Brexit Newsflash: FCA modifies UK application of DTO

In a case of leaving things to almost the last minute, the UK's Financial Conduct Authority (FCA) exercised its Temporary Transition Power and published a Transitional Direction on 31 December 2020 in respect of the UK's onshored version of the Derivatives Trading Obligation (UK DTO) to avoid a conflict with the EU's existing version of the Derivatives Trading Obligation (EU DTO) that would otherwise arise when the Brexit transition period ended at 11:00 pm UK time on New Year's Eve.

Under the EU DTO, in-scope entities have to trade in-scope OTC derivative contracts on an EU trading venue or a non-EU trading venue that the European Commission has said is equivalent. Similarly, the UK DTO will require in-scope entities to trade in-scope OTC derivative contracts on a UK trading venue or a non-UK trading venue that the UK has said is equivalent, although the UK DTO goes further in also applying to EU firms that use the UK's Temporary Permissions Regime (TPR) and UK branches of EU firms authorised in UK.  To date, there has been no such equivalence determination by either the EU or the UK.

The conflict arises in a scenario where there is one counterparty that is subject to the UK DTO (eg a Cayman Islands fund with a UK AIFM, or a UK dealer) that trades an in-scope OTC derivative contract with a counterparty that is subject to the EU DTO (eg an EU dealer or an EU UCITS).  There is also a worst-case scenario where the conflict could arise within the same counterparty, through both the UK DTO and EU DTO applying to that counterparty - eg an EU AIF with a UK AIFM, or an EU dealer trading through its UK branch.

In the Transitional Direction, the FCA has granted temporary relief for market participants by stating that UK firms, EU firms that use the TPR and UK branches of EU firms trading with EU clients (or on behalf of EU clients) that are subject to the EU DTO will be permitted to satisfy the UK DTO by executing on EU trading venues.  This is subject to two conditions:

• the counterparty subject to the UK DTO must take reasonable steps to be satisfied that the client does not have arrangements in place to execute on a trading venue to which both the UK and the EU have granted equivalence (eg US Swap Execution Facilities - SEFs); and
• the EU trading venue has the necessary regulatory status to do business in the UK - eg it is a Recognised Overseas Investment Exchange, has been granted the relevant temporary permission, or benefits from the Overseas Person Exclusion.

The FCA also states that it expects market participants to demonstrate that they are taking all reasonable steps during Q1 2021 to ensure compliance with the UK DTO.

Care should be taken before relying on this temporary modification to the UK DTO.  For instance, many market participants may have already taken steps to move execution onto equivalent third country trading venues such as US SEFs and, if so, that should continue.  In addition, because the temporary modification applies when facing or acting for "EU clients" it may not be relied upon by a non-UK AIF with a UK AIFM or any other UK client when facing an EU dealer. The Transitional Direction also contains a statement that an EEA AIF is out of scope of the UK DTO, presumably even where that EEA AIF has a UK AIFM.