The Case for Coordination

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ISDA Chief Executive Officer Scott O'Malia offers informal comments on important OTC derivatives issues in derivatiViews, reflecting ISDA's long-held commitment to making the market safer and more efficient.

‘DTO’ is not an acronym that may be familiar to all, but it’s a topic that has been climbing the agenda in the EU and UK as October 31 – the possible date for Brexit – nears. With the risk of a disruption in trading activity and split in liquidity, market participants and some regulators are thinking hard about the options.

The issue centres on the derivatives trading obligation, or DTO, in the UK and EU. Following a no-deal Brexit, the UK would become a third country in the eyes of the EU. Without an equivalence determination, European Economic Area (EEA) entities will be unable to satisfy the DTO under the Markets in Financial Instruments Regulation (MIFIR) on UK multilateral trading facilities and organized trading facilities, meaning EEA counterparties and their clients would lose access to an important source of liquidity, leading to fragmentation.

Likewise, UK participants subject to ‘onshored’ MIFIR in the UK would be unable to meet the UK DTO on EEA trading venues. Worse, UK branches of EEA firms could fall into scope of both EU and UK DTOs for certain transactions, subjecting them to a conflict of law.

Firms in the EU and UK could potentially mitigate these challenges by transacting on venues in third-country jurisdictions recognized by both the EU and UK – but that hardly seems an optimal solution, and it may not even be possible to route all the relevant contracts through these third-country venues.

ISDA has raised attention to this issue for some time, and has called for EU and UK authorities to issue equivalence determinations and to recognize each other’s trading venues in advance of a possible no-deal Brexit – a view echoed by Andrew Bailey, chief executive of the UK Financial Conduct Authority, in a recent speech.

In the absence of an equivalence decision, Bailey pledged to work with EU regulators to mitigate the potential for firms to be caught by both the EU and UK DTOs by stipulating which rules firms should follow.

In a speech at ISDA Annual Europe conference on September 19, chairman of France’s Autorité des Marchés Financiers, Robert Ophèle, also raised this issue, and proposed an approach that assumes no equivalence determinations are made in relation to the DTO and trading venues.

Specifically, he suggested a change in the scope of the DTO, so the same requirements apply to locally established firms and local branches of third-country entities. In principle, this would mean UK branches of EEA firms would no longer face a conflicting DTO (they would only have to comply with the UK DTO), and EEA branches of UK firms would have to meet the EU DTO (this is not currently required under MIFIR). On top of this, Ophèle suggested the EU could consider excluding sterling-denominated swaps from the EU DTO (and possibly US dollar-denominated swaps too).

Like Bailey, he emphasized any progress would require coordination between EU and UK authorities to ensure a consistent approach.

This is a positive step that deserves further exploration of the practical implications. We maintain that equivalence and the recognition of trading venues is the optimal solution, and the best way to avoid fragmentation of liquidity.

The importance of coordination between regulators and deference to comparable regulatory regimes was underlined by the Commodity Futures Trading Commission’s Dawn Stump, also speaking at the ISDA Annual Europe conference. “Our regulatory similarities can now be used as a basis to support deference between jurisdictions, which, in turn, helps to promote clarity and market stability. Moving in the opposite direction would undermine the coordination envisioned by the G-20,” she said.

We couldn’t agree more. Close regulatory coordination and a pragmatic, timely and predictable approach to cross-border trading has the potential to address – or, in this case, partially mitigate – fragmentation and avoid unnecessary burdens and duplication on derivatives users.

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