Markets View – Summer Round-Up 2023

As the (relative) quiet of summer draws to an end, we wanted to share with you some of the most interesting big-picture items that we'll be keeping a keen eye as we head into the autumn.

Edinburgh Reforms & FSMA 2023: DAR to Be Different...

As you're no doubt well aware, the new Financial Services and Markets Act 2023 contains a framework for the regulators to make extensive and fundamental changes to the UK financial services sector, revokes retained EU laws,* reforms the financial promotions regime, and includes new objectives for the FCA and PRA among many other measures. You may have seen our Insights piece from 03 July just after FSMA 2023 received Royal Asset.

(* If you are worried about how you are going to keep up with the resulting divergence between EU and UK regulation, please contact Rosali, who is working with our brilliant legal engineers at Simmons Wavelength, to come up with a solution.)

Amidst all the planned changes, it can be hard to grasp the full implications, especially without the more detailed rules. For this edition of Markets View, therefore, we wanted to draw attention to an aspect that represents something of a paradigm shift for UK regulation but perhaps risks being overlooked: the creation of a new Part 5A "Designated Activities Regime" (DAR). Provisions to give effect to this regime just came into force on 29 August 2023.

So, what's happening?

Whereas the traditional FSMA 2000 framework operates on the basis that there are certain 'regulated' activities, and that carrying them on requires a person to become authorised and obliges them to comply with relevant FCA rules, the new DAR establishes a comparable framework based on 'designated' activities. These activities will either be prohibited outright or require compliance with relevant FCA rules (or an exemption) but do not require the firm carrying on the activity to become authorised - or, in other words, firms may be affected even if they fall outside the licensing perimeter.

The power to designate the relevant activities rests with HMT (section 71K) and the power to make the associated regulation rests with the FCA (section 71N). Together, the effect is:

• to give HMT significant discretion to restrict activities through secondary legislation, and

• to extend the FCA's remit for making and enforcing the associated rules.

What to watch out for.

The immediate rationale for the DAR is to find a new home for certain activities captured by soon-to-be-revoked retained EU laws. Basically, the government still wishes to regulate these activities, but feels they don't belong within the existing FSMA regulated activities/authorised persons framework. We're still waiting on for precise details of the initial designated activities, although various possible examples are listed (without limitation) in Schedule 6B of the Act, such as activities related to entering into derivatives (so would capture NFCs subject to EMIR), holding positions in commodity derivatives (this would catch exempt commodity firms trading commodity derivatives) and short selling.

The most interesting thing here, though, will be to see how use of the DAR evolves in the future, as it has the potential to apply to a much wider scope of activities that are currently not regulated. The most likely targets for 'designation' are novel/high risk activities, but technically this new status may be applied to any activity related or connected to the UK's financial markets or exchanges, or financial instruments, financial products or (non-defined) financial investments issued or sold to/by UK persons. It goes without saying, that's an extremely broad remit.

To avoid falling foul of the new DAR, it will therefore be crucially important to stay informed on government policy and regulatory consultations regarding the designation of activities. And rest assured, we will be keeping a careful watch!

ETSs Revisited

You may recall that we looked at the EU's "Fit for 55" package, which is the EU's overhaul and expansion of its flagship Emissions Trading System (EU ETS), in our [last Markets View][1].

Post-Brexit, the UK adopted the EU ETS architecture and created its own separate UK ETS. Like the EU ETS, the UK ETS provides for a system whereby certain energy-intensive companies (Operators) must acquire emission allowances (whether by allocation, auction or trade) to cover the GHG emissions they produce, subject to diminishing overall caps year-on-year. Indeed, the systems are so similar that that they may yet be formally 'linked', although there's no sign this is imminent.

Following the EU's lead, the UK government has proposed changes to UK ETS (via a paper published earlier this summer). But the devil - or should that be the divergence - is in the detail. For one thing, the EU is a step further along the process here: its changes are already embedded in published legislation, whereas the UK's will require various further phases of consultation and drafting. In terms of the proposals themselves, see below for a high level summary and comparison.

A tale of two systems.

Clearly then, while the UK and EU are on a similar wavelength here, the UK is signalling an intent to go its own way and manage things at its own pace (while keeping open the possibility of a formal 'linking' of the ETSs). Overall, a degree of divergence is perhaps unsurprising given the systems' fundamental differences in scale, underlying economic activity and governance - differences that are already apparent in the pricing of their respective allowances, with UKAs trading at increasingly heavy discounts relative to their EU counterparts this year. Needless to say, we will be keeping a careful watch for further details on the UK's proposals and their implications. Our new Carbon Reviewer tool will cover compliance and voluntary carbon credits, enabling subscribers to compare regimes themselves.  Please contact Stephen for more details.

EMIR 3: Clearing the Way

Back in December last year, the European Commission published a legislative proposal setting out amendments to the European Market Infrastructure Regulation (EMIR 3). The proposals are wide-ranging and in many cases technical in nature, but one in particular has caused most consternation: a plan to require FCs and NFC+s who are subject to the EMIR clearing obligation to hold active accounts at EU CCPs for clearing relevant products.

This proposal is squarely aimed at reducing reliance on third-country (particularly UK) CCPs and boosting the EU's internal clearing market and capabilities. In the background, it's worth remembering that the Commission's equivalence decision granting access to UK CCPs is currently set to expire on 30 June 2025.

What's been happening?

The new active account requirement originally articulated by the Commission is set out in a proposed new Article 7a, which lists three categories of derivative contracts to which the active account obligation will apply (set out below), and provides that ESMA shall develop an RTS specifying the proportion of such activity that must be cleared at EU CCPs:

• IRDs denominated in Euro and Polish zloty;

• CDSs denominated in Euro; and

• STIRs denominated in Euro.

Off the back of that proposal, several industry bodies (including ISDA) raised reservations, in particular noting the potential impact in terms of additional costs and competitive disadvantages. In June, notwithstanding these pressures, the European Parliament issued a Draft Report which broadly retains the Commission's overall proposal, while incorporating a few amendments that represent a slight change of tack including:

• Switching to a two-step approach, whereby:

  • Initially there would still be a requirement to hold active accounts, but without the need for a specified proportion of in-scope transactions to be cleared through them (it is left to ESMA to draft an RTS specifying what exactly is meant by 'active' in this context).

  • After 18 months, ESMA would report with an assessment of the impact and, if necessary, move to phase 2 involving development of an RTS specifying the proportion of activity to be cleared at EU CCPs;

• Applying the requirement on a group-wide basis; and

• Tweaking the categories of in-scope derivative by swapping out CDSs for a bucket of "other categories of derivative contracts...identified by ESMA as being of substantial systemic importance".

So, what comes next?

It's a fair question. As things stand, the Parliament's report introduces new possibilities (and questions) but does little to assuage the industry's broader concerns, and so heading into the autumn we anticipate further headaches before we get final clarity. Finally, it's worth flagging that active accounts aren't the only issue in play here - there are several to keep an eye on, e.g. around NFC intra-group transaction reporting, the extension of the trade reporting to non-EU members of EU groups and the centralised supervision of CCPs.