On February 14, 2014, the European Securities and Markets Authority (ESMA) requested that the European Commission (EC) clarify the definition of “derivative” or “derivative contract,” and particularly the definition of currency derivatives and physically settled commodity forwards, for purposes of determining which derivative contracts are subject to regulation under the European Market Infrastructure Regulation (EMIR). In response to part of ESMA’s request, on April 10, 2014, the EC published a consultation paper on foreign exchange (FX) financial instruments (the Consultation Paper).1 Market participants that engage in FX transactions, and are subject to EMIR or indirectly impacted by EMIR (as a result of their derivatives contracts with counterparties in the European Union (EU)), should review the Consultation Paper and consider whether or not to provide comments to the EC. The EC has requested public comments on the Consultation Paper by May 9, 2014.
Background
EMIR aims to reduce risk and increase transparency in the over-the-counter (OTC) derivatives market by imposing obligations on market participants that execute derivatives transactions (similar to Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act)).2 EMIR applies to a broad range of OTC derivatives contracts as defined in the Markets in Financial Instruments Directive (MiFID), including “options, futures, swaps, forward rate agreements and any other derivative contracts relating to securities, currencies, interest rates or yields, or other derivatives instruments, financial indices or financial measures which may be settled physically or in cash.”3 According to ESMA, European Member States have implemented different versions of the MiFID definition of derivative contract, thus leading to a lack of harmonization in the application of EMIR.
To address this issue with respect to FX financial instruments, the EC published the Consultation Paper for public comment to provide guidance and request public input on what types of FX instruments qualify as derivatives contracts subject to EMIR and other European financial regulations. Until the EC provides clarification on this point, ESMA has indicated that the relevant portions of EMIR will not be implemented for certain contracts that are not clearly identified across the EU as “derivatives,” including certain FX forwards.
The Consultation Paper
Generally, the Consultation Paper provides an overview of the FX market and the lack of harmonization in the treatment of FX instruments, including FX spot contracts and FX forwards, for which there is no single adopted definition throughout the EU. The EC has requested public comment on the following 10 points:
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Whether clarification of the definition of an FX spot contract is necessary.
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What are the main uses for, and users of, the FX spot market? How does use affect considerations of whether a contract should be considered a financial instrument?
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What settlement period should be used to delineate between FX spot contracts? Is it better to use one single cut-off period or apply different periods for different currencies? If so, what should those settlement periods be and for which currencies?
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Do you agree that non-deliverable forwards should be considered financial instruments regardless of their settlement period?
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What have been the main developments in the FX market since the implementation of MiFID?
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What other risks do FX instruments pose and how should this help determine the boundary of an FX spot contract?
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Do you think a transition period is necessary for the implementation of harmonized standards?
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What is the approach to this issue in other jurisdictions outside the EU? Where there are divergent approaches, what problems do these create?
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Are there additional implications to those set out in the Consultation Paper of the delineation of an FX spot contract for these and other applicable legislation?
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Are there any additional issues that should be considered in relation to the definition of FX instruments as financial instruments?
1Prior to issuing the Consultation Paper, the EC issued a letter to ESMA on February 26, 2014 (available here) in which the EC agrees with ESMA’s point that there should be a consistent transposition throughout the European Union of the definition of “derivative” or “derivative contract.” The EC also informed ESMA that the issue with respect to the definition of physically settled commodity forwards was discussed during negotiations of the Markets in Financial Instruments Directive II, and the EC will issue a mandate, before summer 2014, requesting advice from ESMA on this matter.
2EMIR regulations could more vigorously regulate a broader range of FX instruments than U.S. regulations under the Dodd-Frank Act. Specifically, many regulations implemented under the Dodd-Frank Act, such as central clearing, electronic trade execution, and margin requirements for uncleared trades do not apply to FX swaps and FX forwards, which could be subject to the full panoply of EMIR derivatives regulations if not similarly exempted. For more information on the regulation of FX instruments under the Dodd-Frank Act, please see Sutherland’s November 19, 2012 Legal Alert.
3See Article 2(5) of EMIR, which defines “derivative” or “derivative contract” according to Annex 1 Section C(4)-(10) of MiFID.
