EU trading obligation sparks Brexit stalemate for derivatives market

ESMA will uphold its approach to derivatives trading obligation requiring activity take place on venues within the EU once Brexit transition period ends.

The EU markets watchdog has refused to change its stance on rules that mean most liquid derivatives will no longer be able to trade on UK venues once the Brexit transition period ends. 

Under the rules, known as the derivatives trading obligation, derivatives that are in-scope of the requirements must be traded on venues within the EU or in third-country venues that have been granted equivalence.  

The European Securities and Markets Authority (ESMA) outlined its approach to the rules in March 2019, and in the most recent update confirmed it does not consider a change in its approach is warranted. It added that without a UK equivalence decision from the European Commission, it will provide no further guidance.

Most trading in derivatives subject to the trading obligation is currently executed on UK trading venues, but without equivalence, this activity will have to shift to Europe from 31 December as the UK’s Brexit transition period comes to an end.   

European banks with entities in the UK that trade derivatives subject to the rules will be particularly impacted, ESMA acknowledged, as they will be subject to conflicting trading obligations in both the EU and the UK. ESMA stated that “this situation is primarily a consequence of the way the UK has chosen to implement the derivatives trading obligation”.   

The development also means that EU and UK counterparties wanting to trade derivatives with each other on a cross-border basis would only be able to do so on swap execution facilities that are based in the US. 

ESMA added that most UK venues that offer trading in derivatives subject to the rules have established venues in the EU, allowing firms in Europe to comply with the trading obligation. However, as market participants are still being onboarded, such as major liquidity providers, ESMA admitted that trading on those venues is currently limited.  

An in-depth report from the International Swaps and Derivatives Association (ISDA) published in September said it is critical that the EU and the UK recognise equivalence of each other’s derivatives trading venues post-Brexit.

Without equivalence, ISDA warned, counterparties subject to the derivatives trading obligation will face significant issues as fragmentation of liquidity in OTC derivatives markets is exacerbated. 

“Given that UK and EU trading venues will operate under substantively the same regulatory  frameworks at the end of the transition period, there are no technical reasons why these  equivalence decisions should not be made,” ISDA said.  

The statement from ESMA on the derivatives trading obligation is the latest in a series of regulatory developments from both the UK and the EU as the deadline on 31 December marking the end of the Brexit transitions draws closer.  

Earlier this month, the UK agreed to allow banks and investors to trade on EU venues under the share trading obligation, despite the EU taking a more complex approach to the rules which is based on certain conditions.  

Shortly after, chancellor Rishi Sunak outlined a set of equivalence decisions for the EU covering certain areas in clearing, central securities depositories, benchmark administrators, as well as derivatives and OTC trading.  

“By taking as many equivalence decisions as we can in the absence of clarity from the EU, we’re doing what’s right for the UK and providing firms with certainty and stability,” Sunak commented at the time.