ESMA confirms DTO to continue post-Brexit

ESMA has this morning released a public statement confirming that the EU Derivatives Trading Obligation (DTO) will continue to apply after Brexit transition. The DTO under Article 28 of MiFIR requires firms to transact certain derivatives (essentially the most liquid, standardised contracts) on an EU trading venue, or that of a third country already judged as equivalent (technically the U.S. and Singapore to date, practically only the U.S.). In the absence of a grant of equivalence with respect to the UK, the continued application of the EU DTO will cut access for EU derivatives traders to the world’s largest trading hub.

“ESMA acknowledges that this approach creates challenges for some EU counterparties particularly UK branches of EU investment firms. However, ESMA considers that EU counterparties can meet their obligations under the DTO by trading on EU trading venues or eligible trading venues in third countries, and this situation is primarily a consequence of the way the UK has chosen to implement the DTO.”

The EC has made no indication that an equivalence decision for UK trading venues is imminent, instead citing the undesirability of preferential third country treatment and that the decision mechanism can only start post-Brexit. A more cynical observer may consider this as spuriously justified intransigence, to effect injury on a new commercial rival. Article 33 of MiFIR allows the Commission to make an equivalence decision in respect of a third country’s DTO, rather than blanket country equivalence. However, it has made no such decisions to date and has signalled a disinclination to do so for the UK. The FCA has shown itself willing to grant a limited form of equivalence via the Temporary Permissions Regime (TPR), though a unilateral grant of equivalence is unlikely without at least a hint of reciprocity. The DTO conflict will also apply in cases where cross border UK-EU business is conducted via a branch in either trading area. Respective DTOs will still apply, with the added complication that for EU firms transacting via a UK branch, the TPR regime will also require the EU firm to comply with the UK DTO.

As things stand, from the 1 January 2021, EU and UK entities will be subject to their respective DTOs, EU firms must confine their trading to the EU, UK firms must execute on a UK venue. Therefore, those UK and EU firms wishing to trade in-scope derivatives with each other will be forced to transact via a US SEF, as both the UK and the EU have judged the US as equivalent. However, this assumes mutual membership of the US trading venue and high trade volumes may require CFTC authorisation.  

Insofar as it just repeats their March 2019 statement, today’s confirmation should come as no surprise, but perhaps some hope of Brexit sanity still persisted. At least in the short term, the consequences for liquidity fragmentation and operational complexity are likely to be severe. Longer term consequences will depend on the persistence of non-recognition; once a liquidity pool dries up, refilling is far from easy.

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