Brexit ‘Cliff Edge’ Risk for CCPs
UK banks may not be able to trade products on EU exchanges after Brexit.
UK central counterparties, which currently manage more than a quarter of global clearing activity, face a potential ’cliff edge’ risk to operations due to Brexit according to the Association for Financial Markets in Europe, which lobbies for the region’s wholesale financial markets.
The UK government triggered Article 50 to leave the European Union on March 29 and negotiations on the terms of departure have to be completed in two years. Afme today published a paper, Implementing Brexit: practical challenges for wholesale banking in adapting to the new environment, outlining the implementation issues for wholesale banks, their clients and supervisory authorities.
The paper warned that clearing and the use of collateral could be significantly disrupted if euro clearing is required to take place mainly or entirely within the Eurozone. Manfred Weber, the leader of the largest political group in the European parliament, said yesterday that euro-denominated clearing should move to the EU27 after Brexit.
Afme said: “Potential impacts could include increased hedging costs (as scope for netting is reduced) and significantly increased capital requirements for use of non-qualifying central counterparties.”
Derivatives clearing will face major implementation challenges after Brexit if UK clearers are longer authorised by the EU and EU27 banks maintaining positions in them could be in breach of regulations and suffer punitive capital increases. Current regulations require clearing members to apply a risk weighting of 2% of the total exposure value to CCPs which are recognised by EU regulators, and these risk weightings could increase after Brexit for exposures to UK clearers.
“There is concern about a major ’cliff edge’ risk to the operations of UK CCPs which, the Bank of England estimates, currently manage more than a quarter of global clearing activity,” Afme added.
Under Emir, only third-country CCPs may apply for EU recognition, meaning that in principle, those from the UK cannot apply for pre-authorisation. “Thus, on day one after Brexit, UK CCPs would not be qualifying CCPs under Emir, triggering the capital impacts which are discussed above,” said Afme.
Open positions in the UK could be moved to EU CCPs but this would not be practical for many reasons including conflicting legal jurisdictions and differences in membership.
In addition, Afme said Brexit creates significant uncertainty for clients holding (or planning to hold) long-dated contracts such as swaps, loans or cross-border revolving credit facilities. After Brexit, a bank which had signed a contract may no longer have the required approvals to lawfully perform the services it had committed to, or could no longer access the necessary market infrastructure. Therefore, changes may be required to the terms of a pre-existing derivative. If changes are substantial this could be considered to be a new contract which would require authorisation in the relevant member state.
“There may also be a significant impact on corporate finance as EU27 companies may be uncertain whether they can or should rely on a single European hub for capital raising and advisory services,” said the report.
The UK generates around 60% of total capital markets revenues in the EU and Afme warned that part of this market capacity could be at risk. Fragmentation of liquidity provision for equity, debt, foreign exchange and commodities might cause secondary spreads to widen and also affect primary issuance.
Banks based in the UK may not be able to trade products on EU exchanges and need to either trade via a regulated broker in an EU27 jurisdiction or set up a regulated entity in the EU27. Similarly, EU27 based banks may no longer have access to UK-based exchanges.
“This will result in longer transaction chains and increased costs,” added Afme. “This problem may be exacerbated by the share trading obligation under MiFID II which will come into force in January 2018.”
Under the incoming MiFID II regulations, shares which are available for trading in the EU generally need to be traded by firms on a regulated market/multilateral trading facility; systemic internaliser, or a third country trading venue which is considered as equivalent, which may not apply to the UK .
“This could have an adverse impact on clients of such firms where the deepest pool of liquidity might be available at the UK trading venue offering more competitive pricing to clients,” added Afme. “EU27 clients and firms would also no longer have access to the liquidity that would be available off-exchange in the UK.”
Afme also warned that affected market participants and supervisors will need more than two years to prepare effectively for Brexit. The report said banks will need a three-year implementation period following the completion of the Article 50 negotiations and the market needs an early indication that a transitional arrangement will be agreed.
These transitional arrangements could include a bridging period to avoid short-term disruption until the new trade relationship between the UK and the EU27 is ratified, and a subsequent adaptation period to allow phased adjustment to the new trade relationship. Simon Lewis, chief executive at Afme, said in a statement: “Financial stability and market efficiency must be safeguarded during the Brexit implementation process and thereafter. These are essential ‘public goods’ for the European economy.”
Law firm Ashurst said in a note that nothing will change for UK businesses until 29 March 2019 as EU law will continue to apply, new directives and regulations will continue to be implemented, and the UK will continue to contribute to the EU’s budget.
“For those businesses which rely on EU-derived rights to trade from the UK into the EU27 (and vice versa), 29 March 2019 will be a date on which fundamental change occurs, unless agreement is reached between the UK and the EU,” added Ashurst.
The law firm said those businesses which are materially affected by Brexit will need to follow closely and monitor the UK/EU27 negotiations over the next two years to ensure that they are strategically positioned, capitalised and resilient enough to deal with whatever the outcome may be.
“Ultimately, the reality of the result may well be more prosaic; there will be no bonfire of regulation, and markets in many goods and services will continue to be accessible, albeit at a cost,” added Ashurst.
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