Financial Instruments
‘Financial instrument’ is the generic term in EU law for a number of instruments for financial investments that can be traded on the capital markets. It is comparable to the definition of a ‘security’ in s 2(a) no 1 of the US Securities Exchange Act of 1933, as both definitions encompass a comprehensive list of financial products. Some differences, however, do exist, eg in regard of the coverage of commodity futures, due to the partially different structure of financial markets supervision in the EU and the United States. In the EU, the more general concept of ‘financial instruments’ increasingly permeates the various national laws of the EC Member States and increasingly shifts the focus away from the traditional approach and understanding of securities (which focused on aspects such as physical certificates, property rights and their function of legitimating the holder or acting as proof of a certain property right). For example, in France the ‘instruments financiers’ (Art L.211-1 Code monétaire et financier) have become the key legal concept, which also affects the valeurs mobilières (Art L.228-1 Code de commerce: Les valeurs mobilières sont des titres financiers au sens de l’article L. 211-1 du code monétaire et financier …).
According to Annex I, section C MiFID (Dir 2004/39) financial instruments include transferable securities, money-market instruments, units in collective investment undertakings (eg investment funds), options, futures, swaps, forward rate agreements and other derivative instruments with various underlyings as well as financial contracts for differences (see also Art 1(1) no 3 Dir 2003/6 or Art 6(2)(a) Dir 2002/ 65). This approach—although not that detailed—had already been used by the Investment Services Directive (Dir 93/22) (ISD, see its Annex, section B), the predecessor of MiFID.
1. Transferable securities
The first sub-category of ‘financial instruments’ covers ‘transferable securities’. While current EU capital markets regulation focuses mainly on ‘financial instruments’, the term and concept of ‘transferable securities’ still serves as an important link in several provisions of the MiFID. It is defined in Art 4(1) no 18 MiFID and is also relevant for other directives since many directives refer to it (eg Art 2(1)(a) of the Transparency Directive (Dir 2004/109)). In respect of older directives, which still refer to the ISD, such as Art 2(1)(a) of the Prospectus Directive (Dir 2003/ 71), the MiFID definition of transferable securities is applied via the dynamic reference in Art 69 s 2 MiFID. However, there are also directives that define securities differently; there is no consistent definition and concept of ‘securities’ within EU Law. For example, the Takeover Directive (Dir 2004/25) focuses on the importance of holding shares in a company and membership rights (‘transferable securities carrying voting rights in a company’, see Art 2(1)(e) of the Takeover Directive). On the other hand, the MiFID definitions of securities and financial instruments play a role even beyond immediate capital markets law, such as in relation to questions of private international law (see recital 30 of the Rome I Regulation (Reg 593/ 2008)).
According to Art 4(1) no 18 MiFID, ‘transferable securities’ means ‘those classes of securities which are negotiable on the capital market, with the exception of instruments of payment, such as: (a) shares in companies and other securities equivalent to shares in companies, partnerships or other entities, and depositary receipts in respect of shares; (b) bonds or other forms of securitised debt, including depositary receipts in respect of such securities; (c) 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’ (similarly Art 2(1)(n) UCITS-Directive (Dir 2009/65 recast of Dir 85/611)).
The regulatory concept of ‘transferable securities’ in EU law deviates from the traditional idea of a ‘security’ and takes a much broader approach. The relevant general criteria of securities according to MiFID are the standardization and the negotiability of these instruments. It is irrelevant, however, whether or not securities are represented by physical certificates, be they global or individual certificates (intermediated securities); securities fall under the provisions of MiFID even if they are registered electronically. This accounts for the advancing immobilization and dematerialization of securities in today’s financial markets (intermediated securities). The necessity of a standardized design follows from the criterion ‘classes’ of securities. Concerning negotiability, the MiFID fails to define whether it covers only instruments which are freely transferable or also instruments which are only transferable by written agreement or by consent of a third party. The broader approach that argues for the latter relies on Art 40(1)(2) MiFID. This provision states that transferable instruments should be ‘freely negotiable’ and thus seems to imply that the scope of Art 4(1) no 18 would be broader and would also include securities with only limited transferability. In order to outline the term ‘freely negotiable’, Art 35 of Reg 1287/2006 (the MiFID implementing regulation) reverts to the absence of restrictions on transfers (such as the necessity of a certification by a public notary according to § 15(3) German GmbHG) or the requirement of fully paid securities (eg § 176 German HGB for the payment of a limited partner (Kommanditist)).
A more limited approach regards the wording in Art 40(1)(2) MiFID as peculiar to that provision which establishes requirements for rules of regulated markets. More importance is attached to the phrasing ‘negotiable on the capital markets’ in Art 4(1) no 18 MiFID. It implies that ‘negotiability’ should be interpreted in regard of the capital markets and hence the trading practices. This would not, however, mean that, for example, registered shares with restricted transferability would be excluded from the scope of the definition. The requirement of the issuers’ consent to the transfer of the securities generally does not provide obstacles for fast-moving markets, as the conditions for withholding consent are limited and transparent. In other cases, however, such as where an intricate formal procedure is required to execute the transfer, the limited approach would not regard the respective instruments as being negotiable in the sense of Art 4(1) no 18 MiFID. Additionally, this approach attaches importance to whether the transaction can be executed unhindered and the purchaser can be certain of having become the rightful (beneficial) owner of the securities. Only then will investors have the confidence in the capital markets which is so important for the functioning of these institutions. Hence, as one aim of the capital market rules is to protect the functioning of the market, securities can only be regarded as ‘negotiable’ if the respective transaction process ensures the trust and confidence of investors. Thus, even though denied by a number of legal scholars, the protection of bona fide purchasers plays an important (at the very least psychological) role in respect of transactions on the capital markets.
Article 4(1) no 18 MiFID also lists various instruments which should be considered as securities (lit a–c). The first category (lit a) consists of equity instruments, such as shares and comparable securities—‘comparability’ in that respect means that these instruments must have membership rights attached to them. The second category (lit b) covers debt instruments, such as bonds and other debt instruments. The third category (lit c) comprises derivative securities such as warrants—independent of whether they are physically or cash settled; underlyings of these derivative instruments can be, for example, the securities listed earlier or other objects and measures (such as currencies (currency), interest rates (interest), commodities, etc).
The definition pursues a rather broad approach (‘and other securities’, ‘and other forms’, ‘any other’) to ensure a possibly gap-less regulation of securities. However, all the listed instruments have to be ‘negotiable’ in the sense stated above. Thus, for example, holdings in closed-end investment companies are not within the scope of the definition as they are often not standardized, hardly comparable with shares and therefore not suited to being traded on capital markets.
A further criterion for defining securities that has evolved in the international debate is the requirement that securities be capable of being credited to an account. The Hague ‘Convention on the Law Applicable to Certain Rights in Respect of Securities Held with an Intermediary’ of 5 July 2006 defines the term ‘securities’ in its Art 1(1)(a) as ‘any shares, bonds or other financial instruments or financial assets (other than cash), or any interest therein’. In the explanatory report the following requirement is added: ‘… [they] must in addition be of a kind capable of being credited to a securities account with an intermediary’ (Roy Goode, Hideki Kanda and Karl Kreuzer, Hague Securities Convention—Explanatory Report (2005) Art 1, note 1-1). A similar definition was published by UNIDROIT in the UNIDROIT Convention on Substantive Rules for Intermediated Securities of 9 October 2009 according to which ‘securities’ means ‘any shares, bonds or other financial instruments or financial assets (other than cash) which are capable of being credited to a securities account […]’ (Art 1 lit a of the UNIDROIT Convention). Due to the slow progress of the ratification of these Conventions, however, their impact on the European and international legal systems is still uncertain.
2. Money-market instruments
Money-market instruments are short-term debt instruments with a maturity of one year or less. The MiFID provides a list of examples to illustrate the term (Art 4(1) no 19 MiFID). It defines money-market instruments to be ‘those classes of instruments which are normally dealt with on the money market, such as treasury bills, certificates of deposit and commercial papers and excluding instruments of payment’. However, in some Member States, such as Germany, the scope of this definition is rather limited as most of the listed money-market instruments (eg certificates of deposit and commercial papers) are considered to be transferable securities. A slightly different approach regarding the definition was taken by the UCITS-Directive. According to its Art 2(1) lit o money-market instruments mean ‘instruments normally dealt in on the money market which are liquid and have a value which can be accurately determined at any time’.
3. Units in collective investment undertakings
According to the MiFID (Annex I, section C, no 3), units in collective investment undertakings are financial instruments (see also recital 7 of the UCITS Directive). The regulatory regime for collective investment undertakings is provided by the UCITS Directive. Undertakings for collective investments in transferable securities (UCITS) are undertakings that raise capital from the public and invest it in transferable securities or in other financial assets according to the principle of risk-spreading; the issued units are repurchased or redeemed at the request of holders out of those undertakings’ assets (Art 1(2) UCITS Directive). Collective investments undertakings of the closed-ended type or undertakings that do not promote their units to the public in the EU or according to their rules sell their units only to the public outside of the EU are not regulated by this directive (Art 3 UCITS Directive, see further eg recital 15 and Art 2(1)(h) MiFID). A definition of ‘units of a collective investment undertaking’ can be found in Art 2(1)(p) of the Prospectus Directive (Dir 2003/71). According to this provision these units are ‘securities issued by a collective investment undertaking as representing the rights of the participants in such an undertaking over its assets’. The definition in Art 2(1)(h) of the Transparency Directive (Dir 2004/109) is almost identical.
4. Futures
The MiFID uses the term ‘future’ but fails to provide a definition. The list in Annex I, section C nos 4–7 and 10 MiFID suggests that this and the other undefined terms should be understood as in finance, namely as derivative contracts (‘and any other derivative contracts’). A derivative is a contract between two or more parties where the value of the obligations depends upon or is derived from one or more underlying assets. As can already be seen in Annex I, section C MiFID, a wide range of assets can be used as underlyings, most commonly shares, bonds, commodities, currencies, interest rates, indexes or derivatives of any kind. Derivatives can be categorized by the contractual rights and duties of the parties (eg option, forward/future, swap), the type of underlying (eg stock, debt, currency) and the market in which they are traded (eg regulated market, over-the-counter).
Futures are, on a basic level, standardized unconditional agreements between a seller and a purchaser that oblige the seller to deliver and the buyer to accept and pay for a defined, standardized quantity of a certain asset (cash or commodity) at a certain date in the future at a price that has been agreed upon when the futures contract was stipulated. While the market price of the asset may change over time, the price the parties have agreed upon is fixed. Hence, futures can be used to hedge (reduce, eliminate) or manage risks, as they enable the parties to transfer the price risk of the underlying asset from one party to the other; however, futures can also be used for arbitrage and speculative purposes. The standardization of futures facilitates the trading of these instruments, as it allows counter-transactions with other parties in order to close opened sell or purchase positions at any time. On the other hand, non-standardized unconditional agreements, so-called forwards, allow the parties to work out the minutiae of their individual agreement according to their specific needs.
5. Options
Likewise, the term ‘option’ is used (eg Annex I, section C, nos 4–7 and 10 MiFID) but not defined in the MiFID. In finance, an option is a derivative (see 4. above) contract that gives the seller the right, but does not oblige him, to buy (call option) or sell (put option) a certain underlying asset within a certain period (American option) or at the end of that period (European option) for a price agreed at the time when the option was sold (the so-called strike price). The seller of the option receives a premium and in return is obliged to carry out the transaction if the buyer of the option exercises his right. If the buyer does not exercise the option within the stipulated period or at the determined date, the option expires. Since the buyer does not have to exercise an option, options are regarded as conditional contracts. Options are traded at regulated markets and over-the-counter (OTC). Options that are traded at regulated markets are standardized and thus can be traded more easily, while non-standardized options have the advantage of enabling the involved parties to develop their individual solutions.
6. Swaps
The term ‘swap’ is also used, but not defined in Annex I, section C, nos 4–7 MiFID. In finance, a swap is an agreement to exchange cash (flows) on one or more specified future date(s) according to the value of the underlying asset (eg interest rates, currencies). Swaps allow the involved parties to benefit from the advantages the other party has in another market. Most commonly used are interest rate swaps and currency swaps. In case of the interest rate swap, the parties agree to ‘exchange’ their obligations to pay interest (interest) for a certain amount of capital, eg paying fixed interest in exchange for variable interest. In case of a (basic) currency swap, the parties exchange equivalent amounts of capital (principal) in one currency for the same amount in another currency and exchange the principal amounts back at the end of the agreed period, usually at the same exchange rate. During the swap period recurring compensation is paid to account for different interest rate levels.
7. Forward rate agreements
A forward rate agreement is an over-the-counter contract in which the parties commit themselves to pay to the other party at a future date a compensation (in the amount of the difference) if at that date the reference interest rate is above (in case of the ‘FRA-buyer’) or below (in case of the ‘FRA-seller’) the contractually stipulated interest rate.
8. Derivative instruments for the transfer of credit risk
Derivative instruments for the transfer of credit risk allow a lender to pass the credit risk of a borrower (the so-called reference borrower) to a third party without making him a party of the lender-borrower relationship. Basic types of credit derivatives are, for example, credit default swaps, total return swaps and credit linked notes. In a credit default swap the seller promises to the buyer—in return for a premium—to pay compensation if a so-called credit event occurs. Credit events are, for example, the bankruptcy of the reference borrower, obligation default, failure to pay or restructuring of the borrower. In a total return swap the parties stipulate that the buyer will forward all (actual) earnings of a reference asset and its appreciations to the seller, while the seller pays fixed or variable interest and compensates the buyer for possible losses in value of the reference asset. This way the buyer does not only take over the credit risk of the borrower, but also assumes the price risk of the reference asset. A credit linked note is a security with an embedded credit default swap. The interest rate of the note and the principal will only be paid/paid back (completely) to the investor if a previously stipulated credit event with regard to the reference borrower or reference asset does not occur. As the issuer of the note receives the full principal in the beginning, it does not assume the credit risk of the note buyer.
9. Financial contracts for differences
A contract for difference (CFD) is an agreement between two parties that stipulates that the ‘seller’ of the CFD will pay to the ‘purchaser’ the amount of the difference between the value of an underlying asset at the time the CFD was bought and its value at the time when the CFD is sold. If the difference is negative, the buyer is obliged to pay the difference to the seller. The duration of a CFD is usually infinite. CFDs allow investors to participate in the performance of the underlying asset without actually purchasing the asset itself and thus reducing the principal that is bound by the investment.
Literature
Alastair Hudson, Credit Derivatives—Law, Regulation and Accounting Issuers (1999); Roy Goode, Hideki Kanda and Karl Kreuzer, Hague Securities Convention—Explanatory Report (2005); Alastair Hudson, The Law on Financial Derivatives (4th edn, 2006); John C Hull, Optionen, Futures und andere Derivate (6th edn, 2006); Charles J, Jr Johnson and Joseph McLaughlin, Corporate Finance and the Securities Laws (4th edn. 2006) Johanna Benjamin, Financial Law (2007); Eva Maria Micheler, Property in Securities (2007); Philip R Wood, Set-off and Netting, Derivatives, Clearing Systems (2nd edn, 2007); Eilis Ferran, Principles of Corporate Finance Law (2008); Niamh Moloney, EC Securities Regulation (2nd edn, 2008); Jean-Claude Zerey (ed), Außerbörsliche (OTC) Finanzderivate—Rechtshandbuch (2008); Clifford E Kirsch, Financial Product Fundamentals: Law—Business—Compliance (2010); Sunil Parameswaran, Fundamentals of Financial Instruments—An Introduction to Stocks, Options, Bonds and Derivatives (2011).
