Markets View – September 2022

Welcome to the September edition of Markets View. In case you’re looking to catch up on the most significant developments over the summer period, this month we’ve got a bumper edition for you. We look at the FCA’s consultation on equity secondary markets reform, the EU’s distributed ledger technology (DLT) pilot scheme, a further extension to European pension schemes’ clearing obligations under EMIR, and consider two new FCA reviews of trade data, including benchmarks and credit rating data. We also provide essential at-a-glance summaries of ESMA proposals to reform the CSDR cash penalties distribution regime, and change clearing and derivatives trading obligations and third-country CCP recognition.

FCA kicks off its post-Brexit MiFID2 reforms with proposals for improving equity secondary markets

Following the HM Treasury / FCA Wholesale Markets Review (WMR), the FCA is consulting on proposals reforming MiFID2-related rules and guidance aimed at improving UK equity secondary markets. These proposals are necessary reading for trading venues, investment firms and UK branches of overseas firms, as they present potential opportunities for reduced compliance costs but equally may require investment into IT and reporting systems. Investment managers and other buy-side firms should also take especial note, as the proposals could help rationalise post-trade transparency obligations and improving the quality of execution they receive.

Designated reporter regime (DRR)

The FCA proposes replacing the SI regime with a new designated reporter regime (DRR) by separating post-trade transparency from systematic internaliser (SI) status and simplifying OTC transaction reporting. Under the DRR, firms would be able to voluntarily register as “designated reporters” with the FCA and the status would apply at entity level, regardless of whether they are an SI in any instrument. Firms may then voluntarily assume trade reporting obligations when trading with their clients in any instrument (equities and non-equities). As now, only counterparties to a trade will be able to report that trade.

Conceptually, the DRR is a like-for like swap for SI status (at least for firms that only had SI status for post-trade reasons). The FCA intends that the SI regime’s fundamental principles would continue to apply, i.e., firms executing trades OTC would have to report transactions through APAs. The DRR should enable market participants to more quickly and easily identify who is responsible for reporting a trade and may also lead to lower operating costs.

The proposals should be reviewed by all current SIs and trade reporting entities, particularly as the proposed changes would require investment in IT and reporting systems. We expect firms will have comments, in particular, about the regime’s proposed scope, namely its limitation to entity-level registration (rather than an opt-in at individual asset class level).

Post-trade transparency

The FCA has proposed excluding certain non-price forming OTC arrangements / trades from post-trade reporting requirements. These transactions were not clearly scoped in by the initial MiFID2 drafting and tend to both add noise to post-trade transparency information and increase firms’ reporting costs, so their exclusion should make post-trade transparency more useful. The two most helpful proposed exclusions involve:

• Requests for market data (RFMD) give-ups - the FCA proposes to exclude these from the reporting obligation, as they often do not provide information additional to that already reported in the market leg of trades concluded by the executing broker. The FCA proposes to include RFMD in the definition of give-up / give-in trades where the trade is passed to hedge the prime broker's derivative position with the client. In contrast, as ESMA confirmed in its recent RTS 1 report, RFMD give-ups will still have to be reported as benchmark transactions in the EU.

• OTC intra-group transactions - where these are undertaken for risk management purposes, e.g., for complying with margin or collateral requirements, the FCA proposes they be excluded from reporting, as they provide no additional visibility in addressable market liquidity. While some systems workflow amendments may be required for investing firms (and APAs), these proposals could streamline reporting around post-Brexit risk management arrangements between UK and EU affiliates. We recommend buy-side firms, though, seek clarification (by responding to the consultation) whether this proposed amendment would cover managed accounts, e.g., where there is a rebalancing, as this does not currently appear to be the case (but logically it should, as such rebalancing does not add to addressable market liquidity).

Besides the above, the FCA proposes to simplify trade flags and other reporting fields and introduce amendments aimed at creating greater consistency / limiting duplications in the use of flags for trades that are exempted from post-trade transparency, the share trading obligation and pre-trade transparency under the negotiated trade waiver (reflecting that unlike in the EU, the double volume cap mechanism is being deleted in the UK). These changes should improve reports’ information content and aid multi-source data consolidation, but as with other changes, would require investment into IT and reporting systems.

Pre-trade transparency waivers

The FCA is proposing changes to the reference price and order management facility (OMF) waivers. This may make venue liquidity slightly more attractive by removing some of the hurdles to benefit from these waivers. These amendments are relatively targeted, so we expect that there will be more material changes to come later in the WMR. The proposed changes include:

• Most relevant market in terms of liquidity (MRMTL) definition - The MRMTL definition used for the MiFIR reference price waiver test would be amended to allow venues operating dark pools to derive reference prices from non-UK venues (provided that the price is transparent, robust and offers the best execution result); and

• Order management facility (OMF) waivers - With the aim of lowering the overall cost of trading for market participants, the FCA proposes removing the minimum size threshold requirement for reserve / iceberg orders benefitting from OMF waivers, and proposes delegating the decision to set a minimum size threshold for these orders to trading venues.

Tick size

For shares traded on UK venues whose main pool of liquidity is located on a trading venue outside the UK (usually the exchange where they are listed), the FCA proposes allowing UK equity trading venues to use a minimum tick size from the most liquid overseas market when that tick size is smaller than the one determined on data from UK venues. This should solve issues with the interaction between tick sizes and overseas markets endemic to the regime since it came into force, lowering transaction costs and providing greater selection and access to overseas shares for UK investors.

Outages

Building on wider regulatory operational resilience reform efforts, the FCA is consulting on the detail of future guidance on trading venue market outage communications and protocols. The guidance, largely in line with previous FCA suggestions, is aimed at both trading venues and members of trading venues. Both these groups should focus on these proposals in case they lead to further implementation work, though we note that the guidance for members of trading venues, relating to outage preparedness, may already be covered in existing policies. In any case, our Trading Venue Reviewer will pick up any trading venue rulebook changes to be consumed by venue members.

Next steps

The deadline for comments on proposals is 16 September 2022. Let us know if you would like any help in considering these proposals and the implications for your business as well as in preparing a consultation response.

EU DLT Pilot Regime—Shaping the future of DLT-based financial markets and digital securities

The EU has published its finalised plans for a DLT pilot regime (DLTPR). The DLTPR provides an opportunity for firms to obtain authorisation to operate DLT market infrastructure (DLT MI) within the EU while taking advantage of certain exemptions from existing financial services regulation. With the DLTPR, the EU has taken a true ‘sandbox’ approach, recognising that DLT is often not well served by traditional regulation, and allowing firms relative freedom to develop technology and infrastructure under supervision.

Under the DLTPR, investment firms, market operators and CSDs already authorised within the EU under MiFID2 or the CSDR may apply for an additional permission to operate certain DLT MI. For authorised investment firms and market operators, this includes either DLT multilateral trading facilities (DLT MTFs), and for authorised CSDs, this includes DLT settlement systems (DLT SS). The DLTPR has also introduced a new infrastructure type, trading and settlement systems (DLT TSS), which may be operated by either investment firms / market operators or CSD. This is a novel development, as it provides an opportunity for CSDs and investment firms to expand their service offerings to cover both trading and settlement (albeit only within the realm of DLT). Significantly, new entrants who are not yet authorised may apply for temporary authorisation concurrently with permission to operate a DLT MI.

Firms may be granted permission for a period of up to 6 years (or until the DLTPR expires) and this permission may be passported EU-wide. At present, it is unclear what will happen to DLT MIs when the regime expires. ESMA will report on the regime’s future midway through the pilot period (i.e., by 24 March 2026), with its views on whether the regime should end, be changed, or be made permanent. Some firms wishing to participate may be put off by the risk of investing in building the necessary infrastructure with no certainty that the regime will survive beyond the six-year period that the DLTPR is set to run.

The financial instruments that may be traded or settled under the DLTPR are limited. The regime only applies to crypto-assets that already fall under EU financial services legislation, i.e., MiFID2, and it places threshold requirements on the assets, both individually and in aggregate. For example, shares traded or settled must be issued by an issuer with a market capitalisation of €500 million or less, and bonds that embed derivatives or utilise a structure that makes risk difficult to understand for clients are excluded entirely. If DLT MI reach an aggregate of €9 million in assets they must start a “transition strategy” designed at decreasing their activity or winding down. While these restrictions may help mitigate risk for clients (especially important given the potential for retail client participation, as discussed below), they will constrain DLT MI operators and may deter some firms from participating. These requirements also imply additional costs for firms as regular reporting will be required to ensure that DLT MI remain under the relevant thresholds.

For firms that receive approval and adhere to the financial instrument restrictions, however, there are some key exemptions from existing regulation (i.e., MiFID2 and the CSDR) available, including:

• For DLT MTF and TSS operators - exemptions from intermediation requirements, opening up the ability to interact with retail investors directly (along the lines of FTX in the US), as well as exemptions to some transaction reporting requirements; and

• For DLT SS and TSS operators - exemptions from some cash settlement requirements, certain arrangements regarding settlement fails and certain CSDR definitions.

These are not automatic blanket exemptions. Firms wishing to operate DLT MI must apply for specific exemptions when applying for permission to operate the DLT MI. They will need to demonstrate why each exemption should be granted, with the idea being that each operator’s granted exemptions should be tailored to their individual business model.

DLT MI operators will also be subject to some additional requirements aimed at mitigating risk. Some of these requirements are client risk management-based, e.g., ensuring certain standards of client asset safeguarding and investor protection procedures are met, or mandating that information for clients on how the DLT MI operates and how this differs from non-DLT infrastructure is published and available. Other requirements focus on operational risks, by for example requiring that all DLT MI operators have robust IT and security systems, as well as a clear business plan and rulebook. Existing sectoral legislation provisions will also continue to apply, insofar as the DLT MI operator is not exempt, and this will include not only EU-wide legislation like MiFID2 or the CSDR, but in many cases may also include non-harmonised provisions of national law.

The DLTPR will largely take effect on 23 March 2023, at which point interested firms may start to apply to their relevant competent authorities to participate. ESMA is currently consulting on the format and content of applications.

European Commission extends deadline for pension scheme arrangement clearing obligation

The European Commission (EC) has published a Delegated Act setting the final deadline for pension scheme arrangement (PSA) compliance with OTC derivatives clearing obligations under EMIR to 18 June 2023. While this is not technically a further extension, the EC has made clear that supervisory authorities should not take action against non-compliant PSAs during this period. This follows a letter from ESMA in January 2022 calling for an end to the extensions, but requesting an implementation period instead.

As discussed in the letter, while PSAs do appear to be largely operationally ready to clear OTC derivatives in general, there is some concern over capacity. Several PSAs have such large portfolios that EU clearing members may not have sufficient capacity to clear their trades. Many PSAs rely on UK CCPs.

There is also concern over liquidity risks, i.e., the need to post collateral in cash in the event of market stress. While PensionsEurope has suggested that the answer could be to allow EU CCPs to provide liquidity to PSAs through temporary conversions of high-quality government bonds to cash, no solution has yet been decided, and the implementation period will provide time to explore this point further.

Regardless, this pseudo-extension will give PSAs some breathing room to prepare. We recommend that they use this additional time to put in place the necessary clearing arrangements with clearing members (noting that the EU commissioner for financial services has made clear that the expectation is that PSAs must clear via EU CCPs) and set-up the necessary facilities to source cash to meet the CCP’s variation margin requirements.

FCA launches reviews into trade data, benchmarks and credit rating data

Following a Call for Input on accessing and using wholesale data launched in March 2020 and a Feedback Statement relating to the same in January 2022, the FCA has commenced a trade data review. The FCA is concerned that ownership of trade data by trading venues may be limiting competition through charges that: result in increased costs to end investors; affect asset managers' investment decisions; and, affect price formation. There is also concern that regulatory provisions for free delayed data may not be effective. The FCA aims to publish its findings on the trade data review (and provide any next steps) in January 2023.

Separately, the FCA aims to launch a combined study of benchmarks and credit rating data this November. This study aims to cover a number of potential issues identified by the FCA including:

• Benchmarks - namely, how benchmarks are priced, contractual terms and barriers to switching; and

• Credit rating data - including pricing and contractual relationships, barriers to entry and the scope for and level of innovation.

The FCA reached out regarding these issues to a sample of trade data suppliers in June 2022 and to users in July 2022. Stakeholders who didn't receive an information request are invited to contact the FCA directly via WholesaleTradeDataReview@fca.org.uk.

At a glance...

ESMA consults on changes to cash penalty collection and distribution

ESMA has released a consultation paper seeking industry feedback on proposed changes to Article 19 of the RTS on settlement discipline. These changes would see CSDs take over the process of collecting and distributing cash penalties in all circumstances. As it currently stands under Article 19, CCPs manage the process for cash penalties resulting from cleared transactions, while CSDs manage the process for uncleared transactions. The consultation is open until 9 September 2022.

The current process has led to additional costs and burdensome adaptations for both CSDs and CCPs alike, as the parallel framework has meant that neither of the two groups is able to operate the penalties process independently. It has also created additional operational risks, particularly in the context of cross-border activities. ESMA notes that stakeholders including CCPs, CSDs, banks and industry bodies, such as EACH, have all previously expressed support for a single framework overseen by CSDs, and as such is merely seeking to confirm that this simplification is "still relevant" now that the CSDR cash penalties regime has been in effect for a few months.

ESMA consults on extending scope of clearing and derivative trading obligations

ESMA has launched a consultation into clearing and derivative trading obligations, primarily focusing on the introduction of new risk-free rates (RFR) and amending the maturity of overnight index swaps (OIS) classes referencing current RFR following the discontinuing of EONIA and LIBOR rates and in line with the ongoing EU benchmark transition. The consultation closes 30 September 2022.

Specifically, ESMA proposes to:

• regarding the clearing obligation (CO), introduce the OIS class referencing the Tokyo Overnight Average Rate (TONA) and extend the maturity of the OIS class referencing the Secured Overnight Financing Rate (SOFR) from 3 to 50 years; and

• regarding the derivatives trading obligations (DTO), introduce certain classes of OIS referencing the Euro Short-Term Rate (ESTR).

These proposals are meant to complement a set of RTS published in February of this year which introduced ESTR and SOFR to the CO and are being introduced following an observed significant increase within the EU in SOFR, TONA and ESTR liquidity. Further amendments to the CO and DTO are expected as the transition away from EONIA and LIBOR continues to progress, so this is a space firms should watch.

ESMA provides update on recognition of third-country CCPs

Following the suspension of several applications by third-country CCPs for recognition within the EU under EMIR, ESMA has now provided an update on how it intends to move these applications forward. For jurisdictions where the European Commission has adopted equivalence decisions (as is the case in China, Chile, Indonesia, Israel and Malaysia), ESMA will begin processing applications and grant recognition as soon as possible, subject to the relevant conditions for recognition being met. For jurisdictions where there is no equivalence decision (i.e., Argentina, Colombia, Russia, Taiwan, Thailand and Turkey), ESMA will start refusing applications, but notes that CCPs that are refused may re-apply for recognition if the EU later adopts an equivalence decision in the relevant jurisdiction.

ESMA has also clarified that CCPs currently operating in the EU under Member State national law who had applied for recognition under the EMIR transition provisions may continue to provide clearing services in the relevant Member State (or States) until a decision is made on their application.