Capital Markets: Derivatives 2024 Comparisons

The Prudential Regulation Authority (PRA), which is part of the Bank of England, and the FCA are the UK regulators with primary responsibility for the supervision and oversight of derivatives market participants in the UK. The PRA’s primary role is the authorisation and prudential regulation of banks, building societies and credit unions, whereas the FCA’s primary role is to establish the business conduct standards that apply to derivatives market participants as well as the trading venues that list derivatives products for trading. The FCA is also responsible for the prudential supervision of firms that are not PRA-regulated.

Other UK regulators play an important role, too. The Bank of England supervises certain key market infrastructures that are vital to the derivatives markets, including CCPs and payment and settlement systems. In addition, the UK energy regulator, the Office of Gas and Electricity Markets, is responsible for the registration of market participants in the wholesale energy market, which also includes wholesale energy derivatives, under UK REMIT.

There are two independent derivatives-clearing obligations under UK law. Under the first obligation, all derivatives concluded on a UK-regulated market must be cleared at a CCP without exception.

Separately, the Bank of England is responsible for determining which standardised OTC derivatives must be cleared at a CCP; this list currently includes a number of interest rate and index credit default products. Whether the clearing obligation applies to an in-scope product depends on the nature of the counterparties to the transaction. Generally, transactions between some combination of FCs and/or non-financial counterparties (NFCs) that exceed the clearing threshold applicable to the relevant asset class (NFC+s) must be cleared unless an exemption applies. Relevant exemptions include qualifying intra-group transactions, which are subject to an application process with the FCA, as well as transactions by certain qualifying pension schemes. In addition, certain “small” FCs are not required to clear OTC derivatives transactions that are otherwise subject to mandatory clearing, provided they do not exceed the relevant clearing threshold.

FCs and NFCs must therefore determine on an annual basis whether, for a given asset class, their cleared and uncleared derivatives not executed on a UK-regulated market or a third-country exchange deemed to be equivalent by the FCA exceed the threshold applicable to a given asset class (currently EUR3 billion for interest rate, FX and commodities products, and EUR1 billion for credit and equity products). If a threshold is exceeded, the FC or NFC must begin clearing the relevant in-scope OTC derivatives within four months of crossing the relevant threshold(s). NFCs are permitted to exclude hedging transactions from the UK EMIR clearing threshold calculation. NFC+s are only required to clear OTC derivatives in the asset classes where they exceed the relevant threshold, whereas a “small” FC that exceeds the relevant threshold in any asset class must then clear OTC derivatives subject to a clearing obligation in all asset classes.

The Bank of England has the authority to suspend the clearing obligation in respect of one or more OTC derivatives, initially for a period not exceeding three months, where certain conditions are met. The suspension period may be renewed for successive three-month periods, up to a maximum of 12 months.

ETDs must by definition be concluded on a UK-regulated market or an equivalent third-country market.

In addition, the FCA may determine that an OTC derivative that is subject to a UK clearing obligation is also subject to a UK trading obligation, provided that the OTC derivative is traded, or admitted to trading, on at least one UK trading venue, and there is sufficient third-party buying and selling interest to support trading in the product. Where the UK trading obligation applies to an OTC derivative, in-scope FCs and NFC+s must conclude all transactions in such an OTC derivative on a UK trading venue, or on a third-country trading venue that is determined to be equivalent for the purposes of the trading obligation. Currently, only venues in Singapore and the United States regulated by the Commodity Futures Trading Commission benefit from such equivalence.

The UK rules are based on the derivatives' clearing and trading obligations working in tandem. This means, for example, that where the clearing obligation is suspended, any corresponding trading obligation is also suspended.

Recent legislative amendments have removed the pre-existing MiFID II requirement that position limits must apply to all commodity derivatives traded on UK trading venues and their economic equivalents. Instead, the FCA has been granted the power to determine which exchange-traded commodity derivatives are subject to position limits.

To that end, the FCA has proposed to focus the UK position limits regime on so-called “critical contracts” (ie, those that are at the greatest risk from abusive practices or disorderly trading and where position limits and position management controls are most likely to mitigate such risks). The actual limits will be based on a market participant’s overall net position in a given critical contract as well as its “related contracts”, including cash-settled lookalikes as well as any other exchange-traded commodity derivative that can result in a position or delivery obligation in a critical contract, or another related contract, or where the settlement price is indirectly linked to the settlement price of the critical contract.

The FCA has set out its proposed framework for identifying critical contracts, which will be based on the following four criteria:

• physical versus cash settlement;
• the size and liquidity of the derivatives market compared to the underlying cash market;
• the type of underlying commodity; and
• the overall size of the market.

Where the FCA determines that a commodity derivative should be added to the list of critical contracts, market participants will have a 45-day notice period to submit comments, following which the determination will be amended or finalised. Trading venues will then have 30 days to establish the relevant limits.

Eligible firms may apply to the FCA for an exemption from an applicable position limit. The current UK framework provides non-financial firms with a so-called “hedging” exemption for positions that qualify as reducing risks relating to their commercial activities. The FCA has proposed to add a new “pass-through” hedging exemption for financial firms that facilitate hedging activities, as well as a further exemption for liquidity providers in critical contracts.

While not expressly required by UK law, many UK trading venues establish position accountability thresholds, which are set at a level below an applicable position limit, for the purpose of monitoring activity in the contract. Where a market participant crosses an accountability threshold, the trading venue’s rules generally provide for certain supervisory responses by the venue, including the provision of information by the market participant. The trading venue often retains the right to require the market participant to reduce its position to below the accountability threshold.

Both UK EMIR and UK MiFIR impose reporting requirements on OTC derivatives transactions.

UK EMIR Derivatives Transaction Reporting

Article 9 of UK EMIR requires UK counterparties and CCPs to report all ETDs and OTC derivatives concluded, modified or terminated to a trade repository registered or recognised by the FCA by the following working day. Although UK-regulated counterparties are currently broadly required to notify the FCA when reporting errors occur, from 30 September 2024, due to UK EMIR Refit, all UK counterparties (including those that are unregulated) that are required to report under UK EMIR must notify the FCA (or in the case of CCPs, the Bank of England) of any material errors or omissions in their reporting as soon as they become aware of them. UK EMIR currently requires 129 reporting fields for each transaction reported, which will increase to 204 on 30 September 2024 due to the requirements under UK EMIR Refit.

UK EMIR requires double reporting. This means that both counterparties to a derivative are solely responsible and legally liable for reporting their side of the derivative with the exception that, due to the changes brought in by UK EMIR Refit, an FC is obliged to report both sides of the OTC derivatives it enters into with an end user that is an NFC below all UK EMIR clearing thresholds (NFC-), unless such NFC- determines to do its own reporting. Further, an NFC- is not required to report any OTC derivative transaction with a third-country entity that would be an FC were it to be established in the UK, where an equivalence decision for reporting has been made for that jurisdiction. In addition, UK EMIR, as amended by UK EMIR Refit, requires an alternative investment fund manager (AIFM) to report on behalf of its alternative investment fund (AIF), and the management company of UCITS to report on behalf of UCITS. Due to the fact that UK EMIR Refit has modified the definition of an FC to include both an AIFM and an AIF, a UK AIFM is required to report the OTC derivatives entered into by any of the third-country AIFs it manages, as well as for its UK AIFs. Delegated reporting is permitted under UK EMIR, but the UK counterparty with the UK EMIR reporting obligation remains solely responsible and legally liable for the reporting.

Due to the UK’s back-to-back clearing model, an ETD can be required to be reported by multiple counterparties. For example, if an investment firm enters into an ETD through its clearing firm, which is cleared through a CCP, the investment firm, clearing firm and CCP will all be required to report the ETD for each part of the chain and side of the transaction they are involved in, resulting in four reports.

UK EMIR provides an exemption from the reporting obligation for intra-group transactions, which requires at least one counterparty to be an NFC (or that it would be if it were established in the UK) and notification to the FCA. The exemption additionally requires that:

• both counterparties are included in the same consolidation on a full basis;
• both counterparties are subject to appropriate centralised risk evaluation, measurement and control procedures; and
• the parent undertaking is not an FC.

UK MiFIR Transaction Reporting

UK MiFIR requires all UK investment firms to report transactions they execute in certain financial instruments to the FCA. Such reports must be made as soon as possible, and no later than the close of the next working day. The requirement applies to trades in financial instruments, including derivatives, to which any of the following criteria apply:

• they are admitted to trading or are traded on a UK, Gibraltar or EU trading venue;
• the underlying is a financial instrument traded on a UK, Gibraltar or EU trading venue; or
• the underlying is an index or basket composed of financial instruments traded on a UK, Gibraltar or EU trading venue.

“Transaction” and “execution” each have specific definitions for the purposes of the transaction reporting regime:

• “Transaction”:
1. includes the purchase/sale of a financial instrument, entering into/closing out a derivative contract or an increase/decrease in the notional amount of a derivative contract; and
2. specifically excludes certain post-trade and settlement-related actions, including contracts arising exclusively for clearing or settlement purposes, the post-trade assignment or novation of a derivative contract and portfolio compressions.
• “Execution” includes the reception and transmission of orders (unless made in accordance with certain specified requirements), the execution of orders on behalf of clients, dealing on own account and making an investment decision in accordance with a discretionary mandate given by a client.

A number of business conduct requirements can apply to parties engaged in derivatives trading in the UK, depending on their status under UK EMIR (eg, FC or NFC) and their regulatory status.

The key conduct requirements under UK EMIR include:

• Margin requirements: Subject to certain exemptions and exceptions, UK EMIR margin requirements (VM and IM) generally apply where an FC or an NFC+ established in the UK enters into non-centrally cleared OTC derivative contracts with either another FC or NFC+, or a third-country counterparty that would be an FC or NFC+ if it were established in the UK.
• Risk mitigation techniques: FCs and NFCs must implement risk mitigation techniques for OTC derivative contracts not cleared by a CCP. These techniques include timely confirmation, portfolio reconciliation, portfolio compression, and dispute resolution processes.
• Mark-to-market and mark-to-model valuations: FCs and NFCs must perform daily mark-to-market valuations of their derivative positions. If market conditions prevent this, they must use reliable and prudent mark-to-model valuations.
• Reporting obligations: as discussed in 3.1.5 Reporting.
• Clearing obligations: as discussed in 3.1.2 Clearing.
• UK FCs, as authorised entities, can also be subject to the full range of requirements under, among other things, UK MiFID II and the FCA’s Handbook. This includes the FCA’s high-level principles, as well as specific requirements relating to, for instance:
1. financial promotions and client communications;
2. client classification and suitability;
3. conflicts of interest;
4. business continuity and outsourcing;
5. the FCA’s senior managers and certification regime;
6. market conduct;
7. anti-money laundering, bribery and fraud; and
8. record-keeping.

It would be prohibitively expensive for many end-users to have the middle- and back-office infrastructure to support compliance with the UK EMIR reporting, clearing and risk management obligations and the UK MiFID II trading obligations. Therefore, UK EMIR, including as amended by UK EMIR Refit, provides substantial relief for those end users who are NFC-s. UK FCs must now report, on behalf of the NFC-, any OTC derivative transaction they enter into with an NFC- unless the NFC- determines to do its own reporting. Further, NFC-s are no longer required to report the OTC derivatives transaction they enter into with third-country entities that would be FCs were they established in the UK, provided a reporting equivalence decision has been made for that jurisdiction. NFC-s are exempt from both UK EMIR clearing and UMRs. NFC-s are, however, subject to the UK EMIR risk mitigation obligation, which requires portfolio reconciliation, dispute resolution and portfolio compression (if certain thresholds are met). However, such compliance obligations in general are more burdensome to the FC than to an NFC-; for instance, an NFC- can elect to be a receiving entity and not a sending entity for the purposes of the portfolio reconciliation obligation.

In contrast, NFC+s are equally subject to all UK EMIR obligations as an FC above one or more clearing thresholds (FC+). However, certain UK EMIR exemptions apply for NFC groups, regardless of whether the NFC is an NFC-. As discussed in 3.1.5 Reporting, an exemption from UK EMIR reporting exists when, among other conditions, one party to the OTC derivative transaction is an NFC and the parent undertaking of the group is not an FC. An intra-group exemption from both the UK EMIR clearing obligation and margin obligation for uncleared OTC derivatives exists for NFCs (and FCs) provided an application is filed with and granted by the FCA.

Uncleared OTC Derivatives

Uncleared OTC derivatives are commonly governed by the standard agreements published by International Swaps and Derivatives Association, Inc. (ISDA), regardless of product type and counterparty, and are generally governed by either English or New York law.

As part of ISDA’s aim to streamline derivatives documents, it has developed a standardised framework of documentation for derivatives transactions. Such documents include:

• the 1992 and 2002 master agreements – a preprinted framework document comprised of boilerplate provisions;
• the schedule to the master agreement – amends the terms of the master agreement as agreed by the parties;
• the credit support document – an optional document that offers each party security against the other party’s credit risk, either in the form of:
1. a credit support annex (CSA); or
2. a credit support deed (CSD); and
• the confirmation – sets out the economic terms of an individual trade.

The master agreement, schedule, CSA (if any) and all confirmations form one single contract. The CSD (if any) is a standalone document.

Cleared OTC Derivatives

Cleared OTC derivatives can also be documented under standard ISDA documentation. However, frequently, a Futures Industry Association (FIA)–ISDA Cleared Derivatives Execution Agreement is used instead of negotiating a full ISDA. Additionally, an FIA–ISDA Cleared Derivatives Addendum is generally used to document the relationship between a clearing member and its client. However, there can be practical differences between the documentation process for cleared and uncleared OTC derivatives. For example, the cleared OTC derivatives documentation process is generally heavily dependent on automated information technology processes. Additionally, the terms of cleared OTC derivatives documents must conform to the relevant clearing house’s contract specifications.

ETDs

The parties involved in ETDs do not execute bilateral derivatives documentation, such as the standard ISDA documentation, but are subject to the rules of the underlying exchange.

ETDs are generally governed by standard documentation in line with the exchange’s contract specifications, as applied through the exchange’s rules. If a party to an ETD is not itself a member of the exchange, it will be required by its clearing firm and/or brokerage firm to negotiate a clearing/brokerage agreement, which is generally bespoke to each such firm.

ISDA has produced standard credit support documents that take the form of either a CSA or a CSD. Generally, the governing law of the credit support document matches the governing law of the ISDA master agreement (although this is not mandatory).

VM

In 2016, ISDA introduced a new CSA for VM that is used for documenting the posting of VM under English law (2016 VM CSA). The 2016 VM CSA forms part of a suite of credit support documents introduced to aid compliance with margin requirements for derivatives that are not subject to mandatory clearing under UK EMIR and comparable legislation in other major financial jurisdictions.

The 2016 VM CSA revises the 1995 ISDA CSA (Bilateral Form–Transfer) (1995 CSA) to allow parties to determine VM arrangements that meet the regulatory requirements for uncleared derivatives (ie, UMRs) that entered into force in March 2017. The structure of the 2016 VM CSA remains consistent with the 1995 CSA. The updates in the 2016 VM CSA relate solely to VM. ISDA has also published a 2016 VM CSA under New York law.

ISDA has also published the 2016 Variation Margin Protocol to help market participants comply with the VM requirements of the UMRs. This enables market participants to amend their CSAs with multiple counterparties to be compliant under the UMRs.

IM

Under UK EMIR, as further detailed in the UMRs, parties to a derivatives agreement are required to post IM if they have uncleared derivatives portfolios with an aggregate average notional amount exceeding certain thresholds.

At a minimum, parties will likely need the following suite of documentation regarding the posting of IM:

• a collateral agreement between the parties – the relevant CSA, CSD or collateral transfer agreement and security agreement (where posted collateral is held outside of the UK or with Euroclear/Clearstream);
• an account control agreement – a tripartite agreement between the parties and the custodian, which sets out control and access provisions in accordance with the relevant segregation requirements under the applicable margin rules;
• an eligible collateral schedule between the parties;
• a custody agreement between a party and the custodian; and
• a Euroclear/Clearstream representative agreement – required where the counterparty posts IM via Euroclear/Clearstream.

Global Master Repurchase Agreement (GMRA)

While repurchase (repo) transactions can be documented individually, they are usually documented under a master agreement. The International Capital Market Association (ICMA) and the Securities Industry and Financial Markets Association (SIFMA) have published standard forms of the repo master agreement, namely, the GMRA.

The 2011 version of the GMRA is generally used to document non-US repo transactions.

The GMRA is comprised of three parts:

• Standard boilerplate legal and credit provisions: These include warranties, events of default, margining provisions and netting provisions.
• Annexes: Annex I allows the parties to modify the boilerplate provisions of the GMRA, and certain other annexes can be added to cover particular types of security.
• Confirmation: This contains the commercial terms of each repo transaction.

Global Master Securities Lending Agreement (GMSLA)

Securities lending transactions are usually documented by the GMSLA, which is a market standard master agreement produced by the International Securities Lending Association (ISLA). The ISLA is a trade association representing the interests of participants in the securities lending market.

The GMSLA was originally drafted to comply with English law on securities lending. It has been developed as a market standard for securities lending and sets out the obligations of the borrower and the lender. It is now recognised as the most-used agreement in the UK and EU bilateral securities lending market. While various versions of the GMSLA exist, the 2010 version is the most widely used for new trading relationships.

The GMSLA is comprised of the following parts:

• Master agreement – the preprinted form;
• Schedule – where the parties can amend the preprinted form;
• Confirmation – sets out the economic terms of individual securities lending transactions; and
• Annexes and addendums – there are various annexes and addendums that the parties might agree to attach to the GMSLA (eg, the agency annex and an addendum for pooled principal agency loans).

Master Repurchase Agreement (MRA)

The MRA, published by SIFMA, is the primary form of standardised repo agreement used for US repo transactions. The latest version of the MRA was published in 1996 by SIFMA.

Master Securities Lending Agreement (MSLA)

The MSLA, published by SIFMA, is the primary form of standardised agreement used for US securities or stock lending transactions.

Master Securities Forward Transaction Agreement (MSFTA)

The MSFTA, published by SIFMA, is the primary form of standardised agreement used to document a US securities forward transaction that is subject to margin requirements under Financial Industry Regulatory Authority Rule 4210.