Proposed Changes to Derivatives Trading Obligation: FCA Consulting Insights
Background:
In 2021, the Financial Conduct Authority (FCA) and HM Treasury embarked on the Wholesale Markets Review, a comprehensive evaluation of the structure, functioning, and regulation of secondary financial markets in the UK. The primary objective of the Review is to ensure that the UK’s wholesale markets are effectively regulated, efficient, and remain a key hub for global financial activities, especially in light of recent developments such as Brexit and global interest rate benchmark reforms.
Development:
As part of the ongoing Review, the FCA recently unveiled a series of proposals related to the regulation of derivatives markets, outlined in Consultation Paper CP24/14. These proposals focus on the derivatives trading obligation (DTO), a regulatory requirement in the UK and EU that mandates certain derivatives to be traded on regulated venues.
Looking Ahead:
The FCA is aiming to finalize its direction to modify the DTO by Q4 2024, with a specific focus on Overnight Indexed Swaps (OIS) based on the U.S. Dollar Secured Overnight Financing Rate (SOFR) to be included from January 1, 2025. Firms affected by these changes will need to adjust their trading strategies and compliance procedures accordingly. It is crucial for firms to be prepared for potential conflicting obligations under the UK and EU DTO regimes if a replacement for the FCA’s transitional powers is not established by the end of the year.
Key Proposals:
On July 26, 2024, the FCA released CP24/14, detailing proposed changes to three main aspects of the DTO:
1. Inclusion of certain OIS products based on SOFR within the DTO scope.
2. Expansion of the list of post-trade risk reduction (PTRR) services exempted from the DTO and other obligations.
3. Utilization of new powers to suspend or modify the DTO after the temporary transitional powers (TTP) expire on December 31, 2024.
Bringing SOFR OIS Products Within the DTO Scope:
The FCA’s proposal to include SOFR OIS derivatives within the DTO is expected to enhance liquidity, transparency, and reduce trading costs. This move follows changes in liquidity profiles of OTC derivatives due to the transition from Interbank Offered Rates (IBORs) to risk-free rates (RFRs) as part of interest rate benchmark reforms. The FCA’s decision to include SOFR OIS within the DTO aligns with actions taken by other regulators and is based on the significant liquidity observed in the SOFR swaps market.
Exempting Eligible PTRR Services:
The FCA’s proposal to exempt eligible PTRR services from certain regulatory obligations aims to align the regulatory treatment of these services with that of portfolio compression trades. These PTRR services play a crucial role in helping counterparties manage exposure to various risks in their derivatives portfolios without altering their fundamental market positions. The FCA’s proposal establishes defined characteristics and conditions for eligible PTRR services to ensure market integrity and efficiency.
Proposed Replacement for the Expiring TTP:
With the TTP set to expire at the end of 2024, the FCA has put forth a proposal to use its power of direction under Article 28a of UK MiFIR to modify the DTO effectively. This adjustment is necessary to prevent conflicting obligations under the UK and EU DTO regimes, particularly for firms like UK branches of EU investment firms. The FCA’s proposed modifications aim to achieve an outcome equivalent to that of the expiring TTP, ensuring market stability and operational continuity.
Insights by Jones Day:
The insights provided by Jones Day offer valuable perspectives on the proposed changes to the derivatives trading obligation and their potential impact on the financial markets. By outlining the key proposals and implications, Jones Day contributes to a better understanding of the regulatory landscape and the importance of aligning UK regulations with global standards.
In conclusion, the proposed changes to the derivatives trading obligation represent a significant step towards enhancing the regulatory framework for derivatives markets in the UK. By addressing key aspects such as the inclusion of SOFR OIS products, exemption of eligible PTRR services, and replacement for the expiring TTP, the FCA aims to promote market stability, efficiency, and alignment with international regulatory practices. Firms operating in the derivatives market should closely monitor these developments and prepare for the upcoming changes to ensure compliance and risk management.
