The consultation paper aims to clarify the classifications of derivatives and provide a consistent approach for entities operating across the EU.
The European Securities and Markets Authority (ESMA) recently published a consultation paper on draft guidelines to clarify the application of the definition of “commodity derivatives” under the current Markets in Financial Instruments Directive (MiFID). Given that the definition of “derivatives” under the European Market Infrastructure Regulation (EMIR) cross-refers to the list of financial instruments enumerated in Annex 1 to MiFID, this initiative will help obviate significant problems that have arisen in the implementation of EMIR caused by the non‑harmonised classification of financial instruments as derivatives.
The source of the harmonisation problem is the use of a defined term in an EU regulation (which takes direct effect throughout the EU) that cross-refers to a definition set out in an EU directive (which relies on each member state of the EU to implement it in their local law as the state sees fit). The different transpositions of MiFID into local law across member states mean that there is no single, commonly adopted definition of “derivative” in the EU, thus preventing the convergent application of EMIR EU-wide (as well as other directives that rely on MiFID definitions of financial instruments). This runs contrary to the purpose behind the use of an EU regulation.
Earlier this year we reported on ESMA’s request to the European Commission to clarify the definition of “derivatives” under EMIR. On 29 September, ESMA published a consultation paper on guidelines they seek to issue to local regulators in each member state to clarify the application of the definition of “commodity derivatives” as financial instruments under points 6 and 7 (C6 and C7) of Section C of Annex I of MiFID.
The purpose of ESMA’s guidelines is to create a level playing field between EU market participants by ensuring the uniform application of the definitions and to clarify the classification of financial instruments. This will provide clear rules for stakeholders, mitigating legal risks and removing difficulties to a consistent approach for entities operating across borders.
In the context of EMIR, ESMA has identified the following areas as unlevel in the market due to the non-harmonised definition of “derivatives”:
The Definition of “Commodity Derivatives” under C6 and C7 of Annex I to MiFID
Annex 1, Section C, of MiFID provides the following definitions under C6 and C7:
The interpretation of definitions C6 and C7 in relation to physically settled forwards is not convergent across the EU. In particular, there is not a common understanding of whether forwards are included within the definition of C6 and what is meant by “physically settled” for both C6 and C7.
ESMA considers that C6 should apply to all commodity derivatives contracts, including forwards, provided they can be physically settled and traded on a regulated market and/or an MTF.
ESMA considers that “physically settled” incorporates a range of delivery methods including the following:
ESMA considers that C7 should apply as a distinct category from C6 in respect of a commodity derivative contract that can be physically settled, but that is not traded on a regulated market or an MTF, providing that it
The consultation period expires on 5 January 2015. ESMA is particularly interested in whether stakeholders believe there is a conflict between the definitions in C6 and C7 and whether the proposed boundaries could result in gaps into which some instruments might fall.
ESMA has made it clear that it is the responsibility of all investment firms to be aware of the boundaries of their activities that require authorisation under MiFID.
We continue to follow these developments closely and intend to publish further LawFlashes in this area in due course.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact the following Morgan Lewis lawyer:
. Consultation paper – Guidelines on the application of C6 and C7 of Annex I of MiFID, 29 September 2014/ESMA/1189.
. Under Article 2(5) of EMIR, “derivative” or “derivative contract” means a financial instrument as set out in points (4) to (1) of section C of Annex I to MiFID.
. For more information, see our 26 February 2014 LawFlash, “ESMA Calls for a Uniform Definition of ‘Derivatives’ under EMIR”, available here. For further information on EMIR, see the following LawFlashes: “Implementing Measures of European Market Infrastructure Regulation Take Effect”, available here; “Obligations Under European Market Infrastructure Regulation Imminent”, available here; and “Update on the European Market Infrastructure Regulation”, available here.