Action Needed on the DTO

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.

In a matter of weeks, EU and UK firms will no longer be able to trade certain liquid derivatives with each other unless they shift their business onto US swap execution facilities (SEFs), a change that will result in higher costs and operational complexity for end users in both the EU and UK. As we pointed out in a recent joint letter with other trade associations, the best way to resolve the issue is to grant equivalence for trading venues – but time is running out.

On the face it, the signs aren’t particularly upbeat. On November 25, the European Securities and Markets Authority (ESMA) confirmed it had no plans to change the application of the EU derivatives trading obligation (DTO), noting that a lack of equivalence would not present a threat to financial stability – a view reiterated by ESMA and European Commission officials at an ISDA event last week.

Under the revised Markets in Financial Instruments Directive and regulation (MIFID II/MIFIR), EU entities trading derivatives subject to the EU DTO are required to execute those transactions on an EU-recognized trading venue. However, after the Brexit transition period ends, the UK will have its own, near-identical version of MIFID II/MIFIR, requiring UK firms to trade derivatives subject to the UK DTO on a UK-recognized venue.

Without equivalence, the only way EU and UK counterparties would be able to trade in-scope derivatives with each other would be to use US SEFs, which are recognized by both jurisdictions. However, this may not be practical or possible for some. Alternatively, EU and UK entities could opt to trade with counterparties in their own jurisdiction, resulting in split liquidity, less choice and potential pricing impacts.

The situation is more acute for UK branches of EU firms – the rules as they stand mean these branches would be subject to both the EU and UK DTOs.

Speaking at the ISDA event last week, Robert Ophèle, chair of the Autorité des Marchés Financiers, set out some of the consequences of not taking action. Based on data from French banks, he estimated that 70% of business executed by UK branches of EU banks would either be lost or would move to US SEFs.

In addition, while several trading venues have set up subsidiaries in the EU ahead of the end of the Brexit transition period, there will be no dealer-to-dealer platform for index credit default swaps in the EU from January 1, 2021, leaving EU firms trading those indices – even with other EU entities – no alternative but to use US SEFs.

Creating a situation where EU firms are forced to either shift their business to US SEFs or trade in fragmented liquidity pools is hardly conducive to the objective of creating a strong capital markets union, Ophèle said. “The creation of a strong EU market in euro-denominated derivatives from scratch is to be supported where possible, but trying to build up a sterling and US dollar derivatives markets in Europe with no critical mass of strong market players in these fields would be detrimental to European market players, without bringing any added value to the European market.”

Ophèle proposed a number of possible workarounds, including changing how the rules apply to branches and narrowing the scope of instruments subject to the DTO. However, we continue to believe that trading venue equivalence is the only way to comprehensively solve this issue. Given the EU and UK versions of MIFID II/MIFIR are virtually identical, we can’t see any technical or legal reason why equivalence isn’t possible, so we would urge regulators to take action.

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