Trading Places: Consultation on Derivative Trading Obligation

At the end of last month, the Financial Conduct Authority’s (FCA) request for comments officially came to a close on the Consultation Paper (CP24/14) it published in late July seeking comments on proposed changes to the derivatives trading obligation (DTO) and post-trade risk reduction services (PTRRS).

The DTO requires certain financial and non-financial counterparties to conclude transactions in specific standardised and liquid OTC derivatives (as selected by the FCA) on regulated trading venues or equivalent third country venues only. PTRRS encompass a variety of services which enable market participants to reduce non-market risks arising from their existing positions and can often involve the creation of contracts which fall under the DTO.

The stated aim of the proposals is to improve the UK’s regulation of derivative secondary markets, reduce systemic risk in derivatives markets and avoid fragmentation and disruption for firms trading over-the-counter (OTC) derivatives subject to the DTO.

Based on the responses received, the FCA intends to publish its direction on the modification of the DTO at some point this quarter. As we wait for the results, here is a brief recap of the proposed changes:

Key Proposals

The Consultation Paper includes proposals on three distinct but interconnected aspects of the DTO:

1. Inclusion of SOFR OIS in DTO

Driven, in large part, by the global transition from LIBOR to risk-free rates, the FCA proposes to include certain overnight index swaps based on the US Secured Overnight Financing Rate (SOFR) (i.e. interest rate swaps referencing SOFR) within the classes of derivatives subject to the DTO. This follows the Bank of England’s inclusion of SOFR OIS under its clearing obligation and the US CFTC’s trading mandate for these instruments.

The FCA intends to implement these changes by amending the UK regulatory technical standards which contain the DTO (onshored Commission Delegated Regulation (EU) 2017/2417) to bring these derivative instruments in-scope.

2. Expansion of PTRR Services Exemptions

The FCA proposes to expand the list of PTRR services exempted from the DTO, to support firms’ risk management practices and to reduce systemic risk in financial markets.

The proposals include extending the exemption for portfolio compression to portfolio rebalancing and basis risk optimization, two widely used risk reduction services.

The Consultation Paper also sets out the characteristics that risk reduction services would need to satisfy for trades used to conduct them to be eligible for exemption. In addition, it seeks to require providers of PTTR services to comply with new disclosure and notification obligations.

3. Power to Suspend or Modify DTO

Lastly, the proposal outlines how the FCA intends to use its powers to suspend or modify the DTO. These are currently contained in temporary transitional powers (TTP) under Part 7 of the Financial Services and Markets Act 2000 (Amendment) (EU Exit) Regulations 2019, but they expire at the end of this year on 31 December 2024.

The FCA was granted a new power to suspend or modify the DTO pursuant to The Financial Services and Markets Act 2023, which inserted Article 28a into the onshored Regulation (EU) No 600/2014 on Markets in Financial Instruments Regulation, if it considers it necessary for the purpose of preventing or mitigating disruption to financial markets and advancing one or more of its operational objectives.

The Consultation Paper sets out the ways in which the FCA intends to use these powers in a similar way it used the TTP, with the aim of preventing market fragmentation and disruption for firms trading OTC derivatives subject to the DTO. They will repeat an existing direction that allows firms subject to the DTO to trade with, or on behalf of, EU clients subject to the DTO on EU venues, provided that certain conditions are met.

Key Stakeholders

• These proposals are likely to impact a number of stakeholders, including:
• Providers of PTRR services
• Trading venues that admit to trading or trade derivatives
• Investment firms and banks dealing in derivatives
• UK branches of overseas firms undertaking investment services and activities

The proposals are also of interest to Approved Publication Arrangements (APAs), central counterparties (CCPs), law firms, consultancies and their related trade associations.

Next Steps

The FCA’s call for comments on the proposals recently came to an end on 30 September 2024. Based on the responses, the FCA will finalize the draft rules, guidance, technical standards, and policy statement, with the direction on the modification of the DTO expected to be published over the next few months. Stay tuned for further updates and, in the meantime, the Consultation Paper can be viewed here and the full text of the proposed draft amendments can be found in Appendix 1.