HSBC and FESE consult with pan-European regulator on physical settlement

The European Securities and Markets Authority (ESMA) has today published a series of responses to its consultation paper which was issued late last year asking for industry input relating to detail with regard to MIFID II ruling on regulated markets, exchanges and trading systems.

One such respondant was the Federation of European Securities Exchanges (FESE) which agrees with the assessment by ESMA that “forwards” are indeed to be subsumed by “any other derivatives” as far as categoric placement is concerned.

In general, FESE detailed that the differentiation between contracts that “can” be physically settled” and those that “must” be physically settled seems an obvious distinction; while the latter only constitutes a subset of the first (“must” < “can”). However, it is important to note in this context that almost all contracts in gas and power trading can be considered as “can be physically settled”. Yet, the overall market share of contracts that “must” indeed be physically settled is significantly smaller as it is directly linked to the ultimate production and consumption of commodities.

FESE also asks ESMA for clarification on those instruments that have a number of legs before being ultimately “physically settled”. In particular, we ask for clarification of how these guidelines will treat those instruments that settle into a future first, before being ultimately “physically settled”.

ESMA, according to FESE, must consider the sudden appearance of “non-MTF” (multilateral trading facility) platforms in relation to the entry into force of EMIR. These non-MiFID regulated trading venues have been explicitly created to avoid being caught under C6. Given that certain NCAs have confirmed them not to be MTFs and hence to remain outside the scope of financial regulation, the current C6 MiFID financial instrument definition does not apply to the products traded on them.

Hence, all contracts concluded on “non-MTFs” do not constitute either Exchange Traded Derivatives (ETDs) or OTC traded derivatives in relation to EMIR. These “non-MTFs” justify their creation on the basis that the must act with discretion. However, it is very difficult to draw the line between discretionary and non-discretionary practices. The electronic trading technology behind the trading screens works de facto very similarly in both cases and execution happens without any real intervention for almost all trades. In reaction to the introduction of EMIR, there has been a very significant shift of liquidity away from “traditional MTFs” to “non-MTFs”.

An example if these impact of these “non-MTF” platforms is that fact that currently almost no OTC derivatives are concluded in the energy markets. Most of the contracts are either ETDs concluded at exchanges or non-financial instruments traded on “non-MTFs”. Against this background, it is important to note that MiFID II is very likely to widen this shift and to diminish the share of financial instruments in energy trading even further.

Given that from 2017 onwards gas and power derivatives that are traded on an OTF and “that must be physically settled” do not fall under C6. This will result in more trading moving outside the reach of financial regulation, should the related delegated act on the definition of physical settlement be too large.

As far as trade organizations are concerned, FESE represents the industry as a whole, therefore it is interesting to note the findings of large institutions whose business involves handling large proportion of order flow. HSBC is a prime example, and the global bank disagrees with the statement made by ESMA in that MiFID II will include reference to certain contracts which “must” be physically settled (such contracts being out of scope).

Force majeure provisions and other default provisions are included in contracts in order to define how parties will respond to default and force majeure situations; they are not provisions about settlement and do not “prevent” physical delivery or provide for voluntary cash settlement at the option of a party.

The proposed guidelines are stated to be produced in order to clarify the scope of EMIR obligations. EMIR has a substantial overlap with the obligations under Title VII of the Dodd Frank Act and many EU firms are obliged to comply with both.

HSBC’s response continues to explain that divergence in the application of similar rules to the same contract may lead to increasing fragmentation in markets for transactions which are heavily relied on by European industries and businesses; such fragmentation will also create a competitive imbalance between the EU and US.

As stated in the ISDA and FIA Europe response, the US explicitly excludes physical forwards where the critical factor is “the intent to make or take delivery”. We therefore suggest that ESMA consider the intention of the parties, in accordance with the CESR feedback statement of April 2005 (CESR/05-291b) which stated that “it is necessary to consider the purpose for which the particular contract is entered into by the parties in addition to its other characteristics”.

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