Post-trade risk reduction services and the DTO: FCA consultation paper
20 August 2024
20 August 2024
The FCA is making a few changes to the derivatives trading obligation 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 our briefing here) 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 our briefing here) following the Wholesale Markets Review (see our briefing here).
The deadline for comments is 30 September 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 3 months after the publication of its policy statement.
List of derivatives subject to the DTO
The FCA is:
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 our briefing here) 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
Power to amend or suspend the DTO
The FCA's temporary transitional powers (TTP) to modify the application of the DTO will expire on 31 December 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 (e.g.UK-authorised 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.