A look at some of the questions raised in the FCA’s open consultation on DTO and PTRR.
The Financial Conduct Authority (FCA) has released a consultation paper on the Derivatives Trading Obligation and Post-trade Risk Reduction Services (CP 24/14). This forms part of an ongoing review of UK wholesale financial markets that the financial conduct regulator has been conducting with HM Treasury, the UK finance ministry, since 2021 (known as the Wholesale Market Review, WMR).
In this public consultation, the FCA calls for feedback on proposed changes to the DTO in three areas. First, on whether selected overnight index swaps (OIS) which reference the US Secured Overnight Financing Rate (SOFR) should be brought under the coverage of the DTO.
Second, on whether it should extend the range of post-trade risk reduction (PTRR) services that are exempt from the DTO,
And, third, on how the FCA will suspend or modify the DTO when transitional powers in force after Brexit, under Part 7 of the Financial Services and Markets Act 2000 (Amendment) (EU Exit) Regulations 2019, expire at the end of 2024.
Overnight Index Swaps
The regulator notes that the liquidity profile of some classes of OTC derivatives has changed since the DTO was introduced in 2017, particularly in response to the managed transition away from the London Interbank Offered Rate (Libor) and other Interbank Offered Rates (Euribor, Eonia) towards risk-free rates.
With the adoption of the Sterling Overnight Index Average (SONIA) to replace GBP Libor, the FCA indicates that it removed derivatives referencing GBP Libor from the DTO and replaced them with OIS referencing SONIA, a reform that came into effect on 20 December 2021.
Similarly, with the transition from USD Libor to SOFR, the regulator has removed derivatives that reference USD Libor from the DTO. This change took effect on 24 April 2023.
Based on its liquidity analysis – which draws on 2023 transaction data from trade repositories, along with spread data from ICE Swap Rate and qualitative data provided by trading venues – the FCA proposes that SOFR OIS are sufficiently liquid to be brought under its trading obligation.
This analysis focuses on SOFR OIS that fall into scope of the Commodity Futures Trading Commission’s (CFTC’s) US trading mandate and its ‘made-available to trade’ (MAT) determinations, involving benchmark tenors of 1 to 7 years, 10, 15, 15, 20 and 30 years.
“While certain tenors are materially less liquid than others, SOFR OIS are not less liquid than the existing classes of derivatives in scope of the DTO,” says the FCA. It suggests that SOFR OIS are traded in large sizes, generally larger than those executed in SONIA OIS and EURIBOR swaps. “While we were able to collect only aggregate information on spreads, the evidence from the ICE Swap Rate benchmark is consistent with the availability of pre-trade information and bid and offer prices in standard market sizes,” it adds.
Post-trade risk reduction
A second question raised for public consultation in CP 24/14 is whether the FCA should expand the list of PTRR services that are exempt from the DTO.
PTRR refers to a category of services, including portfolio compression, portfolio rebalancing and basis-risk optimisation, that enable counterparties to manage risks arising from their derivatives portfolios, including counterparty risk and operational risk. They are designed to do so without changing a counterparty’s fundamental market positions, typically by applying market-risk neutral transactions into existing netting sets.
Under MiFIR, trades concluded through portfolio compression are exempt from the DTO, pre- and post-trade transparency reporting and best execution rules. PTTR service providers are also not required to seek authorisation as an execution venue when operating a multilateral system.
Earlier in the WMR consultation, policymakers asked whether transactions in other types of PTRR services should be treated in the same way as transactions arising from portfolio compression. The majority of respondents indicated that exemptions should be extended to other risk reduction services, subject to appropriate conditions being in place.
In line with this sentiment, the FCA proposes in CP 24/14 that transactions that originate solely from risk reduction services are “non-price forming” and that requiring them to comply with obligations such as the trading mandate would not improve transparency or market efficiency.
By expanding the range of PTRR services that are exempt, the FCA suggests that these changes will boost the UK’s international competitiveness by enabling UK firms to offer innovative and effective PTRR solutions without being subject to “disproportionate regulatory costs”.
Temporary transition powers
The DTO derives from the G20 commitments introduced in the wake of the 2008-9 financial crisis requiring, among other obligations, that standardised derivatives contracts should be traded on regulated exchanges or electronic trading platforms and they should be cleared through registered central counterparties.
In parallel, firms falling into scope of these regulations are required to report the terms of OTC derivatives trades to a registered trade repository, with non-cleared OTC derivatives trades commonly being subject to higher capital charges under subsequent BCBS-IOSCO rules.
The DTO is the regulatory package through which these G20 recommendations were implemented in the EU, and subsequently in the UK.
In the UK, the DTO is enacted through Article 28 of the Markets in Financial Instruments Regulation (MiFIR), which requires that firms falling into scope of the regulation execute standardised and liquid OTC derivatives transactions on regulated trading venues or equivalent third-country venues.
Following the UK’s departure from the EU, the FCA has been using its temporary transitional powers (TTP) to modify the application of the DTO, powers that will extend until the end of 2024.
However, the Financial Services and Markets Act, 2023 has also inserted Article 28a into UK MiFIR that empowers the FCA, subject to HM Treasury’s consent, to suspend or modify the DTO if it deems this necessary to prevent market disruption or to achieve its operational objectives.
In the consultation paper, the FCA specifies that it intends to use its powers under UK MiFIR Article 28a to modify the DTO to achieve outcomes equivalent to that achieved by the TTP – with necessary adjustments to reflect changes to the scope of the UK and EU DTO following the transition from Libor to risk free rates.
If it does not take this action, the regulator suggests, there is a danger that some firms – particularly UK branches of EU investment firms – may be disadvantaged by conflicting DTO obligations in the UK and the EU that could result in disruption to financial markets.
It asks respondents to submit their feedback on CP 24/14 before the close of the consultation window on 30 September 2024.
