FCA Consulting on Proposed Changes to the Derivatives Trading Obligation

On 26 July 2024, the FCA published CP24/14, setting out proposed changes to three interrelated aspects of the DTO. In summary, the proposals concern:

• Bringing certain OIS products based on SOFR within the scope of the DTO;
• Expanding the list of post-trade risk reduction ("PTRR") services exempted from the DTO and other obligations; and
• How the FCA intends to use its new power to suspend or modify the DTO, after its temporary transitional powers ("TTP") expire on 31 December 2024.

These proposals seek to adjust the scope of the DTO to align with similar moves by other regulators, create a more standardised, consistent approach to regulatory exemptions for market-risk neutral transactions and prevent conflicting obligations under the UK and EU DTO regimes. Along with generally improving the regulation of secondary markets, the FCA expects these changes to reduce systemic risk in derivatives markets and avoid fragmentation and disruption for firms trading over-the-counter derivatives subject to the DTO.

For background, the DTO, implemented through Article 28 of the UK's Markets in Financial Instruments Regulation ("UK MiFIR"), requires larger financial and non-financial counterparties to execute certain types of standardised and liquid OTC derivatives (including certain interest rate and credit derivatives) on a regulated trading venue or equivalent third-country venue. Before bringing a new class of derivatives within the DTO, the FCA is required under Article 32 of UK MiFIR to consider whether those derivatives are: (i) subject to the Bank of England's derivatives clearing obligation; (ii) admitted to trading on at least one regulated trading venue; and (iii) sufficiently liquid to trade only on those venues.

Bringing SOFR OIS Products Within the Scope of the DTO

The FCA has proposed to bring SOFR OIS derivatives within the scope of the DTO, which the FCA expects will positively impact liquidity, transparency, and trading costs.

Since the DTO entered into force in 2017, there have been changes to the liquidity profiles of certain OTC derivatives, driven by the global transition from Interbank Offered Rates ("IBORs") to risk-free rates ("RFRs") as part of interest rate benchmark reforms. These liquidity changes have required the FCA to reevaluate which classes of interest rate swaps should be subject to the DTO. 

Early RFR adoption in the GBP market led the FCA to remove GBP LIBOR swaps from the DTO and replace them with OISs referencing SONIA in December 2021. The FCA similarly removed derivatives referencing USD LIBOR from the DTO on 24 April 2023. However, it has yet to replace them by adding OISs referencing SOFR (the benchmark RFR replacement for the U.S. dollar market) to the DTO, due to a slower transition to RFRs in the USD market.

CP 24/14 suggests that SOFR OIS adoption is now at a sufficiently advanced stage to be brought within the scope of the DTO. In the consultation paper, the FCA notes that the SOFR OIS market is the largest interest rate swap market in the world, and bringing SOFR OIS derivatives within the scope of the DTO would align with similar moves by other regulators: 

• SOFR OIS has been under the Bank of England's derivatives clearing obligation since 24 August 2022; and
• SOFR OIS instruments are already subject to the U.S. trading mandate (the U.S. equivalent of the DTO), as required by the Commodity Futures Trading Commission ("CFTC") since 5 August 2023. 

The FCA liquidity analysis also showed substantial liquidity in SOFR swaps over 2023, comparable to existing classes of derivatives subject to the DTO (namely, OISs referencing SONIA and EURIBOR). Accordingly, the FCA has concluded that OISs referencing SOFR are sufficiently liquid to be traded only on relevant trading venues and that they meet the relevant criteria specified in UK MiFIR and the Regulatory Technical Standards for inclusion in the DTO.

The FCA has proposed to impose the DTO for SOFR OISs with trade start types of spot-starting and International Money Market ("IMM") (next 2 IMM dates) and with tenors of 1, 2, 3, 4, 5, 6, 7, 10, 12, 15, 20 and 30 years—the same products and tenors that are subject to the CFTC's trade execution requirement in the United States. The FCA seeks stakeholders' views, in particular, on whether the 12-year SOFR product should be brought within the DTO (given its limited liquidity compared to other SOFR tenors, and the CFTC's choice to exclude 12-year SOFR for IMM swaps with a standard coupon fixed rate from its trade execution requirement).

Exempting Eligible PTRR Services

The FCA has proposed to:

• Disapply the best execution obligation, the obligation to seek authorization as a trading venue, and the DTO for "eligible PTRR services"; and
• Establish characteristics and conditions for "eligible PTRR services" to maintain market integrity and efficiency.

PTRR services help counterparties manage exposure to various types of risk in their derivatives portfolios, such as counterparty and operational risk, without altering their fundamental market positions. These services include portfolio compression, portfolio rebalancing, and basis risk optimization, which all aim to reduce non-market risks in derivatives portfolios by inserting market-risk neutral transactions into existing netting sets.

In its consultation, the FCA describes three main types of PTRR service as they see them and seeks market feedback on whether its descriptions are accurate:

• Portfolio compression terminates offsetting transactions between participants to reduce the number of contracts and gross notional amount, helping reduce operational costs, optimise capital usage, and better manage counterparty credit risk.
• Portfolio rebalancing inserts new transactions to adjust non-market risks without changing market risk, helping to reduce counterparty risk and liquidity strains.
• Basis risk optimisation introduces equal and opposite transactions to neutralize second-order risks without altering overall market risk.

The FCA has proposed exempting additional PTRR services (including portfolio rebalancing and basis risk optimisation services) from certain regulatory obligations, aligning their regulatory position with that of portfolio compression trades. The Financial Services and Markets Act 2023 (by revising Article 31 of UK MiFIR) empowers the FCA to disapply certain obligations—such as the DTO, the best execution obligation and the obligation to seek authorisation as a trading venue—to transactions executed in connection with a risk reduction service. While UK MiFIR currently exempts portfolio compression trades, the FCA has proposed to broaden this exemption to include other "eligible PTRR services" (including trades conducted as part of portfolio rebalancing or basis risk optimisation). 

The FCA has further proposed to establish defined characteristics and conditions that a PTRR service must meet to be exempted. Under this proposal, an "eligible PTRR service" must: (i) not give rise to price-forming transactions; (ii) be provided for the purpose of reducing non-market risks in derivatives portfolios; (iii) be provided by a third-party firm; (iv) be operated on the basis of non-discretionary rules set in advance by the operator; and (v) result in a single set of transactions that binds all the participants.

Under the current proposals, the FCA will maintain some form of public disclosure for PTRR services and require providers of PTRR services to notify the FCA of their intention to rely on the exemptions.

The FCA is separately consulting with the Bank of England on whether transactions arising from PTRR services should also be exempted from the clearing obligation under UK EMIR.

Proposed Replacement for the Expiring TTP 

The FCA has proposed to use its power of direction (under Article 28a of UK MiFIR) to modify the DTO to achieve an outcome equivalent to that currently achieved by the expiring TTP.

The TTP was established in 2019 to give UK regulators the ability to temporarily modify regulatory obligations for financial services following Brexit-related changes. In December 2020, the FCA made a direction under the TTP to modify the application of the DTO. This direction currently allows firms subject to the UK DTO to trade with, or on behalf of, EU clients subject to the DTO on EU venues, provided that certain conditions are met.

The TTP will expire on 31 December 2024. Without action, the FCA has suggested that some firms (in particular, UK branches of EU investment firms) would face conflicting obligations under the UK and EU DTO regimes, which could disrupt the financial markets. The FCA has therefore proposed to use its powers under Article 28a of UK MiFIR to achieve an outcome equivalent to that achieved by its TTP direction. Article 28a allows the FCA to suspend or modify the DTO where necessary to prevent or mitigate market disruption and to advance its operational objectives (subject to consultation with the Bank of England and the Prudential Regulation Authority and receiving the Treasury's consent).

Under the FCA's proposals, it would retain the conditions currently set out under its TTP direction, namely that:

• Firms must be satisfied that a client does not have arrangements in place to execute the trades on a trading venue to which both the UK and EU have granted equivalence; and 
• The EU venue has the necessary regulatory status to do business in the UK. 

The FCA also intends to adjust its direction to reflect the changes to the scope of the UK and EU DTO, following the transition from LIBOR to RFRs, so that the direction only applies to transactions in classes of derivatives that are subject to the DTO in both the UK and in the EU.