Derivatives clearing obligation – modifications to reflect USD interest rate benchmark reform: Amendments to BTS 2015/2205

1: Overview

This Consultation Paper (CP) sets out the Bank of England’s (the Bank’s) proposal to modify the scope of contracts which are subject to the clearing obligation, by adding Overnight Index Swaps (OIS) that reference the Secured Overnight Financing Rate (SOFR) and, subsequently, removing contracts referencing USD Libor. This forms part of the Bank’s work in this area to reflect the reforms to interest rate benchmarks and in particular, the discontinuation of the USD Libor benchmark in June 2023.

This CP follows on from the policy statements (PSs) that were published in September^{footnote [1]} and December^{footnote [2]} 2021 that finalised changes to the clearing obligation to reflect the discontinuation of certain other interest rate benchmarks by January 2022. As the publication of the most widely used USD Libor settings were due to continue until June 2023, and in the interest of international coordination, the Bank did not propose any changes to the clearing obligation in respect of contracts referencing USD Libor and SOFR when consulting on the changes finalised in 2021.

In the light of the changes in market activity observed since then, and aligning with the Commodity Futures Trading Commission’s (CFTC’s) recent announcements,^{footnote [3]} the Bank is now proposing to add OIS contracts referencing SOFR to the clearing obligation and remove contracts referencing USD Libor.

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 [4]}

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

The Bank first consulted on changes to the clearing obligation in light of interest benchmark reform in May 2021 (the May CP).^{footnote [5]} In the May CP, the Bank proposed to remove from the clearing obligation contracts that referenced benchmarks being discontinued by January 2022 and to replace them with OIS, with broadly the same range of maturities, referencing the replacement near risk-free reference rate (RFR) benchmarks selected for each relevant currency.^{footnote [6]}

The Bank finalised the changes proposed in the May CP in September 2021 with the publication of a policy statement (PS) and the final UK technical standards instrument implementing the changes. At the same time – and following a number of announcements by the Japanese authorities recommending TONA as the primary replacement RFR for JPY Libor – the Bank published a further CP proposing to add TONA OIS to the clearing obligation (the September CP).^{footnote [7]} The addition of TONA OIS to the clearing obligation, as proposed in the September CP, was subsequently finalised with the publication of a PS in December 2021, which included the final UK technical standards instrument implementing this change. All of these changes have now come into force.

In the May and September CPs, the Bank did not propose to make any changes to the clearing obligation in relation to contracts referencing USD Libor and its replacement RFR, SOFR, as the publication of the most widely used USD Libor settings were due to continue until June 2023. In the PS published in September 2021, the Bank noted that while there had been a significant increase in the use of SOFR OIS in the UK, the large majority (82%) of outstanding USD denominated interest rate swaps were those referencing USD Libor. In both the September and December PSs, the Bank indicated that it would continue to monitor developments in the USD interest rate derivatives markets and, where possible, co-ordinate with the CFTC on changes to our respective clearing obligations. The Bank also set out its expectation to consult on changes to the clearing obligation relating to contract types referencing USD Libor in 2022.

On 9 May 2022, the CFTC issued a consultation in which they proposed amendments to the US swap clearing requirement (the US equivalent of the clearing obligation) to address the cessation of certain interbank offered rates (IBORs) and the market adoption of alternative RFRs.^{footnote [8]} The CFTC’s proposal includes the addition of SOFR OIS with a maturity range of 7 days to 50 years, to come into force 30 days after the publication of the final rule, and the removal of contracts referencing USD Libor from the clearing requirement, to come into force on 1 July 2023.

1.2: Summary of proposal

In light of the increase in trading activity in SOFR contracts since the turn of the year (see Section 2.2 below),^{footnote [9]} the Bank now considers it appropriate to consult on changes to the clearing obligation in relation to USD interest rate swaps. This is in line with the commitment made in the previous PSs to consult on changes relating to USD interest rate swaps in 2022 and, in doing so, to coordinate with the CFTC on changes to our respective clearing obligations (where possible).

The Bank therefore proposes to modify the contract types which are subject to the clearing obligation in the onshored BTS 2015/2205. Specifically, the Bank proposes to:

• add OIS contracts that reference SOFR, to come into force on 31 October 2022; and
• subsequently remove contracts that reference USD Libor, to come into force around the same time as a number of CCPs contractually convert these contracts and remove them from their list of contracts eligible for clearing.

The SOFR OIS contract type in the clearing obligation will cover broadly the same maturity range as the USD Libor contracts currently cover. However, as with the addition of TONA OIS to the clearing obligation in January 2022, the Bank proposes a minimum maturity for the SOFR OIS contract type of 7 days (as opposed to 28 days for the USD Libor contracts currently subject to the clearing obligation). This reflects the differences in the types of transactions these contract types have historically been used in.

As with the changes made last year, it is proposed that the date on which the removal of USD Libor contracts will come into force will coincide with the contractual conversion of USD Libor contracts by a number of CCPs and the removal of these contracts from their list of contracts eligible for clearing. CCPs are either currently consulting or are due to consult on the precise timings, but have indicated that these changes will likely occur in Spring 2023. However, given the current volume and liquidity of cleared SOFR OIS contracts, the Bank is of the view it would be appropriate to add the SOFR OIS contract type to the scope of the clearing obligation before CCPs’ contractual conversions have taken place. We therefore propose to add SOFR OIS to the clearing obligation on 31 October 2022.

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 the UK technical standards modifying BTS 2015/2205.^{footnote [10]}

1.3: Implementation

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

The proposed changes will be implemented using a single standards instrument (proposed technical standards). The proposed technical standards will be split into two parts to reflect the different dates for the relevant modifications. The draft technical standards can be found in the Appendix.

The Bank is aware of ongoing work on the Future Regulatory Framework (FRF), which is looking at ways to adapt the financial services regulatory framework for the future and to reflect the UK’s new position outside the EU. The Bank is also aware that the changes consulted on in this paper may need to be adapted based on the changes made under the FRF. However, we do not expect this to be required in the near future nor do we expect the policy approach in this consultation to be materially impacted by the FRF.

1.4: Responses and next steps

This consultation closes on Thursday 21 July 2022. 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 amendments to BTS 2015/2205 in September 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 in this CP refer to the version of the legislation which forms part of retained EU law.

1.5: Questions

1. Do you agree with the proposed modifications to the scope of the clearing obligation? If not, please provide your rationale.
2. Do you agree with the proposal to add the SOFR OIS contract type to the clearing obligation on 31 October 2022?
3. Do you agree with the proposal to align the date on which USD Libor contracts will be removed from the clearing obligation with CCPs’ contractual conversions of these contracts?
4. Do you have any other comments on the proposal set out in this CP?

2: Proposal

2.1: Purpose

As with the consultations published in May and September 2021 (which should be read alongside this CP), the purpose of the proposed changes in this CP is to ensure that the broader policy objective of the clearing obligation continues to be met. In practice, this means mitigating the systemic risk that might otherwise arise from no action being taken to amend the scope of the clearing obligation in response to USD interest rate benchmark reform. In pursuing this objective, the Bank intends to protect and enhance the stability of the financial system of the UK.

The policy aims that were set out in the previous CPs remain the key aims that underpin the proposals in this CP, namely:

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

In order to meet the first objective for the changes consulted on in 2021, the Bank proposed to remove contracts referencing the benchmarks being discontinued by January 2022 and to replace them with contracts referencing the relevant RFRs. The RFR contracts being added to the clearing obligation had broadly the same range of maturities as the contracts they would be replacing to further ensure consistency in the OTC derivatives activity covered.

In order to meet the second objective, for the changes consulted on in 2021, the Bank sought to align the timings of the various changes with the broader RFR transition. In particular, the Bank aligned the dates that the modifications came into force with the dates on which a number of CCPs contractually converted outstanding contracts referencing the discontinuing benchmarks to their RFR referencing equivalents, and removed the discontinued benchmarks from the list of contracts eligible for clearing.

While the policy aims set out above remain relevant to the proposals in this CP, and the substance of the approach the Bank proposes to take for USD interest rate swaps in the clearing obligation is the same, the timing proposed is slightly different. This difference is explained below.

2.2: Changes to the scope of the clearing obligation and modification timeline

Consistent with the approach previously taken, the Bank proposes to remove from the clearing obligation contracts referencing USD Libor and add the contract type in the OIS class referencing SOFR. The exact details of the proposed changes to the clearing obligation are as follows:

• Adding the contract type in the OIS class referencing SOFR, with an original maturity of 7 days to 50 years, on Monday 31 October 2022.
• Removing the contract type referencing USD Libor from the Basis Swap, Fixed-to-Float Interest Rate Swap and Forward Rate Agreement classes around the same time as when CCPs contractually convert these contracts and remove the USD Libor benchmark from their list of contracts eligible for clearing.

As with the changes to the clearing obligation implemented in 2021, these changes will not have retrospective effect. OTC derivatives contracts referencing SOFR that are concluded between counterparties before the relevant modification dates will not be subject to the clearing obligation.

SOFR OIS

The difference in the approach proposed in this CP, relative to the approach taken to amending the clearing obligation in 2021, relates to the dates on which the changes are due to come into force. With the previous changes, the addition of the RFR contracts to the clearing obligation came into effect either at the same time or shortly after the removal of the corresponding contracts referencing the benchmarks being discontinued. In this case, the Bank proposes to add SOFR OIS to the clearing obligation ahead of contracts referencing USD Libor being removed. The Bank considers this to be appropriate given the substantial increase in the volume of SOFR OIS contracts traded since the beginning of 2022. This followed the Bank and FCA’s announcement in March 2021 for firms to cease new use of USD Libor as soon as practicable and no later than the end of 2021, in line with the supervisory guidance issued by US authorities.

The Bank’s analysis of EMIR Trade Repository data shows that in January 2022, when comparing SOFR OIS’ market share relative to contracts referencing USD Libor, trades in the former represented 65% of the market (~$940bn notional) relative to a 35% share for the latter (~$500bn notional). This equates to a 35% increase in SOFR OIS’ market share compared to December 2021. Since then, SOFR OIS’ market share has increased further to 81% in April 2022.

Given the substantial increase in volume and liquidity, the Bank considers there to be adequate justification to add SOFR OIS contracts to the clearing obligation ahead of contracts referencing USD Libor being removed. Taking into account the time needed to consult market participants on this change, complete the necessary procedural steps outlined in FSMA and for market participants to carry out their preparations, the Bank proposes 31 October 2022 as the date on which the SOFR OIS contract type will be added to the clearing obligation.

We acknowledge that with the transition from USD Libor contracts to SOFR OIS already underway (and the consequent increase in SOFR OIS’ market share as explained above), the level of OTC derivatives activity covered by the clearing obligation will have decreased in the run-up to SOFR OIS being added. While this has the potential to undermine the objective of the clearing obligation by leaving open the possibility of significant volumes of SOFR OIS contracts being non-cleared, the Bank considers the probability of this happening to be relatively low. In the absence of mandatory clearing, there are other regulatory incentives for counterparties to clear SOFR OIS contracts, such as the EMIR margin requirements. The effectiveness of these incentives is supported by the Bank’s analysis of the EMIR Trade Repository data, which shows that 97% of SOFR OIS contracts were voluntarily cleared in April 2022. The percentage of SOFR OIS contracts that have been subject to clearing has remained broadly consistent since the start of the year, and the Bank will continue to monitor this.

As with the addition of TONA OIS to the clearing obligation on 31 January 2022, the minimum maturity of the SOFR OIS contract type will be 7 days (as opposed to 28 days for the USD Libor contracts currently in place). The Bank is proposing to align the shortest maturity for SOFR contracts with that of existing contracts in the OIS class. The maximum maturity will however remain aligned with the USD Libor contracts being removed in the Basis Swap and Fixed-to-Float Interest Rate Swap classes.

USD Libor

The Bank’s proposed approach to removing contracts referencing USD Libor from the clearing obligation is, as set out above, consistent with the approach previously taken in 2021. In particular, it is proposed that the date on which these contracts will be removed from the clearing obligation will be selected to align with the date on which a number of CCPs are due to contractually convert outstanding USD Libor contracts and remove this benchmark from the list of new contracts eligible for clearing. The Bank considers CCPs’ contractual conversions to be a key step in the broader RFR transition. Therefore, aligning the date on which USD Libor contracts will be removed from the clearing obligation with CCPs’ transition activities helps facilitate the second aim underpinning this proposal.

We recognise that at the time of publication, the dates on which CCPs will undertake these changes have not been confirmed. As with CCPs’ previous contractual conversions, the Bank anticipates that all CCPs authorised or recognised to clear USD Libor contracts in the UK will undertake their conversions around the same time. We understand that this is likely to be in Spring 2023 and propose to make the necessary instrument when these dates have been confirmed.

While the volume of contracts referencing USD Libor relative to those referencing SOFR has notably decreased in recent months, the Bank still considers this volume to be significant enough in absolute terms to warrant mandatory clearing. This is expected to remain the case until closer to the time when the USD Libor benchmark is discontinued, and is something the Bank will continue to monitor.

The costs and benefits of the Bank’s proposed approach – for both the addition of SOFR OIS and the removal of USD Libor contracts – are assessed in Section 3.

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 149/2013^{footnote [11]} (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 [12]}

• 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 [13]}

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 [14]}

The Bank must also consult with both the FCA and the 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 types to be added to and removed from the 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.

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 removing from and adding to the contract types under the existing classes of OTC interest rate swaps. Given this and the ‘consequential’ nature of the changes proposed in light of the broader USD 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 to add to the existing class of ‘Overnight Index Swaps’ (OIS) the contract type referencing SOFR, with an original maturity of 7 days to 50 years.

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. There is no distinction between the contract types currently within the OIS class of the clearing obligation and the SOFR OIS contract type. This is supported by the Bank’s market intelligence, which indicates that the majority SOFR OIS contracts are already being voluntarily cleared (see Section 2.2).

The Bank therefore assesses the proposal in this CP 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 evidenced in Section 2.2, the volume and liquidity in SOFR OIS contracts has already reached a significant enough level to warrant mandatory clearing. While the volume and liquidity in USD Libor contracts has decreased substantially – relative to previous levels as well as relative to trade in SOFR OIS contracts – the Bank still considers the volume and liquidity to be significant enough to warrant mandatory clearing (~$250bn notional in April 2022). The Bank expects this to remain the case up to CCPs’ contractual conversions of USD Libor contracts, as was the case with the GBP Libor and JPY Libor contracts. This is something the Bank will continue to monitor.

Based on the above, the Bank expects the proposed changes to the clearing obligation to meet criterion b) of Article 5(4) EMIR by or at the point the changes come 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

The Bank’s assessment against criterion c) is based on the same premise as the assessment of criterion b). In light of the substantial increase in activity in SOFR OIS contracts that has taken place since the beginning of the year, the Bank considers there to already be fair, reliable and generally accepted pricing information for these contracts. 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 SOFR 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 changes in this consultation to have any material impact on or as a result of: the interconnectedness between counterparties using or likely to use SOFR OIS 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 changes proposed in this CP. Similar to the cost-benefit analyses in the previous CPs, the Bank has not included quantitative estimates for this proposal. This is because the Bank does not anticipate any material costs to firms, or more broadly. 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

In the absence of contracts referencing USD Libor being removed from the clearing obligation, firms would be mandated to clear contracts for which there would be significantly reduced volumes of trade, reduced liquidity in these contracts and thus significant price volatility in the markets in which these contracts are traded. Furthermore, there will be operational barriers once the USD Libor benchmark has been discontinued, as a number of CCPs will no longer clear contracts referencing this benchmark. In this instance, the obligation to centrally clear USD Libor contracts would have an immaterial impact on reducing systemic risk whilst disproportionality imposing higher costs on firms.

Concurrently, if the OIS contract type referencing SOFR is not added to the clearing obligation despite a significant increase in trading volumes and liquidity as a result of USD 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 SOFR OIS contracts are not centrally cleared, therefore potentially increasing systemic risk. As noted in Section 2, the Bank recognises that this is already a possibility with the volume and liquidity of SOFR OIS contracts having increased substantially since the beginning of the year. However, the Bank considers the probability of substantial volumes of SOFR OIS contracts not being cleared to be relatively low between now and 31 October 2022 for the reasons outlined in Section 2.

The Bank also considers there to be benefits in coordinating with the CFTC on the addition of SOFR OIS to our respective clearing mandates. The addition of SOFR OIS to the clearing obligation is expected to take place close to the CFTC’s addition of this contract type to the US swap clearing requirement. This should help to lower the burden on clearing participants who operate internationally and in doing so, facilitate a smoother transition away from USD Libor.

In terms of the proposed timing for the removal of USD Libor contracts from the clearing obligation, the primary benefit of aligning the date with CCPs’ contractual conversions is that it also helps to facilitate a smooth transition. The Bank’s proposed modification date for USD Libor contracts is also expected to be slightly ahead of the CFTC’s corresponding changes to the US clearing requirement, which further helps ensure a smooth transition.

Costs

It is not anticipated that the Bank’s proposal will have materials costs for firms. As the amendments to the scope of the clearing obligation are 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. The Bank does not expect there to be a significant change to the population of firms that are required to clear USD Libor contracts under the current clearing obligation relative to those that will be required to clear SOFR OIS contracts once it has been added.

Furthermore, given the well-communicated nature of the USD interest rate benchmark transition, firms will have had sufficient time to make preparations for RFR transition activities by the time the changes proposed in this CP take effect. These preparations will in part be prompted by the removal of USD Libor contracts 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 proposals do not give rise to equality and diversity implications.

4: Appendix

Draft Bank Standards Instrument: The Technical Standards (Clearing Obligation) Instrument 2022.