In February this year, ESMA sent a letter (the ESMA Letter) to the European Commission asking them to clarify which types of FX contracts fall within the definition of a “financial instrument” under MiFID. Now, five months later, the Commission responds that powers granted to it under MiFID that would have allowed it to issue an implementing act to harmonise the position across Europe have expired. In its letter to ESMA dated 23 July 2014 (the July Commission Letter) admitting it is powerless to change the position for the moment, the Commission has signalled its intention to deal with this issue as part of the implementing measures under MiFID 2. Although the Commission stated that it did not want to pre-judge the MiFID 2 implementing measures, it shared its current thinking on the question of how an FX spot contract should be defined under MiFID 2. Some may regard this as having an impact on interpretation under current MiFID as well.
So, what does this mean for the market in the interim and how will national regulators respond?
FX: To be or not to be… a derivative? The story so far This alert relates to a long-standing issue which was brought to a head in February this year with the beginning of transaction reporting under EMIR. The definition of “derivative” under EMIR refers to certain “financial instruments” as defined in MiFID. However, there is no single commonly adopted definition of derivative across the EU because MiFID has been transposed into national law across EU member states. This prevents the uniform application of EMIR in EU member states. This means that parties to an OTC FX trade from different EU member states may face different national interpretations as to whether or not that trade is subject to EMIR requirements, including the reporting obligation.
The two main issues are:
a lack of consistency and clarity around what is a “spot” and what is a “forward” for FX contracts; and
a lack of consensus over whether or not FX forward contracts, which are intended to be physically settled and which are entered into for “commercial purposes”, should be regarded as derivatives.
Recognising the issue, on 14 February 2014 (two days after the EMIR transaction reporting start date) ESMA sent the ESMA Letter to the Commission asking it clarify the definition of “derivative”.
On 26 February 2014 the Commission provided a partial response to the ESMA Letter (the February Commission Letter). While the Commission did not issue any clear guidance on the boundary between a spot and a forward, it did make a statement regarding physically-settled FX forwards entered into for commercial purposes. It stated that, in its view, FX forwards would be in scope within Section C(4) of MiFID and made a statement that:
“as the notion of 'the commercial purpose' of the conclusion of a derivative contract is only foreseen as a criterion for physically settled commodity derivative contracts in point (7) of Section C of Annex I to MIFID, it cannot be introduced for the purposes of point (4) of Section C of Annex I to MIFID”.
The Commission then published a consultation on the treatment of FX financial instruments, which concentrated on the dividing line between a spot and a forward, the consultation period for which closed on 9 May 2014 (the Commission Consultation).
The July Commission Letter: Summary of Commission steer on how to define FX spot While the Commission said it could not pre-judge the MiFID 2 implementing measures, it noted that a “broad consensus” appeared to have been reached with respect to defining the meaning of “spot” in the context of FX contracts following its consultation earlier this year, namely:
to use a T+2 settlement period to define FX spot contracts for European and other major currency pairs (Euro, Croatian kuna, Bulgarian lev, Czech koruna, Danish krone, Hungarian forint, Polish zloty and Romanian leu (EU Member States currencies), US dollar, Japanese yen, Australian dollar, Swiss franc, Canadian dollar, Hong Kong dollar, New Zealand dollar, Singapore dollar, Norwegian krone and Mexican peso (BIS most traded currencies));
to use the “standard delivery period” for all other currency pairs to define an FX spot contract;
where contracts for the exchange of currencies are used for the sale of a transferable security, to use the accepted market settlement period of that transferable security to define an FX spot contract, subject to a cap of 5 days; and
an FX contract that is used as a means of payment to facilitate payment for goods and services should also be also considered an FX spot contract.
The Commission also suggested ESMA should consider whether the current approach achieves a sufficiently harmonised application of the EMIR reporting obligation pre-MiFID 2 or whether further guidelines are necessary.
ESMA’s response may depend on the response of national regulators to this latest letter from the Commission.
What will national regulators do now? Up to now, many national regulators have put off making any definitive statements about whether they regard certain types of FX contracts as derivatives. Some have issued statements or adopted an unofficial “wait and see” approach, signalling that they intended to wait for the Commission’s implementing act to be published to reflect a harmonised position across the EU, which was expected to have been some time in Q4 this year.
Now that it’s clear this won’t happen until 2017, it remains to be seen whether national regulators decide to adopt the interpretation of FX spot suggested by the Commission and incorporate it into their own national regulations ahead of the implementation of MiFID 2. It is also unclear whether those countries that currently use a “commercial purpose” test to determine whether an FX forward contract is or is not a derivative will change their regulatory guidance or approach in advance of any formal harmonising measures coming out from the Commission in 2017.
Impact on UK position Unlike many other member states, the UK’s position is clearly expressed by the FCA in PERG as regarding FX forwards entered into for commercial purposes as being outside scope. The FCA’s response to the February Commission Letter was to issue a statement saying their position was unchanged.
Further information Links to the July Commission Letter, the February Commission Letter, the ESMA Letter and the Commission Consultation are available below:
The Commission’s latest letter to ESMA dated 23 July 2014 (the July Commission Letter)
The Commission’s initial response to ESMA dated 26 February 2014 (the February Commission Letter)
ESMA’s Letter to the Commission dated 14 February 2014 (ESMA’s Letter)
The Commission Consultation