Introduction and Economic Framework

Before discussing its derivative market, one should be aware that the Grand-Duchy of Luxembourg is the most important hub in Europe for the structuring and setting-up of regulated and unregulated investment fund structures of all types, ranking just behind New York as number two worldwide. Hundreds of international banks and investment fund management companies have been established in Luxembourg for more than 30 years and profit from “short ways” between the acting individuals in all these entities and institutions, living the principle of “everybody knows everybody” in a large community. In the Grand-Duchy of Luxembourg, about 100 different languages are spoken every day in all sectors of public life, business and offices, schools, kindergartens, supermarkets, restaurants, bars and in numerous other places. In Europe, there is no other comparable “international financial place”. This fantastic international framework has brought the Grand-Duchy of Luxembourg to the great success it still profits from today.

All-important international players dealing with derivatives are present in the Grand-Duchy of Luxembourg.

Further, the international ranking for investment vehicles in the country as number one in Europe is still valid in 2025, despite a significant decrease in assets under management due to the economic crisis since early 2022 (relating to Ukraine) and the subsequent rising interest rates – with a direct impact on the use of derivatives in the funds’ portfolios. Global economic insecurity has been followed by the postponement of the launch of many new investment fund projects, or a significant simple abandonment of newly initiated investment fund projects. The market is still suffering from this inexplicable development three years later. However, new investment ideas have arisen since interest rates have become more-or-less stable and an increasing number of new investment funds are in the process of being structured in 2025.

Current Situation

Currently, derivatives are used daily by investment funds in the Grand-Duchy of Luxembourg, in much the same manner as in any other jurisdictions of the EU.

However, derivatives are not used or traded “directly” within the Grand-Duchy of Luxembourg, but cross-border. Derivative traders and portfolio managers dealing with derivatives for the benefit of portfolios of investment structures established in the Grand-Duchy of Luxembourg are mainly located outside the country.

It is important to know that for most of the investment fund structures established in the country, derivatives are a very important and an often-used tool for investment and portfolio management purposes (Gestion efficace du portefeuille – Effiziente Portfolioverwaltung), and are used indirectly probably as often as directly in other countries. However, the active “derivative trading” decision for a Luxembourg fund structure is taken outside the Grand-Duchy of Luxembourg in most cases. Nevertheless, the principles for the use of derivatives and the applicable rules are the same as in all other EU countries. The use of derivatives in the Grand-Duchy of Luxembourg is a “cross-border” issue.

Over the past several decades, the management of portfolios of Luxembourg-based investment funds has been impacted by developments in the USA.

2024 was an eventful year in the US world of swaps/options and other derivatives, and the related US regulations and practices. One of the reasons for this certainly being the Securities Exchange Commission (SEC) implementing new rules for the financial markets, significantly different to the rules in the past. One of these new rules requires all derivative transactions in US treasury securities to be centrally cleared and portfolio fund managers of Luxembourg investment fund structures have had to adopt their investment behaviour in whichever country they are located. They have been impacted by these new US rules in their daily management of Luxembourg-based investment funds, which is also a challenge for Luxembourg-based custodian banks.

Legal Framework – Regulatory Aspects

The regulatory framework for derivatives markets and products in the Grand-Duchy of Luxembourg is primarily shaped (like in all other EU member states) by EU regulations, supplemented by Luxembourg provisions implementing Directive 2014/65/EU on Markets in Financial Instruments (MiFID II).

For AIFMs and for portfolio managers’ legal oversight duties, EU Regulation No 648/2012 on OTC derivatives, central counterparties and trade repositories (EMIR) play a crucial role in the oversight of derivatives markets, with the main objectives of increasing transparency, reducing systemic risk and mitigating counterparty risks. The AIFMD rules on risk management (ie, “gross and commitment methods”) and the relevant rules are also very important for outside portfolio managers and are severely supervised by Luxembourg-based alternative investment fund managers (AIFMs). To ensure proper risk management and market transparency and efficiency, EMIR requires that, in the Grand-Duchy of Luxembourg, among other things: (i) all derivatives transactions in an investment fund are reported to trade repositories, and (ii) standardised OTC derivatives are centrally cleared through central counterparties.

Complementing EMIR, MiFID II – as implemented in the Grand-Duchy of Luxembourg – and EU Regulation No 600/2014 on markets in financial instruments (MiFIR), which cover all types of financial instruments (including derivatives), provide a comprehensive framework for trading and transparency for Luxembourg-based investment structures. With the aim of improving market transparency, enhancing investor protection and improving the functioning of financial markets, MiFID II and MIFID impose, among other things, strict requirements on pre- and post-trade transparency, transaction reporting and conduct-of-business rules. These rules must be observed in Luxembourg on a cross-border basis.

At the national level of control by the Luxembourg Financial Regulator CSSF, the authority supervises the securities markets and ensures that market participants comply with regulatory requirements, focusing on transparency, fairness and investor protection.

Outlook

The use of derivatives (and their particular product structures) for the portfolio of a Luxembourg-based investment fund is historically very much generated by US developments. The most recent US development is the rise of the so-called continuation fund. This new type of US fund provides for new exit plans, refinancing strategies and buy-out mechanisms. In a typical US continuation fund transaction, a new investment vehicle (the continuation fund) uses capital from new investors to acquire one or more assets from an existing fund that is managed by the same fund sponsor. The continuation fund is usually formed specifically for the purpose of making this acquisition. Limited partners in the existing fund are normally offered the option either to be cashed out or to retain their interests in the underlying assets through an investment in the continuation fund. All such transactions are unique, and there is no “standard”.

The legal difference compared to the old “side pockets” in Luxembourg is not yet clear and under discussion – subject to a strict supervisory oversight, and is certainly an issue of valuation in the future that will occupy auditors.

Very new developments in the CSSF’s administrative practice relating to the use of derivatives within a portfolio investment as a “tool” cannot be determined for the time being, but are to be observed.

Conclusion

The legal framework in the Grand-Duchy of Luxembourg for the use of derivatives is quite similar to, and often the same as, those applicable in other EU member states.

All EU rules apply directly to the use of derivatives in the Grand-Duchy of Luxembourg, where their use is limited in most cases to direct investment by fund structures established in the country, but traded cross-border from outside.