The UK Financial Conduct Authority (FCA) today opened a consultation on the derivatives trading obligation (DTO), as the regulator seeks input on its proposal to modify it and the liquidity analysis supporting it.

As specified in Article 28 of UK MiFIR (onshored Regulation (EU) No 600/2014 on Markets in Financial Instruments), the DTO requires that financial and certain non-financial counterparties conclude transactions in standardised and liquid over-the-counter (OTC) derivatives only on regulated trading venues. These trading venues include regulated markets (RMs), Multilateral Trading Facilities (MTFs) and Organised Trading Facilities (OTFs).

Currently, the classes of derivatives that are subject to DTO are swaps referencing to USD LIBOR, GBP LIBOR and the Euro Interbank Offer Rate (EURIBOR) and index Credit Default Swaps (CDS) for contracts with standardised terms, such as payment frequency, trade start type, and notional amount type.

The FCA is proposing to modify the list of derivatives subject to the DTO in line with Articles 28 and 32 of UK MiFIR as further specified under the UK regulatory technical standard (RTS).

The regulator needs to review the DTO in light of the interest rate benchmark reform and the consequential changes that the Bank of England has proposed to the derivatives clearing obligation (DCO) in line with Article 5 of UK EMIR in its consultation. OTC derivatives based on benchmark rates that are being discontinued or may continue on an unrepresentative basis and become subject to use restrictions under UK Benchmarks Regulation need to be excluded from the DTO to ensure its scope remains relevant.

The DTO should extend to derivatives based on relevant risk-free rates (RFRs) that will replace them, provided they are sufficiently liquid or are likely to become sufficiently liquid as transition plans approach or reach completion.

The liquidity analysis indicates that Overnight Indexed Swaps (OIS) referencing the Sterling Overnight Index Average (SONIA) as a class of OTC derivatives is sufficiently liquid to impose a DTO. Hence, the FCA proposes to remove derivatives referencing GBP LIBOR under the current DTO and replace them with OIS referencing SONIA.

The FCA analysis shows that OIS referencing the Euro short-term rate (€STR) do not yet display the same level of liquidity of EURIBOR or other products currently subject to the DTO. The regulator intends to monitor market developments and liquidity in €STR OIS markets over the coming months. It would consider including them in the DTO once it is satisfied that the class of derivatives is sufficiently liquid.

As relevant EURIBOR-based swaps continue to be sufficiently liquid at the current time the FCA proposes to maintain them as part of the DTO.

Liquidity in OIS referencing the Secured Overnight Financing Rate (SOFR) as a class of OTC derivatives is developing. It may well increase rapidly over coming months. But, at the time of this analysis may not yet meet relevant criteria to be sufficiently liquid for the purposes of the DTO. The Bank has not proposed any changes to the DCO for USD products and contract types referencing USD LIBOR continue to be subject to the DCO. In absence of a change to clearing mandates, the FCA intends to monitor market developments and liquidity in USD LIBOR and SOFR products over the coming months as relevant deadlines and milestones are likely to impact liquidity.

The FCA is seeking views on the proposals by 25 August 2021.