A derivative is a type of financial instrument value thereof being based on the change in value of an underlying asset or a basket of assets.
Examples of assets on which a derivative contract can be written include equities, commodities or emission allowances.
The value of a derivative can also be derived from the value of a market variable (e.g. an interest rate, an exchange rate or a stock index).
Derivatives contracts are used by financial and non-financial economic actors to manage risks related to changes in interest rates, currency fluctuations, the default of a business counterpart etc.
Derivatives allow market participants to redistribute risk among each other, for example, exporters are able to fix their prices despite fluctuating exchange rates, and banks can offer fixed-rate mortgages even as interest rates move etc.
Derivatives can be used for insuring against risk (hedging) as well as for speculative purposes.
Hence, derivatives are a vital part of financial markets and account for hundreds of trillions of euros in volume.
ESMA Annual Statistical Report of 9 December 2019 (ESMA50-157-20, p. 4) highlights the following parameters of the EU derivatives market at the end of 2018:
- EUR 735tn in total notional amount outstanding in 66mn open trades,
- over 85% of the notional amount held by investment firms, credit institutions and central counterparties (CCPs),
- about 10% of total notional amount between counterparties in the same group (EUR 78tn),
- the market continued to be dominated by interest rate derivatives (IRDs) at 76% of notional amount,
- about 15% of the notional amount was in currency, with another 6% in equity, credit and commodities,
- over-the-counter (OTC) contracts accounted for 90% of outstanding notional amount in 4Q18 with the remainder in exchange traded derivatives (ETDs),
- 7% of the total notional amount was in OTC contracts executed on trading venues with characteristics comparable to ETD (i.e. on MTFs and OTFs),
- for IRDs 63% of the outstanding notional amount was centrally cleared, with 25% cleared for credit derivatives (CDs),
- central clearing rates grew for IRDs outstanding from 61% to 63% and ended 2018 broadly unchanged for CDs at 25%,
- the proportion of ETD contracts over all assets was stable at around 10% through the year,
- OTC contracts executed on trading venues grew strongly for currencies, IRDs and CDs, and over all asset classes grew from 3% to 7% of notional amount.
Different transpositions of MiFID I Directive across the European Union Member States caused there was no single, uniform legal definition of derivative or derivative contract in the EU (this was particularly true in the case of foreign exchange (FX) forwards and physically settled commodity forwards).
As a result, under the MiFID I the same contract might be considered a derivative contract in one EU Member State and a spot contract in another Member State (EMIR Review Report no. 1 of 13 August 2015 - Review on the use of OTC derivatives by non- financial counterparties (2015/1251), p. 15), with the consequence that the latter would not be reported to trade repositories.
Article 2(1)(29) MiFIR
'derivatives' mean 'those financial instruments defined in point (44)(c) of Article 4(1) of Directive 2014/65/EU; and referred to in Annex I, Section C (4) to (10) thereto'.
This situation has changed with the MiFID II Directive entry into force on 3 January 2018 where the derivatives legal definition is stipulated in Article 2(1)(29) of MiFIR (see box).
The UK Financial Conduct Authority (FCA) in a document Markets in Financial Instruments Directive II Implementation – Consultation Paper I (CP15/43), December 2015 underlines (p. 266), the scope of financial derivatives under MiFID is wider than under the the former Investment Services Directive (ISD - the MiFID I predecessor) and includes the following types:
- derivative instruments relating to securities, currencies, interest rates or yields, or other derivative instruments, financial indices or measures, that may be settled physically or in cash (C4), emission allowances or certain other things;
- commodity derivatives;
- derivative instruments for the transfer of credit risk (C8);
- financial contracts for differences (C9); and
- derivatives on miscellaneous underlyings.
Pursuant to the FCA, the scope of MiFID I Section C4, C8 and C9 "does not extend to spot transactions, transactions which are not derivatives (such as forwards entered into for commercial purposes) and sports spread bets".
Derivatives' and spot markets are subjected to divergent legal frameworks.
See the 'commodity derivatives' for further comments on the interpretation of the narrower category in points (5), (6), (7) and (10) of Section C of Annex I to the MiFID Directive.
- the broader definition of the financial instrument,
- the interpretation of 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 in Section C7 of 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'.
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'.
Directive 2014/65/EU (MiFID II) Annex I, Section C (4) to (10):
(4) Options, futures, swaps, forward rate agreements and any other derivative contracts relating to securities, currencies, interest rates or yields, emission allowances or other derivatives instruments, financial indices or financial measures which may be settled physically or in cash;
(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;
(8) Derivative instruments for the transfer of credit risk;
(9) Financial contracts for differences;
(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;
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
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;
(b) it is standardised so that the price, the lot, the delivery date and 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 shall be 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) 2 trading days;
(b) the period generally accepted in the market for that commodity, asset or right as the standard delivery period.
A contract shall not be considered a spot contract where, 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 referred to in paragraph 2.
3. For the purposes of Section C(10) of Annex I to Directive 2004/39/EC of the European Parliament and of the Council (18), a derivative contract relating to an underlying referred to in that Section or in Article 8 of this Regulation shall be considered to have the characteristics of other derivative financial instruments where one of the following conditions is satisfied:
(a) it 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) it is traded on a regulated market, an MTF, an OTF, or a third country trading venue that performs a similar function to a regulated market, MTF or an OTF;
(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 Annex I to Directive 2014/65/EU, and as not having the characteristics of other derivative financial instruments for the purposes of Sections C(7) and (10) of that Annex, where the following conditions are both met:
(a) it is entered into with or by an operator or administrator of an energy transmission grid, energy balancing mechanism or pipeline network,
(b) it is necessary to keep in balance the supplies and uses of energy at a given time, including the case when the reserve capacity contracted by an electricity transmission system operator as defined in Article 2(4) of Directive 2009/72/EC is being transferred from one prequalified balancing service provider to another prequalified balancing service provider with the consent of the relevant transmission system operator.
Derivatives under Section C(10) of Annex I to Directive 2014/65/EU
(Article 4(1)(2) of Directive 2014/65/EU)
In addition to derivative contracts expressly referred to in Section C(10) of Annex I to Directive 2014/65/EU, a derivative contract shall be subject to the provisions in that Section where it meets the criteria set out in that Section and in Article 7(3) of this Regulation and it relates to any of the following:
(a) telecommunications bandwidth;
(b) commodity storage capacity;
(c) transmission or transportation capacity relating to commodities, whether cable, pipeline or other means with the exception of transmission rights related to electricity transmission cross zonal capacities when they are, on the primary market, entered into with or by a transmission system operator or any persons acting as service providers on their behalf and in order to allocate the transmission capacity;
(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, except where the contract is already within the scope of Section C of Annex I to Directive 2014/65/EU;
(e) a geological, environmental or other physical variable, except if the contract is relating to any units recognised for compliance with the requirements of Directive 2003/87/EC of the European Parliament and of the Council (19);
(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;
(h) an index or measure based on actuarial statistics.
MiFID II, Annex I, Section C (4) to (10)
MiFIR, Article 2(1)(29)
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, Articles 7, 8
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, Articles 38, 39