On 26 July, the Financial Conduct Authority (FCA) published a consultation paper on aspects of the derivatives trading obligation (DTO) as part of HM Treasury’s Wholesale Markets Review.

The FCA is consulting on the following proposals:

1. Include certain overnight index swaps (OIS) based on the US Secured Overnight Financing Rate (SOFR) within the classes of derivatives subject to the DTO

Proposals

• Impose the DTO for SOFR OIS to trade start types spot-starting and IMM (next 2 IMM dates) with tenors of 1, 2, 3, 4, 5, 6, 7, 10, 12, 15, 20 and 30 years.
• Changes to come into force 3 months after the publication of the FCA’s policy statement.

2. Expand the list of post-trade risk reduction (PTRR) services exempted from the DTO and from other obligations

Background

• FSMA 2023 allows the FCA to (i) make rules to exempt trades conducted as part of PTRR services if the FCA considers it necessary or expedient for the purpose of advancing one or more of its operational objectives; and (ii) impose conditions or exceptions where appropriate.

Proposals

• Eligible PTRR services are to meet three additional essential characteristics: It is provided by a firm that is not party to a transaction resulting from the service; it is operated on the basis of non-discretionary rules set in advance by the operator that are based on specified parameters; and it results in a single set of transactions that bind all the participants.
• Eligible PTRR services are not to be subject to the following obligations: The best execution obligation in section 11.2A of the Conduct of Business sourcebook; the obligation in rule 5AA.1.1 in the Market Conduct sourcebook to operate a multilateral system as a multilateral trading facility or an organised trading facility, if the firm has a Part 4A permission; and the trading obligation imposed by Article 28 MiFIR.
• Expand eligible PTRR services to include portfolio rebalancing and basis risk optimisation (in addition to portfolio compression).
• Amend the conditions listed in Article 17 within the FCA’s rules on PTRR services (to have agreements with users of the service in place in relation to the legal effects of portfolio compression and the time at which those effects become legally binding) so they apply to all eligible PTRR services.
• Maintain the obligation for firms providing PTRR services to keep complete and accurate records of all risk reduction exercises which they organise or participate in and for such records to be made available to the FCA promptly upon request.
• Disapply the transparency requirements to transactions that arise from PTRR services (rather than requiring them to be reported with a flag).
• Amend the provisions in Article 18 to apply the disclosure requirement to all PTRR services benefitting from the exemption.
• Require providers of PTRR services to publish, no later than the close of the following business day after a PTRR service exercise is complete, the essential information about the transactions resulting from a risk reduction exercise. For portfolio compression, the disclosure includes: the total number of transactions and aggregate volume submitted for compression; and the total number of transactions and aggregate volume of derivatives terminated or modified. For other PTRR services, the disclosure includes: the total number of new derivative transactions; and the value of these transactions expressed in terms of aggregate volume.
• To not maintain the obligation to publish through an APA.
• Require firms providing PTRR services to notify the FCA of the intention to rely on the exemptions, including a description of the services provided to evidence them as eligible PTRR services, and update this when there is a change in the types of services provided.
• Changes to come into force 3 months after the publication of the FCA’s policy statement.

3. How the FCA intends to use its power to suspend or modify the DTO once its transitional powers expire

Background

• Since Brexit, the FCA has been using its temporary transitional powers (TTP) to modify the application of the DTO. The TTP expire on 31 December 2024.
• FSMA 2023 gives the FCA power to suspend or modify the DTO if it considers this necessary for the purpose of preventing or mitigating disruption to financial markets and advancing one or more of its operational objectives.

Proposals

• Modify the DTO in such a way as to achieve an outcome equivalent to that achieved by the TTP direction.
• Adjust the TTP direction to reflect the changes to the scope of the UK and EU DTO following the transition from LIBOR to risk free rates, so that it only applies to transactions in classes of derivatives that are subject to the DTO in the UK and in the EU.
• Maintain the conditions set out in the original TTP direction (that firms need to be satisfied their clients do not have arrangements in place to execute the trades on a trading venue to which both the UK and EU have granted equivalence and that the EU venue has the necessary regulatory status to do business in the UK).
• Require firms to demonstrate that they have taken reasonable steps to establish that the conditions in the TTP direction are met.

The consultation closes on 30 September 2024. The FCA will publish a policy statement with final rules in Q4 2024.

If you have any question, please contact Aniqah Rao.