Markets View – February 2024

Welcome to the February edition of Markets View! In this latest installation, we hope to bring you a bit of mid-winter sunshine with news (much of it good news!) from MiFID to EMIR, carbon markets and more.

MiFID3: No-Action Stations!

First up, in a welcome development for the industry, on 13 February 2024 ESMA issued a no-action letter requesting national regulators not to prioritise supervisory actions against firms who do not publish detailed annual reports on trading venues and execution quality(technically still required under RTS 28) for 2024. As we mentioned in last month's Markets View, various trade bodies have been requesting this guidance from ESMA for a number of months now.

ESMA's letter will provide comfort to firms, who, without it, would have been required to publish RTS 28 reports by 30 April 2024 because reforms to MiFIR and MiFID (which include deleting the RTS 28 reporting obligation) would not have come into effect by that date.

ESMA's no-action letter will remain effective until the above-mentioned MiFIR and MiFID reforms are implemented by Members State into national law (likely by 2025).

EMIR 3.0: Are We There Yet?

EMIR has been a regular feature of recent Markets Views, and keeps on giving. The trilogue negotiations which we mentioned back in December have borne fruit, with the EU Council and Parliament having reached provisional political agreement and published final texts. It's worth noting that these texts are still subject to formal approval and adoption procedures before they enter into force.

What's the news?

The principal concern remains around the introduction of an 'active account requirement', which you may recall essentially seeks to shift clearing away from third country CCPs (like the UK's LCH) towards EU CCPs, to build up the EU's own clearing capacity. On that front, the industry is mostly pleased with latest text - in particular the watering down of the previous proposal to mandate that a proportion of activity must be cleared at EU CCPs (as covered in Markets View last year).

In its new guise, the active account requirement really contains two requirements: first, to open and maintain an active account at a EU CCP (the operational obligations); and second, if the portfolio is large enough, to clear a certain number of representative contracts in that account (the representativeness obligation). We set out further details of both these obligations below.

Who needs to open an account?

FCs and NFC+s subject to the clearing obligation in EMIR will need to open an active account at an EU CCP if they trade in: IRDs denominated in Euro and Polish zloty, and STIRs denominated in Euro (we'll call these Article 7a(2) contracts). You may recall the old proposal covered CDSs denominated in euro as well - those have now been cut out, for the moment at least. As with the clearing obligation, whether the active account requirement applies will depend on number of trades in the counterparty's group. Once counterparties are subject to the requirement, they must notify ESMA and their regulator and they have 6 months to establish their active account at an EU CCP.

What trades need to be cleared from that account?

Those FCs and NFCs with a notional clearing volume outstanding of more than six billion euros in Article 7a(2) contracts must use their active accounts to clear derivative contracts "representative" of those two types. Not all contracts will be subject to the representativeness obligation.  ESMA will determine which by identifying:

• up to three classes of derivative contracts belonging to clearing services of substantial systemic importance (which to start with are the Article 7a(2) contracts mentioned above); and then,

• up to five subcategories of trades, per derivative class, based on a combination of size (up to three trade size ranges can be specified) and maturity (up to 4 maturity ranges can be specified).

The number of prescribed derivative contracts to be cleared by each counterparty should be at least five trades per subcategory on average per year.  However, if a counterparty clears more than half their trades in this way, then the representativeness obligation is one trade.  Client clearing is to be excluded from the calculations.

Final thoughts

While on the whole it's a positive story, we note just a few flies loitering around the proverbial ointment:

• We saw that the more-than-slightly-cheeky Recital (12) is being retained - this requires providers of clearing services to inform their clients about the option to clear derivatives at an EU CCP, which is justified rather tenuously by the need "to ensure the financial stability of the Union". Whether that's compelling enough to fend off arguments and about anti-competitiveness and countermoves by other governments, time will tell.

• We also note that, by shifting the requirement from a 'proportional' basis to a minimum limit, there is potential to disadvantage market players who make relatively small numbers of trades, to the extent they have to clear a higher proportion of them at EU CCPs.

Carbon Copies: Big Moves in Global ETSs

We're seeing significant ventures by both China and Brazil in the regulated carbon market space.

China has recently signed into law a new regulation on its own ETS, which was launched in 2021 - for more details on this, see what our colleagues have (just!) published in ESG View.

Meanwhile, Brazilian lawmakers are pushing forward a bill that would establish a "cap-and-trade" system (similar to the UK ETS and the EU ETS) aimed to incentivise local companies to reduce carbon emissions. There's potentially a big positive impact here as, like China, Brazil is currently one of the largest global emitters of greenhouse gases (GHGs). This is also timely as the country gears up for hosting the international climate meeting, COP30, in 2025.

The proposed Brazilian ETS, the Brazilian Greenhouse Gas Emissions Trading System (SBCE), provides for a system to limit GHGs emissions and trade assets that represent emissions, emission reductions or removals of GHGs in the country (whose trading will be regulated under Brazilian capital markets laws). The overall structure offers some interesting points of comparison with the UK & EU ETSs.

Whereas the UK & EU ETSs both apply to specific polluting sectors (energy-intensive industries, power generation, commercial aviation and - most recently in the EU - maritime transport), the SBCE does not specify which sectors will be subjected to emissions obligations. Instead, it sets up compliance obligations for any companies that exceed 25,000 tonnes of CO2 emissions per year. One controversial point to note here is that the proposed Brazilian ETS excludes primary agriculture and livestock farming, despite this being a leading source of emissions in Brazil. The reasoning owes to the difficulties of establishing a methodology to measure the emissions from agriculture business. Nevertheless, some commentators have pointed to this as a major flaw in the proposed plans.

The SBCE proposal also builds interesting bridges with the voluntary market. The role of UK/EU "emission allowances" is taken by "Brazilian Emissions Quotas", but beyond that polluters in Brazil will also be able to use a certain proportion of approved types of voluntary carbon credits to meet their obligations - in contrast to their UK/EU counterparts (although as we mentioned back in December's Markets View, the latter may be seeing "greenhouse gas reductions" and "negative emissions" in due course). This approach also has the potential to be controversial of course, as many would prefer to see polluters take direct steps to reduce emissions rather than lean on use of carbon credits.

UK Digital Securities Sandbox

As some of you may have been following, a 'Digital Securities Sandbox' will be opened to applications by the Bank of England and FCA later in 2024 - the final timings and regulatory rules are still to be confirmed, so stay tuned! It will be open to UK firms looking to trial developing technology - such as distributed ledger technology or blockchain, or technology facilitating digital assets more generally - to perform the activities of CSD and MTFs. The list of in-scope assets is broad, covering debt, equity, money market instruments and units in collective investment undertakings.

Having advised in the crypto native space since its inception, we're big fans of the Sandbox and see it as having great potential to streamline trading, reporting and settlement processes for TradFi, thereby improving efficiency and lowering costs. At its root, it's a product of FSMA 2023, which gave HM Treasury the power to create FMI sandboxes through statutory instruments. The relevant instrument in this case is SI 1398/2023, which came into force on 08 January 2024 and disapplies and modifies various bits of legislation while allowing the regulators to make new rules for a Digital Securities Sandbox.

The overall intent is to enable firms to overcome some of the obstacles to innovation inherent in legislation that was drafted before the advent of digital assets technology: for example, where existing legislation required CSD activities and operation of a trading venue to be performed by separate entities, the Sandbox will allow these to be combined in one entity.

The Sandbox will operate until 8 January 2029, subject to any extension.

You may have seen that last summer Simmons & Simmons assisted UK Finance in preparing its response to HMT's consultation on the Sandbox, and we continue to follow developments closely. If it's caught your interest too, we'd love to hear from you.