Markets View – March 2024

As we near the end of March, we're delighted to bring you the latest edition of Markets View, which this month contains a veritable smörgåsbord of markets regulation-themed treats -- including our thoughts on HMT's new plans for a private intermittent exchange system, news from the world of UK commodities and EU carbon markets, and a timely reminder of the changes being ushered in by MiFID3. As always, please don't hesitate to reach out if you have any feedback.

PISCES -- Neither Fish nor Fowl

In last month's Markets View, you may recall that we looked at the Digital Securities Sandbox, the first financial market infrastructure (FMI) sandbox enacted under new powers granted to HM Treasury under FSMA 2023.

HM Treasury has now launched a Consultation on a new parallel development, also under the FMI sandbox, to build a regulatory framework for a new category of intermittent exchanges for shares in companies not admitted to trading. The Private Intermittent Securities and Capital Exchange System (fishily dubbed PISCES) is to be established by the end of 2024, initially for a proposed 5 years.

The public offer of securities by private limited companies has long been prohibited in the UK without an approved prospectus, restricting the growth of smaller companies. The new secondary PISCES markets are intended to facilitate earlier access to capital outside the public markets by companies not admitted to trading (both PLCs and private companies) -- including by international companies not headquartered in the UK. It is hoped this will improve the pipeline of companies ready for initial public offerings. Capital raising by the issuing of new shares or the trading of bonds or ETFs will not be permitted on PISCES.

PISCES platforms will open for intermittent trading windows (e.g. monthly, quarterly, biannually, etc). There will be no requirement to disclose information to the public, only to the "private perimeter" of any investors permitted to trade. Retail investors will generally not be permitted, at least during the trial phase of the platform, although the government is consulting on whether they should allow self-certified sophisticated investors, high net-worth investors and employees of a company participating on PISCES (who may be shareholders of such a company). A tailored market abuse regime will apply, as well as bespoke transaction reporting obligations.

Firms wishing to operate a PISCES platform must either have an FCA permission to arrange deals in investments, or operate an MTF/OTF under Part 4A FSMA 2000, or be a Recognised Investment Exchange (RIE) exempt person -- so all existing trading venue operators would be eligible to operate PISCES.

The PISCES consultation is open until 17 April 2024, and a statutory instrument and FCA consultation are expected later in 2024.

CP23/27 (Commodities) -- A Mixed Bag

You may have seen the FCA's CP23/27, published in December last year as part of the UK's Wholesale Markets Review, setting out the FCA's proposals to reform the commodity derivatives regulatory framework.

We collaborated with the FIA to help draft their response to the consultation, which was published last month and is available here. On the off-chance that you haven't already read it, we thought that we would use this opportunity to share some of the key issues raised by FIA members.

While members were supportive of the proposals' overall intentions, the detail of several proposals raised concerns -- none more so than the planned approach to replacing the ancillary activities exemption ("AAE").

As things stand, the AAE falls away on 01 January 2025 and will be replaced with a new qualitative test supported by PERG guidance, issued by the FCA. This is causing a major headache, because the current PERG guidance does not give firms the legal certainty that they need to determine whether they fall within/outside the exemption. Worse still, January 2025 is ticking ever closer, so firms who rely on the current exemption may not have time to gain the authorisation they may need in place of their current reliance on the AAE. The clear message here is that - as a priority - the FCA needs to engage with HMT to provide more time, and to ensure that the new regime gives market participants the legal certainty they need.

Some of the other key takeaways, in brief:

• A key theme of the Consultation Paper is the delegation of powers to trading venues (ICE Futures Europe and the LME) within an overall framework established by the FCA. There is undoubtedly support for transferring certain responsibilities in this way. However, the caveat with this approach is that these venues are commercial enterprises, so the relationship between their economic self-interest and their regulatory obligations needs to be handled delicately.

• The FCA proposes to transfer the power to set position limits for "critical" and "related" commodity derivative contracts to trading venues themselves, to leverage their knowledge of the relevant markets. However, there are a few unanswered questions around how the FCA determines contract criticality, and around the excessive breadth given to the definition of "related" contracts. Particular concerns were raised around the very limited time period that the FCA proposes for making updates to the list of critical contracts

• The FCA outlines two new exemptions (besides the existing hedging exemption) -- the "pass-through hedging exemption" and the "liquidity provider exemption" -- that would be granted by trading venues. Members were generally supportive of these proposals (albeit with some reservations), but added a request for an exemption of firms in financial distress due to bankruptcy/insolvency of a client/affiliate, as a way to try and avoid forcing transactions and stoking market instability.

• The FCA also proposes to introduce limitations (or "ceilings") for exemptions and to create "accountability thresholds" for critical contracts. Again, these would be set by the trading venues. Members immediately pointed to the potentially burdensome implications of triggering such ceilings/thresholds (e.g., the fact that trading venues would be expected to identify market participants who exceed a threshold to the FCA), and the risk that they therefore unintentionally act as additional hard limits.

That's just a very quick run-down of some of the many points raised in the response. We look forward to seeing how the FCA tackles these issues in its Policy Statement.

EU ETS -- Accentuate the Negative (Emissions)

We've previously touched on updates to the EU's Emissions Trading System ("EU ETS"), and the EU is continuing to provide regular correspondence on this topic. Not only have several new rules come in since the New Year for various industries, as flagged in last December's Markets View, but the EU is continuing to publish guidance and communications about how it plans to use this scheme to achieve its environmental goals.

Of particular interest is a recent Communication from the European Commission that considers the role of carbon capture technologies in the EU's environmental goals, including a consideration of how such technologies could be accounted for in the EU ETS. This was one of the interesting topics that the EU previously marked for future consideration in the context of last year's EU ETS Amending Directive.

In this latest Communication, the Commission envisages that industrial carbon management technologies, such as carbon capture technologies, will form a key part of the EU's carbon strategy. This is because certain industries will have limited alternative options if they are to reduce their emissions to hit aggressive emission reduction targets. Moreover, the Commission identifies economic opportunities in scaling up these new technologies. It is therefore proposing three pathways to focus on:

• Capturing CO2 for storage ("CCS").

• Removing CO2 from the atmosphere (often called "Direct Air Capture" or "DAC").

• Capturing CO2 for utilisation ("CCU").

The EU ETS already incentivises the use of CCS. Polluters caught by EU ETS can avoid having to surrender allowances for their emissions if those emissions can be considered to have been permanently captured. Therefore, the cost of EU Allowances ("EUAs"), which is expected to remain strong as the EU emissions cap continues to decrease in the coming years, acts as an incentive for polluters to capture CO2 instead of releasing it into the atmosphere.

However, the EU ETS does not currently recognise industrial carbon removals via DAC. The Commission is therefore looking at whether it should do so. Under their current thinking, this might involve either (1) integrating carbon removals into the EU ETS itself, where removals may be used to meet compliance obligations; or, (2) creating a (very vaguely described) "separate compliance mechanism...connected directly or indirectly to the EU ETS". Overall, the paper shows that the Commission's thinking on this point is still at an early stage -- perhaps unsurprising, since it is not due to deliver a formal report until 2026. Nevertheless, it is interesting to see their thought process here: in particular, one of the key stumbling blocks identified is the gap between the estimated carbon removal price (EUR 122-539/ton) and the EUA price (currently ~EUR 60), creating an obvious challenge around directly integrating negative emissions into the EU ETS.

CCU is similarly addressed in the EU ETS at present, in connection with allocations of EUAs for sustainable fuels for aviation and shipping. The EU ETS Amending Directive also tasked the Commission with identifying conditions whereby emissions are negated because they are considered permanently chemically bound in a product (i.e. the same as CCS, but the emissions are put in a product rather than stored) -- something the Commission is currently working on. However, the Commission has a more significant role in mind for CCU and again is looking to the EU ETS to provide the framework to incentivise its uptake. One of the big issues to address in this space is the double-counting of CO2 that is captured and then used in non-permanent products/fuels. Again, we can expect more detail on this in the 2026 report.

At Long Last...MiFID3

Following approval by the EU Parliament and Council, the EU MiFIR/D Review (also known as "MiFIR/D 3") changes were finally published in the EU's Official Journal on 8 March 2024.

When will the changes actually apply? Good question. The majority of the changes are made to MiFIR and these will technically become effective on 28 March 2024. For the small number of changes made to MiFID, these will only become effective once transposed by each member state into national law - the deadline for this is 29 September 2025.

However these timings have been the subject of recent discussion in the industry, as ESMA has acknowledged in a press release. So, whilst the MiFIR changes are technically in force from 28 March 2024, it would appear that some of those obligations cannot fully be complied with until the related underlying legislation is prepared. Much of that underlying legislation is not expected to be available for at least 6 months, or even longer in some cases. To this end, we understand that some industry bodies are preparing responses to the EU Commission to try to obtain further clarity on how and when firms should comply with those obligations.

We'll keep you updated on those developments; but, in the meantime, we wanted to take the opportunity to provide a brief summary of the key changes:

• Ban on Payment for Order Flow for retail clients and opt-up professionals and a ban on payments from execution venues to distributors in return for distributors forwarding client orders to the execution venue. For firms established in member states where such payments are currently permitted, there is a transitional exemption allowing those payments to continue in relation to clients domiciled or established in that member state until 30 June 2026 -- provided that the member state applies to ESMA by 29 September 2024 to obtain the exemption.

• Consolidated Tape Providers ("CTPs"). Whilst CTP provisions existed already, no entity has applied to become a CTP to-date. The new provisions significantly bulk up the CTP regime, streamlining the authorisation process, detailing how/by whom data is to be provided to CTPs and detailing the operating and revenue requirements for CTPs.

• Multilateral Systems definition. The definition has moved from MiFID to MiFIR, to enable a harmonised interpretation of the definition across the EU.

• Systematic Internaliser ("SI") definition. The quantitative assessment of the definition is replaced with a qualitative assessment.

• Volume cap. The new regime removes the double volume cap and replaces it with a single volume cap (7% EU-wide threshold), which will only apply to the reference price waiver and not to the negotiated trade waiver.

• Pre-trade transparency. The new regime limits the requirement to publish firm or indicative quotes to a central limit order book and periodic auction systems, revises the Article 9 MiFIR waiver, seeks to accommodate the specificities of derivatives by only applying the transparency regime to sufficiently standardised derivatives and only requires SIs to publish firm quotes in equities relating to a minimum size.

• Post-trade transparency. The discretion for a National Competent Authority to defer publication on non-equities is removed, conditions for deferral are specified and a separate regime is set out for derivatives. In addition, a new status of Designated Publishing Entity ("DPE") is established, allowing a firm to be responsible for making a transaction public without needing to take on SI status. A register of DPEs is to be maintained by ESMA.

• ESMA's 2021 Reasonable Commercial Basis ("RCB") Guidelines. ESMA's Guidelines are incorporated into MiFIR, with additional underlying legislation to set out how RCB should be applied.

• Transaction reporting. The new regime clarifies that transactions in OTC derivatives executed on venue should be reported, specifies when transactions in OTC derivatives executed off-venue should be reported, allows for a broader exchange of transaction data among national regulators and requires a globally agreed UPI to be used.

• Tick sizes. SIs are allowed to match at midpoint at any size.

• Share Trading Obligation ("STO"). Only shares that have an EEA ISIN and are traded on a trading venue are subject to the STO.

• Derivatives Trading Obligation ("DTO"). The DTO is aligned with the EMIR clearing obligations for derivatives, including concurrent DTO suspension under MIFIR where there is a suspension of the clearing obligations under EMIR. ESMA is also given the power to request that the Commission suspends the DTO in certain circumstances and a new additional stand-alone DTO suspension mechanism is introduced to allow the Commission to react swiftly as needed.

• Post trade risk reduction services ("PTTRS") are risk management tools for OTC derivatives, of which portfolio compression is a sub-set. To date, portfolio compression has thus far been excluded from best execution. The new regime asks the Commission to specify what constitutes PTTRS (not necessarily limited to portfolio compression only), and excludes those PTTRS from the DTO, pre-/post-trade transparency requirements and best execution.

• Dealing on own account ("DoA") exemption. The scope of the DoA exemption is expanded to include (a) non-financial entities that are members/participants in a Regulated Market or Multilateral Trading Facility to execute transactions for the purpose of liquidity management or for the purpose of reducing risks directly relating to commercial activity or treasury financing activity; and, (b) persons having direct electronic access to a trading venue.

• Best execution reporting. The best execution publication obligations, also known as "RTS27" and "RTS28" reports, are deleted. Whilst these changes will not become effective until member states remove the obligations in national law (the current deadline is 29 September 2025), as reported in our previous Markets View, no-action letters from ESMA have been issued for 2024 -- meaning that firms do not need to comply with these obligations for 2024.

• Open access provisions. Exchange traded derivatives are excluded from the open access provisions in articles 35 and 36 MiFIR.

• Best execution policy. The new regime requires underlying legislation to be prepared to set out the criteria to be taken into account by firms when defining and assessing the order execution policy in relation to professional and retail clients.

• Commodity derivatives and Emissions allowances review. The EU Commission is required to carry out assessments and report on the position limits regimes, the ancillary exemption and harmonised data sets.

Market Watch

The FCA have not yet published a new Market Watch in March. Previous versions can be found on FCA's website.

As a reminder, Market Watch is the FCA's newsletter on market conduct and transaction reporting issues, and we encourage firms to monitor the trends and key areas that the FCA is focused on through these regular publications. We will also make sure to keep you posted via Markets View!