PERG 13 Guidance on investment services and activities and investment firms

Q27. Where do we find a list of financial instruments?

There are eleven categories of financial instruments, which are listed in Part 1 of Schedule 2 to the Regulated Activities Order. This list essentially corresponds to the list in Section C of Annex 1 to MiFID, where they are lettered and numbered C1 to C11. 

Transferable securities

Q28. What are transferable securities?

Transferable securities refer to classes of securities negotiable on the capital markets but excluding instruments of payment. We consider that instruments are negotiable on the capital markets when they are capable of being traded on the capital markets.

Transferable securities include (to the extent they meet this test):

• • shares in companies (whether listed or unlisted, admitted to trading or otherwise), comparable interests in partnerships and other entities and equivalent securities;
• • bonds and other forms of securitised debt;
• • depositary receipts in respect of the instruments above;
• • securities giving the right to acquire or sell transferable securities (for example, warrants, options, futures and convertible bonds); and
• • securitised cash-settled derivatives, including certain futures, options, swaps and other contracts for differences relating to transferable securities, currencies, interest rates or yields, commodities or other indices or measures.

Examples of instruments which, in our view, do not amount to transferable securities include securities that are only capable of being sold to the issuer (as is the case with some industrial and provident society interests) and OTC derivatives concluded by a confirmation under an ISDA master agreement.
Transferable securities are set out in paragraph 1 of Part 1 of Schedule 2 to the Regulated Activities Order and defined in MiFIR. They correspond to the instruments set out in paragraph 1 of section C of Annex 1 to MiFID, which are defined in article 4.1(44) of that Directive.

Money market instruments

Q28A. What are money market instruments?

This means those classes of instruments which are normally dealt in on the money market. Examples include treasury bills, certificates of deposit, commercial paper and other instruments with substantively equivalent features. A money market instrument does not include an instrument of payment.

An instrument is only a money market instrument if it also meets the following conditions:

• • it has a value that can be determined at any time;
• • it does not fall into paragraphs 4 to 10 of Part 1 of Schedule 2 to the Regulated Activities Order (derivatives); and
• • it has a maturity at issuance of 397 days or less.
  Money market instruments are set out in paragraph 2 of Part 1 of Schedule 2 to the Regulated Activities Order and defined in paragraph 2 of Part 2 of Schedule 2 to the Regulated Activities Order. They correspond to the instruments set out in paragraph 2 of section C of Annex 1 to MiFID, which are defined in article 4.1(17) of that Directive and in article 11 of the EU MiFID Org Regulation.

Collective investment undertakings

Q29. What are units in collective investment undertakings?

This category of financial instrument includes units in regulated and unregulated collective investment schemes and units or shares in an AIF (whether or not the AIF is also a collective investment scheme). In our view, in accordance with article 1.2(a) and 2.1(o) of the Prospectus Directive, units or shares in an AIF include shares in closed-ended corporate schemes, such as shares in investment trust companies, and so are also units in collective investment undertakings for this purpose (as well as being. transferable securities). There is guidance on what an AIF is in chapter 16 of PERG (Scope of the Alternative Investment Fund Managers Directive).
Units in collective investment undertakings are set out in paragraph 3 of Part 1 of Schedule 2 to the Regulated Activities Order and correspond to the financial instrument in paragraph 3 of Section C of Annex 1 to MiFID.

Derivatives: general

Q30. Which types of derivative are financial instruments?

The following derivatives are financial instruments:

• • derivative instruments relating to securities, currencies, interest rates, emission allowances or certain other underlyings (see Q31A to Q31S);
• • commodity derivatives (see Q32 to Q33C);
• • derivative instruments for the transfer of credit risk (see Q31);
• • financial contracts for differences (these are included in paragraph 9 of Part 1 of Schedule 2 to the Regulated Activities Order and correspond to the financial instrument in paragraph 9 of Section C of Annex 1 to MiFID); and
• • derivatives on miscellaneous underlyings (see Q34).

The scope of these derivatives does not extend to sports spread bets.

Credit derivatives

Q31. What are derivative instruments for the transfer of credit risk? 

Derivative instruments that are designed for the purposes of transferring credit risk from one person to another. They include, for example, credit default products, synthetic collateralised debt obligations, total rate of return swaps, downgrade options and credit spread products.
This category of financial instrument is set out in paragraph 8 of Part 1 of Schedule 2 to the Regulated Activities Order and corresponds to the financial instrument in paragraph 8 of Section C of Annex 1 to MiFID.

General financial and emission derivatives: General

Q31A. Which types of financial derivative fall within this heading?

This category of financial instrument is set out in paragraph 4 of Part 1 of Schedule 2 to the Regulated Activities Order and corresponds to the financial instrument in paragraph 4 of Section C of Annex 1 to MiFID. It covers:

• • options;
• • futures;
• • swaps;
• • forward rate agreements; and
• • any other derivative contracts;

relating to:

• • securities;
• • currencies;
• • interest rates or yields;
• • emission allowances; or
• • other derivatives instruments, financial indices or financial measures.

A derivative contract is covered whether it is settled physically or in cash.

General financial and emission derivatives: Treatment of foreign exchange contracts

Q31B. Is every foreign exchange contract a financial derivative?

No. There are two exclusions:

• • There is an exclusion for spot contracts (see the answer to Q31C).
• • There is an exclusion for a foreign exchange transaction connected to a payment transaction (see the answer to Q31G).
  These exclusions are set out in paragraph 3 of Part 2 of Schedule 2 to the Regulated Activities Order. They correspond to the exclusion in article 10 of the EU MiFID Org Regulation.

Technically these exclusions relate to the “any other derivative contracts” type of derivative contract listed in the answer to Q31A. However, in the FCA’s view, no contract that has the benefit of one of these exclusions could be a future under any of the other categories listed in that answer either. 

Recital 13 to the EU MiFID Org Regulation says that these exclusions do not apply to an option or a swap on a currency, regardless of the duration of the swap or option and regardless of whether it is traded on a trading venue or not. The FCA believes that this statement also applies to the Regulated Activities Order exclusions discussed in this answer.

Q31C. What is the exclusion for foreign exchange spot contracts mentioned in Q31B?

A contract for the exchange of one currency against another currency is excluded if under its terms delivery is scheduled to be made within a specified number of trading days. The number of trading days depends on the type of contract. For these purposes, there are three types of contract.

The first type of contract is one for the exchange of one major currency against another major currency. The contract is exempt if under its terms delivery is scheduled to be made within two trading days.

The second type of contract is one for the exchange of a non-major currency against either another non-major currency or against a major currency. The contract is excluded if under its terms delivery is scheduled to be made within the longer of:

• • two trading days; and
• • the period generally accepted in the market for that currency pair as the standard delivery period.

The third type of contract is one used for the main purpose of the sale or purchase of a transferable security or a unit in a collective investment undertaking. The contract is excluded if under its terms delivery is scheduled to be made within whichever is the shorter of the following:

• • the period generally accepted in the market for the settlement of that security or unit as the standard delivery period; or
• • five trading days.

An example of this third category is as follows. Say that X buys a share in Country P for delivery in four days’ time (the standard settlement time in Country P for share purchases). X wishes to pay for the shares (and for associated taxes and costs) in local currency. The exclusion applies if X enters into the contract for the purchase of the local currency four or fewer days before the share settlement date.

If a foreign exchange contract falls into the third category (contract for the purpose of purchase of securities) it does not also fall into one of the other two categories.

If there is an understanding between the parties to the contract that delivery of the currency is to be postponed beyond the date specified in contract, it is the longer period that is used to calculate the delivery period.

Physical settlement does not require the use of paper money. It can include electronic settlement. 

Recital 13 to the EU MiFID Org Regulation says that this exclusion only applies if there is a direct and unconditional exchange of the currencies being bought and sold. The FCA believes that that statement broadly also applies to the Regulated Activities Order exclusion discussed in this answer. However, a contract may still benefit from the exclusion if the exchange of the currencies involves converting them through a third currency.

See the answer to Q31E for what major and non-major currency means and see the answer to Q31F for what a trading day means.

Q31D. How are contracts for multiple exchanges of currency treated under the exclusion for foreign exchange spot contracts mentioned in Q31C?

Recital 13 to the EU MiFID Org Regulation says that the exclusion can cover a single contract with multiple exchanges of currencies. In such a contract, each exchange of a currency should be treated separately for the purpose of the exclusion. The FCA believes that that statement also applies to the Regulated Activities Order exclusion discussed in this answer.

Q31E. What are the major currencies referred to in the answer to Q31C?

The major currencies for these purposes are the US dollar, euro, Japanese yen, Pound sterling, Australian dollar, Swiss franc, Canadian dollar, Hong Kong dollar, Swedish krona, New Zealand dollar, Singapore dollar, Norwegian krone, Mexican peso, Croatian kuna, Bulgarian lev, Czech koruna, Danish krone, Hungarian forint, Polish złoty and Romanian leu.

All other currencies are non-major currencies for these purposes.

Q31F. What does a trading day mean in the answer to Q31C?

A day is a trading day if it is a day of normal trading in the jurisdiction of both the currencies that are exchanged.

If either of the following conditions is met:

• • the exchange of the currencies involves converting them through a third currency for the purposes of liquidity; or
• • the standard delivery period for the exchange of the currencies references the jurisdiction of a third currency;

a day is a trading day if it is a day of normal trading in the jurisdiction of both the currencies that are exchanged and also in the jurisdiction of that third currency.

Q31G. What is the second exclusion for foreign exchange contracts mentioned in Q31B?

A contract is excluded if:

• • it is a means of payment (see the answer to Q31H for what this means);
• • it must be settled physically (although non-physical settlement is permissible by reason of a default or other termination event);
• • at least one of the parties is not a financial counterparty as defined in article 2(8) of EMIR;
• • it is entered into in order to facilitate payment for identifiable goods, services or direct investment; and
• • it is not traded on a trading venue.

The table in the answer to Q31M gives some examples of what is and is not covered by the exclusion.

Q31H. What do identifiable and means of payment as referred to in the answer to Q31G mean?

The most straightforward example (Example (X)) of what this means is a contract where one of the parties to the contract:

• • sells currency to the other party which that other party will use to pay for specific goods or services or to make a direct investment; or
• • buys currency from the other party which the first party will use to achieve certainty about the level of payments that it is going to receive:
  • o for specific goods or services that it is selling; or
  • o by way of a direct investment.

See Example (10) in Q31M (Can you give me some more examples of how the means of payment exclusion referred to in the answer to Q31G works?) for an example of the second type of foreign exchange contract in Example (X) (contract to achieve certainty about the level of payments).

The table in the answer to Q31M gives some more examples of what identifiable goods and services means.

The foreign exchange contract must be a means of payment. Therefore, the exclusion requires that not only should the currency contract facilitate payment for identifiable goods, services or direct investment but that it should also be a means of payment. This combined requirement does not mean that there has to be a three-party arrangement between the buyer and seller of goods or services and the foreign exchange supplier. So, for example, if a UK company (A) is buying goods from an exporter in Germany (B) and is paying in euro and A buys the euro forward from a bank (C), there is no need for C to issue some sort of instrument to B (Example (Y)).

Instead, this combined requirement means that the currency contract that is to be excluded should facilitate the payment in the way described in Example (X) at the start of this answer or that there should be an equivalent close connection between the currency contract and the payment transaction.

Even though there is no requirement for a formal instrument of payment, the exclusion can cover such arrangements. So, in Example (Y) in this answer, the exclusion may apply to an arrangement that involves bank C issuing a euro letter of credit at the request of A for the benefit of B.

Q31I. What do goods, services and direct investment mean in the answer to Q31G?

The reference to goods and services should be interpreted widely. It can cover, for example, intellectual property (such as computer software and patents) and land.

However, in the FCA’s view, financial instruments are only covered by the exclusion if they constitute a direct investment.

In the FCA’s view, making a direct investment means making a capital investment in an enterprise to obtain a lasting interest in that enterprise. A lasting interest implies the existence of a long-term relationship between the direct investor and the enterprise, and an investor’s significant influence on the management of the enterprise.

The requirement for the investment to be direct does not prevent the investor acquiring an investment in a wholly-owned subsidiary of a holding company by making the investment in the holding company. However this requirement does mean that the investor should acquire its investment from the enterprise or holding company itself rather than by acquiring a stake through the secondary market.

A foreign exchange contract connected to the purchase of a financial instrument may still be covered by the exclusion for spot contracts if the payment instrument exclusion does not apply. The spot exclusion makes particular provision for purchases of transferable securities and units in a collective investment undertaking (see the answer to Q31C). The result is that the means of payment exclusion does not undermine the specific provisions of the spot contract exclusion dealing with such transactions.

Q31J. How is an agent treated under the means of payment exclusion referred to in the answer to Q31G?

This question is about a foreign exchange contract carried out through agents where:

• • at least one of the principals is a non-financial counterparty (see the answer to Q31G for what a financial counterparty means);
• • both the agents are financial counterparties; and
• • the contract would otherwise meet the exclusion conditions.

If the agents contract with each other on a principal-to-principal basis with back-to-back contracts with their respective clients, the exclusion is not available for the contract between the two agents. It may be available for the contracts between the agent and its client.

If the arrangement is made in such a way that there is a single contract, to which the two principals are party and which is entered into on their behalf by the agents, the exclusion is available.

Q31K. How do I know whether the conditions for the means of payment exclusion described in the answer to Q31G are met?

A financial counterparty (A) selling currency to a client may want to know whether the client (B) is going to use the foreign currency in a way that meets the exclusion conditions. This may be relevant to whether conduct of business obligations that apply to investment services apply to the services provided by A.

A non-financial counterparty (A) may sell currency to another non-financial counterparty (B) in circumstances where the currency that A buys is not being used in a way that qualifies for the exclusion. A may therefore want to rely on B using the currency that B purchases in a way that would qualify.

In each example, the application of the exclusion depends on the use to which the other party is going to put the currency.

In these examples A may rely on B’s assurances about the purpose of the currency purchase as long as it has no reason to doubt what B says. Such an assurance could be given in several ways:

Where B is an ordinary individual consumer or a small business, A may not be able to rely on B’s judgement about whether the exclusion applies. In that case A should decide whether the exclusion applies based on questions A asks B (Option 1).

Q31L. Can a flexible forward come within the means of payment exclusion described in the answer to Q31G?

A forward contract may have a flexible delivery date. For example a forward contract may:

• • say that delivery can take place at any point in a two-week period rather than on a fixed date; or
• • have an expiry date by which delivery has to be taken but part, or parts, of the delivery can take place before that date.

A flexible delivery date within a defined and reasonably short window can still benefit from the exclusion. If the delivery period is very long, it is doubtful whether the requirement for the contract to facilitate payment for identifiable goods, services or direct investment (see the answer to Q31G) can be met.

These examples provide for delivery of the full amount by the end of the delivery period. There might also be a contract under which the purchaser may choose not to take delivery of part. An example of this kind of foreign exchange contract is as follows:

A UK importer of goods buys from a German seller and has to pay in euro. The importer may not know exactly how much it wants to import during the next quarter but may want to fix its foreign exchange risk in advance. The foreign exchange contract allows the importer to take delivery of no more than it needs to pay the exporter. Any balance not needed to pay for imports is cancelled and is not available to the importer.

In the FCA’s view, if the contract meets the conditions of the exclusion (and in particular the need for there to be identifiable goods or services) the exclusion potentially applies.

The requirement for there to be identifiable goods or services means that the maximum amount that can be drawn down under the flexible forward contract should be a reasonable estimate of what is payable under an identified potential payment transaction or transactions. The table in the answer to Q31M gives examples of what a reasonable estimate means.

An argument against the availability of the means of payment exclusion is that a flexible forward contract is an option and that the exclusion is not available for an option. However, in the FCA’s view, the approach in the answer to Q31B applies. That is, a flexible forward contract that meets all the conditions of the exclusion is not a traditional option but rather a hybrid contract that is in the “any other derivative” contract category listed in the answer to Q31A (Which types of financial derivative fall within this heading?), even in the example in which the unused balance is cancelled.

Another argument against the availability of the exclusion for a flexible forward under which the unused balance is cancelled is that it does not meet the requirement for the contract to be settled physically. In the FCA’s view this argument is not correct because this requirement is aimed at preventing net cash settlement and does not deal with the cancellation of the contract resulting in there being no need for any kind of settlement.

Q31M. Can you give me some more examples of how the means of payment exclusion referred to in the answer to Q31G works?

Q31N. How do the examples in the table in the answer to Q31M apply to an exporter or importer with a large portfolio of contracts?

This question deals with the fact that the examples in the table in the answer to Q31M have relatively simple facts, where the purchaser of the foreign currency only has one or a few payment obligations. In many cases a seller or buyer of goods will have frequent payment transactions for which it needs foreign exchange and it may not wish to meet this need by having a separate currency contract for each import or export contract.

The exclusion can still apply in these cases. This is because, as the examples in the table in the answer to Q31M illustrate, there is some flexibility in the amount and timing of currency contracts, the ability to estimate currency needs, the ability to close out currency contracts and the use of different currency providers.

However the requirements of the exclusion still apply, including the need to show that the currency contract is a means of payment that is entered into in order to facilitate payment for identifiable goods, services or direct investment. This means that it will be necessary to look at all the importer or exporter’s incoming and outgoing payments and currency resources each time the importer or exporter enters into a new currency contract to see whether the exclusion is available for that new currency contract.

Say:

• • a UK importer (A) has bought €100,000 worth of goods under a contract with a Eurozone supplier (Contract P);
• • the supplier has issued an invoice but the sum is not yet due from A;
• • A buys the €100,000 forward; and
• • later A buys another €100,000 forward.

When A enters into the second currency contract, changes to Contract P or to A’s payment profile may mean that:

• • the new currency contract will better facilitate the payment obligation under Contract P and the first currency contract will facilitate another identified payment obligation; or
• • the first contract no longer facilitates the payment under Contract P and A needs the new currency contract to allow it to make the payments due under Contract P. 

When deciding whether the exclusion applies to the second currency contract entered into by A there is no need to treat the first currency contract as tied to the payment under Contract P just because the payment due under Contract P justified the application of the exclusion when A entered into the first currency contract. Instead it is necessary to look again at all A’s incoming and outgoing payments and currency resources at the time A enters into the second currency contract (including both currency contracts).

Q31O. I am a payment services provider under the Payment Services Regulations. How do the spot contract and means of payment exclusions referred to in the answers to Q31C and Q31G apply to me?

(See PERG 15 (Guidance on the scope of the Payment Services Regulations 2009) for the Payment Services Regulations)

This answer only relates to a payment service provider authorised under the Payment Services Regulations. It does not cover, for example, banks that are subject to the conduct of business requirements of those Regulations.

The Payment Services Regulations allow you to provide foreign exchange services that are closely related and ancillary to your payment services. That right does not allow you to provide foreign exchange derivative services that would otherwise require authorisation as an investment firm under the Act. You therefore need to consider the availability of the foreign exchange exclusions discussed in this section for your foreign exchange business.

The most common sort of foreign exchange contract you are likely to carry out is where you execute a payment for your customer that involves a currency conversion. For example, you may make a payment for your customer in euros from the customer’s sterling payment account to a payee's payment account. The foreign exchange part of this transaction is separate from the payment part of the transaction (see Q12 in PERG 15.2 (We provide electronic foreign exchange services to our customers/clients. Will this be subject to the PSD regulations?)).

The foreign exchange part of this example may involve a derivative within paragraph 4 of Part 1 of Schedule 2 to the Regulated Activities Order if it has a forward element. However, in practice, it is likely that such foreign exchange transactions will not involve an investment service because the spot exclusion applies.

The following are examples of how the delivery period should be calculated for the spot exclusion. They are all based on a payment being made in one currency funded from a payment account in another currency.

• • If your customer asks for the payment to be made immediately, the delivery period starts on the date of request.
• • If your customer asks for the payment to be made some time after the request and the foreign exchange conversion is to be carried out at the spot rate on the transfer date, the delivery period starts on that transfer date.
• • If your customer asks for the payment to be made some time after the request and the foreign exchange conversion rate is fixed on the date the customer gives you your instructions, the delivery period starts on that instruction date.
• • The date on which the payment is received by the payee’s payment services provider should normally be treated as the delivery date.
• • If you debit your customer’s payment account after receipt by the payee’s payment services provider and the foreign exchange conversion rate is fixed on the debit date, the availability of the exclusion is based on the gap between the debit date and the payment to the payee’s payment services provider.

If your customer wants to make a foreign currency transfer some time in the future and buys the foreign currency from you in advance at the spot rate and immediately credits it to a payment account with you, the spot exclusion should apply.

If the delivery period is too long for the spot contract exclusion to apply, the means of payment exclusion is potentially available because you are not a financial counterparty for the purposes of that exclusion.

However, the means of payment exclusion only applies if the payment by your customer meets the requirements about identifiable goods, services or direct investments described in the answer to Q31G.

Q31P. Can a non-deliverable forward come within the exclusion for spot foreign exchange contracts in the answer to Q31C or the means of payment exclusion in the answer to Q31G?

No.

A non-deliverable forward is a cash-settled foreign exchange contract relating to a thinly traded or non-convertible foreign currency against a freely traded currency. The first currency may be non-convertible for example because of exchange controls or restrictions on currency dealing. On the contracted settlement date, the profit or loss is adjusted between the two counterparties based on the difference between the contracted rate for the non-deliverable currency and the prevailing spot rate. The price for the convertible currency may be expressed in terms of a second convertible currency.

As settlement is for the difference between an exchange rate agreed before delivery and the actual spot rate at maturity, a non-deliverable forward is not a spot contract, regardless of the settlement period, and the means of payment exclusion is also not available. See the answer to Q31R about why settlement for a difference does not come within either exclusion.
This answer is consistent with recital 12 to the EU MiFID Org Regulation.

Q31Q. How is holiday spending money treated under the spot contract and means of payment exclusions referred to in the answers to Q31C and Q31G?

One way of buying holiday currency is for the holidaymaker to order currency to be collected, for example, a week after the order, to be paid for at the currency seller’s spot rate on the day of collection. This contract is not a financial instrument either because it is not a derivative within paragraph 4 of Part 1 of Schedule 2 to the Regulated Activities Order in the first place or because the spot contract exclusion described in the answer to Q31C applies.

Another way of buying holiday currency is for the holidaymaker to order currency to be collected, for example, a week after the order, to be paid for at the currency seller’s spot rate on the day the currency is ordered. This type of contract is potentially a derivative within paragraph 4 of Part 1 of Schedule 2 to the Regulated Activities Order. However, the means of payment exclusion is potentially available. The holiday can be treated as identifiable goods or services even though the holidaymaker may not know what restaurant they are going to eat at or what tourist attractions they are going to visit.

In either case the seller of the holiday money may agree to buy back any unused currency at a price fixed at the same time as the rate at which the holidaymaker is to buy the currency is fixed and linked to the original rate. Such an arrangement may also benefit from the means of payment exclusion. This is because the promise to buy back the currency is so closely connected to the original purchase that it can be seen as being an integral part of the same transaction.

These answers are relevant to whether the currency seller is an investment firm. The holidaymaker will of course not be an investment firm because a holidaymaker buying holiday money is not acting on a professional basis in the way described in the answer to Q4.

Q31R. How does netting affect the exclusions for foreign exchange contracts in the answers to Q31C and Q31G?

A foreign exchange contract may involve a valuation of the currencies being bought and sold for the purposes of settlement and a single payment being made.

The spot contract exclusion described in the answer to Q31C requires there to be exchange and delivery. The means of payment exclusion described in the answer to Q31G requires there to be physical settlement delivery. Therefore neither exclusion applies to a contract involving this type of netting. An instrument that provides for a single payment like this is more like a swap, which is outside the scope of the exclusions.

The fact that a foreign exchange contract provides for early termination and netting on default does not mean that the exclusions cannot apply. Similarly, the existence of force majeure provisions dealing with bona fide inability to settle physically does not prevent a contract from benefiting from the exclusions.

The parties to a foreign exchange contract may also have entered into other foreign exchange or financial contracts with each other. The result may be that the parties exchange multiple cash flows during a given day. In order to reduce operational and settlement risks they may agree to net those cash flows into one payment for each currency (payment netting). For example the parties may each have to make and receive multiple payments in sterling, euro and US dollars on the same day. The result of payment netting is that there will only be three payments to be made on that day, one in each of the three currencies. This sort of payment netting is compatible with the exclusions.

Q31S. I enter into my foreign exchange contracts on a trading venue. What exclusions or exemption can I rely on?

The spot contract exclusion described in the answer to Q31C may be available.

The means of payment exclusion described in the answer to Q31G will not be available.

If neither exclusion is available, and the contract is a derivative within paragraph 4 of Part 1 of Schedule 2 to the Regulated Activities Order, you may find the own account exemption described in the answer to Q40 helpful. Although that exemption is usually unavailable to those who have direct electronic access to a UK trading venue, this is not the case where the contract is for hedging purposes.

Commodity derivatives

Q32. Which types of commodity derivative are financial instruments?

Broadly speaking, the following commodity derivatives are financial instruments:

• • a derivative relating to a commodity derivative, for example, an option on a commodity future (paragraph 4 of Part 1 of Schedule 2 to the Regulated Activities Order);
• • cash-settled commodity derivatives (as explained in more detail in Q33A) (paragraph 5 of Part 1 of Schedule 2 to the Regulated Activities Order);
• • physically settled commodity derivatives traded on certain markets or facilities (as explained in more detail in Q33B) (paragraph 6 of Part 1 of Schedule 2 to the Regulated Activities Order); and
• • other commodity derivatives capable of physical settlement and not for commercial purposes or wholesale energy products traded on an EU OTF that must be physically settled (as explained in more detail in Q33C) (paragraph 7 of Part 1 of Schedule 2 to the Regulated Activities Order).

The definition of commodity derivative in MiFIR also includes derivatives falling into paragraph 10 of Part 1 of Schedule 2 to the Regulated Activities Order (see the answer to Q34 for this type of derivative).

Q33. What is a commodity?

“Commodity” means any goods of a fungible nature that are capable of being delivered, including metals and their ores and alloys, agricultural products and energy such as electricity (article 3 of the Regulated Activities Order). The fact that energy products, such as gas or electricity, may be “delivered” by way of a notification to an energy network (such as notifications under the Network Code or the Balancing and Settlement Code) does not prevent them being “capable of being delivered” for these purposes. If a good is freely replaceable by another of a similar nature or kind for the purposes of the relevant contract (or is normally regarded as such in the market), the two goods will be fungible in nature for these purposes. Gold bars are a classic example of fungible goods. In our view, the concept of commodity does not include services or other items that are not goods, such as currencies or rights in real estate, or that are entirely intangible.

Q33A. Can you tell me more about commodity derivatives within paragraph 5 of Part 1 of Schedule 2 to the Regulated Activities Order?

This type of commodity derivative is one that must be settled in cash or one that provides for settlement in cash at the option of one of the parties. A derivative that only allows a party to opt for cash in the event of default or termination is not included.
This type of derivative corresponds to the derivative in paragraph 5 of Section C of Annex 1 to MiFID.

Q33B. Can you tell me more about commodity derivatives within paragraph 6 of Part 1 of Schedule 2 to the Regulated Activities Order?

This type of commodity derivative is one that:

• • can be physically settled; and
• • is traded on a UK regulated market, a UK MTF or a UK OTF .

This category of commodity derivative excludes a wholesale energy product traded on a UK OTF that must be physically settled. Paragraph 4 of Part 2 of Schedule 2 to the Regulated Activities Order  defines physical settlement in more detail.

A contract that can be physically settled but which is not traded on a regulated market, MTF or OTF might still fall within the paragraph 5 or 7 category of commodity derivative even though it falls outside the paragraph 6 category.
The paragraph 6 type of commodity derivative corresponds to the derivative in paragraph 6 of Section C of Annex 1 to MiFID. There is further EU material about it in articles 5 and 6 of the EU MiFID Org Regulation.

Q33C. Can you tell me more about commodity derivatives within paragraph 7 of Part 1 of Schedule 2 to the Regulated Activities Order?

This type of commodity derivative is one that meets all the following conditions:

• • It can be physically settled.
• • It is not a commodity derivative within paragraph 6 of Part 1 of Schedule 2 to the Regulated Activities Order.

• • It is not a spot contract. A spot contract means one under the terms of which delivery is scheduled to be made within the longer of the following periods:

  • o two trading days; or
  • o the period generally accepted in the market for that commodity, asset or right as the standard delivery period.

  For these purposes a contract is not a spot contract where, irrespective of its explicit terms, there is an understanding between the parties to the contract that delivery of the underlying is to be postponed and not to be performed within the spot period described earlier in this answer.

• • It meets one of the following criteria:
  • o it is traded on a trading venue other than a UK trading venue that performs a similar function to a regulated market, an MTF or an OTF (an “equivalent overseas trading venue”); or
  • o it is expressly stated to be traded on, or is subject to the rules of, a UK regulated market, a UK MTF, a UK OTF or an equivalent overseas trading venue; or
  • o it is equivalent to a contract traded on a UK regulated market, UK MTF, UK OTF or equivalent overseas trading venue. Equivalence in a contract is judged by reference to the price, the lot, the delivery date and other contractual terms such as quality of the commodity or place of delivery.
• • It is standardised so that the price, the lot and the delivery date are determined principally by reference to regularly published prices, standard lots or standard delivery dates.

Certain contracts entered into with or by an operator or administrator of an energy transmission grid, energy balancing mechanism or pipeline network are excluded from the paragraph 7 category of commodity derivative.

The paragraph 7 type of commodity derivative also excludes a wholesale energy product traded on an EU OTF that must be physically settled. Paragraph 4 of Part 2 of Schedule 2 to the Regulated Activities Order defines physical settlement in more detail.
The paragraph 7 type of derivative corresponds broadly to the derivative in paragraph 7 of Section C of Annex 1 to MiFID. There is further EU material about this kind of derivative in recital 5 to, and articles 5, 6 and 7 of, the EU MiFID Org Regulation.

Miscellaneous derivatives 

Q34. What types of derivatives fall into paragraph 10 of Part 1 of Schedule 2 to the Regulated Activities Order?

There is a miscellaneous category of derivatives in paragraph 10 of Part 1 of Schedule 2 to the Regulated Activities Order, which is supplemented by paragraphs 7 and 8 of Part 2 of Schedule 2 to the Regulated Activities Order.  These relate to:

• • climatic variables;
• • freight rates;
• •
• • inflation rates or other official economic statistics;
• • telecommunications bandwidth;
• • commodity storage capacity;
• • transmission or transportation capacity relating to commodities, whether cable, pipeline or other means;
• • an allowance, credit, permit, right or similar asset which is directly linked to the supply, distribution or consumption of energy derived from renewable resources;
• • a geological, environment or other physical variable;
• • any other asset or right of a fungible nature, other than a right to receive a service, that is capable of being transferred;
• • an index or measure related to the price or value of, or volume of transactions in, any asset, right, service or obligation ; or
• • an index or measure based on actuarial statistics.

Paragraph 10 derivatives must also meet at least one of the following criteria:

• • the contract is settled in cash or may be settled in cash at the option of one or more of the parties, otherwise than by reason of default or other termination event; or
• • the contract is traded in a regulated market, an MTF, an OTF or a non-UK trading venue that performs a similar function; or

• • the contract meets the following criteria in the answer to Q33C:

  • o it is not a spot contract;
  • o it meets any of the requirements about trading on (or being stated to be traded on), being subject to the rules of or being equivalent to contracts traded on, certain trading venues;
  • o standardisation; and
  • o it does not fall within the exclusion about transmission grids, energy balancing mechanisms or pipeline networks.

  All these criteria are explained in more detail in the answer to Q33C.

A contract of insurance or reinsurance is not a paragraph 10 commodity derivative. Neither is a contract falling under one of the other paragraphs of part 1 of Schedule 2 to the Regulated Activities Order.
The paragraph 10 type of derivative corresponds to the derivative defined in paragraph 10 of Part C of Annex 1 to MiFID, as supplemented by recital 6 to, and articles 7 and 8 of, the EU MiFID Org Regulation.

Emission allowances

Q34A. How are emission allowances treated?

They are covered in the following ways:

• • Regulation 5(8) of the UK auctioning regulations deems as an investment service or activity the reception, transmission and submission of a bid for a financial instrument on an auction platform by

  an investment firm permitted to carry on these activities under the regulations.

  • The UK auctioning regulations regulate bids for allowances in the form of two-day spot contracts or five-day futures.

  • The UK auctioning regulations allow the following to bid:

  • − aircraft operators and others referred to in (5) below;

    − MiFID investment firms (other than collective portfolio management investment firms) and UK credit institutions and similar third country investment firms; and

  • − a person exempt under paragraph 1(k) in Part 1 of Schedule 3 to the Regulated Activities Order (see Q44 to Q45 for more on this exemption).
• • An emission allowance is itself a financial instrument under paragraph 11 of Part 1 of Schedule 2 to the Regulated Activities Order. It corresponds broadly to the financial instrument in paragraph 11 of Part C of Annex 1 to MiFID.
• • An option, future, swap, forward rate agreement or any other derivative contract relating to emission allowances is included as a derivative under paragraph 4 of Part 1 to Schedule 2 to the Regulated Activities Order.

It is not always clear how all this overlapping legislation fits together but in the FCA’s view, it works like this:

1. (1)

    An emission allowance auctioned as a five-day future or a two-day spot contract is regulated under either the EU auction regulation or the UK auctioning regulations.

2. (2)

    The five-day future auction product is a financial instrument under paragraphs 4 and 11 of Part 1 of Schedule 2 to the RAO.

3. (3)

    The two-day spot contract product is also a financial instrument. It is included under paragraph 11 of Part 1 of Schedule 2 to the RAO.

4. (4)

    In the FCA’s view, an emission allowance (including when auctioned under the EU auction regulation or the UK auctioning regulations) will not come within paragraph 1 of Part 1 to Schedule 2 of the Regulated Activities Order.

5. (5)

    The UK auctioning regulations provide certain exemptions for aircraft operators and operators of plant and other installations. These exemptions continue to apply whether or not an exemption in Part 1 of Schedule 3 to the Regulated Activities Order is available, but only for bidding activities covered by the UK auctioning regulations.

6. (6)

    Thus for example, regulation 16 of the UK auctioning regulations enables business groupings of operators in (5) to be eligible to apply for admission to bid. The exemption in (12) below may not cover all such persons but they are still entitled to submit bids under the UK auctioning regulations.

7. (7)

    The mere fact of being exempt under Part 1 of Schedule 3 to the Regulated Activities Order does not allow someone to bid under the UK auctioning regulations. The UK auctioning regulations regulate who can and cannot bid.

8. (8)

    The UK auctioning regulations cover the reception, transmission and submission of a bid. This corresponds to the investment services and activities of the reception and transmission of orders in relation to one or more financial instruments, execution of orders on behalf of clients and dealing on own account.

9. (9)

    Therefore, the UK auctioning regulations activities of receiving, transmitting and submitting a bid are all also investment services, whether the emission allowance is auctioned as a five-day future or a two-day spot contract. However, a person exempt under (5) is not acting as an investment firm when bidding (subject to (10)).

10. (10)

     If a person who is allowed to bid under the UK auctioning regulations is also authorised as an investment firm (because for example it wants to carry out other investment services for which it needs authorisation), its bidding activities will be investment services and regulated as such.

11. (11)

     The investment services and activities that apply to a product covered by the UK auctioning regulations are not limited to the bidding activities listed in paragraph (8) of this list. All the investment services and activities apply to emission allowances auctioned as a financial instrument. Therefore, for example, giving personal recommendations about emission allowances (including bids) is an investment service. Anyone carrying out such activities will be an investment firm, unless some other exemption is available.

12. (12)

     Paragraph 1(f) Part 1 of Schedule 3 to the Regulated Activities Order exempts an operator with compliance obligations under the trading scheme order 2020 from the definition of investment firm for the purposes of the Regulated Activities Order.

    1. (a)

        The exemption covers some of the same ground as the exemption in the UK auctioning regulations described in (5) to (7) above. However, this overlap neither extends nor narrows the effect of the UK auctioning regulations exemption.

    2. (b)

        The exemption also covers activities not covered by the UK auctioning regulations. So, for example, the exemption covers buying and selling the underlying emission allowance or the five-day future or two-day spot auction product in the secondary market.

    3. (c)

        See the answer to Q35A for more details about the conditions of the exemption.

13. (13)

     An EU firm will be carrying on the regulated activity of bidding in emissions auctions if they bid from the UK on an EU auction platform.

Structured deposits

Q34B. How are structured deposits covered?

A structured deposit is not a financial instrument. This means, for example, that a firm does not become an investment firm by advising on or selling them.
However, certain conduct of business rules that apply to investment services also apply to structured deposits.

Introduction

Q35. Where do we find a list of exemptions from the definition of investment firm?

The exemptions can be found in Part 1 of Schedule 3 to the  Regulated Activities Order and Regulation 8 of the MiFI Regulations. They broadly correspond to the exemptions in articles 2 and 3 of MiFID.

Q35A. Can you give me a complete list of exemptions?

Q35B. How are the Schedule 3 exemptions relevant?
A person is not an investment firm as defined in the Regulated Activities Order or the Act and is not a MiFID investment firm or a MIFIDPRU investment firm if it has an exemption in Part 1 of Schedule 3 to the Regulated Activities Order. However, a person with such an exemption can still be an investment firm as defined in the Glossary. Please see the table in the answer to Q-1 (Are all the different types of investment firm mentioned at the start of this chapter basically the same?) for more details.
Q35C. Broadly speaking, who do the Schedule 3 exemptions cover?
They are likely to be relevant to insurers, group treasurers, professional firms to which Part XX of the Act applies, many authorised professional firms, professional investors who invest only for themselves, pension schemes, depositaries and operators of collective investment schemes or other collective investment undertakings (such as investment trusts), journalists, and commodity producers and traders. 
Insurance

Q36. We are an insurer. Are we exempt?

• Yes. More specifically, you are exempted from the definition of investment firm if you fall into one of the following categories:
  ● The Society.
  ● A firm with permission for:
  o effecting contracts of insurance or carrying out contracts of insurance);
  o insurance risk transformation; or
  o managing the underwriting capacity of a Lloyd’s syndicate as a managing agent at Lloyd’s.
  The exemption is available when carrying on those activities and any other activities permitted by rules made by the FCA or the PRA.

Intra-group activities

Q37. We are a non-financial services group company providing investment services to other companies in the same group. Are we exempt under the group exemption?

Yes, you are exempted from the definition of investment firm if you provide these services exclusively for your parent company, your subsidiaries and those of your parent company. The exemption is narrower than the corresponding exclusion in article 69 of the Regulated Activities Order (groups and joint enterprises) insofar, for example, as it does not apply to investment services supplied to a joint venture participant (see PERG 2.9.10 G).

Q38. We also buy and sell financial instruments for ourselves. Are we still able to use the group exemption?

Yes. As long as your own account dealing does not involve you providing an investment service to non-group entities, you can still rely on the group exemption in respect of the services you provide solely to other group companies.

So far as your own account dealing is concerned, you may be able to rely upon the own account exemption (see Q40) or the commodities exemption (see Q44 to Q45) if you meet the relevant conditions. The ability to combine reliance on the group exemption and the own account and commodities exemptions could be relevant to companies performing group treasury functions.

The answer to Q46 (Is it possible to combine Schedule 3 exemptions?) explains why it is possible to combine exemptions.

Incidental services as part of a professional activity

Q39. We provide investment services as a complement to our main professional activity. Are we exempt?

Yes, you are exempted from the definition of investment firm under paragraph 1(d) in Part 1 of Schedule 3 to the Regulated Activities Order. The exemption is further defined in Part 2 of that Schedule. The exemption is only available if:

• • you provide these services in the course of your professional activity;
• • a close and factual connection exists between your professional activity and the provision of the investment service to the same client, such that the investment service can be regarded as accessory to your main professional activity;
• • the provision of investment services to the clients of your main professional activity does not aim to provide a systematic source of income to you;
• • you do not market or otherwise promote your ability to provide investment services, except where these are disclosed to clients as being accessory to your main professional activity; and
• • your professional activity is regulated by legal or regulatory provisions or a code of ethics that do not exclude the provision of investment services.

The exemption is relevant, for example, to firms belonging to designated professional bodies, such as accountants, actuaries and solicitors, to whom Part XX of the Act applies. It could also apply to authorised professional firms which provide investment services in an incidental manner in the course of their professional activity. In our view, the criteria set out in PROF 2.1.14 G in relation to section 327(4) of the Act are also relevant to considering whether a firm can rely on the this Schedule 3 exemption (see further guidance in PROF 2.1.16G).

If an authorised professional firm has the standard requirement on its permission that it “...must not carry on the specified regulated activities otherwise than in an incidental manner in the course of the provision by it of professional services (that is, services which do not consist of regulated activities)”, our assumption is that it is exempt if it complies with this requirement.

If you are an authorised professional firm that does not benefit from the exemption, you may also wish to consider whether you are eligible to be treated as a MiFID optional exemption firm (see Q48 and Q49).

The exemption may also apply to journalists, broadcasters and publishers (where they are subject to regulation or a code of ethics), although in most cases the FCA would not expect these persons to fall within the definition of investment firm (see Q4).
The exemption corresponds to the exemption in article 2.1(c) of MiFID as supplemented by article 4 of the EU MiFID Org Regulation. 

Own account

Q40. We regularly buy and sell financial instruments ourselves but never as a service to third parties. Are there any exemptions which might apply to us?

Yes, you could be exempted from the definition of investment firm under paragraph 1(e) of Part 1 of Schedule 3 to the Regulated Activities Order. However, the exemption does not apply if you:

• • are a market maker (please see Q41 below);
• • are a member of, or a participant in, a UK regulated market or MTF (except that non-financial entities can be members or participants as described in the answer to Q40A);
• • have direct electronic access to a UK trading venue; and in relation to this condition, please note that:  
  o non-financial entities can however have such access, as described in the answer to Q40A; and
  o direct electronic access is defined in paragraph 7 of Schedule 3 to the Regulated Activities Order;
• • apply a high-frequency algorithmic trading technique (see Q41A); or
• • deal on own account when executing client orders.

This exemption does not apply to dealing on own account in commodity derivatives, emission allowances or derivatives thereof (the exemption discussed in the answer to Q44 (Activities in relation to commodity derivatives) is relevant instead).

Article 2(1)(d) of MiFID says that persons exempt under the commodities exemption described in the answer to Q44 are not required to meet the conditions laid down in the MiFID own account exemption corresponding to the own account exemption described in this answer in order to be exempt. In the FCA’s view, that does not mean that you can do business of the type covered by the article 2.1(d) exemption without meeting the exemption conditions described in this answer just because you qualify for the commodities exemption. Recital 22 to MiFID confirms that the two exemptions apply cumulatively. Another reason for this conclusion is that articles 2.1(d) and (j) apply to different asset classes and there does not seem to be any reason apparent from MiFID why exemption under article 2.1(j) should be relevant to the asset classes in article 2.1(d).
This is also the position for the Regulated Activities Order provisions discussed in this chapter: a person may rely on the commodities exemption even if they do not meet the conditions of the own account exemption but qualification for the commodities exemption does not mean that the person is exempt as respects the activities covered by the own account exemption.

See the answer to Q46 for more information about combining this exemption with other exemptions, particularly the exemption for commodity derivatives business.
The exemption corresponds to the exemption in article 2.1(d) of MiFID. 

Q40A. When can a non-financial entity have direct electronic access to or be a participant in a trading venue without losing the benefit of the own account exemption described in the answer to Q40?

The paragraph 1(e) own account exemption can still be available if you are a member of, or a participant in, a regulated market or an MTF or you have direct electronic access to a UK regulated market, MTF or OTF, as long as:

• • you are a non-financial entity; and
• • your transactions are objectively measurable as reducing risks directly relating to your commercial or treasury financing activity, or the commercial or treasury financing activity of your group.

Q40B. What does direct reduction of risk mean in the answer to Q40A?

The second condition described in the answer to Q40A (objectively measurable reduction of risks) is designed to allow a non-financial business to hedge without losing the exemption. The following points are relevant to whether hedging meets this second condition:

• • The exception covers hedging for commercial activities as well as treasury activities. It can therefore cover risks to a change in value of your group’s assets, services, inputs, products, commodities or liabilities.
• • Hedging may cover potential indirect impacts on your business as well as direct ones.
• • A transaction may qualify as risk-reducing taken on its own or in combination with other hedging transactions.
• • A transaction may be treated as risk-reducing even though it is not a perfect hedge. Thus for example your group may use proxy hedging through a closely correlated instrument to cover an exposure, such as an instrument with a different but very close underlying in terms of economic behaviour.
• • If your group uses portfolio or macro hedging, it may not be able to establish a one-to-one link between a specific hedging transaction and a specific risk directly related to the commercial and treasury financing activities being hedged. The risks related to the commercial and treasury financing activities may be complex. For example, the risks may cover several geographic markets, products, time horizons or entities. Nevertheless, macro or portfolio hedging used to hedge a risk in relation to your group’s overall risks may be treated as risk-reducing.
• • Positions do not qualify as risk-reducing solely on the grounds that they form part of a risk-reducing portfolio on an overall basis. In such cases your group’s risk management systems should prevent such transactions from being categorised as risk-reducing.
• • A risk may evolve over time and, in order to adapt to the evolution of the risk, a hedging transaction initially executed for reducing risk may have to be offset through the use of additional hedging transactions. As a result, hedging of a risk may be achieved by a combination of hedging transactions and offsetting transactions that close out earlier hedging transactions that have become unrelated to the risk.
• • If a transaction originally qualifies as risk-reducing it does not stop being treated as risk-reducing just because the risk it hedges has since evolved.
• • A transaction may be treated as risk-reducing if it qualifies as a hedging contract pursuant to International Financial Reporting Standards as they have effect in the United Kingdom.

Q40C. What does non-financial entity mean in the answer to Q40A?

In the FCA’s view, non-financial entity means the same thing as it does in MiFID RTS 21.

Q41. What is a market maker?

It has the same meaning as it does in MiFIR. Therefore, a market maker is “a natural or legal person holding themselves out on the financial markets on a continuous basis as being willing to deal on own account by buying and selling financial instruments against that person’s proprietary capital at prices defined by that person”. In our view anyone who satisfies the definition will be a market maker for the purposes of the exemption, even if they have not entered into the agreement with the regulated market required by MAR 5A.5.3R (Market making agreements).
The definition corresponds to the definition of market maker in article 4.1(7) of MiFID.

Q41A. What is a high-frequency algorithmic trading technique?

This question is included here because it is relevant to the own account exemption described in the answer to Q40 and to the commodities exemption described in the answer to Q44.

The term is defined in paragraphs 8 and 9 of Schedule 3 to the Regulated Activities Order. It is a type of algorithmic trading technique characterised by:

• • infrastructure intended to minimise network and other types of latencies, including at least one of the following facilities for algorithmic order entry:
  • o co-location;
  • o proximity hosting; or
  • o high-speed direct electronic access;
• • system-determination of order initiation, generation, routing or execution without human intervention for individual trades or orders; and
• • high message intraday rates which constitute orders, quotes or cancellations.
  For the purposes of MIFID, the term is defined in article 4.1(40) of that Directive.

Employee share and company pension schemes

Q42. Is there an exemption relating to employee share schemes and company pension schemes?

Yes, there is an exemption from the definition of investment firm in paragraph 1(g) of Part 1 of Schedule 3 to the Regulated Activities Order for persons providing investment services consisting exclusively in the administration of employee-participation schemes, for example employee share schemes and company pension schemes. In our view, whilst administration for these purposes could extend to services comprising reception and transmission or execution of orders on behalf of clients or placing, it would not include personal recommendations in relation to, or managing, the assets of employee share schemes or company pension schemes.

This exemption can also be combined with the “group exemption” in paragraph 1(c) of Part 1 of Schedule 3 to the Regulated Activities Order, by virtue of paragraph 1(h) of Part 1 of Schedule 3 to the Regulated Activities Order. See the answer to Q46 for more about combining exemptions.
The corresponding MiFID exemption is in article 2(1)(f) of that Directive.

Collective investment undertakings

Q43. Are we right in thinking that there is an exemption for collective investment undertakings and their operators?

Yes, there is an exemption from the definition of investment firm under paragraph 1(j) of Part 1 of Schedule 3 to the Regulated Activities Order. Generally speaking, collective investment undertakings are specifically exempt, as are their depositaries and managers. For collective investment undertakings within the scope of the UCITS Directive or AIFMD the "manager" corresponds to the management company or AIFM of the undertaking. So far as collective investment schemes which are outside the scope of the UCITS Directive or AIFMD are concerned, the “manager” corresponds, in essence, to the operator of a scheme and not to a person who is managing the assets of the scheme (unless that person is also the operator). In our view, the manager of a collective investment undertaking only benefits from the exemption in respect of any investment services or activities it may carry on in that capacity. To the extent that it also provides investment services or performs investment activities in a different capacity, for example, if it provides investment advice to, or manages the assets of, an individual third party, these services and activities fall outside the scope of this exemption.

In the case of UCITS management companies, some requirements applying to investment firms will apply to those who provide portfolio management services (other than collective portfolio management), investment advice or safekeeping and administration services in relation to units to third parties (see Q6). UK AIFMs will also be subject to some requirements applying to investment firms if they provide investment services or activities for an undertaking other than a fund for which they are appointed as manager or operator. Full-scope UK AIFMs are only able to provide a limited range of such activities (see Q6A).

Exemption for commodity derivatives business

Q44. Who can rely on the exemption in article 2.1(j)?

You may be able to rely on the exemption if:

• • you deal on own account in commodity derivatives or emission allowances or derivatives thereof; or
• • provide other investment services in commodity derivatives or emission allowances or derivatives thereof to clients or suppliers of your main business (or if you are part of a group, the group’s main business); or
• • both.

This exemption can include someone dealing on own account as a market maker.

If you deal on own account when executing client orders you can only meet the exemption condition if the client is a client or supplier of your group’s main business.

The article 2.1(j) exemption does not apply to you if you apply a high frequency algorithmic trading technique.

The exemption will only apply if what you do is ancillary to your main business (see Q45 for more about this).

The exemption is not available if your group’s main business is any of the following (see the answer to Q44A for what main business means in this context):

• • the provision of investment services; or
• • the provision of banking services; or
• • acting as a market maker in relation to commodity derivatives.

Q44A. How do I know whether my main business is investment, banking or commodities?

When considering what is a group’s ‘main business’ for the purpose of the requirement described in the answer to Q44 that your main business should not be investment services, banking services or commodity derivatives market making, in our view various factors are likely to be relevant including turnover, profit, capital employed, numbers of employees and time spent by employees. These factors should then be considered in the round in deciding whether any one operation or business line amounts to your group’s main business.

The determination of your main business as described in this answer is not directly related to the test for deciding whether your commodities business is ancillary to your main business (the ancillary test is referred to in the answer to Q45). This is because the ancillary test compares the size of your commodity derivatives and emission allowance business (see guidance in PERG 13Q32 to 33C and 34A) with the rest of your business but does not specify how to identify what your main business is within your non-commodities business.

Q44B. Are there any formalities for using the commodities exemption?

It is a condition of the commodities exemption described in the answer to Q44 that you upon request, report to the competent authority the basis on which you consider that the requirement for the commodities business to be ancillary is met.

The FCA is the relevant competent authority for these purposes.

If you carry out some occasional commodity derivatives activities you may not need to rely on this exemption. See the answer to Q7 (We provide investment services to our clients. How do we know whether we are an investment firm for the purposes of article 4.1(1) MiFID?) for more on this.

Q44C. Can the commodities exemption be combined with other exemptions?

Yes.

There is no requirement that someone relying on this exemption must not carry on an activity covered by one of the other exemptions. In particular, this exemption can be combined with the exemption for own account transactions described in the answer to Q40 (see recital 22 to MiFID). For more on combining exemptions, please see the answer to Q46.

Q45. What is an ancillary activity for the purposes of the commodities exemption ?

You can find the meaning of ‘ancillary’ for the purposes of the commodities exemption described in the answer to Q44 in MiFID RTS 20 (regulatory technical standards for the criteria to establish when an activity is considered to be ancillary to the main business). You will need to consider whether your commodity derivatives business exceeds the main business threshold as stipulated in article 3 of MiFID RTS 20.

This answer does not give a full summary as the definition is too detailed for PERG.

The test as stipulated by article 3 of MiFID RTS 20 has two calculation methods. If the result of either calculation is that you fall below the specified threshold, you meet the test.

• • One method is based on the size of group trading activities in commodity derivatives and emission allowances.
• • The second measure compares the estimated capital employed for carrying out commodity derivative and emission allowance activities with group capital.

Both methods are based on commodities trading activities in the EEA, as if the UK were still part of the EU.

Q46. Is it possible to combine Schedule 3 exemptions ?

Various other answers to questions in this section deal with certain detailed combinations of exemptions:

• • Q42 deals with employee share schemes and company pension schemes.
• • It is possible to combine the exemption for own account dealing in paragraph 1(e) of Part 1 of Schedule 3 to the Regulated Activities Order and the exemption for commodity derivatives in paragraph 1(k) of Part 1 of that schedule. The answer to Q40 deals with the treatment of the commodity derivatives business of a firm relying on paragraph (1)(e). The answer to Q44C deals with the treatment of business within paragraph (1)(e) for a firm relying on the commodity derivatives exemption in paragraph (1)(k).

In certain cases, a firm will not need to combine exemptions. For example, an insurer relying on the exemption described in the answer to Q36 (We are an insurer. Are we exempt?) does not need to rely on any other exemption.

The answer to this question (Q46) is about whether there is a more general principle that exemptions in paragraph 1 of Part 1 of Schedule 3 to the Regulated Activities Order can be combined.

There is an argument that the drafting of some of the exemptions does not allow this approach. For example, the group exemption (see the answer to Q37) says that the exemption is available to persons providing investment services exclusively for their fellow group members. However, in the FCA’s view, it is generally possible to combine exemptions in paragraph 1 of Part 1 of Schedule 3 to the Regulated Activities Order. There is no clear prohibition in Schedule 3. There is no reason apparent from the Act, the Regulated Activities Order or UK law on markets in financial instrument why combining exemptions should not be allowed. This approach has support from recital 22 to MiFID, which says that exemptions apply cumulatively and that the ability to combine the exemptions in articles 2.1(d) (own account dealing) and 2.1(j) (commodity derivatives) is just an example of this principle.

Where an exemption is only available if the person only carries on a limited range of investment services or activities (as is the case for example with the group exemption) it can be argued that this restriction does not cover a service or activity which is covered by another exemption. This is on the basis that an exempt activity is not an investment service or activity for these purposes. The European Commission’s Q&A’s dealing with MiFID 1 take this approach.

Treating an exempt activity as not being an investment service or activity in this way only applies for the purpose of paragraph 1 of Part 1 of Schedule 3 to the Regulated Activities Order, meaning that it is only relevant for deciding whether a person comes within any of the types of investment firm listed at the start of this chapter.

Q46A. Is it possible to combine the Schedule 3 and the MiFID optional exemptions?

The FCA does not believe that it is generally possible to combine the Schedule 3 exemptions with the MiFID optional exemption. However, in the FCA’s view, a firm that relies on the paragraph 1(j) collective investment undertaking exemption (see Q43) can combine this with the MiFID optional exemption in relation to business falling outside the paragraph 1(j) exemption.

If, however, you are subject to the UCITS Directive or the AIFMD you may be restricted in your ability to carry out all the activities within the MiFID optional exemption.

Locals

Q47. We traded on an investment exchange as a local firm and were exempt from MiFID 1 . Are we exempt under MiFID?

[deleted]
The MiFID optional exemption

Q48. What is this exemption?

It is an exemption provided for in regulations 6 to 8 of the MiFI Regulations. It applies to a firm whose permission permits it to carry on regulated activities as an exempt investment firm. The answers to Q49 to Q53 explain the exemption in more detail, including what the effect of the exemption is.
A firm with the benefit of this exemption is a MiFID optional exemption firm and the exemption is normally referred to as the MiFID optional exemption.
You will not benefit from this exemption unless you apply to the appropriate regulator for, and are granted, such permission. You will not be able receive such permission unless your business meets the conditions described in the answer to Q49.

The exemption corresponds to the optional exemption contained in article 3 of MiFID. Articles 3.1(d) and (e) of MiFID provided additional optional exemptions, but they were never implemented in the UK and are not reflected in any of the UK provisions discussed in this chapter.

Q49. Which firms might fall within this exemption?
The exemption is likely to be relevant to many financial advisers (see Q50) including some corporate finance advisers. It may also be relevant to some venture capital firms.

A firm with a permission described in the answer to Q48 is subject to a requirement under section 55L (Imposition of requirements by FCA) or 55M (Imposition of requirements by PRA) of the Act to comply with all the following:

• • they must not hold clients’ funds or securities and must not, for that reason, at any time, place themselves in debit with their clients;
• • they must not provide any investment service other than reception and transmission of orders or investment advice, or both, in relation to transferable securities and units in collective investment undertakings;
• • they may (in the course of providing the investment services mentioned in the previous bullet point) transmit orders only to one or more of the following:
  • o other investment firms authorised under the Act or authorised under MiFID;
  • o UK credit institutions authorised under the Act, excluding credit unions and friendly societies;
    o credit institutions authorised under the CRD;
  • o branches of third country investment firms or credit institutions which are subject to, and comply with, prudential rules considered by the appropriate regulator to be at least as stringent as those laid down in FCA rules made under Part 9C of the Act (Prudential regulation of FCA investment firms), PRA rules that are CRR rules as defined in section 144A of the Act (CRR rules), MiFID, the EU CRR or the Solvency 2 Directive;
  • o collective investment undertakings authorised under the law of the United Kingdom or of an EEA State to market units to the public, and managers of such undertakings;
    • o a company that meets the following conditions (such as an investment trust company): 
       - its exclusive object is to invest its funds in various stocks and shares, land or other assets with the sole aim of spreading investment risks and giving its shareholders the benefit of the results of the management of their assets; and
       - its securities are listed or dealt in on a United Kingdom regulated market or a regulated market in an EEA State.

Where you provide personal recommendations or receive and transmit orders in relation to derivatives which are financial instruments but not transferable securities, you will fall outside the scope of this exemption. In our view, this would be the case, for example, if you provided either or both of these investment services in relation to OTC derivatives concluded by a confirmation under an ISDA master agreement (see PERG 13 Annex 2 Table 2).

Q50. We are an IFA and have a permission which covers (i) arranging (bringing about) deals in investments; (ii) making arrangements with a view to transactions; and (iii) advising on investments, in each case in relation to securities but not derivatives. We are not permitted to hold client money or investments and do not have dealing or managing permissions in relation to financial instruments. Do we meet the eligibility conditions for the exemption?

The FCA expects so, assuming you do not:

• • carry on activities outside your permission; or
• • transmit orders to persons other than those listed in Q49 (for example, you will fall outside the exemption if you transmit orders directly to collective investment schemes whose units cannot be marketed to the public in the UK either because they are unregulated schemes or non- UK authorised collective investment schemes); or
• • place financial instruments without a firm commitment basis (see Q22 and Q23).

We would generally not expect IFAs to be placing financial instruments without a firm commitment basis as we associate placing of financial instruments with situations where a company or other business vehicle wishes to raise capital for commercial purposes, and in particular with primary market activity.

Q51. What happens if we breach any of the qualifying conditions (see Q49)? Do we then lose the exemption?

You are required to notify us of a breach (see SUP 15.3.11 R). We will then consider whether you should continue to benefit from the exemption and what, if any, supervisory or occasionally enforcement action is appropriate in the circumstances.

Q52. If we fall within the exemption does this prevent us from acquiring passporting rights under MiFID?

[deleted]

Q53. What is the practical effect of exercising the optional exemption for those firms falling within its scope?

You are not a MiFID investment firm for the purposes of the Handbook. Nor are you a MIFIDPRU investment firm subject to the prudential requirements in MIFIDPRU. You are also not an investment firm as defined in the Act.
However, you are still an investment firm as defined in the Regulated Activities Order and an investment firm as defined in the Glossary.
Certain MiFID requirements of the UK law on markets in financial instruments apply to firms making use of the exemption but a firm with the benefit of the exemption is excluded from others.

The list of investment services is set out in Part 3 of Schedule 2 to the Regulated Activities Order. It broadly corresponds to the list in Section A of Annex 1 of MiFID. The different kinds of financial instruments are listed in Part 1 of Schedule 2 to the Regulated Activities Order. The list of financial instruments broadly corresponds to the list of financial instruments in Section C of Annex 1 to MiFID.

Table 1 - Investment services and activities and the Part 4A permission regime

Table 2: Financial instruments and the Part 4A permission regime