Brexit and Contract Continuity for Derivatives Markets
The United Kingdom’s (UK) decision to leave the European Union (EU) on the 29th of March 2019 poses significant challenges for the continued orderly functioning of financial markets, with potentially detrimental impact on end-users of some financial instruments.
As a result of Brexit, EU financial services legislation will no longer apply to the UK. This in turn means that passporting rights that have enabled the provision of cross-border financial services both to and from the UK will cease. Contingent on whether the UK leaves the EU in an orderly fashion – i.e. through ratification of the existing withdrawal agreement, which foresees a transitional period for the UK lasting until the end of 2020 and which is extendable by up to two years on request – the impact on the continuity of cross-border financial contracts ranges from limited to severe.
The political dynamics around Brexit are in constant flux at the moment with all outcomes – ranging from Brexit on the terms of the withdrawal agreement, hard Brexit without a deal, or the UK staying in the EU either by means of revocation of the Article 50 notification or due to the results of a second referendum – remaining possible.
With this in mind, should the UK leave the EU without a deal – a so-called hard Brexit – this would pose a challenge to the continuity of contracts in particular in derivatives markets.
Continuity of contracts in OTC derivatives markets refers to both carrying out contractual obligations under existing transactions and to the ability to carry out lifecycle events associated with such transactions. This could impact a significant stock of legacy derivatives contracts, not all of which will mature before March 2019 (or even before the end of the proposed transition period in December 2020). Concurrently this means that even though an approval of the withdrawal agreement and the included transitional provision would provide market participants with additional time to repaper existing contracts, the problem of continuity of contracts and the ability to carry out lifecycle events would still apply to contracts that run beyond the end of the transitional period.
To mitigate some of the most severe effects on financial market participants, the European Central Bank and the Bank of England launched a joint working group earlier in 2018 to address contract continuity issues. At present, the joint working group has yet to present its final work. In the meantime the European Commission (EC), the European Securities and Markets Authority (ESMA), as well as a number of Member States have implemented or suggested contingency measures in the event of a hard Brexit.
In terms of the solutions being proposed, there is however an important distinction between the actions taken at Member State level, which offer more wide-ranging preservation of contractual continuity, and European-level action, which only provides short-term relief in order to enable market participants to repaper their existing contracts with EU counterparties.
Against this backdrop, Germany, France and Sweden are in the process of adopting domestic legislation that would preserve contract continuity in OTC markets for limited time period to allow for an orderly market transition.
Contrastingly, the measures envisaged by the EC would only preserve continued access to UK central counterparties for cleared contracts, as the EC does not consider that EU-level public action could resolve contract continuity challenges in OTC derivatives markets. In this context, the EC encourages market participants to adjust their contracts to life-cycle events, seek the relevant authorisations and take appropriate measures to repaper existing contracts with EU 27 counterparties. Similarly, ESMA has proposed amendments to the EMIR Regulatory Technical Standards on the bilateral risk mitigation techniques, which merely provide for a time-limited transitional period during which European counterparties can novate contracts that were not subject to EMIR bilateral margins rules at the time they were first concluded without triggering the margining obligation. This is done only in order to facilitate their repapering in the EU in the event of a no-deal Brexit.
Ultimately, for the time being no comprehensive public solution has been provided to address the challenge of contract continuity in OTC derivatives markets.