Derivatives and Structured Products Legal Outlook 2023
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We saw a wide range of sustainable transactions launched in 2022 and expect volume and variety to increase further in 2023 as investors continue to actively seek more sustainable investment opportunities. Carbon allowances have been a particular focus across the market, with the development of standardised documentation in the secondary trading market and the use of innovative structured product solutions to provide hedging and investment opportunities.
Following on from the publication of ISDA’s “Legal Implications of Voluntary Carbon Credits” in December 2021, December 2022 saw the publication of the ISDA 2022 Verified Carbon Credits Definitions (the ISDA VCC Definitions). These are in the form of a standard definitional booklet for physically settled secondary market Verified Carbon Credit (VCC) transactions and are accompanied by template confirmations for VCC spot, forward and option transactions. We were delighted to work with ISDA on the ISDA VCC Definitions – please see our note for more information on how they can be used and some of the key provisions. The International Emissions Trading Association also published template documentation for the secondary trading of VCCs in 2022. These are important developments for the secondary market, and we expect to see this space further develop in 2023 as market participants start to use and adapt the new documentation.
In April 2022, ISDA launched a survey to assess the current state of sustainability-linked derivatives (SLDs) documentation and published the results of the survey in November 2022. Given the strong member interest in the product, ISDA has convened a working group to develop standardised provisions for documenting SLDs, which we expect to see published during 2023. This will be a key development for SLDs and should lead to further expansion of the market.
The trend for sustainable products continued in 2022 and is set to carry on in 2023 as investors seek both new sustainable products and “business as usual” products with an added ESG element.
As mandated as part of EMIR REFIT, new technical standards on the reporting requirements and procedures for data quality under EMIR were published in the Official Journal in October 2022. Reports will need to be made in accordance with the new standards, following an 18-month implementation period, from 29 April 2024. In late December 2022, ESMA published Guidelines clarifying certain aspects of the amended rules, together with validation rules and reporting instructions.
With the level of detail to be reported significantly extended, including 89 new reporting fields, and a total number of 203 reporting fields, the implementation period will provide valuable time for counterparties to make necessary changes to processes and documentation. To read more about the new reporting requirements see: EMIR – new reporting requirements published in the Official Journal.
It should also be noted that the Commission’s recent proposal setting out amendments to EMIR, so-called EMIR 3, provides for the removal of the existing exemption from reporting requirements for certain intragroup transactions involving an NFC.
The FCA and Bank of England have jointly consulted on changes to reporting requirements, procedures for data quality, and registration of trade repositories under UK EMIR. The great majority of these proposals were aligned with the new EU EMIR reporting technical standards. However, the UK proposals have not yet been finalised. It is now expected that the UK changes will take effect from 30 September 2024, some months after the equivalent rules in the EU.
With the US, UK, EU and other jurisdictions having adopted or considering adopting new reporting standards to implement the global initiatives on the harmonisation of reporting for derivatives, the market can expect the regulators in Hong Kong to review their reporting rules during the course of 2023. A consultation on (amongst other things) the use of unique transaction identifiers (UTIs) was initially published by the Hong Kong Monetary Authority and the Securities and Futures Commission in April 2019. The conclusions to this consultation have yet to be published – market participants can expect the regulators to re-focus their attention on mandatory reporting in due course.
On 5 December 2022, the CFTC’s rewrite of its swap data reporting rules (Parts 43 (real-time public reporting), 45 (swap data recordkeeping and reporting), 46 (swap data recordkeeping and reporting: pre-enactment and transition swaps) and 49 (swap data repositories)) went live; and reporting counterparties, swap data repositories, swap execution facilities, and designated contract markets were required to comply with the amendments to those rules as of such date.
However, the compliance date for the amendments to CFTC regulations 43.4(h) (post-initial cap sizes for block trades) and 43.6 (block trades and large notional off-facility swaps) is 4 December 2023, and the existing swap categories and block thresholds remain unchanged until such date. Additionally, the CFTC expects market participants to use the data transmission standard, ISO 20022, and the Unique Product Identifier when they become available for implementation; but the CFTC has not yet provided a specific implementation date with respect to those requirements.
Clearing will be a hot topic during 2023 following the Commission’s publication of a legislative proposal (the Proposal) setting out amendments to EMIR, so-called EMIR 3, in December 2022.The Proposal reflects the findings of the Commission’s targeted review of the central clearing framework in the EU as well as some concerns identified during recent turmoil in energy markets and more general points that have become apparent in the operation of EMIR.
The timing for progress of the Proposal through the legislative process and entry into force is not yet clear and may well extend beyond 2023. Furthermore, various provisions require technical standards to be made by ESMA and/or include a phase-in period meaning that, as was the case with EMIR REFIT, EMIR 3 is expected to take some years to come fully into effect.
The targeted review of the central clearing framework of the EU conducted by the Commission in 2022 focussed on improving the attractiveness of EU CCPs and reducing exposures to systemically important third country CCPs (Tier 2 CCPs) that provide clearing services identified by ESMA as of substantial systemic importance for the financial stability of the EU or one of its member states. To this end, the Proposal includes the introduction of a requirement that FCs and NFC+s clearing specified contracts, clear at least a proportion of those contracts at accounts with EU CCPs.
ESMA, in cooperation with the other ESAs and after consulting the ESCB, is mandated to develop draft technical standards specifying the proportion of activity in the specified derivative contracts that would result in a reduction in clearing in those derivatives at Tier 2 CCPs, and thereby ensure that clearing in such derivative contracts at Tier 2 CCPs is no longer of substantial systemic importance.
FCs and NFC+s subject to these requirements would need to report annually to the competent authority of the relevant CCP the extent to which they clear through EU CCPs. EU clearing members and clients will also need to report annually to their competent authority the extent to which they clear through recognised third-country CCPs.
The Proposal includes measures to improve the attractiveness of EU CCPs by, amongst other things, making the process for CCPs to expand their product offering shorter and less complex. Amendments requiring clearing members and clients providing clearing services to provide clients and indirect clients with better visibility and predictability of margin calls are also proposed.
The Proposal includes an amendment to the way the clearing thresholds are calculated under EMIR, to distinguish between cleared and non-cleared transactions rather than between exchange-traded derivatives and OTC derivatives. This is helpful for EU entities that enter into derivatives transactions on UK venues, that are currently treated as OTC derivatives and therefore in-scope of the clearing threshold calculations.
The energy crisis has also driven developments relating to clearing, with amendments to increase the clearing threshold for commodity derivatives from €3bn to €4bn, and temporary expansion of the pool of collateral considered eligible for energy derivatives by CCPs, subject to certain strict conditions, entering into force on 29 November 2022.
The exemption from clearing for EEA pension schemes is set to expire on 18 June 2023 and there is no scope under EMIR for further extension of this exemption. Both ESMA and the Commission have called for EEA pension schemes subject to the clearing obligation to be prepared to clear in-scope transactions from 19 June 2023. On the other hand, the Proposal includes an amendment to EMIR to permit EU FCs and NFC+s to transact with third country pension scheme arrangements that are not subject to a clearing obligation under their national laws, without the EMIR clearing obligation applying.
Further changes to the scope of the clearing obligation in light of the ongoing progress on interest rate reform are expected, and in particular extension of the clearing obligation to certain TONA products, and a wider range of SOFR products, reflecting increasing liquidity in such products.
ESMA has recently announced that it will withdraw recognition decisions for six CCPs established in India previously recognised under EMIR. The application of these decisions is deferred to 30 April 2023. Counterparties relying on ESMA recognition to clear through any of these CCPs will need to follow these developments closely and respond accordingly.
The transitional exemption from clearing for intragroup transactions with counterparties in non-equivalent jurisdictions is in the process of being extended to 30 June 2025. Regulatory forbearance is in place pending entry into force of this extension. The Proposal sets out amendments to repeal the current “equivalence” provisions in Article 13 of EMIR, and to permit transactions with third country affiliates to be treated as intragroup transactions within the scope of the exemptions, unless the third country concerned is classified as high risk or non-cooperative with respect to money laundering, terrorist financing or tax evasion, or otherwise identified as a country that may not benefit from these exemptions by the Commission by way of delegated act.
The next EMIR Review was expected to be carried out over the next year or so, with the Commission due to assess the application of EMIR by 18 June 2024. However, some issues anticipated to be addressed in the EMIR Review have instead been covered in the Proposal, and the Proposal provides for the next EMIR Review to be deferred to five years from the Proposal amendments coming into force. This means a delay for changes that might usefully be made to EMIR but are not included in the Proposal, such as an exemption from the clearing obligation for post-trade risk reduction exercises.
Under UK EMIR, the exemption from clearing for transactions with UK and EEA pension schemes expires on 18 June 2023, unless extended by the Treasury. In the absence of an extension, any UK pension scheme subject to the clearing obligation will need to ensure that it has arrangements in place to clear in-scope derivatives ahead of that date.
The Bank of England’s policy on tiering and comparable compliance of third country CCPs was implemented on 1 December 2022. The Treasury has also announced the extension of the Temporary Recognition Regime for third country CCPs by a further 12 months to 31 December 2024. Those relying on this temporary regime should, however, be mindful that a number of CCPs do not wish to seek recognition in the UK and have entered into the run-off period. This period is due to end on 1 July 2023, however, we note that an amendment proposed to the Financial Services and Markets Bill would allow the Bank of England to extend this period. The derecognition decisions made by ESMA outlined above may also cause affected CCPs to enter the run-off period post end-April 2023.
In the UK, certain interest rate products relating to SOFR and TONA are already in scope of the clearing obligation. The Bank of England has issued a Policy Statement indicating that contracts referencing USD LIBOR will be removed from the scope of the clearing obligation on 24 April 2023 (which is when CCPs will contractually convert outstanding USD LIBOR contracts).
There are no proposals in the UK to increase the clearing threshold for commodity derivatives as introduced in the EU.
Finally, the transitional exemption from clearing for intragroup transactions with counterparties in non-equivalent jurisdictions under UK EMIR will expire, unless extended by the Treasury, on 31 December 2023. Industry advocacy is ongoing on this point, particularly in light of the amendments to the EU intragroup regime set out in the Proposal.
The CFTC has finalised its rulemaking setting out an interest rate swap clearing determination to account for the transition from LIBOR and other IBORs to alternative reference rates, predominantly overnight, nearly risk-free reference rates.
Certain OIS classes, which are generally those for which their corresponding IBOR rates have ceased publication or become non-representative, were added to the clearing mandate, and the corresponding requirement in respect of certain IBORs removed. The classes of swaps required to be cleared can be found online at 17 C.F.R. § 50.4.
On 1 July 2023, the clearing mandate will remove from the clearing requirement swaps denominated in:
With initial margin now fully phased-in following completion of Phase 6 in September 2022, potential in-scope counterparties will need to conduct the annual calculation of their AANA on an ongoing basis. Going forward, AANA will continue to be determined by reference to month-end positions for March, April and May, however, where the €8bn AANA threshold is exceeded, an entity will come in-scope for initial margin from the beginning of the following calendar year.
The EBA has consulted on technical standards on initial margin model validation, and is expected to publish a final report and draft technical standards in Q1 2023. However, amendments in the Commission’s legislative proposal (the Proposal) setting out changes to EMIR, so-called EMIR 3, published in December 2022, would remove the mandate for these technical standards, providing instead for the EBA, in cooperation with the other ESAs, to issue guidelines or recommendations for uniform application of the requirements for exchange of collateral. It is therefore possible that these technical standards may not ultimately be made.
The temporary derogation from margin for single stock equity options and index options expires in early January 2024. Industry advocacy seeking continued exemption is underway. Counterparties relying on this exemption should monitor developments and make preparations for compliance with regulatory margining as necessary.
The transitional exemption from margining for intragroup transactions with counterparties in non-equivalent jurisdictions is in the process of being extended to 30 June 2025. Regulatory forbearance is in place pending entry into force of this extension. The Proposal sets out amendments to repeal the current “equivalence” provisions in Article 13 of EMIR, and to permit transactions with third country affiliates to be treated as intragroup transactions within the scope of the exemptions, unless the third country concerned is classified as high risk or non-cooperative with respect to money laundering, terrorist financing or tax evasion, or otherwise identified as a country that may not benefit from these exemptions by the Commission by way of delegated act.
Following a joint consultation by the PRA and FCA earlier in the year, amendments to the UK EMIR margin rules came into force on 15 December 2022.
These amendments include an extension to the transition period for continued use of EEA UCITS as eligible collateral until 31 March 2023 and extend the scope of eligible collateral to include any third-country funds, not just EEA UCITS, but subject to strict conditions.
Fall-back transitional provisions for firms first coming in scope for margin requirements have also been introduced. Under these provisions:
For more information on these recent changes to the UK EMIR margin rules see PRA and FCA make changes to UK EMIR margin rules for uncleared derivatives.
As in the case of EMIR, following the completion of Phase 6, counterparties potentially in-scope for initial margin will need to conduct the annual AANA calculation process on an ongoing basis.
It is also the case that the temporary derogation for single stock equity options and index options under UK EMIR will expire from early January 2024, unless extended. As in the EU, affected counterparties should monitor developments and prepare for regulatory margin compliance for these products as necessary.
Finally, the transitional exemption from margining for intragroup transactions with counterparties in non-equivalent jurisdictions under UK EMIR will expire, unless extended by the Treasury, on 31 December 2023. Industry advocacy is ongoing on this point, particularly in light of the amendments to the EU intragroup regime set out in the Proposal.
With the completion of the phase-in period under CFTC’s margin requirements (the CFTC Margin Rules) and the Prudential Regulators’ margin requirements (the PR Margin Rules) in September 2022, potential in-scope counterparties will need to continue to conduct an annual calculation of their AANA on an ongoing basis to determine whether they have become (or continue to be) in-scope for regulatory initial margin.
The observation period, averaging days and compliance dates are different under the CFTC Margin Rules and the PR Margin Rules. Accordingly, in-scope counterparties should perform AANA calculations under both rulesets if facing dealers subject to the CFTC Margin Rules and PR Margin Rules (or otherwise, should perform AANA calculations under the relevant ruleset to which its dealer counterparty is subject).
Under the CFTC Margin Rules, the observation period is March, April and May of the relevant year (with the averaging based on the aggregate notional amount of relevant transactions on the last business day of each month during the observation period) and the compliance date is 1 September of the relevant year, whereas under the PR Margin Rules, the observation period is June, July and August of the previous year (with the averaging based on the aggregate notional amount of relevant transactions on each business day during the observation period) and the compliance date is 1 January of the relevant year. Note that the CFTC AANA observation period of March, April and May of the relevant year is aligned with the EMIR/UK EMIR AANA observation period, however, the compliance date for the CFTC Margin Rules is 1 September of the relevant year whereas for EMIR/UK EMIR it is 1 January of the following year.
Initial margin has been fully phased-in from September 2022 under the margin requirements of each of the Hong Kong Monetary Authority (HKMA) and the Securities and Futures Commission (SFC). Under both sets of rules, initial margin applies on a permanent basis from 1 September 2022 for each subsequent 12-month period if both the entity directly subject to the margin requirements and its covered counterparty have a group AANA of non-centrally cleared OTC derivatives exceeding the HK$60 billion threshold. AANA is calculated by reference to month-end positions for March, April and May preceding the 1 September starting date in a relevant year. Potential in-scope counterparties will need to conduct the annual AANA calculation on an ongoing basis.
Under the SFC’s rules, the temporary exemption from margin requirements for non-centrally cleared single-stock options, equity basket options and equity index options will expire on 4 January 2024, unless extended. Affected counterparties should monitor developments and prepare for regulatory margin compliance for these products as necessary. The same products are permanently exempt from margin requirements under the HKMA’s rules until further notice.
Risk mitigation standards (other than margin) contained in the HKMA’s rules are subject to a phase-in schedule and, starting from 1 September 2023, these risk mitigation standards will apply permanently with no threshold. In-scope counterparties will have to put in place documentation and operational procedures to comply with these requirements, to the extent that they have not already done so.
2022 was a significant year for the derivatives market in China as we saw the coming into effect in August of the PRC Futures and Derivatives Law (FDL), which sets out a comprehensive legal and regulatory framework for the exchange-traded futures market and the OTC derivatives market in Mainland China. For the OTC derivatives market, the FDL provided, for the first time at the national legislation level under PRC law, express recognition for the enforceability of close-out netting provisions and the single agreement concept commonly used in OTC derivatives documentation. With the publication by the International Swaps and Derivatives Association, Inc. (ISDA) of the industry PRC law netting and collateral opinions, in August 2022, there is now a strong basis for the market to conclude that the PRC is a “clean-netting” jurisdiction.
On the OTC derivatives clearing front, the FDL provides a statutory foundation for protection to key concepts in the central clearing process such as settlement finality, close-out netting and default management measures. The FDL will also be instrumental to the success of the recently announced Swap Connect scheme as it gives legal certainty to the clearing link between the Hong Kong central counterparty and its PRC counterpart.
Overseas market participants trading OTC derivatives with Chinese counterparties will have to assess carefully the implications of the PRC becoming a “clean-netting” jurisdiction; the application of regulatory margin requirements being an important point to consider. In the UK, recent amendments to the UK EMIR margin rules for uncleared derivatives have introduced a 12 month implementation period for counterparties first coming in scope for regulatory margin due to a change in netting status. It remains to be seen whether there will be any clarity from EU regulators in this regard.
Please see here for the client alert we have published on the FDL.
In 2022, following confirmation that the much-criticised mandatory buy-in (MBI) rules would not apply from 1 February 2022 along with the rest of the CSDR settlement discipline regime, attention quickly turned to what form any future revised MBI rules would take.
The European Commission kicked this process off in March 2022 with its CSDR REFIT legislative proposal. Under the proposal, the MBI regime would only be introduced in relation to a particular instrument or transaction type if settlement efficiency in those instruments or transactions does not improve as a result of cash penalties and other settlement discipline measures. The proposal also introduced two new exemptions to the settlement discipline regime, for settlement fails not attributable to the parties and transactions not involving two trading parties, the exact scope of which would be determined later via a delegated act.
Since then, other EU institutions have set out their positions on the proposal, with the ECB stating a preference to remove the MBI regime altogether (a position that was initially supported by the Parliament’s ECON Committee). The Council subsequently agreed its negotiating mandate in December 2022 which broadly follows the original Commission REFIT proposal with some important amendments, including to expand the list of out-of-scope transactions to cover securities financing transactions, financial collateral arrangements and transactions that include close-out netting provision.
Trilogue negotiations will begin once the Parliament has finalised its compromise text (expected to be in Q1 2023), and any final regulation is not expected to enter into force until the end of 2023 at the earliest. However, the application of the MBI regime has already been formally postponed until 2 November 2025, so market participants will have several years to prepare for any new MBI rules taking effect.
The cash penalties regime has been in operation since 1 February 2022, despite the suspension of the MBI rules. In 2023 the framework will be amended to remove the specific cash penalty collection and distribution process to be carried out by central counterparties and revert to the standard CSD collection process, aligning the position for cleared and uncleared transactions.
Article 3(1) CSDR, which requires listed securities issued by EU entities to be represented in book-entry form, applies to new securities issued after 1 January 2023. In practice this will only have a limited impact, restricting the issuance of certain listed bearer securities held outside of the clearing systems. The requirement will apply to all existing securities from 1 January 2025.
The CSDR settlement discipline regime was not onshored as part of Brexit and there are currently no plans to introduce equivalent rules in the UK. UK entities are, nonetheless, indirectly impacted by the EU regime where they settle in-scope transactions on an EU CSD (e.g. Euroclear and Clearstream), irrespective of whether the firm is a direct or indirect participant of that EU CSD, and/or use an EU broker or custodian that seeks to pass on (contractually) its CSDR obligations. As part of its “Edinburgh Reforms” package, the UK government announced the launch of an Accelerated Settlement Taskforce, whose mandate will include assessing current settlement performance in the UK and recommending potential improvements and reforms. The taskforce will publish its initial findings by December 2023, with a full report and recommendations made by December 2024.
For more information on CSDR, please see our Financial Regulation Outlook 2023.
Following the cessation of the publication of 24 LIBOR settings (including all Euro and Swiss Franc settings) at the beginning of January 2022, the efforts to transition away from LIBOR continue. This table summarises the status of the GBP, Yen and USD settings.
|1 January 2022||31 December 2022||31 March 2023||30 June 2023||31 March 2024||[30 September 2024]|
|Overnight, 1-week, 2-month and 12-month GBP settings||Publication ended|
1 and 6 month GBP settings
|Published as “synthetic” GBP LIBOR settings but new use not permitted with limited exceptions||Publication as “synthetic” GBP LIBOR setting ends|
3 month GBP setting
|Published as “synthetic” GBP LIBOR setting but new use not permitted with limited exceptions||Publication as “synthetic” GBP LIBOR setting ends|
|Spot-next, 1-week, 2-month and 12-month Yen settings||Publication ended|
1, 3 and 6 month Yen settings
|Published as “synthetic” Yen LIBOR settings but new use not permitted with limited exceptions||Publication as “synthetic” Yen LIBOR setting ended|
|1-week and 2-month USD settings||Publication ended|
Overnight and 12 month USD settings
|Publication continues based on bank submissions but new use not permitted with limited exceptions||Publication ends|
1, 3 and 6 month USD settings
|Publication continues based on bank submissions but new use not permitted with limited exceptions||FCA consultation to be published as “synthetic” USD LIBOR setting with new use not permitted with limited exceptions||Publications as “synthetic” USD LIBOR setting end – this end date is under consultation|
Pursuant to the Financial Services and Markets Bill, UK BMR, along with the bulk of retained EU law related to financial services, is set to be rewritten, primarily in regulators’ rule books. Various provisions of UK BMR are to be split between the existing regulatory perimeter under the regulated activities order (RAO) and the proposed designated activities regime (or DAR), a new regulatory framework for the regulation of certain activities relating to financial markets. There is no formal deadline for this process, which is expected to take a number of years to complete.
As mandated by the EU BMR Review process, two main areas will continue to develop in 2023:
Manufacturers and issuers of structured notes and repackagings will be faced with a wave of regulatory reforms in 2023 and beyond, in the form of proposed changes to both the EU and UK prospectus regimes and a number of measures aimed at protecting retail investors, including changes to the EU and UK PRIIPs regimes, the FCA’s new Consumer Duty and enhancements to the financial promotions rules.
The Commission published proposals to reform the EU prospectus regime in December 2022, by way of the Listing Act. Aspects that are likely to impact structured products are fairly targeted. Areas to watch include proposals relating to incorporation by reference, the use of supplements to introduce a new type of security and reform of the third country equivalence regime.
For more detail, see European Commission proposes changes to Prospectus Regulation - Key points for debt securities.
The EU Listing Act is subject to a comment period, currently scheduled to end in March 2023. Amendments will follow the usual EU legislative process and so will not apply until 2024 at the earliest.
The UK also published reform proposals in December 2022, in the form of the Public Offers and Admission to Trading Statutory Instrument (SI) as part of the wider Future Regulatory Reform Framework and the extensive package of Edinburgh Reforms. It will overhaul the current public offer, admissions to trading and prospectus regime by revoking the EU-derived UK Prospectus Regulation and replacing it with a new general prohibition on public offerings subject to specified exemptions. Principal exemptions will apply to offers where the securities are admitted to trading on UK markets. Most of the existing public offer exemptions, including the minimum denomination exemption (with a reduced £50,000 threshold) will also be retained.
The SI is intended to be made under powers in the Financial Services and Markets Bill once it has become law during 2023. In parallel with this legislative process, the FCA is expected to consult on the development of its rules that will comprise the detail of the new regime, including requirements on prospectus format and content.
For more detail, see Towards a new UK prospectus regime: Legislation published in draft.
For more detail on the Future Regulatory Framework and the Edinburgh Reforms, see “UK approach to financial regulation” below and Future regulatory framework: The Edinburgh Reforms.
Changes to the presentation and content requirements of the key information document (KID) began to apply from 1 January 2023. The changes are aimed at making KID information, in particular in relation to performance scenarios and costs, more understandable and not misleading.
Separately, in May 2022 the Joint Committee of the European Supervisory Authorities (ESAs) published a joint supervisory statement clarifying their expectations on the “What is this product?” section of the KID and identifying poor practices by reference to example language (some of which appeared in structured products KIDs) that was overly generic, complex or unclear.
The ESAs also provided their advice to the Commission on its broader PRIIPs Level 1 review, where they recommended significant changes to the regime. These include changes to the KID format to include a short-form summary, or ‘dashboard’, and allow information to be layered by importance, replacing performance scenarios with a more flexible narrative-based description (something the UK has already implemented) and adding a new section on ESG information where applicable.
The ESAs’ advice will feed into the Commission’s retail investments strategy, which it currently plans to release in Q1 2023.
For more detail, see EU authorities propose changes to PRIIPs regime and our Financial Regulation Outlook 2023.
Manufacturers and distributors of PRIIPs sold to UK retail investors had until 31 December 2022 to implement the changes set out in the FCA’s March 2022 policy statement. Most notably for structured products, the KID must now include narrative information on performance rather than a prescriptive performance scenario section. These changes cover similar ground to, but diverge from, the recent changes implemented in the EU, meaning that two separate KIDs will now need to be produced and maintained where a structured product is sold to retail investors in the UK and EU.
In the longer term, the EU-derived UK PRIIPs Regulation will be revoked “as a matter of priority” once the Financial Services and Markets Bill becomes law. HM Treasury published a consultation (closing on 3 March 2023) on its plans to revoke the PRIIPs regime.
For more detail, see Edinburgh reforms: Government plans to revoke the PRIIPs Regulation.
The FCA will become responsible for establishing a future retail disclosure regime and has published a wide-ranging discussion paper seeking views on fundamental aspects of the new framework such as the format and presentation of the disclosures and who should be responsible for preparing them. The discussion paper closes for responses on 7 March 2023.
For more detail, see FCA seeks views on retail disclosure in a world without UK PRIIPs.
From 31 July 2023, UK-authorised manufacturers offering structured products to retail investors (whether or not they have a direct relationship with the end consumer) will need to comply with the FCA’s new Consumer Duty.
The Duty will require firms to act to deliver “good outcomes” for retail clients. The FCA has stressed that is a “higher and more exacting” standard of conduct that is currently required under existing Handbook Principles 6 and 7, which cover treating customers fairly and client communications. Detailed cross-cutting rules and outcomes then underpin the Duty.
The structured products market is continuing to grapple with a number of challenges thrown up by the Duty, including in relation to compliance with the price and value outcome (which potentially goes further than existing value for money testing obligations), revisiting distributor relationships to ensure manufacturers have they information they need and reviewing consumer communications.
For more detail, see The Consumer Duty Series Webinar - Wholesale broker-dealers, Investment banks, Financial intermediaries and our Financial Regulation Outlook.
Changes to the FCA’s financial promotions regime aimed at protecting retail investors from high-risk investments could potentially impact UK-authorised firms that approve and communicate financial promotions in relation to certain types of repackaging and unlisted structured products. The new requirements, which include enhanced risk warnings, cooling off periods and better appropriateness tests, will be fully phased in on 1 February 2023.
For more detail, see FCA strengthens financial promotions rules for high-risk investments and firms approving financial promotions.
A broad programme of work is underway to shape the future of financial services regulation in the UK. The changes will impact all financial entities that operate in the UK’s financial system.
The Financial Services and Markets Bill will provide the Treasury with power to deliver the outcomes of a review into how the financial services regulatory framework should adapt following Brexit. In particular, it reflects the proposed blueprint set out in the Future Regulatory Framework for a return to a "FSMA model" of regulation.
In December 2022, the government released a package of reforms, the “Edinburgh Reforms” to financial services regulation.
Together with the Financial Services and Markets Bill, which sets up the process for a “lift and shift” of regulations off statute books and into regulators’ rulebooks, these proposals will set the UK regulatory agenda, not only for 2023 but for many years to come.
The government will deliver the programme by splitting retained EU law into “tranches” and expects to make “significant progress” on tranches 1 and 2 by the end of 2023. Tranche 1 contains a number of files that are relevant to derivatives and structured products, including the admission to trading and public offer regimes and the securitisation rules. Tranche 2 will include a far-reaching review of UK PRIIPs and retail disclosure, for which the government and the FCA have already launched consultations. For more detail on these reforms, see “Structured products regulatory developments” above.
Whilst UK EMIR falls within tranche 3 and, therefore, the “lift and shift” is expected follow the earlier tranches, substantive changes to UK EMIR are also expected to result from the Wholesale Markets Review, including exempting PTRR exercises from the clearing obligation. These changes are expected to be included in primary legislation as Parliamentary time allows, so are not expected to come into force in 2023.
To read more about the future UK regulatory framework, please see our Financial Regulation Outlook 2023 and Future regulatory framework: the Edinburgh Reforms.
The fintech, distributed ledger technology (DLT) and digital asset markets continued to develop rapidly in 2022.
Despite the volatility and uncertainty in digital asset markets, and in particular the cryptocurrency markets, institutional interest in the use of DLT and other technologies in financial markets has remained constant, with the launch of several high-profile tokenisation initiatives, including innovation to digital securities.
Moving into 2023, the main themes that we expect to see in so far as they relate to derivatives and structured products are:
As part of Linklaters’ “Legal Outlook” series, our global fintech team has published its Fintech Legal Outlook 2023, which includes further detail on what we look forward to in 2023 in the fintech space.
Despite the high hopes we all had for the global CLO market in 2022 following the record-breaking issuance levels seen in 2021, we instead saw a decline in issuance levels due to the difficult market conditions that resulted from central bank tightening, the fallout following the Russian invasion of Ukraine and inflationary pressures.
We have however seen a much brighter start to 2023. In the first two weeks of the year there has been both a tightening of CLO liabilities and a rise in asset prices, and the expectation is that the market will bounce back with issuance levels returning to some resemblance of ‘normal’ by the end of the year.
Another reason for optimism is the expansion of the triple A investor base. The end of 2022 saw some of the historically active triple A investors return to the market along with some new ones. The hope is that this trend will continue and will help pull triple A spreads tighter.
One area which is expected to receive continued focus in 2023 is ESG. Particularly on the European side, we expect that the market will continue to move from negative screening of assets to focusing more on positive screening. 2023 will also see the start of PASIS Reporting in accordance with Article 4 of the SFDR by a number of EU CLOs and our expectation is that this will become a standard requirement in all EU CLO transactions. We also expect that an increasing number of European CLO managers will opt to provide regular ESG reporting on their portfolios as part of their quarterly reports following the emergence of the third party ESG rating solutions that the rating agencies began offering at the end of last year. For more detail, see ESG Reporting for CLO Managers.
From a legislative perspective, the EU Commission published its long-awaited review report of the Securitisation Regulation in October 2022. In their report the European Commission clarified the position with respect to the jurisdictional scope of Article 7 of the EU Securitisation Regulation and it is now clear that non-EU CLOs will be required to use the ESMA data templates when preparing reports for investors if they want to be able to market their deals to EU investors. This has been a significant shift for the US CLO market in particular, which had taken the view that a deal could be compliant with the EU Securitisation Regulation without full Article 7 reporting. The Commission also invited ESMA to review the existing reporting templates with a view to simplifying them and to draw up a separate, more simplified form of reporting template for private securitisations (which would include CLO transactions). The market awaits the outcome of this review by ESMA but the hope is that any such proposed amendments to the transparency rules will make such reporting easier going forward and will also help to reduce the competitive disadvantages currently faced by EU investors who require non-EU CLOs and EU lending banks who require non-EU CLO warehouse facilities to fully comply with Article 7 of the EU Securitisation Regulation in order to be able to invest or lend, as applicable.
On the UK side, in December 2022 as part of the extensive package of Edinburgh Reforms, the UK government published a draft statutory instrument and policy note on the securitisation regulation illustrating the rules allowed to be made by the FCA and the PRA on securitisation, which are intended to replace the current securitisation regime inherited from the EU. In particular, the UK government, the PRA and the FCA are expected jointly to propose appropriate amendments to the definitions of private and public securitisations, disclosure and due diligence requirements (including clarification on what documentary due diligence a UK institutional investor needs to perform in order to satisfy its obligations under the UK securitisation rules). They also commit to bringing forward targeted reforms to certain risk retention provisions, including introducing a process for transferring the risk retention manager where investors have chosen to replace the CLO manager.
The market is also awaiting the outcome of the FCA’s consultation on sustainability disclosure requirements (SDR) and investment labels. The consultation closes to comments on 25 January 2023 and it is expected that the FCA will publish final rules and a policy statement by the end of Q2 2023.
On the US side, we expect that arrangers and managers will continue to focus on developing agreements and procedures to address the SEC’s Marketing Rule that became effective in November 2022. Other regulatory developments that may impact the US CLO industry in 2023 include the SEC’s proposed Private Funds Rule, which would impose new compliance, reporting and disclosure obligations on advisers of private funds (including most CLOs), and the National Association of Insurance Commissioners’ new risk-based capital proposal that would apply to the CLO holdings of insurance companies. These proposals have drawn considerable industry comments and the market is now awaiting further pronouncements from the regulators. Lastly, the remaining USD LIBOR settings (including three-month USD LIBOR, which is referenced by many legacy US CLO transactions) are expected to cease publication after June 30, 2023. This will trigger reference rate replacement mechanics in US CLO indentures and for most deals will result in a transition to Term SOFR.
Risk sharing (synthetic securitisation) transactions look set to remain an important tool for banks managing their regulatory capital requirements and credit risk, subject to some potential regulatory impediments, in particular the introduction of the output floor, which looms large on the horizon.
There have been a number of regulatory developments during 2022, ending with the package of proposed reforms to financial services regulation announced by the UK government on 9 December 2022 (the Edinburgh Reforms) indicating that the regulatory regime for balance sheet synthetic securitisations in the UK may further diverge from that in the EU in the near future. However, it remains to be seen what will follow in the way of concrete proposals.
The output floor (as part of the implementation of the Basel III reforms) is due to be implemented in a phased manner from 1 January 2025 to 1 January 2030. The output floor means that a bank using internal models will need to calculate RWAs using the standardised approach and then multiply the amount obtained by 72.5%. This will have a disproportionately adverse effect on the retained senior tranche in SRT transactions. Market participants continue to advocate for transitional relief, the most likely solution being a reduction of the “p-factors” in the formula.
In the UK, responses to the PRA consultation on Basel 3.1 standards are required by the end of March 2023 and it remains to be seen if the PRA will be more receptive to industry concerns than EU regulators.
In 2022, the EU market continued to see an increase in EU STS compliant balance sheet synthetic securitisations. Will 2023 be the year when UK banks are also able to benefit from an STS regime for synthetic securitisations?
As part of the Edinburgh Reforms, the UK government published a draft statutory instrument on the securitisation regulation illustrating the rules allowed to be made by the FCA and the PRA on securitisation, which are intended to replace the current securitisation regime inherited from the EU. In particular, the UK government, the PRA and the FCA are expected jointly to propose appropriate amendments to the definitions of private and public securitisations, disclosure and due diligence requirements applicable to UK synthetic securitisations. The drafting of the detail of the substantive rules, including the scope of the STS criteria, has been delegated to the FCA. Interestingly, the drafting refers to STS criteria for non-ABCP securitisations, but until further clarity is provided by the FCA, it is unclear if this will include balance sheet synthetic securitisations. In any case, the proposals are very much in draft form and there is currently no visibility on the timeline for publication of the STS criteria or finalisation of the proposed amendments.
The European Commission’s review report on the functioning of the EU Securitisation Regulation, published on 10 October 2022 has opened the door to a review of the unpopular ESMA data templates in 2023. More streamlined templates, particularly for private transactions, would be welcomed.
The vexing question of how EU investors (and, indirectly, non-EU originators) comply with EU Securitisation Regulation data requirements rumbles on, with a number of industry bodies seeking clarification in a joint letter to the European Supervisory Authorities at the end of 2022.
For market colour and developments during 2023, please listen to our SRT podcast 'Tranche Up'.
At Linklaters, we deploy technology extensively across our derivatives and structured product matters – a trend that we see growing over the course of 2023. There is however something unique in our approach, in addition to leveraging off-the-shelf technology, we have also designed a solution specifically to help our clients conduct capital markets matters more efficiently.
Our flagship product is CreateiQ, a platform built to make the process of drafting, negotiating and executing contracts faster and more accurate. In addition, CreateiQ allows market participants to collaborate with their legal advisers in a single place and gives them access to all of the incredibly valuable data that is in their contracts, which is still for the most part otherwise inaccessible and therefore not used.
Finally, CreateiQ is the only technology company that has deep relationships with industry trade bodies like ISDA and ISLA, allowing us to give our users access to over 100 industry standard documents through solutions like ISDA Create.
As we look to 2023, we see three main themes in derivatives and structured products technology adoption:
If you would like to learn more about CreateiQ and ISDA Create, please don’t hesitate to get in touch at email@example.com.