Bank of England Warns On Derivatives
Continuity of £26 trillion of outstanding derivatives contracts is in doubt after Brexit.
The Bank of England warned that new legislation is required to ensure the continuity of around £26 ($35) trillion of outstanding uncleared derivatives contracts after the UK leaves the European Union.
Today the UK central bank’s latest Financial Stability Report said: “To preserve continuity of existing cross-border insurance and derivatives contracts, UK and EU legislation would be required. Six million UK policyholders, 30 million European Economic Area (EEA) policyholders, and around £26 trillion of outstanding uncleared derivatives contracts could otherwise be affected.”
About £12 trillion of the affected contracts mature after the second quarter of 2019, when the UK is scheduled to leave the EU. The report continued that the UK government is considering all options for mitigating risks to the continuity of outstanding cross-border financial services contracts.
Without legislation financial companies in the UK and the European Economic Area may lose their passporting rights and not be able to service certain outstanding uncleared over-the-counter derivative contracts with counterparties in the other jurisdiction. The Bank said amending existing contracts and/or undertaking other ‘lifecycle events’ could constitute regulated activities in some EEA states and in the United Kingdom but after Brexit this may not be legal.
“Such lifecycle events include: rolling open positions, exercising options and trade compression. Lifecycle events are common in servicing derivative contracts,” added the report. “Some – such as trade compression – may be required by regulators.”
The Bank of England continued that financial companies are assessing whether they can service contracts using local exemptions or permissions at exit but the process for local authorisation varies across member states. Where companies lack the necessary regulatory permissions, they may need to move (or ‘novate’) uncleared OTC derivative contracts to legal entities that do have the appropriate permissions. For example, a UK bank would need to novate its contracts with EEA counterparties to a legal entity based in the EEA but such novations require time to prepare and execute and the consent of all parties.
“Each major dealer will have several thousand counterparties, with whom contracts will require renegotiation, potentially impacting tens of thousands of underlying clients,” warned the Bank of England. “There are no precedents for these types of multiple large-scale novations within an 18-month period.”
Therefore, the EEA needs to legislate to protect the long-term servicing of existing contracts with UK counterparties and vice versa. The report also warned that separation of derivatives clearing could increase its costs and so reduce its benefits.
“Industry estimates suggest that a single basis point increase in the cost resulting from splitting clearing of interest rate swaps could cost EU firms €22bn ($26bn) per year across all of their business,” said the Bank.
Law firm Ashurst said in a briefing note, Derivatives and the Withdrawal Bill – what it does and what it fails to do, this month that the UK government’s withdrawal bill provides that direct EU legislation is incorporated into UK law “as it has effect in EU law immediately before exit day”. Examples of direct EU legislation include the Emir which covers mandatory clearing, reporting and margining for OTC derivatives.
Ashurst continued that direct EU legislation contains provisions under which member states give each other reciprocity and recognition for the application of national law, regulation and supervision.
“The unilateral adoption of these provisions by the UK can never give the full effect to EU legislation that it has under EU law,” added Ashurst.
Even if Emir is adopted in UK there are very many provisions which are founded on the assumption that the state applying those provisions is a member of the EEA and these provisions are not designed for direct transposition into the law of a non-member state. For example, Emir requires that entities established in the EU wishing to provide clearing services as a CCP must be authorised to do so by the competent authority in their home member state.
“These provisions lose their meaning in relation to UK CCPs when transposed into UK law, as the UK will no longer be a member state and therefore UK CCPs will no longer be ‘established in the Union’,”said Ashurst.
EMIR also requires that third-country CCPs who wish to provide clearing services to clearing members within the EU must first be recognised by ESMA. The UK will become a third country after Brexit and therefore, without agreement from the EU it is unlikely that CCPs based in the UK will be recognised to provide clearing services to clearing members based in the EU.
In addition, in June this year the European Commission said substantially systemically important CCPs will have to establish themselves within the trading bloc and be authorised by European Securities and Markets Authority, whereas the majority of euro derivatives are currently cleared by LCH, the CCP owned by the London Stock Exchange Group.
“These are controversial proposals, and they have been the subject of extensive commentary in the press, as well as lobbying efforts from Isda and other industry groups,” added Ashurst. “While there have also been reports in the press that the Council has proposed restrictions on the Commission’s proposals, in particular to prevent legacy trades from falling within their scope, the outcome for clearing of OTC derivatives in London remains uncertain, regardless of the adoption of current EU legislation under the Bill which would apply similar supervision standards to UK CCPs as those applied under Emir.”
Ashurst said its note did not attempt to cover the myriad conduct of business and authorisation issues which will arise under MiFID and MiFID II as a result of the withdrawal bill.
“The House of Lords European Union Financial Affairs Sub-Committee highlighted the need to address the grandfathering of existing derivatives contracts under EU law in its letter to the Chancellor of the Exchequer, Philip Hammond, on 9 November 2017,” added Ashurst. “The letter stressed the ‘urgent need for an agreement on a standstill transition period as a priority for the UK Government in the negotiations.’ ”
The letter continued that if an implementation agreement is not agreed before the first quarter of next year, a significant number of relocation plans are being put in motion, and there will be a need for large-scale novation of derivative contracts to ensure contractual continuity in the absence of a reciprocal agreement to grandfather existing transactions.
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