Following the focus on the monumental LIBOR transition we have seen over the last few months, we now must turn our attention to the Derivatives Trading Obligation – so what does this mean for investment firms?
1. What is the Derivatives Trading Obligation (DTO)?
The DTO requires in scope financial counterparties to conclude transactions in standardised and liquid OTC derivatives only on regulated trading venues. As a result of Brexit and MiFID II / MiFIR regulation, the UK and EU represent two separate Derivatives Trading Obligations:
- For the EU DTO, in-scope entities must trade in-scope OTC derivatives contracts on an EU trading venue or a non-EU trading venue that the European Commission has deemed is equivalent (e.g. Swap Execution Facilities, or SEFs).
- While the same applies for the UK DTO, it goes further in applying to EU firms using the UK's Temporary Permissions Regime (TPR) and branches of overseas firms authorised in the UK. Firms subject to the UK DTO, trading with EU clients that are subject to EU DTO will be able to execute on EU venues providing that an equivalent venue cannot be used; and that the EU venue has the necessary regulatory status to do business in the UK.
2. Can we call DTO LIBOR Day 2?
The DTO has been a hot topic over recent years due to Brexit transition planning leading to a segregation between the UK and EU DTOs. It is again top of agenda due to the transition away from LIBOR towards risk-free rate (RFR) alternatives such as SONIA, €STR and SOFR.
It is in this context that the FCA and ESMA both published consultation papers in the summer of 2021, to help understand market sentiment on the instruments in scope of their respective UK and EU Derivatives Clearing Obligations (DCO) and DTOs. Since then, both regulators have published their final policy statements on the changes to their respective DTOs.
One thing is clear, the impact of the DTOs does not stop with these final policy statements. The DTO topic is already an important Day 2 consideration for investment firms that have implemented LIBOR changes. With the implication from the regulators that the DTO regulation will evolve, it is imperative that investment firms monitor this landscape, as well as for other regulation closely affecting this topic, such as the Clearing Obligations.
3. Impact and Priorities
The introduction of the RFR first initiatives last year have gone some of the way to ensure the markets have taken the required steps to transition away from LIBOR with respect to the DTOs. These initiatives aim to support and encourage liquidity providers and interdealer brokers (IDBs) in facilitating a shift in liquidity towards RFRs, away from LIBOR. This has been achieved through changes involving IDBs moving the primary basis of their pricing screens and curve construction for IRS from LIBOR to SONIA and SOFR, resulting in these swaps becoming the primary pricing point  .
However, there remains a significant amount to consider. Investment firms subject to either DTO will need to ensure their trading desks, strategists, middle office and back office functions are cognizant and educated on the changing regulation of in scope products, potential future developments and the impact it will have on their execution and operational processes. For instance:
- Front-office will need to ensure they execute trades correctly. Electronic pricing screens (and voice traded deals) will need to be configured appropriately to ensure clients can meet their relevant trading obligation. This is important for sales and trading desks at banks, end clients and interdealer broker teams to consider.
- Trading venues need to ensure that clients subject to EU/UK DTOs can maintain execution in the same volumes. Any trading venues (including sister UK/EU venues which were set up as a result of Brexit transition planning or their SEF venues which are deemed equivalent) must ensure they can maintain volumes for DTO products with the same standard of client service and delivery.
- Investment Firms should consider the cost impact of this evolving regulation and the implications for additional set up required for products, execution and clearing as part of the changes in the end-to-end process, for themselves as well as clients.
- Opportunity to optimise and evaluate the static data set up which historically is ill-maintained with duplicated data that is no longer fit for purpose. This will ensure users and clients have a more consistent and efficient process.
- Downstream trade flow processes, such as booking and confirmation of trades will need to be configured and processed via existing embedded systems (such as MarkitWire), the set-up with inhouse operational systems along with liquidity and capital management considerations.
- Other factors include ensuring correct and compliant regulatory reporting of trades; and required permissions and processes for clearing.
Given the strategy for Brexit planning for DTO, this will require products newly in scope of DTO to be mirrored across UK and EU venues, or indeed equivalent venues such as the SEF. However, it also highlights a question for investment firms on the divergence between UK and EU regulation, on whether an evaluation of the process can be considered to prevent duplicating technology and operational processes - to ensure a balance between serving clients, meeting their trading obligation and ensuring the most efficient process. A blog on the Brexit Bifurcation highlighting general key considerations was published at the end of last year.
In terms of timelines, many banks and trading venues will be shifting focus to ensure compliance with their respective DTOs once the LIBOR transition efforts have settled into the new year. Banks should pivot focus with LIBOR resources to attend to related prioritised Day 2 considerations such as DTO, to ensure boots are on the ground to understand and tackle the evolving regulatory landscape. It is likely that resource will be spread across DTO compliance and the remaining USD LIBOR benchmark transition required by mid-2023.
Firms should evaluate and assess their front-to-back current state trade flow against the target state for OTC derivatives newly subject to DTO. There is also the consideration for the assessment of the process to ensure a more mature and strategic operating model given the tactical solutions implemented as a result of Brexit and now, the LIBOR transitions. This will be key in highlighting gaps and defining requirements, to ensure trading venues and investment firms are able to meet their regulatory requirements.
Nonetheless, one thing is clear, in that the horizon for future changes to the UK and EU DTOs have already been set out. Both the FCA and ESMA indicate the liquidity of products not currently in scope of DTO will be monitored on an ongoing basis to determine if they warrant a DTO in the future. This suggests an iterative change in regulation over the coming years as currently certain markets are in a multi-rate environment thus products and their liquidity can evolve to meet the criteria of a Derivatives Trading Obligation.