FCA consults on further derivatives markets reforms

The FCA has proposed changes to the derivatives trading obligation and post-trade risk reduction (PTRR) services, as part of a package of rules and proposals for reforming the UK’s wholesale markets, published on 26 July 2024. Other elements of the package include proposals for the framework that will replace the current UK Prospectus Regulation, and final rules in relation to payment for investment research.

CP 24/14 is part of the Wholesale Markets Review (WMR) that the FCA has been conducting alongside HM Treasury, as well as the broader implementation of the G20 commitments to improve the functioning of derivatives markets, and the reform to interest rate benchmarks.

What does this mean?

The FCA is consulting on three elements of the UK derivatives market framework. These are:

Instruments subject to the Derivatives Trading Obligation (DTO): The DTO requires certain counterparties to trade certain standardised and liquid over-the-counter (OTC) derivatives only on regulated trading venues (or equivalent third country venues). Classes of derivatives brought under this trading mandate are published via a public register and must meet the following conditions:

1. Be subject to the derivatives clearing obligation, as set by the Bank of England.

2. Be admitted to trading on at least one regulated trading venue.

3. Be sufficiently liquid to trade only on those venues.

Overnight index swaps (OIS) referencing SONIA, the UK risk free rate (RFR), have been included in the DTO since December 2021. Since October 2022, OIS referencing SOFR, the benchmark US RFR, have been subject to the clearing obligation and from August 2023 those products have been subject to the CFTC’s US trading mandate.

The FCA proposes that SOFR OIS are sufficiently liquid to be brought under the DTO, based on the available evidence and market data. The tenors and contract types the FCA proposes to impose the DTO for mirror the trade execution requirements set by the CFTC.

The FCA proposes that these changes will come into effect three months after the publication of the final rules, to provide firms with sufficient time to make the necessary systems changes.

Exempting PTRR services from the DTO: The WMR concluded that the existing exemption from the DTO for transactions resulting from portfolio compression should be extended to other forms of PTRR services. The FCA was given powers to do this via rules by the Financial Services and Markets Act (FSMA) 2023. The CP includes proposals to extend the exemption to trades conducted as part of portfolio rebalancing and basis risk optimisation. It also includes the proposed characteristics that those services would need to satisfy for trades used to conduct them to be eligible for exemption, as well as the associated disclosure obligations.

For PTRR services to be eligible for the exemption, they must meet the existing requirements set out in Article 31 of FSMA 2023, as well as three additional characteristics, which are:

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.
They result in a single set of transactions that bind all the participants.

On this basis, the FCA deems portfolio compression, portfolio rebalancing and basis risk optimisation to be eligible PTRR services. Existing obligations on firms providing portfolio compression services will be maintained and extended to cover the two additional types of PTRR service.

The FCA proposes to disapply a range of regulatory requirements to eligible PTRR services. The CP also proposes to extend the disclosure requirements that currently apply to portfolio compression to the other forms of eligible PTRR services, however the existing obligation to publish through an Approved Publication Arrangement (APA) will be removed.

Modifying the DTO once the FCA’s temporary powers expire: The FCA currently has temporary transitional powers enabling it to modify the application of the DTO. These powers expire on 31 December 2024. Absent further action from the FCA, some firms would be caught by the conflicting EU and UK DTOs. The FCA therefore proposes to use its powers granted under UK MiFIR Article 28a to modify the DTO in a way that maintains the current outcomes. The direction will apply only to derivatives that are subject to the DTO in both the UK and EU.

The FCA notes that its proposed changes are aimed at promoting the stability and resilience of the UK’s OTC derivatives market, and that it has not observed any disruptions in derivatives trading since the Transitional Direction for the DTO came into effect.

What do firms need to do?

Assess the proposals within the context of the wider reforms to UK wholesale markets.

Begin preparing to implement relevant reporting and systems changes.

Assess the potential impact of the proposals on risk and collateral management processes.

Firms should consider the FCA’s proposals within the context of the wider reforms to UK wholesale financial markets, including the FCA’s proposed changes to the transparency regime for fixed income and derivatives markets.

Firms that are active in derivatives markets will need to implement updates to their reporting processes and systems to reflect the revised scope of the DTO and the exemptions for PTRR services. Firms should begin preparing for these changes now, given the expected implementation date in Q1 2025.

The FCA notes that increased levels of participation in PTRR services should reduce levels of non-market risk and lower initial margin requirements, with net positive benefits for market participants. Firms should assess the likely impact on the changes proposed in this CP on their risk and collateral management processes. Technology-enabled solutions are likely to be effective in helping to identify potential efficiency gains.