Commodity derivatives (MiFID definitions)
Commodity derivatives are financial instruments the value of which depend on that of a commodity, such as grains, energy or metals.
The use of commodity derivatives is widespread across industries and types of counterparties, notably non-financials.
ESMA Report on Trends, Risks and Vulnerabilities No. 2. 2017 “EU derivatives markets ─ a first-time overview” (ESMA50-165-421, p. 6) indicates 305,685 different counterparty IDs were reported to trade repositories for the commodity derivatives asset class, which makes it the largest derivatives asset class in terms of market participants.
The said ESMA’s Report also notes that in the commodity derivatives market:
- around five million open commodity derivatives transactions were reported to the trade repositories, 54% of them ETD derivatives;
- in terms of notional amounts ETDs accounted for EUR 5.4tn (60%) of notional values compared to EUR 3.6tn (40%) for OTC.
Most of these transactions involved a non-EEA counterparty.
10 EU and 11 third countries’ central counterparties (CCPs) were present in this market, as well as 149 clearing members.
Commodity derivatives' legal definition is comprised in Article 2(1)(30) of MiFIR (see box) and is relevant for multiple MiFID II and MiFIR legal qualifications, for instance position limits legislative framework applies only to commodity derivative (physically settled as well cash settled).
Article 2(1)(30) MiFIR
"'commodity derivatives' mean "those financial instruments defined in point (44)(c) of Article 4(1) of Directive 2014/65/EU; which relate to a commodity or an underlying referred to in Section C(10) of Annex I to Directive 2014/65/EU; or in points (5), (6), (7) and (10) of Section C of Annex I thereto"
The definition of "commodity derivative" under Article 4(1)(50) of MiFID II cross references the definition of commodity derivative under Article 2(1)(30) of MiFIR which states 'commodity derivative' means those financial instruments defined in Article 4(1)(44)(c) of MiFID II; which relate to a commodity or an underlying referred to in Section C(10) of Annex I of MiFID II; or in points (5), (6), (7) and (10) of Section C of Annex I thereto.
Article 4(1)(44)(c) of MiFID II covers the category of transferable securities (classes of securities which are negotiable on the capital market) being "any other securities giving the right to acquire or sell any such transferable securities or giving rise to a cash settlement determined by reference to transferable securities, currencies, interest rates or yields, commodities or other indices measures" (instruments of payment are excluded from the definition).
Broadly speaking, (5) of Annex I, Section C relates to cash settled derivatives, (6) physically settled derivatives traded on trading venues, (7) physically settled derivatives traded outside trading venues and (10) cash settled derivatives with what ESMA has termed as more "exotic" underlyings such as climatic variables, freight rates or inflation rates or other.
Point (44)(c) of Article 4(1) of Directive 2014/65/EU (MiFID II):
'transferable securities' mean 'those classes of securities which are negotiable on the capital market, with the exception of instruments of payment, such as:
...
(c) any other securities giving the right to acquire or sell any such transferable securities or giving rise to a cash settlement determined by reference to transferable securities, currencies, interest rates or yields, commodities or other indices or measures'.
The definition of commodity derivative under Article 2(1)(30) of MiFIR is broad, comprising also securitised derivatives and cash settled derivatives which do not have a tangible underlying such as climatic variables (ESMA's Opinion (Annex), Amended draft Regulatory Technical Standards on the methodology for the 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, Recital 13).
An increase in the scope of commodity derivatives under MiFID II is visible, particularly, as regards cash-settled forwards traded on OTFs.
The definition of "commodity derivatives" under MiFID II/MiFIR legal framework does not, however, encompass emission allowances and derivatives of emission allowances (since points 4 and 11 in Section C of the Annex I to MiFID II Directive (covering carbon credits) are not included).
The above view is shared by the European Securities and Markets Authority (ESMA), which in the Consultation Paper ESMA's guidelines on information expected or required to be disclosed on commodity derivatives markets or related spot markets under MAR, 30 March 2016, ESMA/2016/444, p. 13) said: "the definition of commodity derivatives does not include derivatives of emission allowances, as point (4) of Section C of Annex I of MiFID II is not cross-referred to in the definition of commodity derivatives". This was also upheld in ESMA Preliminary report of 15 November 2021, Emission Allowances and derivatives thereof, ESMA70-445-7.
The definition of "commodity derivatives" under MiFID II/MiFIR legal framework also excludes physical holdings.
Perimeter Guidance Manual, Chapter 13, Guidance on the scope of MiFID and CRD IV, FCA, p. 13
Which types of commodity derivative fall within MiFID scope?
Broadly speaking, the following commodity derivatives fall within the scope of MiFID:
- a derivative relating to a commodity derivative, for example, an option on a commodity future (C4);
- cash-settled commodity derivatives (C5);
- physically settled commodity derivatives traded on certain markets or facilities (C6); and
- other commodity derivatives capable of physical settlement and not for commercial purposes (C7).
The definition of commodity derivative in MiFIR also includes derivatives falling into paragraph C10 of Section A of Annex 1 to MiFID.
Contracts in securities (such as exchange traded products (ETPs)), which have a commodities underlying are in the ESMA opinion "commodity derivatives".
ESMA considers that the boundary between the respective definitions applicable to commodity derivatives, laid down in Section C of the Annex I of MiFID II, is as follows:
a. Contracts which must be settled in cash fall under C5;
b. Contracts which may be settled in cash at the option of one of the parties fall under C5. This means that a C5 contract may be physically settled if the party with the option to settle in cash does not exercise this option;
c. Contracts which must be physically settled fall under C6 or C7, depending upon the place of execution;
d. Contracts that can be physically settled in all cases fall under C6 or C7, depending on the place of execution, except for where there is an option, at one of the parties' behest, to cash settle.
This means a C6 or C7 contract could be cash settled provided it is by mutual consent of the counterparties.
Where there is not mutual consent to cash settle, the contract must result in being physically settled for it to be a C6 or C7 instrument (see ESMA's Consultation Paper on MiFID/MiFIR of 22 May 2014 (ESMA/2014/549), p. 281).
For further, detailed remarks and the interpretation of the "physical" way of settlement, which, according to ESMA, is included under Sections C6 and C7 of the Annex I to the MiFID (point c above) see: "contracts that must be physically settled".
Note, that when it comes to MiFID I classifications, ESMA issued specific Guidelines on the application of the definitions in Sections C6 and C7 of Annex I of Directive 2004/39/EC (MiFID) of 6 May 2015 (ESMA/2015/675) and the Guidelines on the application of C6 and C7 of Annex 1 of MiFID of 20 October 2015 (ESMA/2015/1341) - see box below).
The EU's two biggest commodity derivatives regulated markets are based in the UK and there are in the region 1.800 commodity derivatives contracts trading on the trading venues in the UK (UK HM Treasure MiFID II Consultation Impact Assessment, p. 10).
Trading volumes in the class of commodity derivatives are used as an important metric for various legal qualifications.
For example, under MiFID II ancillary activity exemption the proportion of non-hedging trading activity in commodity derivatives to the firm's total EU trading activity in commodity derivatives (adopted as an approximation of the firm's "main activity") serves as an element of necessary assessments whether the trader needs to apply for a MiFID licence.
Under the current technical standard on EMIR reporting, the commodity derivatives are identified either with CO in common data field Product ID 1 in the case of OTC derivatives or with CFI codes (O**T** or FC****) for ETD.
Under the amended technical standard on reporting the commodity derivatives would be reported with value “Commodity” in the common data field “Asset class”.
The relevant classes of commodity derivatives are defined as follows:
- metals – “commodity base” field reported as ‘ME’,
- oil products – “commodity details” reported with ‘OI’,
- coal – “commodity details” reported with ‘CO’,
- gas – “commodity details” reported with ‘NG’,
- power – “commodity details” reported with ‘EL’ or ‘IE’,
- agricultural products – “commodity base” reported with ‘AG’,
- other commodities including freight and C10 – “commodity base” reported with ‘FR’ or ‘IN’ or ‘EX’ or ‘OT’ or “commodity details” reported with ‘WE’,
- derivatives on emission allowances – “commodity details” reported with ‘EM’.
The commodity derivatives' definition (Article 3(1)(24)) under the Market Abuse Regulation (MAR) cross-references to Article 2(1)(30) of MiFIR, so the said term is understood in the uniform manner across these legislative pieces.
See also:
- the broader definitions of the financial instrument, and a derivative,
- the interpretation of the Section C7 of the Annex I to the MiFID Directive - Contracts having the characteristics of other financial instruments,
- detailed comments on the third limb of the trading criterion of the financial instrument's definition the Section C7 of the Annex I to the MiFID Directive 'contracts equivalent to a contract traded on a regulated market, an MTF, an OTF contract or such a third country trading venue'.
Annex 1 points (5), (6), (7) and (10) of Section C of Directive 2014/65/EU (MiFID II):
(5) Options, futures, swaps, forwards and any other derivative contracts relating to commodities that must be settled in cash or may be settled in cash at the option of one of the parties other than by reason of default or other termination event;
(6) 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, a MTF, or an OTF, except for wholesale energy products traded on an OTF that must be physically settled;
(7) Options, futures, swaps, forwards and any other derivative contracts relating to commodities, that can be physically settled not otherwise mentioned in point 6 of this Section and not being for commercial purposes, which have the characteristics of other derivative financial instruments;
(10) Options, futures, swaps, forward rate agreements and any other derivative contracts relating to climatic variables, freight rates or inflation rates or other official economic statistics that must be settled in cash or may be settled in cash at the option of one of the parties other than by reason of default or other termination event, as well as any other derivative contracts relating to assets, rights, obligations, indices and measures not otherwise mentioned in this Section, which have the characteristics of other derivative financial instruments, having regard to whether, inter alia, they are traded on a regulated market, OTF, or an MTF;
Articles 38 and 39 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)
Article 38
(Article 4(1)(2) of Directive 2004/39/EC)
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;
(b) it is cleared by a clearing house or other entity carrying out the same functions as a central counterparty, or there are arrangements for the payment or provision of margin in relation to the contract;
(c) it is standardised so that, in particular, the price, the lot, the delivery date or other terms are determined principally by reference to regularly published prices, standard lots or standard delivery dates.
2. A spot contract for the purposes of paragraph 1 means a 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.
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.
3. For the purposes of Section C(10) of Annex I to Directive 2004/39/EC, a derivative contract relating to an underlying referred to in that Section or in Article 39 shall be considered to have the characteristics of other derivative financial instruments if one of the following conditions is satisfied:
(a) that contract is settled in cash or may be settled in cash at the option of one or more of the parties, otherwise than by reason of a default or other termination event;
(b) that contract is traded on a regulated market or an MTF;
(c) the conditions laid down in paragraph 1 are satisfied in relation to that contract.
4. A contract shall be considered to be for commercial purposes for the purposes of Section C(7) of AnnexI to Directive 2004/39/EC, and as not having the characteristics of other derivative financial instruments for the purposes of Sections C(7) and (10) of that Annex, if it is entered into with or by an operator or administrator of an energy transmission grid, energy balancing mechanism or pipeline network, and it is necessary to keep in balance the supplies and uses of energy at a given time.
Article 39
(Article 4(1)(2) of Directive 2004/39/EC)
Derivatives within Section C(10) of Annex I to Directive 2004/39/EC
In addition to derivative contracts of a kind referred to in Section C(10) of Annex I to Directive 2004/39/EC, a derivative contract relating to any of the following shall fall within that Section if it meets the criteria set out in that Section and in Article 38(3):
(a) telecommunications bandwidth;
(b) commodity storage capacity;
(c) transmission or transportation capacity relating to commodities, whether cable, pipeline or other means;
(d) an allowance, credit, permit, right or similar asset which is directly linked to the supply, distribution or consumption of energy derived from renewable resources;
(e) a geological, environmental or other physical variable;
(f) any other asset or right of a fungible nature, other than a right to receive a service, that is capable of being transferred;
(g) an index or measure related to the price or value of, or volume of transactions in any asset, right, service or obligation.
Guidelines on the application of C6 and C7 of Annex 1 of MiFID of 20 October 2015 (ESMA/2015/1341)
"Application of C6 of Annex 1 of MiFID I
1. ESMA considers that definition C6 of Annex 1 of MiFID applies in the following way:
a. C6 has a broad application, applying to all commodity derivative contracts,
including forwards, providing that:
i. they can or must be physically settled; and
ii. they are traded on a regulated market and/or an MTF.
b. "Physically settled" incorporates a broad range of delivery methods and includes:
i. physical delivery of the relevant commodities themselves;
ii. delivery of a document giving rights of an ownership nature to the relevant commodities or the relevant quantity of the commodities concerned (such as a bill of lading or a warehouse warrant); or
iii. another method of bringing about the transfer of rights of an ownership nature in relation to the relevant quantity of commodities without physically delivering them (including notification, scheduling or nomination to the operator of an energy supply network) that entitles the recipient to the relevant quantity of the commodities.
Application of C7 of Annex 1 of MiFID I
2. ESMA considers that definition C7 of Annex 1 applies in the following way:
a. C7 forms a category that is distinct from C6 and applies to commodity derivative contracts that can be physically settled which are not traded on a regulated market or an MTF providing that the commodity derivative contract:
i. is not a spot contract as defined under Article 38(2) of Regulation 1287/2006/EC;
ii. is not for the commercial purposes described under Article 38(4) of Regulation 1287/2006/EC; and
iii. meets one of the three criteria under Article 38(1)(a) and also the separate criteria under Article 38(1)(b) and 38(1)(c) of Regulation 1287/2006/EC.
b. "Physically settled" incorporates a broad range of delivery methods and includes:
i. physical delivery of the relevant commodities themselves;
ii. delivery of a document giving rights of an ownership nature to the relevant commodities or the relevant quantity of the commodities concerned (such as a bill of lading or a warehouse warrant); or,
iii. another method of bringing about the transfer of rights of an ownership nature in relation to the relevant quantity of commodities without physically delivering them (including notification, scheduling or nomination to the operator of an energy supply network) that entitles the recipient to the relevant quantity of the commodities.
3. Physically settled commodity derivatives which do not fall within the definition of C6, i.e. are not traded on a Regulated Market or an MTF, may fall within the definition of C7 and the definitions of C6 and C7 form two distinct categories as C7 applies to commodity derivatives "that can be physically settled not otherwise mentioned in C6".
4. The other characteristics of commodity derivatives under C7 - "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" - are further defined under Article 38 of Regulation 1287/2006/EC.
5. ESMA notes that the conditions defined in Article 38 of Regulation 1287/2006/EC, are to be applied cumulatively."