of other financial instruments (i.e. Section C7 of the Annex I to the MiFID Directive)".

 

The purpose of EU legislation is harmonisation of definitions to allow for a harmonised application of provisions regarding financial instruments in all EU Member States and to create regulatory certainty.

 

 

MiFID I

 

Article 38(1)(a) of the 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

 

"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"

Trading criterion under the MiFID I legal framework is stipulated in Article (38(1)(a) of the 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) - see box.

 

In the Final Report ESMA's Technical Advice to the Commission on MiFID II and MiFIR of 19 December 2014, ESMA/2014/1569 (p. 415-416) the European financial regulator interpreted the three alternatives listed in Article 38(1)(a)) of the Regulation No 1287/2006 in the way, that they 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 an off-venue contract is expressly stated to be the equivalent of an on-venue contract.

 

ESMA added, moreover, that: 

 

- Article 38(1)(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,

 

- While the first two of the three above-mentioned alternatives of the trading criterion are 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) is 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.

 

ESMA's propositions have been subsequently included in Article 7 of the Commission Delegated Regulation (EU) 2017/565 of 25 April 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).

  

 

MiFID II level 2 ESMA's proposal

 

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

  

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 regulated 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.

 

The effect of the above modification is the requirement for the contract to be "expressly stated" to be equivalent to the on-venue contract has been removed and now (under MiFID II) it will be sufficient that the contract "is" equivalent.

  

The problems caused by this redrafting have been noticed in the consultation process as ESMA observed, respondents mostly "did not agree with changing the third limb of the trading criterion to a pure equivalence test, claiming that it would reduce objectivity and may bring commercial transactions for the physical delivery of agricultural products into scope. 

 

ESMA however still sees the benefit of raising objectivity by introducing this wording and removing the complete discretion by the parties to the contract which would also lead to more consistency in the application of the third limb and would reduce the potential for avoidance. Therefore, ESMA decided to maintain its proposal."

 

It follows, in order to establish whether given physical forward is a financial instrument under MiFID II, counterparties will have to implement the process for ongoing comparison of their trading conditions with on-venue contracts (and, moreover, not only with contracts traded on regulated markets, MTFs and OTFs, but also with those traded on third-country trading venues). This appears particularly onerous.

 

The existing formula, maybe discretional for the parties, is, in parallel, relatively objective when it comes to legal certainty issues. Where the contract does not expressly state to be equivalent, it is, currently, not a financial instrument (other metrics notwithstanding).

 

 

Article 7(1)(a) of the Commission Delegated Regulation (EU) 2017/565 of 25 April 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

 

Article 7
Other derivative financial instruments

(Article 4(1)(2) of Directive 2014/65/EU)

 

1. For the purposes of Section C(7) of Annex I to Directive 2014/65/EU, a contract which is not a spot contract in accordance with paragraph 2 and which is not for commercial purposes as laid down in paragraph 4 shall be considered as having the characteristics of other derivative financial instruments where it satisfies the following conditions:

 

(a) it meets one of the following criteria:

 

(i) it is traded on a third country trading venue that performs a similar function to a regulated 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;

 

(iii) it 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

 

...

 

Under MiFID II the express content of the contract will not have a decisive legal significance, since the mere objective assessment of "equivalency" will prevail.

 

Items to be analysed are in particular the price, the lot, the delivery date, but - still - this catalogue is non-exhaustive.

 

This legal concept does not seem entirely consequent, not to mention the REMIT carve-out or C 6 energy derivatives contracts where physically settled forwards traded on an OTF deserved  preferential treatment.

 

It appears, the OTC trading is in that regard much less welcomed by the European financial regulator than an OTF.

 

Another thing is, intended "equivalency" design causes the process for listing on-venue products has the potential for severely disturbing of the ongoing OTC business, as counterparties are exposed to the risk of being surprised by the changes in the status quo of the traded products.

 

The viability of the effective monitoring for all on-venue products - given the scale of the process and the products' multitude as well as the market flexibility - may be questioned.

 

The threats involved with replacing the wording in the trading criterion (point 32-35, Technical Advice, § 3.iii) from "expressly stated to be equivalent" (to an on-venue contract) to "equivalent" have been also raised by the energy producers industry (Eurelectric letter to European Commissioners of 10 April 2015 EURELECTRIC concerns regarding proposed MiFID II implementing rules).

 

As the Eurelectric argues, the aforementioned amendment regarding Section C7 of Annex I secondary legislation "could inadvertently define bilateral commercial contracts for delivery of commodity derivatives in the future as commodity derivatives. For example, a bilateral contract for the future delivery of power and gas between a producer and an industrial end-consumer could be classified as financial instruments under MiFID II."

 

According to Eurelectric, "such commercial commodity delivery contracts display no characteristics of traditional financial instruments and are entered into for commercial purposes".

 

 


 

 

 

In the Eurelectric's opinion the said regulatory risk could be triggered by a combination of two factors:

 

- the term "equivalent" is not defined and can thus be construed very widely – all commercial commodity delivery contracts thus run the risk to be qualified as commodity derivatives because they "look-alike" platform traded contracts.

 

- this change puts the emphasis on the "commercial purpose" test which is very restrictive (Art. 38(4) of Regulation 1287/2006). It covers only contracts entered into with power transmission/gas pipelines operators for balancing purposes, but not all contracts entered into between energy producers/suppliers and energy consumers.

 

Recital 5 of the Commission Delegated Regulation (EU) 2017/565 of 25 April 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

 

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.

 

 

However,  despite the reservations expressed by industry, the wording of Article 7 in the Commission Delegated Regulation of 25 April 2016 is exactly the same as the aforementioned ESMA's proposals.

 

Does it mean that we face serious regulatory risk under MiFID II with respect to OTC commodity forwards? Not entirely.

 

The newly added Recital 5 to said Commission Delegated Regulation  of 25 April 2016 indeed changes much.

 

The said Recital 5 stipulates that the 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).

 

Referring to the content of the Recital 5 the European Commission has recalled that under ESMA's advice, over-the-counter contracts will be considered C7 financial instruments if they are equivalent to exchange traded ones with regard to any of the main terms of the contracts such as price, lot or delivery date.

 

This is a major change from the MIFID I rules where parties to contracts had to expressly state equivalence (i.e. opt in) in order for an over-the-counter contract to be considered C7.

 

In comparison to ESMA's proposals, the addition by the European Commission of the Recital to the Regulation of 25.04.2016 has significantly narrowed the equivalence test.

 

It is expressed in the Commission Staff Working Document Impact Assessment Accompanying the document Commission Delegated Regulation supplementing Regulation (EU) No 600/2014 of the European Parliament and of the Council with regard to definitions, transparency, portfolio compression and supervisory measures on product intervention and positions {C(2016) 2860 final} {SWD(2016) 156 final}, 18.5.2016, SWD(2016) 157 final, p. 53, which reads:

 

"This option would largely take ESMA's advice, but would seek to narrow which over-the-counter instruments can be deemed 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 be considered C7 financial instruments. This will ensure that 'physical forwards' used by commodity producers to sell their produce forward will not be considered financial instruments."

 

In the European Commission's opinion leaving the ESMA's proposals unchanged might potentially lead to many smaller commercial entities being captured by MIFID authorisation requirements.

 

It would therefore disproportionately impact stakeholders who rely on forwards which are linked to exchange traded contracts for their physical transactions.

 

Indeed many commodity physical producers use forward contracts linked to exchange traded products to sell their production forward.

 

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).

 

Under ESMA's proposals these contracts will be considered C7 financial instruments.

 

For some sectors, like agriculture, which rely on forwards for the majority of their sales of physical products, it is possible that the entirety of the activity will consist in financial instruments; and thus these businesses will fail the ancillary activity test.

 

This would involve, in extremis, many small businesses, such as farmers and agricultural cooperatives, needing to be MiFID authorised.

 

Recital 5 of the Regulation (EU) 2017/565 of 25.04.2016 narrows the equivalence tests so as to exclude over-the-counter contracts that are not exactly equivalent to exchange traded contracts.

 

The said Impact Assessment of 25.04.2016 expressly acknowledges "the vast majority of contracts used for physical delivery would not be captured by this definition".

 

As such, the approach as adopted in the Regulation of 25.04.2016 would meet the co-legislators' intent to focus the MIFID provisions on non-commercial entities.

 

It would also allow businesses which have different capital structures to industrial companies such as cooperatives, which buy and sell production forward, not to be unduly impacted by the legislation.

 

Finally, whilst Regulation of 25.04.2016 limits the scope of MIFID II compared to ESMA's proposals, it would still considerably increase the coverage compared to MIFID I rules, where parties had to explicitly opt-in for contracts to be considered C7 financial instruments.

 

In conclusion, the European Commission expressed an opinion that the text of the Regulation "would likely allow for stakeholders to continue their commercial activity".

 

 

 

 

IMG 0744

    Documentation    

 

 

 

 

 

Commission Delegated Regulation (EU) 2017/565 of 25 April 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 DirectiveArticle 7(1)(a)(iii), Recital 5

 

Annex I Section C7 of the Directive 2014/65/EU of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments and amending Directive 2002/92/EC and Directive 2011/61/EU

  

Final Report ESMA's Technical Advice to the Commission on MiFID II and MiFIR of 19 December 2014, ESMA/2014/1569 (p. 415-417)

 

Commission Staff Working Document Impact Assessment Accompanying the document Commission Delegated Regulation supplementing Regulation (EU) No 600/2014 of the European Parliament and of the Council with regard to definitions, transparency, portfolio compression and supervisory measures on product intervention and positions {C(2016) 2860 final} {SWD(2016) 156 final}, 18.5.2016, SWD(2016) 157 final, p. 53 et seq.

 

Annex I Section C7 of the Directive 2004/39/EC of the European Parliament and of the Council of 21 April 2004 on markets in financial instruments amending Council Directives 85/611/EEC and 93/6/EEC and Directive 2000/12/EC of the European Parliament and of the Council and repealing Council Directive 93/22/EEC

 

Article 38(1)(a)(iii) of the 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) 

 

Guidelines on the application of C6 and C7 of Annex 1 of MiFID of 20 October 2015 (ESMA/2015/1341)

 

 

 

 

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    Links    

 

 

 

 

Physically settled commodity derivatives in MiFID II

 

Derivatives

 

OTC derivatives

 

C6 energy derivatives contracts

 

Viability of the EU OTC commodity forward markets hinged on one word in the recital of the European Commission Regulation

 

 

 

 

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Last Updated on Wednesday, 30 August 2017 11:38
 

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