2021: Brexit, No equivalence and the day of the SEF
The transitional period ended on 31 December with no relief for European Union (EU) firms on the derivatives trading obligation (DTO) from the European Commission (EC) and only limited adjustments from the United Kingdom (UK). This left many firms with conflicting and incompatible DTOs in the EU and the UK without equivalence (albeit based on identical rules) and no apparent option other than to trade the relevant derivatives on a US Swap Execution Facility (SEF), or in Singapore.
As we reached the half way point in January IHS Markit interrogated the data processed by IHS Markit's MarkitWire platform to assess the impact of Brexit on OTC interest rate swap trading for the three currencies subject to the DTO in the EU and the UK and the CFTC's Made Available to Trade (MAT) requirements in the US.
- EU firms must meet the EU DTO by trading certain IRS on an EU MTF/OTF or an 'equivalent' venue, currently limited to US SEFs and Singapore based venues,
- UK firms must meet the UK DTO by trading certain IRS on a UK MTF/OTF or an 'equivalent' venue, currently limited to US SEFs and Singapore based venues (with some limited relief, see below),
- US firms must meet the MAT requirements by trading certain IRS on a US SEF or an exempt foreign swap trading venue, currently; UK MTFs/OTFs, EU MTFs/OTFs and Singapore based venues.
So, US firms can access global on-venue liquidity, UK firms can too (except for EU venues*) and EU firms can too (except for UK venues)
- An EU firm can only trade certain IRS subject to both the EU and UK DTOs with a UK firm on a venue that allows both firms to comply with their local trading obligations,
- A UK branch of an EU firm is subject to both the UK and the EU DTO.
This is madness, is there any relief?
- Without mutual equivalence, the FCA used its temporary transitional power (TTP) to modify applications of the UK DTO that conflict with the EU DTO, providing limited relief in specific circumstances, which is available to the end of March 2021. This allows UK banks to trade on an EU venue (if it is a Recognised Overseas Investment Exchange, granted the relevant temporary permission or benefits from the Overseas Person Exclusion) for client business (no wholesale market activity or hedging) only where the client could not trade on a SEF or Singapore based venue. However, the FCA expects firms and other regulated persons to be capable of demonstrating that they are taking reasonable steps during the first quarter of 2021 to ensure compliance with the UK DTO.
What did the market expect?
Many hoped that equivalence, even temporarily, would follow a trade deal. However, currently the focus is on the MoU on financial services that both sides committed to agree by the end of March, which creates an environment for equivalence between the jurisdictions to be reached. However, in the absence of such an agreement, it was inevitable that some activity would move from MTFs / OTFs to SEFs and EU and UK firms would have less access to global liquidity.
What happened? (Spoiler alert - no surprises here…)
- EUR IRS trading on SEFs jumped from approximately 11% in December 2020 to almost 23% in the first two weeks of January, while MTF/OTF fell from 42% to 35%. For on venue activity only, this was a jump on SEFs from 21% to 39% and a fall on MTF/OTF from 79% to 61%.
- GBP IRS trading also jumped from approximately 11% in December 2020 to almost 23% in the first two weeks of January, while MTF/OTF fell from 32% to 28%. For on venue activity only, this was a jump on SEFs from 27% to 45% and a fall on MTF/OTF fell from 73% to 55%.
- USD IRS trading jumped from approximately 36% in December 2020 to approximately 47.5% in the first two weeks of January, while MTF/OTF fell from 12% to 9.5%. For on venue activity only, this was a jump from 75% to 83% and a fall on MTF/OTF from 25% to 16.5%.
Time and time again the data shows us that the OTC derivative markets are global in nature and very agile. Trading liquidity in OTC interest rate derivatives tends to concentrate on a currency by currency basis, liquidity begets liquidity…
We saw in 2013-2015 how the CFTC cross border rules pushed trading overseas, and more recently the implementation of CFTC's prohibition of PTNGU did the same (albeit to a much lesser extent due to other factors).
However, now the combination of a hard-ish Brexit, the lack of EU - UK equivalence combined with the equivalence available from both the EU and UK to use US SEFs, was always going to reverse and surpass that. The data never lies.
Of course, the real cost of fractured global liquidity is more expensive hedging and ultimately higher costs to end users; companies, investors, pension funds and ultimately us all.
Time will tell whether a belated equivalence deal between the EU and UK will reverse this shift to SEFs or even whether the 'success' of the EC strategy around the Share Trading Obligation (STO), which is likely to make the EC more determined to see through their similar strategy on DTO leaves us with a EUR and GBP IRS market based in New York…
Note: The calculations are based on (i) all new single currency interest rate swaps; Including IRS & OIS (fixed versus floating), fixed versus fixed swaps and basis swaps (floating vs floating) referencing all floating rate options (indices).