31 Jul 2015 Proposed New Rules on FX Financial Instruments under MiFID II
MiFID FX spot contracts relating currencies
Much discussion has arisen on whether or not FX spot contracts relating to currencies are to be considered as financial instruments as defined under the Mark ets in Financial Instrument Directive1 (the “MiFID”). This lack of a clear and harmonized definition as to which instruments should be considered as FX financial instruments has led to mark et uncertainty with regard to regulatory requirements, particularly with respect to proper adherence with the reporting requirements imposed under the European Mark et Infrastructure Regulation (the “EM IR”)2.
The foreign exchange (FX) market is one of the largest financial markets in the world. It is the market in which participants are able to buy, sell, exchange and speculate on currencies. Transactions in FX are performed to fulfil a number of functions including for hedging forei gn currency risk for financial assets or commercial contracts or investment or speculation in forei gn currency. Different financial instruments are used to execute FX transactions including but not limited to swaps, options, forwards and spots.
The regulation of FX financial instruments and markets has been flagged as raising regulatory uncertainties at an EU level. This article is to provide an update on the key issues that have come to light.
MiFID I establishes the general framework regulating financial markets in the European Union. However, the financial crisis has exposed weaknesses in the functioning and in the transparency of financial markets, thus, the discovered need to strengthen the framework for the regulation of markets in financial instruments, particularly the need to increase transparency , better protection to investors, reinforc e confidence, address unregulated areas, and ensure that supervisors are granted adequat e powers to fulfil their tasks 3.
The financial crisis also led the leaders of the Group of Twenty (G20) nations to highlight the necessity of introducing a series of measures to improve counterparty risk management and increase the transparency of the over-the-count er (“OTC”) derivatives market. This resulted in the adoption of EMIR in 2012, which was specifically designed to reduce the counterpart risk of OTCs and increase transparency within the markets, through reporting obligations.
Point (4) of Section C of Annex I to MiFID defines financial instruments as “Options, futures, swaps , forward rate agreements and any other derivati ve 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”4. In the Commission Q&A on MiFID5 it was stipulated that spot FX contracts are not considered to be financial instruments for the purposes of MiFID6
The lack of harmonization in respect of the financial instruments definition particularly in respect of spot FX contracts has been raised by the European Securities and Markets Authority (“ESMA”) as potentially leading to an inconsistent application of MiFID, EMIR7 and potentially other EU legislation that rely on the MiFID definition of financial instruments.
The issue that arose with the different legislations in force is that of determining when an FX contract is a currency payment or FX spot contract on the one hand, or an FX forward contract on the other. The main distinction being the fine line in settlement delivery date in respect of an FX spot and an FX derivative.
ESMA argued that “Differences in the definitions of what constitutes a derivative or derivati ve contract will result in the inconsistent application of EMIR, whose primary objective is regulati ng derivatives transactions”8 and urged “that for ensuring a consistent application of EMIR it is essential that the references to the MiFID definitions in the context of EMIR are clarified”9.
An analysis carried out by ESMA found that it is not controversial that contracts that settle within two (2) trading days are considered spot contracts and that contracts that settle after seven (7) trading days are FX forwards. However, some member states consider that contracts that settle up to seven (7) days are not to be deemed to be derivative contracts. For contracts which have a settlement date between three (3) and seven (7) trading days, there are different definitions adopted by the different Member States to determine whether or not such contracts are derivative contracts for the purposes of the definition provided by MiFID. 10
During the public consultation and also during certain European Securities Committee meetings, a broad consensus appeared to have been reached in relation to the definition of an FX spot contract 11, which included the following:
- a T+2 settlement period should be used to define FX spot contracts for European and other major currency pairs and the standard delivery period for all other currency pairs;
- to use the “standard delivery period” for all other currency pairs to define a FX spot contract;
- where contracts for the exchange of currencies are used for the sale of a transferable security, the accepted market settlement period of that security should be used to define an FX spot contract, subject to a five (5) day cap; and
- an FX contract that is used as a means of payment to facilitate payment for goods and services should also be considered to be an FX spot
Future Legislative Change – MiFID II
Omnibus I (Directive 2010/78/EU) introduced a sunset clause in Article 64a of MIFID I which provides that “the powers conferred on the Commission in Article 64 to adopt implementing measures that remain after the entry into force of the Lisbon Treaty on 1 December 2009 shall cease to apply on 1 December 2012“.
The clarifications on FX financial instruments as broadly agreed to will therefore be implemented through MiFID II.
MiFID II is to come into effect as from 3 January 2017.
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1 Directive 2004/39/EC on markets in f inancial instruments and amending Council Directives 85/611/EEC and 93/6/EEC and Directive 2000/12/EC
2 Regulation (EU) No 648/2012 on OTC derivatives, central counterparties and trade repositories
3 Directive 2014/65/EU on markets in f inancial instruments and amending Directive 2002/92/EC and Directive 2011/61/EU, provision 3
4 Section C of Annex 1 of Directive 2004/39/EC (MiFID).
6 “spot market f oreign exchange agreements are not considered to be f inancial instruments f or the purposes of MiFID”