In the final entry in our series of blogs on Sustainability-Linked Derivatives (SLDs) (Part 1 here and Part 2 here), we consider issues relating to the regulation of SLDs.
Two key spheres of regulation that may impact the use of SLDs are (i) those relating to ESG products in general and (ii) those relating to OTC derivatives. The former includes the EU Taxonomy Regulation and the Sustainable Finance Disclosure Regulation which establish criteria for determining whether economic activity is environmentally sustainable and oblige market participants to provide information including how their activities align with these criteria. Although such regulations will have implications for firms that decide to trade SLDs, our main focus in this blog will be on the latter type of regulation, governing OTC derivatives in general, specifically in the context of EU and UK law.
As a fledgling product type, exactly how SLDs relate to the laws and regulations governing OTC derivatives trading is an evolving topic. Nevertheless, a central question when considering the regulatory obligations which may attach to such products is whether their ESG characteristic elements (the KPIs and consequent cashflow adjustments) are incorporated into the derivative transaction itself, or contained in a separate agreement that itself references the underlying OTC derivative instrument. ISDA has in some of its papers on SLDs referred to these as Category 1 and Category 2 SLDs, respectively.
Where the underlying derivative is already classified as such under EU/UK law, to the extent that the addition of SLD KPIs do not materially alter the core rights and obligations of that transaction it seems likely that the addition of features consistent with a Category 1 SLDs will not alter this classification – the transaction will remain an OTC derivative. Such SLDs would therefore also be subject to the same gamut of regulatory obligations that might apply to the derivative regardless of the additional ESG linked features – including clearing, reporting, portfolio reconciliation, dispute resolution and margin requirements. Nevertheless, depending on the status of the parties to the relevant transaction, it is possible that the precise nature of these regulatory obligations could be affected by the KPIs.
For Category 2 SLDs, on the other hand, the regulatory position is less clear. Although these transactions are unlikely to fall within the main types of derivatives listed in MIFID II, under EU law they could potentially be caught by the broad category of "other derivative contracts … which have the characteristics of other derivative financial instruments". Further, under UK law there is a subset of contracts for differences defined in the FSMA (Regulated Activities) Order 2001 (capturing contracts whose value is based on fluctuations in a reference factor) which may also be broad enough to encompass Category 2 SLDs. Whether a Category 2 SLD will fall within scope of these classifications and thus count as a derivative for regulatory purposes will depend on the constitutive details particular to it. Market participants who make use of this type of SLD should therefore consider carefully the structure of the relevant KPIs and cashflow adjustments if they wish to avoid additional regulatory commitments.
Readers will no doubt be familiar with the regulatory obligations that apply to derivatives under EU and UK law, and hence to any SLDs characterised as such, whether Category 1 or Category 2. We do not propose to cover these here, except to note the following considerations:
- Firstly, it is possible that KPI-related cashflow adjustments will have implications for the valuation of, and any margin required in respect of, the underlying derivative. For example, it is still an open question whether the risks captured by margin calculation methods such as ISDA’s Standard Initial Margin Model ought to include those related to KPIs, or whether such risks need not be taken into account. If they were to be included, SLDs could be subject to greater margin requirements than the underlying transactions on their own, which may have a limiting effect on the market for them.
- Secondly, a technical question may arise with respect to Category 1 SLDs and how these transactions are characterised – are they rate/FX derivatives with an ESG overlay, or a new category of underlying asset class (the “ESG” underlying variable) for OTC derivatives themselves? This distinction may matter for a number of reasons, not least EMIR reporting and the application of the hedging test and its various asset class categories for NFC classification purposes. As the products develop, market participants will need to make fine judgments and develop consensus on such matters, depending on individual transaction terms.
These questions will no doubt receive detailed scrutiny as the volume of trade in SLDs increases. Indeed, as will be apparent from this series of blog posts, there are many other questions about SLDs also awaiting exploration, and surely several others to be introduced as the market for SLDs advances.