The FCA is making a few changes to the derivatives trading obligation (DTO) and post-trade risk reduction services. This includes notification and disclosure requirements. Firms should review proposals to ensure adequate arrangements are in place in time for implementation of the rules.

The changes include bringing certain overnight index swaps (OIS) based on the US Secured Overnight Financing Rate (SOFR) within the classes of derivatives subject to the DTO; and expanding the list of post-trade risk reduction (PTRR) services exempted from the DTO and from other obligations. These are in light of market developments and also follow the FCA’s consultation on a transparency regime (see FCA: Non-Equity Transparency Proposals) for OTC derivatives (where some wondered if technical trades arising from post trade risk reduction would be within scope of the new regime).

The proposals are set out in consultation (CP24/14) and are being laid out by the FCA as the result of new powers it was given under UK MiFIR via FSMA 2023 (see Financial Services and Markets Act 2023: Setting out the post Brexit framework for financial services) following the Wholesale Markets Review (see MiFID II UK Shake Up – More Marathon Than Sprint).

The deadline for comments is September 30, 2024, following which the FCA will publish a policy statement with supporting materials. It plans to publish its direction on the modification of the DTO in Q4 2024. The FCA plans for the changes to come into force three months after the publication of its policy statement.

List of derivatives subject to the DTO

The FCA is:

• proposing to impose the DTO for SOFR OIS to trade start types spot-starting and IMM (next two IMM dates) with tenors of 1, 2, 3, 4, 5, 6, 7, 10, 12, 15, 20 and 30 years; and
• seeking views on bringing 12-year SOFR products in the scope of the DTO (it notes that the CFTC, in its MAT determination, made the 12-year SOFR product subject to its trade execution requirement for spot starting swaps and IMM swaps with a par fixed rate, but not for IMM swaps with a standard coupon fixed rate).

For a derivative to be brought under the DTO it needs to be: subject to the derivatives clearing obligation; admitted to trading on at least one regulated trading venue; and sufficiently liquid to trade only on those venues.

SOFR OIS have been under the clearing obligation since 2022. As of December 2021, derivatives referencing GBP LIBOR were removed from the DTO and replaced with OIS referencing SONIA. The FCA also removed derivatives referencing USD LIBOR from the DTO (these changes were set out in Handbook Notice 108) as a result of the transition from USD LIBOR to SOFR. This change entered into force on 24 April 2023.

The FCA has received feedback as to whether the proposed transparency regime laid out in its consultation paper on improving transparency for bond and derivatives markets (see FCA: Non-Equity Transparency Proposals) covers transactions resulting from PTRR. The FCA considers that the current consultation is the best area to deal with PTRR services and considers that its proposals facilitate the use of PTRRs services.

Exemptions for post-trade risk reduction services

PTRR services enable counterparties to manage their exposure to types of risk from derivatives portfolios.

New Article 31(1) of UK MiFIR contains a definition of risk reduction service and allows the FCA to disapply certain obligations in relation to activities and transactions (to be further specified by the FCA) carried out for risk reduction purposes.

Under MiFIR, trades concluded as part of portfolio compression are exempted from the derivatives trading obligation, best execution requirements, and pre- and post-trade transparency (subject to aggregated information being made public).

Notable proposals:

• Maintaining the existing exemptions from the DTO for trades conducted as part of portfolio compression.
• Expanding the exemptions to trades conducted as part of portfolio rebalancing and basis risk optimisation, which are widely used risk reduction services.
• Requiring providers of PTRR services to comply with disclosure and notifications obligations.
• Proposing that “eligible PTRR services” (revised article 31 of MiFIR) will not 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 an MTF or an OTF for firms with a Part 4A permission; and the trading obligation under Article 28 MiFIR.
• Proposing that eligible post trade risk reduction services must meet three additional essential characteristics (this is to separate systems operated by risk reduction services from other systems, including those of trading venues): they are provided by a firm that is not party to a transaction resulting from the service; they are operated on the basis of non-discretionary rules set in advance by the operator that are based on specified parameters; and they result in a single set of transactions binding all the participants. The FCA considers it can reduce of conflicts of interest by requiring the service to be performed by a third-party provider.
• Broadly maintaining the conditions in Article 17 within FCA rules on PTRR services, with amendments so they apply more to all eligible risk reduction services (the FCA states that fulfilling these conditions will make the PTRR service agreement with its users an “eligible agreement” for FCA rules).
• Maintaining the obligation for firms providing risk reduction services to keep complete and accurate records of all risk reduction exercises that they organise/participate in and for such records to be made promptly available to the FCA upon request.
• Applying the disclosure requirement in Article 18 of the MiFIR Delegated Regulation (which sets out the information to be made public concerning transactions concluded through a portfolio compression) to all risk reduction services benefitting from the exemption.
• A notification requirement for firms operating a PTRR service (notification would include a description of the services provided to demonstrate that they are eligible post-trade risk reduction services and will need to be updated when there is a change in the types of services provided).
• Requiring providers of risk reduction services to publish essential information about the transactions resulting from a risk reduction exercise (this would be no later than the close of the following business day after a PTRR service exercise is complete). For portfolio compression, this includes: the total number of transactions and aggregate volume submitted for compression; the total number of transactions and aggregate volume of derivatives terminated or modified. For other risk reduction services, the disclosure will include: the total number of new derivative transactions: and the value of these transactions expressed in terms of aggregate volume.

Power to amend or suspend the DTO

The FCA’s temporary transitional powers (TTP) to modify the application of the DTO will expire on December 31, 2024. FSMA 2023 gives the FCA a power of direction to suspend or modify the DTO to prevent or mitigate disruption to financial markets and advance one or more of its operational objectives. The FCA plans to make adjustments to its new direction so that it only applies to transactions in classes of derivatives subject to the DTO in both the UK and in the EU.

The FCA states that this approach would enable persons to continue to be able to trade derivatives in scope of the DTO on EU trading venues in certain cases (efor example UK-authorized firms, including asset managers and UK branches of EU firms, will be able to execute transactions on EU trading venues, where certain conditions apply).

Firms will still need to be satisfied: that their clients do not have arrangements in place to execute the trades on a trading venue granted equivalence by both the UK and EU; and that the EU venue has the necessary regulatory status to do business in the UK. Firms are expected to show reasonable steps to establish that the conditions are met.

The information provided is not intended to be a comprehensive review of all developments in the law and practice, or to cover all aspects of those referred to.
Readers should take legal advice before applying it to specific issues or transactions.

Tim Cant and Jake Green are partners, Sid Ulker is of counsel and Vidhi Mahajan is a senior associate in the financial regulation practice at Ashurt.