How are SLDs characterized under US, EU and UK regulations? ISDA looks at the regulatory frameworks
ISDA’s recent white paper, Regulatory Considerations for Sustainability Linked Derivatives, looks at the regulatory frameworks established for derivatives in the European Union, United Kingdom and the United States as such regulations apply to sustainability linked derivatives (SLDs).
Among the key questions the paper considers is whether SLDs could be classified as swaps under US regulations and/or over-the-counter (OTC) derivatives under EU and/or UK regulations and, if so, which exemptions or exclusions may apply.
In this DLA Piper Commodities Alert, we discuss ISDA’s US, EU and UK regulatory considerations for SLDs as swaps or OTC derivatives.
ISDA’s white paper creates two categories of SLDS:
- Category 1 SLDs: In Category 1 SLDs, the Key Performance Indicators (KPIs) and related impacts on cashflows are embedded within the derivative transaction.
- Category 2 SLDs: In Category 2 SLDs, the KPIs and cashflows related to them are in separate agreements that reference the underlying derivative transaction for setting the reference amount to calculate the KIP-linked cashflows.
The threshold question
To determine the regulatory regime applicable to an SLD, market participants must ask themselves the following threshold question, depending upon the jurisdiction:
- US jurisdiction: Is the SLD (either Category 1 or Category 2)a swap or a security-based swap?
- EU/UK jurisdiction: Is the SLD (either Category 1 or Category 2) an over-the-counter derivative?
Category 1 SLDs: US regulatory analysis
Because Category 1 SLDs include a derivative transaction that is probably categorized as a swap under US regulation, the inclusion of KPI-linked cashflows is unlikely to change this categorization. Therefore, Category 1 SLDs will most likely be subject to US derivatives regulations as a swap.
US derivatives regulation provides exemptions from clearing, on-platform trade execution and margin requirements for swaps involving certain non-financial market participants that are using the swaps to hedge or mitigate financial risk. To qualify for this exemption, Category 1 SLDs must make clear that the addition of the KPI-linked payment terms are linked solely to the sustainability of the non-financial entity’s operations and not for speculative, investment or other trading purposes.
Category 2 SLDs: US regulatory analysis
The question as to whether Category 2 SLDs are categorized as swaps under US regulation is more complicated. In general, the US regulatory framework for swaps includes, among other things, an agreement, contract or transaction that:
- Is an option for the purchase or sale of, or based on the value of, a commodity (broadly defined)
- Provides for any purchase, sale, payment or delivery dependent on the occurrence (or otherwise) of an event or contingency associated with potential financial, economic or commercial consequences or
- Provides for the exchange of payment(s) based on the value or level of one or more commodities (broadly defined), while simultaneously providing for a transfer of the financial risk associated with a future change in the value or level (but not any ownership in or liabilities associated with the underling corresponding asset).
To answer the threshold question with regard to Category 2 SLDs in the US, the market participant needs to assess the facts of the Category 2 SLD transaction in relation to each of the prongs listed above.
ISDA provides assistance with such analysis in its white paper by determining that Category 2 SLDs most likely are not options because no party to the Category 2 SLD is paying a premium for the right, but not the obligation, to buy or sell an asset.
For the second prong, ISDA directs the market participant to analyze whether the KPI payment is associated with a potential financial, economic or commercial consequence. For various reasons, ISDA believes that currently such KPI payments under Category 2 SLDs are not linked to potential financial, economic or commercial consequences. One such reason is that ISDA believes that the KPI payment is only payable to a party that meets a sustainability target, not a hedging, speculative or investment target, and in some cases such payment is made to charity, rather than to the other party.
For the third prong, ISDA provides that although the Category 2 SLD could been seen as an exchange of payment, such payment is not based on a transfer of financial risk. ISDA summarizes that the payment is unlikely to be characterized as hedging or insurance against the failure to meet a KPI target because the payment is based on the parties’ meeting certain sustainability goals. In other words, payment is intended to motivate the parties to reach their sustainability goals and is not meant to transfer financial risk. On this analysis alone, one may conclude that ISDA finds Category 2 SLDs not to be swaps as defined under US regulations.
However, ISDA does not stop at the above analysis. It further considers whether Category 2 SLDs may be considered contracts for difference (CFDs) and therefore may fall within the definition of a swap or security-based swap under US regulation.
A CFD is generally an agreement to exchange the difference in value of an underlying asset between the time at which a CFD position is established and the time it is terminated. Therefore, ISDA guides market participant to assess the structure of the Category 2 SLD to determine whether the KPI-linked payments go in one direction or two. If the payments are in two directions, then the Category 2 SLD may be considered a swap or security-based swap under US regulation.
The commercial agreement exemption
US regulations provide a list of certain commercial transactions that should not be considered swaps, although technically they fall within the swap definition. The list is not exhaustive, but was designed to help with similar, subsequently developed transactions. Although SLDs are not included on this list, this list can be used to analyze Category 2 SLDs for the threshold question.
The Commodity Futures Trading Commission (CFTC) and the Securities Exchange Commission (SEC) have indicated that to qualify for the commercial agreement exemption, the agreement or transaction should:
- Not contain severable payment obligations
- Not be traded OTC or on an organized market
- Be entered into by commercial or non-profit entities to serve an independent commercial, business or non-profit purpose and/or
- Not be entered into for speculative, hedging or investment purposes.
Applying this list to Category 2 SLDs, ISDA summarizes as follows. Most Category 2 SLDs (a) do not contain payment terms that are severable from the KPI-linked agreement; (b) are negotiated individually to meet specific business requirements and are not traded on an organized market or OTC; and (c) are not entered into for speculative, hedging or investment purposes because KPIs do not have a market price or an impact on share price. Because of all of this, ISDA finds, Category 2 SLDs are most likely subject to the Commercial Agreement Exemption.
ISDA does, however, advise market participants that this analysis must be conducted based upon the actual facts of the Category 2 SLD transaction.
Category 1 SLDs: EU and UK analysis
Because Category 1 SLDs include a derivative transaction under EU and UK laws, the inclusion of KPI-linked cashflows is unlikely to change this categorization. Therefore, the Category 1 SLDs will most likely be categorized as a derivative transaction under EU and/or UK laws.
The nature and extent of the amendments to the derivative transaction from the KPIs may give rise to questions as to which category of derivative transaction (and, by extension, financial instrument) the transactions may fall into, as well as the related regulatory and compliance obligations that may apply.
Category 2 SLDs: EU analysis
Under EU law, a derivative is a subset of a financial instrument listed in the Markets in Financial Instruments Directive (MIFED II). MIFED II determines when market participants dealing in derivatives are to be regulated. In general, MIFED II defines the following as derivatives:
- Options, futures, swaps, forwards and other derivatives contracts where the underlying is a financial instrument, currency, rate, emission allowance or other derivative or index, whether physically settled or cash settled
- Options, futures, swaps, forwards and other derivatives contracts where the underlying is a commodity if settled in cash or where it is physically settled in specific enumerated circumstances
- Credit derivatives
- Financial CFDs
- Other cash-settled derivative contracts relating to climate variables, among other things.
ISDA summarizes that because Category 2 SLDS have payouts that do not directly relate to financial instruments, currencies, rates, emission allowances (assuming not a carbon derivative), other derivatives, indices or commodities or involve a transfer of credit risk or financial CFD, they most likely do not fall within the majority of financial instruments under EU law.
However, MIFED II has a broad catch-all providing that brings in any other derivatives that relate to assets, rights, obligations, indices and measures not otherwise mentioned that have characteristics of financial instruments. Given this catch-all provision, ISDA concludes that it is possible for Category 2 SLDs to fall within MIFED II’s definition of derivative and to be regulated as such.
Additional EU rules provide more detail on the types of instruments that are covered by the catch-all, including:
- Derivative contracts that are settled in cash and
- Such contracts related to allowances, credits, permits, rights or similar assets directly linked to the supply, distribution or consumption of energy derived from renewable resources, a geological, environmental or other physical variable, any asset or right of fungible nature (other than the right to receive a service) that is capable of being transferred, and an index or measure related to price, value or volume of transactions in any asset, right, service or obligation.
ISDA suggests that market participant analyze the facts of the KPI in the Category 2 SLD to determine whether it fits into any of the instruments covered by the catch-all. However, given the broad nature of this catch-all, ISDA advises that it should be expected that some of the Category 2 SLDs will fall within the definition of a derivative under EU law.
Category 2 SLDs: UK analysis
In general, a derivative under EU law will also be a derivative under UK law. The UK law also includes additional definitions of specific types of derivatives, including options, futures, and CFDs.
ISDA summarizes that a Category 2 SLD is most likely not an option or a future under UK law. ISDA does, however, provide that a Category 2 SLD may be considered a CFD under UK law.
The UK CFD definition is the mostly the same as the EU definition. However, there is a difference in that the UK has one category of CFD that is wider in scope. The wider-scoped CFD is a contract the purpose or supposed purpose of which is to secure a profit or avoid a loss in relation to fluctuations in value or price of property of any description, or an index or other factor designated for that purpose in the applicable contract. UK regulatory guidance provides that the “other factors” language is a catch-all provision meant to include a wide range of elements, among them measures that typically constitute a KPI in a Category 2 SLD.
ISDA advises market participants to analyze the actual facts of the Category 2 SLD to determine whether it would fall within this catch-all provision in the CFD definition.
Hedging-related issues in the non-financial counterparty threshold: EU and UK analysis
To determine which obligations under the European Market Infrastructure Regulation (EMIR) and UK EMIR apply to counterparties entering into derivatives under EU and UK law, the market participant needs to analyze the classification of such counterparties by reference to thresholds. These thresholds are called clearing thresholds. Clearing thresholds measure the gross notional value of OTC derivatives contracts entered into by that counterparty and applicable members of its group over a relevant time period.
To calculate the clearing thresholds, non-financial entities are permitted to exclude contracts that qualify as hedging contracts from their calculations. To be a hedging contract, the OTC derivative must reduce risk directly related to the commercial or treasury financing activities of either the non-financial counterparty or the other non-financial counterparties within its entity group.
When non-financial entities fall below the clearing threshold, it is not required to clear or margin its OTC derivatives, although it will be subject to confirmation, portfolio reconciliation, portfolio compression and dispute resolution obligations.
For Category 1 SLDs where the original instrument was used for hedging purposes, market participants should determine whether the instrument continues to satisfy the hedging criteria written above with the inclusion of the KPIs. For Category 2 SLDs, ISDA reiterates that because these types of SLDs are usually not entered into for hedging purposes but to meet sustainability goals, that these types of SLDs would unlikely satisfy the criteria as a hedging contract for the purposes of a non-financial counterparty’s clearing threshold calculation.
For any questions related to the ISDA white paper or the categorization and regulation of SLDs in the US, EU or UK, please contact DLAPiperCommodities@dlapiper.com or any of the authors of this Commodities Alert. You may find the complete ISDA white paper here.