Derivatives clearing obligation – introduction of contracts referencing TONA: Amendment to BTS 2015/2205

Consultation paper
Published on 29 September 2021

1. Overview

This Consultation Paper (CP) sets out the Bank of England’s (the Bank’s) proposal to add Overnight Index Swaps (OIS) that reference TONA to the scope of contracts which are subject to the derivatives clearing obligation. This forms part of the Bank’s continuing work in this area to reflect the ongoing reforms to interest rate benchmarks.

This CP follows on from the consultation published in May titled ‘Derivatives clearing obligation – modifications to reflect interest rate benchmark reform: Amendments to BTS 2015/2205’ (the May CP) and the subsequent policy statement (PS) of the same title, which has been published today.

In the May CP, the Bank did not propose to add to the clearing obligation any replacement contracts for those referencing JPY Libor. This was due to uncertainty at the time regarding which contract(s) referencing a replacement benchmark for JPY Libor would meet the criteria for being subject to the clearing obligation. However, following recent announcements by the Japanese authorities, the Bank considers that it is now appropriate to add TONA OIS contracts to the clearing obligation as a replacement for contracts referencing JPY Libor. The removal of contracts referencing JPY Libor from the clearing obligation was confirmed in the PS referred to above and will come into force on 6 December 2021.

The proposals in this CP would result in further changes to Commission Delegated Regulation (EU) 2015/2205 of 6 August 2015 supplementing Regulation (EU) No 648/2012 of the European Parliament and of the Council on OTC derivatives, central counterparties and trade repositories with regard to regulatory technical standards on the clearing obligation (hereafter Binding Technical Standards (BTS) 2015/2205), being technical standards made under Article 5(2) of the European Market Infrastructure Regulation (EMIR).footnote [1]

This CP is relevant to financial and non-financial counterparties that are subject to the clearing obligation under EMIR, and to central counterparties (CCPs).

1.1. Background

In the May CP, the Bank proposed to remove from the clearing obligation contracts that reference benchmarks being discontinued by January 2022 and to replace them with OIS, with the same range of maturities, which reference the replacement near risk-free reference rate (RFR) benchmarks selected for each currency.footnote [2]

The changes proposed in the May CP were limited to benchmarks being discontinued by January 2022. Specifically:

  • to remove contracts referencing EONIA and replace them with contracts referencing €STR
  • to remove contracts referencing GBP Libor and replace them with contracts referencing SONIA; and
  • to remove contracts referencing JPY Libor.

Due to uncertainty regarding which contract(s) referencing a replacement benchmark for JPY Libor would meet the criteria for being subject to the clearing obligation, the Bank did not propose introducing any replacement contract(s) into the clearing obligation at the time.

However, there have been a number of recent announcements by the Japanese authorities. Specifically:

  • that market participants should cease the initiation of new transactions in JPY Libor swaps by no later than end September 2021 and that TONA will become the primary replacement RFR for JPY Libor in interest rate swaps;footnote [3]
  • that liquidity providers have been recommended to change the quoting conventions from JPY Libor to TONA in the JPY interest rate swaps market as part of a ‘TONA first’ initiative;footnote [4] and
  • the publication of a consultation paper by the Japanese Financial Services Agency (JFSA) on 8 September 2021, which sets out the JFSA’s proposed amendments to the Japanese clearing obligation.footnote [5]

As a result of these announcements, trading and liquidity in interest rate derivatives contracts referencing JPY Libor have begun to migrate to contracts referencing TONA.

1.2. Summary of proposal

In light of the recent announcements made by the Japanese authorities and the anticipated changes in market activity as a result of these announcements, the Bank proposes to introduce a clearing obligation for OIS that reference TONA, to come into force on or shortly after 6 December 2021. The TONA OIS contract type in the clearing obligation will cover broadly the same maturity range as the JPY Libor contracts it is replacing. However the minimum maturity of the TONA OIS contract type will be 7 days (as opposed to 28 days for the JPY Libor contracts currently in place), which reflects differences in the types of transactions these contract types have historically been used in.

As with the changes consulted on in the May CP, the date on which the proposed modification in this consultation comes into force will coincide with the date associated with the broader RFR transition. Specifically, the date will coincide with the contractual conversion of JPY Libor contracts by a number of CCPs.

The details of the proposed contracts to be added to the clearing obligation are set out in Section 2.

This CP should be read alongside UK technical standards modifying BTS 2015/2205.footnote [6]

1.3. Implementation

The Bank is proposing to amend BTS 2015/2205 using the Bank’s powers under Article 5(2)(a) of EMIR and under Section 138P of the Financial Services and Markets Act 2000 (FSMA).

The proposed change will be implemented using a single standards instrument (proposed technical standards) which can be found in the Appendix.

1.4. Responses and next steps

To enable the change to come into force on or shortly after 6 December 2021, the consultation period will remain open for four weeks closing on Wednesday 27 October 2021. The Bank invites responses to the questions set out below, which are based on the proposal in this consultation. Firms and other respondents should send their responses or enquiries to: FMIFeedbackMailbox@bankofengland.co.uk

Following consideration of any responses, the Bank will submit the proposed technical standards to HM Treasury for approval, in accordance with Section 138R of FSMA. Subject to approval by HM Treasury, the Bank intends to make and publish the amendment to BTS 2015/2205 by the end of November 2021.

The Bank will continue to keep the scope of the clearing obligation under review, including by monitoring developments in the ongoing transition in USD interest rate derivatives markets, with a view to consult in 2022.

The proposal set out in this CP has been designed in the context of the UK having now left the European Union and the transition period having come to an end. Unless otherwise stated, any references to EU or EU-derived legislation refer to the version of the legislation which forms part of retained EU law.

1.5. Questions

  1. Do you agree with the proposed modification to the scope of the clearing obligation? If not, please provide your rationale.
  2. Do you agree with the proposed date for when this modification will come into force? If not, please provide your rationale.
  3. Do you have any other comments on the proposal set out in this consultation?

1.6. Use of data

By responding to this consultation, you provide personal data to the Bank of England. This may include your name, contact details (including, if provided, details of the organisation you work for), and opinions or details offered in the response itself.

The response will be assessed to inform our work as a regulator and central bank, both in the public interest and in the exercise of our official authority. We may use your details to contact you to clarify any aspects of your response.

The consultation paper will explain if responses will be shared with other organisations. If this is the case, the other organisation will also review the responses and may also contact you to clarify aspects of your response. We will retain all responses for the period that is relevant to supporting ongoing regulatory policy developments and reviews. However, all personal data will be redacted from the responses within five years of receipt. To find out more about how we deal with your personal data, your rights or to get in touch please visit our Privacy page.

Information provided in response to this consultation, including personal information, may be subject to publication or disclosure to other parties in accordance with access to information regimes including under the Freedom of Information Act 2000 or data protection legislation, or as otherwise required by law or in discharge of the Bank’s functions. Please indicate if you regard all, or some of, the information you provide as confidential. If the Bank of England receives a request for disclosure of this information, we will take your indication(s) into account, but cannot give an assurance that confidentiality can be maintained in all circumstances. An automatic confidentiality disclaimer generated by your IT system on emails will not, of itself, be regarded as binding on the Bank of England.

2. Proposal

The purpose of change proposed in this consultation is consistent with (and should be read alongside) that set out in the May CP. That is to ensure that the broader policy objective of the clearing obligation continues to be met which, in practice, means mitigating the systemic risk that might otherwise arise from no action being taken to amend the clearing obligation in response to interest rate benchmark reform. In pursuing this objective, the Bank intends to protect and enhance the stability of the financial system of the UK.

In recognition of the interaction between the broader interest rate benchmark reform and the policy objective of the clearing obligation, the Bank set out two aims in the May CP:

  • to keep the level of OTC derivatives activity covered by the clearing obligation broadly unchanged; and
  • to avoid undermining the transition away from EONIA/Libor to RFRs.

In order to meet the first aim, the basis of the Bank’s proposal was to remove all contracts referencing the benchmarks being discontinued by January 2022 from the clearing obligation, and to replace them with contracts referencing the relevant RFRs. Also in line with this aim, the Bank proposed that the RFR contracts being added to the clearing obligation would have the same range of maturities as the contracts they would be replacing.

The reason a replacement for JPY Libor contracts was not selected for the clearing obligation when the Bank previously consulted in May was due to uncertainty regarding which replacement RFR contract(s) would meet the criteria in Article 5(4) EMIR. However, given the recent announcements outlined in Section 1, the Bank now has greater certainty that TONA OIS contracts will meet the clearing obligation criteria (see Section 3).

In terms of meeting the second aim set out above, the Bank has sought to align the timings of the various changes to the clearing obligation with the broader RFR transition. In particular, the Bank has aligned the dates that the modifications consulted on in May will come into force with the dates a number of CCPs are due to contractually convert outstanding contracts referencing the benchmarks to be discontinued, and remove these benchmarks from the list of contracts eligible for clearing. This remains the Bank’s preferred approach, including for the change proposed in this CP.

2.1. Change to the scope of the clearing obligation and modification timeline

Consistent with the proposals described in Section 2.2 of the May CP, the proposed change in relation to TONA aims to maintain consistency in the level of activity covered by the clearing obligation and avoid undermining the transition away from JPY Libor to TONA.

The Bank proposes to modify the contract types subject to the clearing obligation by adding, on or shortly after Monday 6 December 2021, the contract type in the OIS class referencing TONA with an original maturity of 7 days to 30 years.

This proposed modification will act as a replacement for the contract types referencing JPY Libor, which will be removed from the clearing obligation on Monday 6 December.footnote [7]

Where this change does not precisely follow the requirements in respect of the existing JPY Libor clearing obligation is the minimum maturity of the contracts in scope. The JPY Libor contract types that will be removed from the clearing obligation have a minimum maturity of 28 days, which differs to the 7 days proposed for the TONA OIS contract type. The Bank is proposing to align the shortest maturity for TONA contracts with that of the existing contracts in the OIS class, while the maximum maturity will remain aligned with the soon to be removed JPY Libor contract types.

The modification proposed in this CP will not have retrospective effect. OTC derivatives contracts referencing TONA that are concluded between counterparties before 6 December 2021 or shortly after (depending on when the change comes into force) will not be subject to the clearing obligation.

Coordination with international authorities

Reflecting the international nature of OTC derivatives trading and clearing, the Bank has discussed its proposed approach with several national and international authorities responsible for the equivalent clearing obligations in their jurisdictions.

3. The Bank’s statutory obligations

The Bank proposes to exercise its power under section 138P FSMA, to make technical standards in accordance with Article 5(2)(a) EMIR.

Pursuant to Article 5(2)(a) EMIR the Bank may make technical standards specifying the class or classes of OTC derivatives that should be subject to the clearing obligation referred to in Article 4 EMIR. Pursuant to Section 138P(2)(b) FSMA the Bank’s power to make technical standards includes the power to modify, amend or revoke any EU tertiary legislation made by an EU entity under the original EU power which forms part of retained EU law. BTS 2015/2205 constitutes EU tertiary legislation for this purpose. Article 5(4) EMIR sets out criteria that must be taken into consideration when the Bank makes technical standards for the purposes of Article 5(2)(a) EMIR, and Article 7 of Commission Delegated Regulation (EU) No 149/2013footnote [8] (hereafter BTS 149/2013) expands on these criteria.

The Bank may make a standards instrument if it has been approved by HM Treasury. Before submitting a standards instrument to HM Treasury for approval, the Bank is required to publish a draft of the proposed technical standards accompanied by:footnote [9]

  • a cost benefit analysis; and
  • an explanation of the Bank’s reasons for believing that making the proposed technical standards is compatible with the Bank’s financial stability objective;footnote [10]

The Bank is also required by the Equality Act 2010 to have due regard to the need to eliminate discrimination and to promote equality of opportunity in carrying out its policies, services and functions.footnote [11]

The Bank must also consult with both the Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA) pursuant to Section 138P(4) of FSMA ahead of making the standards instrument.

3.1. Assessment against criteria in Article 5(4) EMIR and Article 7 BTS 149/2013

This section sets out the Bank’s analysis against the criteria in Article 5(4) EMIR. In assessing the contract type to be added to the scope clearing obligation against the criteria in Article 5(4), the Bank has also taken into consideration the relevant requirements in Article 7 BTS 149/2013.

As with the modifications proposed in the May CP, the proposal in this consultation does not involve specifying any new classes of OTC derivatives that should be subject to the clearing obligation. Instead, it involves adding to the contract types under the existing classes of OTC interest rate swaps. Given this and the ‘consequential’ nature of the change proposed in light of the broader interest rate benchmark reform, the Bank has taken a proportionate approach to its assessment against the criteria in Article 5(4) EMIR when read together with Article 7 BTS 149/2013. Consistent with this, the Bank has not provided significant amounts of quantitative data as part of its analysis.

Under Article 5(4) EMIR, with the overarching aim of reducing systemic risk, the development by the Bank of technical standards for the purposes of Article 5(2)(a) EMIR shall take into consideration the following criteria:

  1. the degree of standardisation of the contractual terms and operational processes of the relevant class of OTC derivatives;
  2. the volume and liquidity of the relevant class of OTC derivatives;
  3. the availability of fair, reliable and generally accepted pricing information in the relevant class of OTC derivatives.

In preparing those technical standards, the Bank may take into consideration the interconnectedness between counterparties using the relevant classes of OTC derivatives, the anticipated impact on the levels of counterparty credit risk between counterparties as well as the impact on competition across the United Kingdom.

Article 7 BTS 149/2013 sets out additional considerations in relation to each of these criteria, which the Bank has also taken into account for the purposes of its assessment below.

Criterion a): degree of standardisation

The Bank proposes adding a new contract type within the existing class of ‘Overnight Index Swaps’. As noted in the May CP, the degree of standardisation of contractual terms and operational processes are the same for all OIS contracts irrespective of the term of the transaction or the benchmark being referenced. The standardised nature of the contract terms and processes is supported by the Bank’s market intelligence. The Bank’s analysis of EMIR trade repository data shows that in August 2021, 76% of TONA OIS transactions were voluntarily cleared.

The Bank therefore assesses its proposal to meet criterion a) under Article 5(4) EMIR. In reaching this conclusion, the Bank has also taken into account the relevant considerations in Article 7(1) BTS 149/2013 including the requirement for contractual terms to incorporate common legal documentation and master netting agreements, and the requirement for operational processes to be subject to automated post-trading life cycles.

Criterion b): volume and liquidity

As was recognised in the May CP, given the unique circumstances driving the change proposed in this consultation – notably the discontinuation of JPY Libor at a future date – the Bank considers it appropriate to make a forward-looking assessment of what we anticipate will be the volume and liquidity in TONA OIS contracts at the point the change takes effect.

At a high level, given the benchmark transition is primarily from JPY Libor to TONA, the Bank judges that if criterion b) was assessed to be met for contracts referencing JPY Libor, it is reasonable to expect a similar outcome for contracts referencing TONA, once the transition has completed. This is supported by EMIR trade repository data which shows that since May, TONA OIS’s share of JPY denominated interest rate swaps in UK markets has grown from 6% to 40% in August.

As benchmark reform continues to progress in line with its aims and objectivesfootnote [12], it is expected that volume and liquidity will continue to shift from interest rate swaps referencing JPY Libor to TONA OIS. The Bank therefore expects that the modification proposed to the clearing obligation will meet criterion b) under Article 5(4) EMIR by or at the point it comes into force. In reaching this conclusion, the Bank has also taken into account the relevant considerations in Article 7(2) BTS 149/2013 including the proportionality of margins to the risks the clearing obligation seeks to mitigate and the stability and depth of the market.

Criterion c): availability of fair, reliable and generally accepted pricing information

As with the qualitative assessment of criterion b) and the approach taken in the May CP, the Bank’s assessment against criterion c) is also forward-looking and based on the same premises. Hence, as benchmark reform continues to progress, the Bank expects that there will be fair, reliable and generally accepted pricing information for TONA OIS contracts by or at the point the proposed change to the clearing obligation comes into force. In reaching this conclusion, the Bank has also taken into account the relevant considerations in Article 7(3) BTS 149/2013 including the accessibility of information to accurately price TONA OIS contracts on a reasonable commercial basis, both before and after the contract type becomes subject to the clearing obligation.

The interconnectedness between counterparties and the anticipated impacts on counterparty credit risk and competition

The Bank does not consider the proposed change in this consultation to have any material impact on or as a result of the interconnectedness between counterparties using or likely to use the RFR contracts; the levels of counterparty credit risk between counterparties; or on competition across the United Kingdom.

3.2. Cost benefit analysis

This section sets out an analysis of the costs and benefits of introducing the change proposed in this CP. Similar to the cost benefit analysis in the May CP, the Bank has not included quantitative estimates for the proposal as it does not anticipate that the costs to firms will be material. The Bank considers that data collection to support quantitative analysis would not be proportionate as the proposal in this CP is in response to anticipated changes in market activity resulting from the broader interest rate benchmark reform.

Affected firms and markets

The proposal in this CP is relevant to financial and non-financial counterparties that are subject to the clearing obligation under EMIR, and to CCPs.

Benefits

If the OIS contract type referencing TONA is not added to the clearing obligation, despite a significant increase in trading volumes and liquidity as a result of benchmark reform, this will serve to undermine the overarching policy objective of the clearing obligation. This is because it would leave open the possibility that substantial volumes of trades in contracts referencing TONA might not be centrally cleared, which has the potential to increase systemic risk.

Hence, the primary benefit of the Bank’s proposal is the mitigation of the risk of no action being taken in response to interest rate benchmark reform.

Costs

As noted above, it is not anticipated that the Bank’s proposal will have materials costs to firms. As the proposed amendment to the scope of the clearing obligation is a consequence of interest rate benchmark reform, the level of OTC derivatives activity covered by the clearing obligation should remain broadly the same once the transition has been completed. Furthermore, the Bank expects that the firms required to centrally clear the TONA OIS contacts under the Bank’s proposal will be the same counterparties that are clearing contracts referencing JPY Libor under the current scope of the clearing obligation.

Given the well-communicated nature of the broader interest rate benchmark reform, firms will have had sufficient time to make preparations for the transition from JPY Libor to TONA by the time the change proposed in this CP takes effect. These preparations will in part be prompted by the removal of contracts referencing JPY Libor by CCPs from their list of contracts eligible for clearing.

3.3. Compatibility with the Bank’s objectives

The Bank considers that the proposal in this CP advances its objective to protect and enhance the stability of the financial system of the United Kingdom. The policy objective of the clearing obligation is to reduce systemic risk which, when met, contributes to the protection and enhancement of financial stability.

3.4. Equality and diversity

The Bank considers that the proposal does not give rise to equality and diversity implications.

4. Appendix

  1. Unless otherwise stated, any references to EU or EU-derived legislation refer to the version of the legislation which forms part of retained EU law.

  2. Further background on the objectives of the clearing obligation for OTC derivatives and interest rate benchmark reform can be found in the May CP.

  3. Preparations for the discontinuation of LIBOR in the JPY interest rate swaps market

  4. Release of the Transition of Quoting Conventions in the JPY interest rate swaps market ("TONA First")

  5. FSA press release

  6. EU exit instrument: The technical standards (European market infrastructure) (amendment etc.) (EU exit) (No.2) instrument 2019, EU exit instrument: The technical standards (European market infrastructure) (amendment etc) (EU exit) (No. 4) instrument 2020 and Bank Technical Standards (Clearing Obligation) Instrument 2021

  7. Policy statement: Derivatives clearing obligation – modifications to reflect interest rate benchmark reform: Amendments to BTS 2015/2205

  8. Of 19 December 2012 supplementing Regulation (EU) No 648/2012 of the European Parliament and of the Council, with regard to regulatory technical standards on indirect clearing arrangements, the clearing obligation, the public register, access to a trading venue, non-financial counterparties, and risk mitigation techniques for OTC derivatives contracts not cleared by a CCP

  9. Section 138S of FSMA

  10. Section 138J(2)(d) of FSMA, read together with Section 138S and Schedule 17A paragraph 10 of FSMA

  11. Section 149 of Equality Act 2010

  12. As set out in the May CP.

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