MiFID 2 Anatomy™
/fɪˈnanʃ(ə)l ˈɪnstrʊm(ə)nt/ (n.)
Colloquially, a contract creating financial liabilities between two parties. It can, but need not, be negotiable, but its main feature — its sine qua non — is that it cannot be created, maintained, managed, looked after, transferred, monetised or redeemed — it cannot move or breathe, in other words — except through the agency of someone who will deduct a fee from the proceeds of your investment for the privilege.
“Derivatives”, “transferable securities”, “securitised derivatives”, “structured finance products”...
Step this way for a one-way trip down an open manhole. The definitions aren’t “disjunctive”: something that is a transferable security can also be a money market instrument, a unit in collective investment scheme. Alas, a “derivative”, in MiFID speak, is restricted to those countenanced in sections 4-10, but that may not be the end of the matter:
‘derivative’ or ‘derivative contract’ means a financial instrument as set out in points (4) to (10) of Section C of Annex I to 2004/39/EC (EUR Lex) as implemented by Article 38 and 39 of 1287/2006 (EUR Lex);
Details fiends will note a rather winsome circularity here, for each of the limbs (other than “financial contracts for differences”) employs the expression “derivative contract”, being the very one it purports to describe.
a derivative contract the execution of which does not take place on a regulated market as within the meaning of Article 4(1)(14) of MiFID or on a third-country market considered as equivalent to a regulated market in accordance with Article 19(6) of MiFID
The implication here is that those taking place on a trading venue (such as an OTF or MTF) which is not a regulated market nonetheless count as OTC derivatives. But in any weather, this leaves the question of asset-backed securities unaddressed. Could something that at first glance falls outside the scope of paras 4-10, but on closer inspection may also falls within it — say, a transferable security with an embedded derivative, like a credit-linked note or even a plain old repackaging, for example — count as a “derivative contract”? European Commission draftspersons are sometimes cavalier with words you wish they’d been more careful about, and this is such a time. Unintended consequences hover over either interpretation.
You may be minded, as the JC was, once, to wonder whether a these may qualify as a “securitised derivative”, a “structured finance product” or a “commodity derivative” — all legislative terms in the MiFID/MiFIR/EMIR memeplex. Proceed only if you are unusually tolerant to tension headaches, or have a lot of time to kill on a wet afternoon. For as best we can make out:
‘commodity derivatives’ means those financial instruments defined in point (44)(c) of Article 4(1) of MiFID; which relate to a commodity or an underlying referred to in Section C(10) of Annex I to MiFID; or in points (5), (6), (7) and (10) of Section C of Annex I thereto;
Which means securities, such as certificates, do qualify as commodity derivatives if they relate to a commodity, but emissions (and non-commodity underliers) do not. We know this because even the BaFIN thinks this. Fair enough: non-commodities aren't commodities, but there appears to be no equivalent widening of non-commodity derivatives to include funded, asset-backed or securitised instruments.
“...except for wholesale energy products traded on an OTF that must be physically settled”
This curious exception to the physically-settled commodity derivatives class in point (6) is known elsewhere as the “REMIT carve-out”, and is dealt with in some depth here by our friends at — an excellent site you must explore if you haven’t already. REMIT is Regulation No 1227/2011. Why “REMIT”? Regulation on wholesale Energy Markets Integrity and Transparency, of course.
In any case, but for that odd exception for wholesale gas and power traded on an OTF — which is a non-non-discretionary venue not qualifying as a regulated market or an MTF, so chapeau for the multi-dimensional negative there and note this is a very limited carve-out pertaining to wholesale participants in the gas and power industry — exchange-traded commodity futures and options are in scope for MiFID, even where physically settled. Which we think makes sense: it would be arbitrary indeed to exclude a class of exchange-traded derivatives just because of their settlement method, when most of the “regulatey” things about them — the risk, the market infrastructure, the consumer protection requirements, the capital and solvency issues for clearers and settlers — are exactly the same.
“...having the characteristics of other derivative financial instruments and not being for commercial purposes”
Limb (7) throws a curve ball. A cautious fellow might squeak a bit and say, but any physically settled commodity derivative has some of the characteristics of other financial derivatives, so where does this leave me? Well, the implementing regulation (EC) No 1287/2006 — which was further restricted in 2017 — has something to say about what this means:
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.
In practice this narrows things down a lot. Either it is (in a loose sense) exchange-traded, or standardised by reference to lot size, delivery date and so on. It feels like this is targeting standardised, fungible contract types; OTC trades are not meant to be included.
What isn’t a MiFID financial instrument
A good place to look (if your interest level counts as “fiendish”) is the snappily titled Commission Delegated Regulation 2017/565/EU (EUR Lex) of 25 April 2016 supplementing Directive 2014/65/EU (EUR Lex) 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.
Why aren’t debt securities traded on exchange?
Unlike shares which can trade on exchange, in organised trading facilities or over-the-counter, debt securities (bonds, notes, MTNs, certificates of deposit and so on) tend to trade only over-the-counter. They are not traded on exchange, and (while in bearer form) tend not to be traded in the secondary market nearly as often.
A given issuer tends to issue only one type of share (okay, maybe two - ordinary shares and preference shares). All of its ordinary shares are the same and are interchangeable (technically, they’re “fungible” with each other), meaning the same security is common across all venues in the market. That’s what gets listed, and it is (relatively) liquid.
By contrast, debt securitiess come in all kinds of shares and sizes. The same issuer might issue hundreds of different series with different economic characteristics, maturities and yields and features. Bonds of one series are not fungible with bonds of other series. Hence a given bond is generally far less liquid than an ordinary share of the same issuer. This, there are more issuers, and issues of bonds with different characteristics, which makes it difficult for bonds to be traded on exchanges. Another reason why bonds are traded over the counter is the difficulty in listing current prices.
- That’s MiFID and not MiFID II to its friends — even though MiFID II has updated somewhat the Section C of Annex I to include emissions certificates.
- “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;”
- See the BaFIN on position limits.
- An earlier requirement for a margin requirement was removed by Article 7 of Commission Delegated Regulation (EU) 2017/565