The Legal Landscape of Financial Instruments pursuant to MiFID II

Josef Bergt

2023

Introduction

The EU Markets in Financial Instruments Directive II (MiFID II) plays a crucial role in defining financial instruments within the scope of banking and financial services. This article delves into the intricate legal definitions and implications of financial instruments as outlined in Annex I Section C MiFID II, exploring their evolution and relevance in contemporary financial markets.

Legal Definition of Financial Instruments

The first type of financial instruments are transferable securities. MiFID II defined transferable securities in its Art. 4 para. 1 no. 44: Transferable securities means those classes of securities which are negotiable on the capital market, with the exception of instruments of payment, such as: 

• shares in companies and other securities equivalent to shares in companies , partnerships or other entities, and depositary receipts in respect of shares;
• bonds or other forms of securitised debt, including depositary receipts in respect of such securities;
• any other securities giving the right to acquire or sell any such transferable securities or giving rise to a cash settlement determined by reference to transferable securities, currencies, interest rates or yields, commodities or other indices or measures.

Transferability (transferable securities)

According to Annex I Section C No. 1 of MiFID II, 'transferable securities' are listed as financial instruments. Therefore, shares, debt securities, or other rights that cannot be transferred through legal transactions among living persons (e.g., due to legal restrictions on transferability) are not considered financial instruments. However, free transferability is not a prerequisite; thus, securities that are not freely tradable but can be transferred with some difficulty (e.g., requiring the issuer's or a third party's consent) can still qualify as financial instruments.

Standardization (classes of securities)

The shares, debt securities, or other rights must also be standardized. Standardization is present when there is interchangeability in terms of fungibility. A low degree of standardization is sufficient: a series of interchangeable investment instruments with similar essential characteristics (e.g., obligor, term, nature, and extent of the membership right or promised performance) indicates standardization. In contrast, a bearer bond tailored to the investment wishes of an individual investor, such that it cannot be grouped with other instruments issued by the same issuer into a category is not standardized. 

Negotiable on the Capital Market

Transferability, even limited transferability, and standardization suggest the tradability of the instrument on capital markets. It suffices that an instrument of this type is generally suitable for organized trading.

Further financial instruments include:

• Money-market instruments;
• Units in collective investment undertakings
• Various options, futures, swaps, forwards and other derivative contracts
• Derivative instruments for the transfer of credit risk
• Financial contracts for differences;
• Emission allowances consisting of any units recognised for compliance with the requirements of Directive 2003/87/EC (Emissions Trading Scheme).

Evolution of the Definition

Originally based on the EU's Directive 93/22/EWG and MiFID I, the definition of financial instruments has expanded significantly. 

Shares and instruments with equity-like interest 

• Domestic Shares: Shares issued by domestic stock corporations fall under this definition. This includes bearer shares, registered shares, and preferred shares. The transferability of shares (restricted transferability) does not affect their classification but consequently it may be possible that they do not qualify as transferable securities and thus are not deemed financial instruments.
• Foreign Shares: The comparability of foreign shares with domestic shares is determined through a functional approach, focusing on investor protection. E.g., Shares from Swiss, Austrian, Dutch, Belgian, German and UK companies are considered comparable to Liechtenstein shares and vice versa.

European Company (Societas Europaea or SE) shares are also included under this category.

Depositary Receipts Representing Shares

Depositary receipts are also tradable securities representing ownership in foreign securities. They include inter alia American Depository Receipts (ADRs), European Depository Receipts (EDRs), Global Depository Receipts (GDRs), International Depository Receipts (IDRs), and Crest Depository Interests (CDIs).

Debt Securities and Instruments with debt-like interest

Debt Securities

• Bearer Bonds: These are standard debt instruments. They are typically issued as part of a series. Exceptions occur when they are tailored to individual investors, lacking the necessary standardization.
• Order Bonds: These bonds are payable to a named person or their order. They are considered debt securities.
• Payment Instruments: Instruments intended for payment purposes, such as cash, electronic money, or checks, do not fall under the definition of financial instruments.
• Depositary Receipts Representing Debt Securities: Similar to those representing shares, these receipts are considered financial instruments.

The acceptance of funds on the basis of issued debt securities like bonds per legal exemption may not classify as the operation of the deposit business .

Other Rights

• Options and Similar Instruments: Standardized options, including option certificates and instruments leading to cash payments based on various reference values, fall under this category. This includes instruments like share options, double currency bonds, and inflation-linked bonds.

Money Market Instruments

• Characteristics: These instruments are defined in Art. 11 of the Delegated Regulation (EU) 2017/565 and include treasury bills, commercial papers, and other similar instruments with a maturity of up to 397 days.
• Examples: Short-term promissory note loans, financing facilities, financial swaps, treasury bills, commercial papers, deposit certificates, Euronotes, repurchase agreements, and day-to-day funds designed for trading.

Emission Allowance

Emission allowances refer to permits or credits that allow the holder to emit a specific amount of greenhouse gases, typically measured in tons of carbon dioxide equivalent. These allowances are a key component of cap-and-trade systems, which are used as a tool for controlling pollution and incentivizing reductions in greenhouse gas emissions.

Under such systems, a cap is set on the total amount of certain greenhouse gases that can be emitted by factories, power plants, and other installations. Companies are allocated or can purchase a certain number of allowances, and if they emit less than their allowance, they can sell the surplus to other companies, or save it for future use.

In the context of MiFID II, these emission allowances are treated as financial instruments because they can be traded on the market, and their trading involves financial contracts. It needs to be differentiated between verified and voluntary reductions.

• Verified Reductions:
• Verified reductions are typically part of regulatory or compliance markets.
• They are mandated by government policies or international agreements, such as the Kyoto Protocol or the European Union Emissions Trading Scheme (EU ETS).
• Emission reductions are quantified, monitored, and verified by independent third parties according to strict standards and protocols.
• Companies or entities are often required to hold a certain number of emission allowances or credits that match their actual emissions. These can be traded in the compliance market.
• The primary goal is to ensure that emission reduction targets set by governments or international bodies are met.
• Voluntary Reductions:
• Voluntary reductions occur in markets where entities voluntarily choose to offset their emissions.
• These are not mandated by law but are undertaken by companies, organizations, or individuals aiming to reduce their carbon footprint or meet corporate social responsibility goals.
• The standards for verification in voluntary markets can vary, but many follow recognized protocols and are verified by third parties.
• Credits from voluntary reductions can be purchased by those who wish to offset their emissions beyond regulatory requirements.
• Voluntary markets often support innovative or community-based projects that might not qualify under stricter compliance market rules.

Voluntary carbon credits are typically not traded on regulated platforms and do not fall under the standard categories of financial instruments defined in MiFID II. They are part of a market where entities voluntarily offset their carbon emissions by purchasing credits from projects that reduce, avoid, or sequester emissions. These markets operate outside of the regulatory frameworks that MiFID II is designed to oversee.

Conclusion

Understanding the diverse range of financial instruments, is crucial for financial institutions, investors, and legal practitioners. This analysis provides an overview of these instruments, their legal classification, and their practical implications in the financial market.

Source: BaFin Factsheet on Information on financial instruments pursuant to section 1 (11) sentences 1 to 5 KWG (shares, investments, debt instruments, other rights, units in investment funds, money market instruments, foreign exchange, units of account, emission certificates, crypto assets and swarm financing instruments)

Executive Summary:

• Broad Definition of Financial Instruments: MiFID II defines a wide range of financial instruments, including equity instruments, debt instruments and derivatives (the latter two forming non-equity instruments).
• Adaptation to Market Changes: The legal definition of financial instruments has evolved to reflect changes in financial markets and technologies.
• Debt Securities: Bearer and order bonds are standard debt instruments, with specific exceptions for non-standardized instruments.
• Other Financial Instruments: Options, money market instruments, and emission certificates each have distinct characteristics and legal implications.
• Market Impact: These instruments play a significant role in the financial market, offering various investment and financing options.