Clarifying a derivative in Europe – the legal perspective

In the wake of the trade reporting mandate going live last week, ESMA (the European Securities and Markets Authority) made a request to the European Council seeking clarification, as a matter of urgency, as to the definition of what does, and what does not, constitute a derivative or derivative contracts. Varying definitions have emerged across Europe, which has resulted in turbulence in the commencement of the trade reporting mandate in Europe.

You can see our news story from earlier this week here:

A single definition must be sought. We spoke to Richard Frase, a partner at financial law firm Dechert, for the legal perspective on the varying definitions that exist. Richard advises on all aspects of financial services law for Dechert and has extensive experience covering both wholesale and retail markets and including regulation and compliance, derivatives and trading documentations.


Thomas Murray Data Services: How have the varying definitions crept in, and why is this is such an issue?

Richard Frase: “It is a big issue, particularly in the foreign exchange area, because there are a lot of asset managers that do not do derivatives but do put on foreign exchange hedges for their securities and other positions. These transactions, traditionally, have been considered as forward contracts or commercial purpose contracts, which were not entered into for purposes of investment, only to hedge currency exposure. That is indeed the way that they are treated under MiFID. There is also an equivalent exemption under the CFTC’s implementation of the Dodd-Frank Act in the US.

“The way EMIR has been implemented, however, although it is based on MiFID, has produced a definition of a derivative that does not really address the commercial purpose or forward position, and does not address what the difference is between a forward, a future and a spot in any detail.

“There is a huge difference for a lot of people between what happens if just ordinary derivatives are caught and what happens if it extends to this type of foreign exchange contract. For a manger dealing in lots of derivatives, it is not that much of an issue. It is just a case of a bit more reporting. For managers that do not really do derivatives, it can be the difference between no reporting at all and suddenly finding that you have got hundreds of transactions to report. So, from this perspective, it is very important.

“Because of the way EMIR works, you identify whether a trade is spot or forward or future, not by reference to who the manager is, but by reference to who the client is. A lot of these clients are scattered around Europe. So, if you have a client in Luxembourg, you have to find out what the CSFF thinks, if you have a German client you have to find out what BaFin thinks and so on and so forth, round Europe. This could leave you with multiple interpretations.

“That is where we are now. Although the FCA had looked at this issue in some detail and submitted guidance that reflects the traditional position in the UK, the other European regulators have not looked at it in that way. A lot of them really have not produced any guidance at all.”


From your perspective, what has Dechert been advising its clients?

“I think that, like a number of EMIR situations, we have had to advise clients that there is no clear answer. At some stage, they will have to take a view as to what level of risk they think is involved and how cautious they want to be. The latest statement from ESMA suggested that the requirement would be put on ice while a common European view was formulated.”


Do you have a view on who is right with this, as regards what does and does not constitute a derivative – the FCA or the other NCAs?

“I think that if you look at what the function of all this is, it ought to be to report derivatives – so if you have a spot underlying which settles inside three days, then you are going to take out the FX hedge for three days in order to hedge it properly. It would be invidious to start treating that as a future or a reportable derivative because it runs for one day longer than the two day model that has been cited as the norm. There are also some foreign currencies that do not have a two day settlement period, so I think that two days is too rigid.

“There needs to be a flexibility within sensible boundaries. Given the purpose of these transactions, and given that they are not open investment positions, I think that some recognition of that ought to be in the system.”


How have the NCAs been coping with the implementation of trade reporting?

“Our focus is on the UK, as well as keeping an eye on developments in one or two other countries. I think that everyone is doing their best and there are so many uncertainties that some regulators have said, unofficially, that they do not expect people to get everything right on day one, but they must try. Others have remained silent.”


Are there any other potential banana skins in the regulation?

“Probably – they always seem to emerge right at the last minute, though! The FX issue had been on the radar for some time and it is slightly odd that it has come to a head now. Because EMIR is so detailed I think that everyone is worried that if they do not get the right answer they will be in trouble. They trouble is, there is no right answer.”


Why was the derivative issue not addressed sooner? Why did they wait until the reporting mandate had gone live to address this?

“Last summer there was a suggestion to the Commission that they should do something similar to the US FX forward treatment, but this was not taken up. That left us with the question as to what is an FX contract within the scope of the regime, and I do not think that it was until fairly recently that people realised that there were a number of different interpretations as to what amounted to a spot transaction. I think that’s the biggest thing – the question of whether it is a forward or being used for commercial purposes is ancillary to that.”


Are you encouraging your clients that are reporting, to continue reporting their FX forwards where applicable?

“I think that if a firm has the infrastructure and the facilities to do it, then it is easier to continue to report than to stop. It is certainly safer. For businesses for whom this is a completely new obligation and would not otherwise be reporting, this is a much more refined decision.

“Given that the obligation to report is on the client, a fund manager should also consider the client’s view on this.”

Tags: RegulationTrade ReportingderivativesDechert