Whether it’s contending with CCP equivalence, the move to RFRs or emergence of crypto derivatives, the financial markets continue to transition to a post-Brexit landscape. In a Q&A with DerivSource, Julia Smithers Excell, Partner at global law firm, White & Case LLP, reviews the major milestones met in 2021 and sheds light on the challenges that derivatives market participants face in the coming year as part of the ongoing Brexit transition.
REVIEW OF 2021:
Q. What are the most significant milestones met in 2021 as the global financial markets address the changes required to support a Brexit transition?
A. First and foremost I want to take this opportunity to give a big shout-out to the UK regulators – the Bank of England, Prudential Regulation Authority (PRA) and Financial Conduct Authority (FCA) – for all their hard work and engagement with other regulators and supervisors globally, and with industry and trade associations, to ensure stability and continuity for cross-border derivatives activities during the Brexit transition period and into 2021.
From the onshoring of EU rules, to rulebook amendments, work on equivalence assessments, drafting of Memoranda of Understanding paving the way for global supervisory co-operation, equivalence and comparable compliance determinations, and work on the Temporary Transitional Powers (TTP) and Temporary Permissions Regimes (TPR), they have done a massive amount to support stability and continuity for derivatives markets, financial market infrastructure (FMI) and market participants in the UK and beyond.
This work has continued during 2021 with the roll-out of post-Brexit UK discussion and consultation papers and new UK rules impacting the derivatives market and FMIs. These have ranged from HM Treasury’s (HMT) consultations on strengthening the UK’s central counterparty (CCP) resolution regime, on the UK’s overseas persons framework for cross-border access to the UK, and on introducing a Senior Managers and Certification Regime for FMIs, and the Bank’s UK European Market Infrastructure Regulation (EMIR) consultations on its approach to tiering and granting comparable compliance to non-UK CCPs, to the regulators’ development of a new FMI Sandbox to support FMIs’ use of distributed ledger technology (DLT) in the services they provide to market participants – all summarised in their useful UK regulatory initiatives grid which helps firms (and regulators themselves) track and co-ordinate the cumulative impact of the myriad changes serving to develop the UK’s post-Brexit regulatory regime for markets.
The November 2021 version of this UK grid now runs to 45 pages – from the derivatives perspective it includes UK implementation of non-cleared Over-the-Counter (OTC) derivatives margin obligations phases 5 and 6 in September 2021 and 2022, a 2022 consultation on the status of European Economic Area (EEA) Undertakings for the Collective Investment in Transferable Securities (UCITS) as eligible collateral, changes to the scope of the UK EMIR clearing and trading obligations to reflect the ongoing transition from the London Interbank Offered Rate (LIBOR) to risk-free rates (RFRs), and the 2022 completion of the next phase of UK EMIR REFIT covering clearing access on fair and reasonable terms (FRANDT) and derivatives reporting requirements. It also covers the proposals in the UK’s 2021 Wholesale Markets Review of the onshored Markets in Financial Instruments Directive II (MiFID II) and Markets in Financial Instruments Regulation (MiFIR) and the FCA’s changes to UK MiFID conduct and organisational requirements – which may, if implemented, exempt post-trade risk reduction services from the derivatives trading obligation, realign the scope of the derivatives trading and clearing obligations, and simplify best execution reporting.
Last but by no means least, I’d flag that they have also achieved the creation of a brand new spot and futures market in the form of the UK Emissions Trading Scheme (ETS), to replace the UK’s participation in the EU Emissions Trading System (ETS) and enhance the UK’s carbon pricing policy.
And all this, at the same time as working through the impacts and terrible toll during 2020-21 of the pandemic on all stakeholders, putting huge pressure on resourcing, policy, implementation and market monitoring for regulators, supervisors, FMIs, market participants and trade associations alike.
Q. What are some of the challenges revealed in 2021 in the derivatives space?
A. To highlight just a few:
–Brexit equivalence: In terms of what remains outstanding from Brexit, there’s still the absence of EU recognition of the equivalence of UK trading venues for the derivatives trading obligation (DTO). Also on the EU side, there’s the need to extend beyond June 2022 current EMIR margin and clearing derogations for intra-group derivatives transactions with non-EU affiliates. Issues also remain with an EMIR provision intended to assist EU firms with a mechanism to avoid duplicative or conflicting rules (and related equivalence determinations) including in the implementation of non-cleared OTC derivatives margin obligations phases 5 and 6.
–Transition to RFRs: Even with all the benchmark transition work already done by trade associations, FMIs and market participants on contractual fallbacks to risk-free rates, concerns remain over some jurisdictional aspects of benchmark cessation and statutory replacement rates (as well as the cumulative pressures on firms’ teams implementing LIBOR transition by the end-2021 deadline), with further papers likely upcoming in 2022 on changes to the USD Interest Rate Swap (IRS) derivatives clearing obligation.
–Dash for cash: The initial pandemic-driven ‘dash for cash’ has generated continuing discussion among, and reports by, global regulators around the issues summarised in a 2020 speech by Bank of England Deputy Governor Sir Jon Cunliffe on the need to ensure “that derivatives clearing and margining can adjust to sharp price changes as efficiently and smoothly as possible, and to dampen down as far as possible pro-cyclical effects without reducing appropriate protection against counterparty credit risk”. Their outcome will feed into 2022 global regulators’ work programmes to improve FMI resilience – and national regulators in different jurisdictions may or may not ultimately take consistent views from a domestic implementation perspective.
–Crypto derivatives: More recently, Sir Jon has spoken of regulators’ increasing concerns around the potential impact of crypto futures and derivatives on the stability of the financial system, citing more than $40bn current open interest in crypto derivatives and leveraged positions at both regulated and unregulated FMIs, and mentioning the growth of decentralised finance (DeFi) DLT applications replicating derivatives trades. These concerns have led to actions such as the Basel June and December 2021 papers on the prudential treatment of crypto asset exposures (which mooted punitive bank capital rules) and on “DeFi risks and the decentralisation illusion” (covering crypto derivatives trading on decentralised exchanges), and the FCA’s continuing outright ban on sales of crypto derivatives to UK retail – by contrast, US regulators have started authorising crypto derivative Exchange-Traded Funds (ETFs). And the November 2021 adoption by the Council of the EU of its position on the proposed EU Regulation on Markets in Crypto Assets (MiCA), as part of the EU digital finance package, progresses the creation of a new EU-specific regulatory framework for the crypto asset markets.
LOOK AHEAD TO 2022:
Q. Looking ahead, what do you think will be the most significant challenges the derivatives markets face in the coming year and as they prepare for the ongoing Brexit transition?
A. Out of the many I’ve already listed, I’ll focus on clearing – as the UK is home to some of the world’s most systemically important FMIs.
Assuming the EU temporary equivalence determination for UK CCPs is indeed extended beyond end June 2022 (and that CCPs and market participants have certainty by very early in the New Year that this will happen) the answers depend on what, if any, additional conditions accompany it, and what the recitals to the determination announce in terms of policy drivers for the time limit of the extension.
Assuming the EU temporary equivalence determination for UK CCPs is indeed extended beyond end June 2022 (and that CCPs and market participants have certainty by very early in the New Year that this will happen) the answers depend on what, if any, additional conditions accompany it, and what the recitals to the determination announce in terms of policy drivers for the time limit of the extension. The deadline in the EU’s current determination was expressly intended to give EU clearing members time to reduce their exposure to UK CCPs, EU CCPs to develop further capacity, and European Securities and Markets Authority (ESMA) to conduct a review of UK CCPs’ systemic importance. Commissioner McGuinness‘ November 2021 extension announcement has trailed a new set: sufficient time for yet more EU capacity to be developed, for the attractiveness of EU clearing to be improved, for infrastructure development to be encouraged, and for supervisory arrangements to be reformed. So it looks like we may see EU carrots, rather than sticks – and, if so, it will very much depend on how attractive these are to tempt market participants to move more of their cleared derivatives portfolios to the EU – the Commissioner mentioned cost-effectiveness, enhanced liquidity and an expanded range of clearing solutions on offer.
Q. How will the UK plan to hold onto derivatives clearing?
A. Rather than there being a ‘UK plan to hold onto’ it as such, I’d flag the February 2021 remarks to the UK House of Commons Treasury Select Committee by Andrew Bailey, Governor of the Bank of England, anticipating various EU moves – and also the UK’s reaction. He focused on the consequences of the temporary EU equivalence determination for UK CCPs being allowed to expire, noting that this would likely mean that only around 25% of the UK’s large EUR derivatives clearing business would move to the EU, with the balance continuing to clear in London for efficiency and other reasons – and that this raised cost and efficiency questions around the viability of that 25% tranche if transferred on its own to the EU. He noted that this in turn raised questions about how the 75% balance could also be moved to the EU and mentioned an old EU ‘stick’ in this context: the potential resurrection by the EU of the failed EUR location policy of requiring EUR derivatives to be cleared in the eurozone by regulatory fiat. (You may remember the then UK Chancellor, George Osborne, beating the European Central Bank in court on this issue back in 2015.) The Governor’s comment: “I have to say to you, quite bluntly, that that would be highly controversial. It would be something that we would want to and have to resist very firmly.” Turning to a second potential EU ‘stick’ – of penalising banks for not moving their clearing business to the EU – he warned “That would be very controversial. Frankly, it would be a very serious escalation of the issue.”
Q. What are some of the other challenges market participants should be aware of going into 2022?
A. There are a few to consider:
–I’d flag the DTO again: hand-in-hand with clearing goes derivatives trading, which is already impacted by the lack of EU equivalence decision, leading to the liquidity fragmentation and the move of derivatives caught by both UK and EU DTO rules to US swap execution facilities already widely reported on during 2021.
–And I’ll pick out the Central Securities Depositories Regulation (CSDR): while the February 2022 implementation date of the EU CSDR’s settlement discipline regime and its mandatory buy-in rules looks set to be pushed back temporarily, concerns remain around how they may ultimately impact derivatives margin transfers due to their potentially wide and cross-border application on current drafting.
–Also detailed EU FRANDT rules: the conditions under which the commercial terms for OTC derivatives clearing services will be considered ‘fair, reasonable, non-discriminatory and transparent’ – will start impacting firms’ onboarding processes, commercial terms and RFPs in 2022, despite various interpretational issues remaining.
–EU pension schemes: EU pension schemes will lose their temporary EU EMIR derivatives clearing exemption when it expires in June 2022 (UK pension schemes already lost it at Brexit) unless it is extended again for a final time to 2023 (mirroring the UK EMIR extension timeline for UK and EU pension schemes). Leaving the exemption to expire will not necessarily lead to a big uptick in EU derivatives clearing volumes due to these entities’ technical difficulties with CCP margin posting which were the drivers for this exemption in the first place.
–UK TTP and TPR: And the UK TTP and TPR regimes smoothing the Brexit transition are due to expire in 2022, as do the EU temporary derogations for the novation of legacy OTC derivatives from UK to EU counterparties without triggering EU EMIR clearing or margin requirements.
–EU Benchmarks Regulation (BMR): Finally, looming on a slightly longer horizon, market participants and benchmark administrators still await certainty that the amended EU BMR rules permitting EU supervised entities to use non-EU benchmarks up to end-December 2023, will be extended again to end-2025 (mirroring the UK’s extended timeline) giving more time for a much-needed review of the BMR’s third country benchmarks regime.
Q. What needs to happen in Europe to ensure a smooth outcome of some of the above challenges?
A. Obviously the more EU equivalence determinations for the UK in as many areas as possible, the better! But we apparently still need to wait until the EU is happy to announce that it has a better handle on how UK rules will diverge from the EU’s – and since both EU and UK rules are changing all the time for lots of different reasons, it’s not at all clear when (if ever) that will be…
Q. What are some of the actions that financial institutions can take this year to ensure they are as resilient as possible to any possible future upheaval caused by some of the stated challenges? What other advice would you give the market and market participants?
A. Firstly, operational resilience of firms and FMIs, as well as risk management of any outsourcing and of their third-party contractors and service providers, is a big area of focus for UK, EU and global regulators – which has only sharpened as a result of the pandemic. I’ve already mentioned the additional work on UK CCP resolution (including dealing with losses arising at a CCP other than by reason of clearing member default, e.g. a cyber attack; the EU is well ahead with its own CCP recovery and resolution rules) and globally on CCPs’ margin requirements; the Bank of England also recently issued letters to Central Securities Depositories (CSDs) and CCPs on their outsourcing to cloud service providers specifically. It’s important that firms engage with their supervisors and map and identify their important business services at Board level so senior management can prioritise these if disrupted; they also need to set impact tolerances for these and ensure they can remain within them by testing and addressing any vulnerabilities. The November 2021 adoption by the Council of the EU of its position on the proposed Digital Operational Resilience Act (DORA), as part of the EU digital finance package, progresses the creation of a new EU regulatory framework on digital operational resilience to prevent and mitigate cyber threats.
Secondly, climate change and Environmental, Social and Governance (ESG) issues. Discussions over the categorisation of derivatives under the EU green taxonomy, capital and disclosure rules have continued, including how they should be dealt with under green asset ratio obligations and key performance indicators measuring sustainability alignment. And the UK is starting to consult on its own new post-Brexit ESG rules, including the discussion paper on diversity in the financial sector produced by the 3 UK regulators in July 2021. So firms need to engage with – and keep on top of – diverging ESG regulatory developments in multiple jurisdictions. In the meantime increasing numbers of ESG derivatives are being transacted by firms both bilaterally OTC and on exchange as Exchange-Traded Derivatives (ETD). And the 2021 papers published by the global Taskforce on Scaling Voluntary Carbon Markets highlighted industry focus on different voluntary carbon markets being scoped in various jurisdictions and the need for proper governance, consistent legal frameworks, and accurate and reliable ESG data, benchmarks and ratings methodologies.
Thirdly, reporting, transparency and data: the focus on data quality and efficiency is also a theme for the reporting and transparency regimes for trading venues and market participants on both sides of the Channel. I’ve already mentioned some of the developments from UK regulators; while their Digital Regulatory Reporting initiative has been around for a while, they are aiming to transform their management and collection of data by defining and adopting common data standards, potentially coding their reporting instructions, and integrating reporting for a more streamlined approach to consistent data collection across domains, sectors and jurisdictions. This will only be successful in reducing regulatory reporting burdens in the UK if firms actively collaborate with the UK regulators on this workstream. Separately in the EU, the outcome of consultations on the establishment of a European Single Access Point for financial and non-financial data will, it is hoped, ultimately benefit market participants’ access to meaningful EU information (including on ESG data). Whether the EU’s proposed MiFID II/MiFIR Review changes will be successful in their second attempt to create a consolidated tape (and will work for the derivatives market) remains to be seen.
Q. What goals would you like the derivatives markets to achieve in 2022 to support a streamlined Brexit?
A. You may recall the International Organization of Securities Commissions’ (IOSCO) June 2019 report on harmful, unintended market fragmentation in derivatives markets, which considered the practical steps which IOSCO and its global members could take to mitigate these adverse effects. These included deference between regulators through the use of cross-border regulatory tools in parallel with increased supervisory and enforcement cooperation. IOSCO then published a June 2020 report on the underlying processes which authorities rely on when making deference determinations, and identified best practices to make these more efficient. IOSCO’s conclusion to that 2020 report says it all: “derivatives markets are global by nature. To fully realise the benefits of a global economy, policymakers and regulatory authorities are called upon to develop efficient deference mechanisms and processes that promote safe global capital markets and avoid unintended and harmful market fragmentation which may hinder capital formation, give rise to financial stability concerns and/or limit investor choice.”.
Just like derivatives markets, climate change is cross-border by nature too, inviting global consistency in the development of taxonomies, disclosures, carbon markets and capital rules. So an action like linking the new UK ETS with the EU’s ETS is an efficient way of helping those jurisdictions reach net zero more quickly, as well as providing potentially beneficial impacts for liquidity, carbon pricing, price discovery, cost-effectiveness and wider access to different abatement options like carbon capture and storage. DLT and machine learning/artificial intelligence also do not recognise jurisdictional boundaries – and derivatives markets innovation (as well as market stability and investor protection) in these areas may be limited by a similar lack of proactive cross-jurisdictional regulatory and supervisory co-operation.
In the meantime, all derivatives markets participants and FMIs can do is to keep tracking and implementing the growing regulatory and supervisory divergence across different jurisdictions in these many areas.
Any views expressed in this publication are strictly those of the authors and should not be attributed in any way to White & Case LLP.