Derivatives (MiFID definitions)
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.
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6 December 2023 ESMA Market Report, EU Derivatives Markets 2023, ESMA50-54821-2930
Commission Delegated Regulation (EU) amending Delegated Regulation (EU) 2015/63 as regards the methodology for the calculation of liabilities arising from derivatives
EU Derivatives Markets, ESMA Annual Statistical Report 2021
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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.
More actual data can be found in ESMA Market Report, EU Derivatives Markets 2023 (6 December 2023, ESMA50-54821-2930), in particular ESMA observes that "outstanding notional amounts in the EU derivatives market grew 29% to EUR 314tn in 4Q22 from EUR 244tn in 4Q20. Intragroup notional amounts particularly grew, up 91% from 4Q20, to EUR 44tn. There was little change in the relative shares of asset classes. Interest rate derivatives (IRDs) were 78% of notional amount in 4Q22 (+1pp from 4Q20), currency 14% (+1pp), while equity, credit and commodities were 5%, 2% and 1% respectively. There was a shift away from non-banks to banks (62%, +7ppt), with credit institutions and investment firms continuing to hold the most notional amount, while CCPs account for 7% and non-financials 4%. Largely as the result of continued trading in UK trading venues that are no longer recognised as equivalent, the share of ETD and OTC exchanged on trading venues both fell. ETD fell to 5% by 4Q22 (-3ppt from 4Q20), while on-trading-venue OTC fell to 11% (-5ppt from 4Q20). Nonetheless, the share of outstanding notional amounts for OTC IRDs and credit that were cleared continued to grow, from 71% in 4Q20 to 77% in 4Q22 for IRDs, and from 41% to 45% for credit. The UK remains the locus of much derivative trading in Europe, with 52% of outstanding notional amounts held in EEA-to-UK contracts (+3ppt from 4Q20). EEA exposures to other third counties also grew (to 22%, +3ppt)".
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.
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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;
Physically settled commodity derivatives in MiFID II
Contracts that must be physically settled
C6 energy derivatives contracts
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- 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".
To sum-up, not all financial instruments are derivatives, and not all derivatives are financial instruments.
Derivatives' and spot markets are subjected to divergent legal frameworks:
- 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'.