Commission Delegated Regulation of 25.4.2016 implementing MiFID II represents the coup de grâce for the hotly-debated topic of equivalency as the criterion for the differentiation of forward contracts being financial instruments from other physically settled OTC derivatives.
This step change from purely formal criterion based on the literal wording of the contract to the objective metric dependent only on verifiable trading data seems, however, as it stands, unworkable for legal practitioners.
Spot contracts (i.e. those for which, put simply, delivery is scheduled to be made within the period of two trading days) are, luckily, beyond the scope of these complications.
However, when it comes to longer perspectives, the issue arises how to organise the process for ongoing comparison of physical OTC forwards in scope of the company business with their potential match in the form of the standard on-venue contract traded not only regulated markets and MTFs, but also OTFs as well as third-country trading venues.
The purpose of this examination is not negligible, then - it is to establish whether given physical forward is a financial instrument under MiFID II, hence whether it is subject to the EMIR reporting, etc.
Article 7(1)(a) of the Commission Delegated Regulation (EU) 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
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
When making comparison between:
- current framework - stipulated in 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), and
- the one applying as from 3 January 2018 (Article 7(1)(a)(iii) of the Commission Delegated Regulation (EU) 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, 25.4.2016 C(2016) 2398 final),
it is clearly visible that the essence is the financial instruments under MiFID II will no longer be OTC physically settled forward contracts "expressly stated" to be equivalent to the on-venue contract, but contracts that "are" equivalent.
In other words, subjective assessment has been replaced with the objective one.
But the devil is in the details, as ever.
MiFID II Delegated Regulation mandates to include in this analysis "the price, the lot, the delivery date and other contractual terms".
Particularly, "other contractual terms" may rise doubts as regards the level of granularity of this specific examination.
For example, what about different delivery locations? Are OTC forwards for physical delivery of electricity in Sweden equivalent to the same on-venue contracts with delivery in Greece?
It can be supposed they are not, but if somebody requested legal reasoning for this response, there may appear ambiguities.
In this context it is useful to note the concept for Economically-Equivalent OTC Contracts (EEOTC) developed for the purposes of the MiFID II position limits legal framework, currently subject to the equally vivid discussion (see for example ESMA's Opinion, Draft Regulatory Technical Standards on methodology for calculation and the application of position limits for commodity derivatives traded on trading venues and economically equivalent OTC contracts, 2 May 2016, ESMA/2016/668).
To exclude unreasonable netting under the position limits regime, the definition of the EEOTC formulated under this framework is very narrow.
The initial approach was the OTC contract had to posess not similar, but identical specifications to the contract on a trading venue, to qualify.
But in the said Opinion of 2 May 2016, ESMA/2016/668 (p. 12) ESMA "covered two additional possibilities where the contractual specifications might not be identical but still qualify as EEOTC. In case the specifications of the OTC contract in respect of lot sizes and delivery dates would be different from the on-venue contract this would not stop the OTC contract from being considered EEOTC. However, in the case of delivery dates the divergence with the exchange-traded contract is limited to one day. Different delivery locations will in ESMA's view, generally mean different economic characteristics."
"If, however, minor differences in delivery arrangements or other contract parameters are in future used with the apparent intent of circumventing the regime, ESMA may propose further amendments to the definition," ESMA added.
To conclude, considering human creativity and invention, it can be expected the equivalency criterion under the MiFID II position limits regime will be dynamic over time.
However, I suppose there is little chance to be correct to transfer uncritically interpretations on the EEOTC's scope from position limits legislation onto the territory of financial instruments' very definition under the said Article 7(1)(a)(iii) of the Commission Delegated Regulation of 25.4.2016. Or, maybe, I am wrong.
Nevertheless, it will be interesting to observe how these two competing legal frameworks for equivalency assesment work in practice.
Financial Instruments Reference Data System (FIRDS), inevitably, will play its role in that regard.