EUA’s and CER’s Daily Futures Contracts traded on ECX are physically deliverable within two trading days - are they spot contracts or financial instruments triggering regulatory framework of MIFID?
Background in short
Section C10 of the Annex I to the MIFID Directive enumerates different classes of financial instruments. The said specification is crucial to triggering regulatory framework of MIFID Directive – obviously, when we deal also with an “investment services and activities” and conditions to qualify under exemptions provided for in Article 2(1) of the Directive are not met.
Regulatory framework of MIFID means for the CO2 broker the necessity to register as an investment firm – which, in exchange for the fulfillment of multiple, legal and organisational requirements, gives the entity the “European passport” i.e. the freedom to act in all Member States.
But there is an important question for many CO2 brokers, to what extent they can trade without triggering MIFID requirements. This question is, in principle, reduced (with the above-mentioned reservations) to determination whether a given contract relates to financial instrument or not.
Physical OTC forward
It follows from the Section C10 of the Annex I to the MIFID Directive as well as the Article 38(3)(a) of the Commission Regulation No 1287/2006 of 10 August 2006 implementing Directive 2004/39/EC of the European Parliament and of the Council as regards recordkeeping 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) that OTC options, futures, swaps and other derivative contracts relating to emissions allowances are regulated under MiFID if they can be settled in cash.
Depending on the detailed terms of the contract, the obligations of the parties have to be satisfied by the delivery of emission allowances or through a cash settlement process.
When carbon contract is traded via bilateral bespoke contracts (over-the-counter) and there is no possibility for cash settlement (the physical delivery only) such a OTC forward is non-financial instrument and not covered by MiFID. This conclusion leads us to the assessment that CO2 brokers not having investment firm’s legal status may engage in such contracts without violating the MIFID regulatory framework.
Exchanges and MTF
An important exception to this rule relates to carbon derivatives traded on exchanges and MTF. The said products - also if physically settled - are under the full scope of MiFID and harmonised throughout the EU. The legal basis for this qualification establishes
the Article 38(3)(b) of the cited Commission Regulation No 1287/2006.
This provision generates an interesting situation - the contract, conditions of which qualify it, in the common opinion, as “strictly spot”, becomes a financial instrument when comes up to the exchange. This is the case with the Daily Futures of the ECX.
The Article 38(2) of the cited Commission Regulation No 1287/2006 defines a spot contract as “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.”
In the said definition is also added that “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.” but this addition has no significance for the purposes of conclusions of this article.
EUAs and CERs Daily Futures contract specifications
Looking from the perspective of this definition at the detailed EUAs and CERs Daily Futures contract specifications of the product listed on the ECX exchange, one can be confused, because this specifications read:
1. Contract is a Daily Contract. Only one Daily Contract is listed at any one time with a Contract Date of that on which trading occurs,
2. The Contracts are physically deliverable,
3. Delivery is between Clearing Members and ICE Clear Europe during a Delivery Period. The Delivery Period is the period beginning at 18:30 hours on the Contract Date and ending at 19:00 hours on the second Business Day following the relevant Contract Date.
So, the physical delivery and the term for it ending within two business days indicate that the contract – if not traded on the exchange – would be qualified as a classical spot and not the financial instrument.
But such a conclusion would not be correct. The classification of EUAs and CERs Daily Futures as a financial instruments is supported - apart from the abovementioned Article 38(3)(b) of the Regulation No 1287/2006 - by the following arguments:
1. ICE Clear Europe will act as central counterparty to all trades and guarantees the financial performance of the ICE Futures Europe contracts registered in the name of its Members (see to that effect the Article 38(1)(b) of the Regulation No 1287/2006 in conjunction with the Article 38(3)(c) thereof);
2. Margin & Payment - the Buyer will pay full contract value by 09:00 on the first Business Day following the relevant trade date. A separate Variation Margin payment/call will be made by 09:00 on the first Business Day following the relevant trade date and the Seller will pay Seller Security by 09:00 on the first Business Day following the relevant trade date. A separate Variation Margin payment/call will be made by 09:00 on the first Business Day following the relevant trade date in order to reflect the profit/loss on the contract (the argument about margining also refers to the Article 38(1)(b) of the Regulation No 1287/2006 in conjunction with the Article 38(3)(c) thereof);
3. The contract is standarised (see in that sense the Article 38(1)(c) of the Regulation No 1287/2006 in conjunction with the Article 38(3)(c) thereof);
4. The ECX expressly describes the product as “ICE FUTURES ECX CARBON FINANCIAL INSTRUMENTS” (see in that sense the Article 38(1)(a)(ii) of the Regulation No 1287/2006 in conjunction with the Article 38(3)(c) thereof).
To conclude, EUA’s and CER’s Daily Futures Contracts listed on ECX are financial instruments, and CO2 brokers wishing to trade in them need to examine the exemptions from MIFID provided for in Article 2 of the Directive.
Taking into account that definition of financial services and activities, pursuant to Section A of the Annex I do the Directive, has a particular broad extent and covers, inter alia, not only reception and transmission of orders in relation to one or more financial instruments, execution of orders on behalf of clients, and portfolio management, but also dealing on own account and investment advice (Section A names in that regard eight different categories), if the requirements for qualification under particular exemption for the given broker (depending, amongst other things, on the extent and the scope of it’s business activity) are not met, the said broker should register as an investment form and be subject to MIFID regulatory framework. This means, of course, many (“bureaucratic”, some may say) requirements and regulatory supervision.
Finally, it is appropriate to make the reservation that there are also other exceptions to the rules described in this article but because of it’s limited scope they are not mentioned.