The shadows of a hard Brexit on the European Derivatives Market and possible mitigation strategies

On 28 October 2019, EU leaders have agreed a further flexible extension of the Brexit, which is now planned to occur by January the 31st 2020 at latest. Accordingly, a hard Brexit is a circumstance that seems to have become extremely unlikely, at least in the nearest future. Nonetheless, notwithstanding such further derogation to Article 50 TFEU, the UK and the EU are still a long way from reaching an agreement. Therefore a British withdrawal from the EU without a deal is a circumstance which is still possible in principle.

As it is well known, the consequences of a no-deal Brexit would have an enormous impact on overall economy both in Britain and in continental Europe. However, when it comes to capital markets, should a hard Brexit be carried out, one sector in particular has been indicated by majority commentators to be the most at risk from disruption; namely trade in derivatives.

Along with New York, the City of London represents the epicentre of the global derivatives market, together hosting more than 80% of the world’s transactions in derivatives, for an amount of approximatively $475.2 trillion per year. Indeed, the London Clearing House nowadays clears the most derivatives denominated in Euro[1]. Acknowledging the loss of such an extremely important financial hub, EU institutions have started to set up a regulatory package aiming at making other jurisdictions more attractive and enhance the competitiveness of other EU financial centres, such as Frankfurt or Paris.

In the light of such critical situation, in October 2018 the International Swaps and Derivatives Association (ISDA) and other national financial entities published the report on “The impact of Brexit on OTC derivatives”, highlighting the main issues posed by Brexit which could, whether immediately or on short term basis, adversely impact the derivative market[2].

In general, problems are related, on one hand, to the regulatory vacuum triggered by the instant disapplication of the acquis communautaire in Britain from the moment where Brexit will be carried out and, on the other, to the contractual uncertainty, which will arise consequently to such legal gap. Indeed, on grounds of nowadays’ state of the British regulatory framework, there would be no “regulatory equivalence” pursuant to Article 25(6) of Reg. (EU) No. 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties and trade repositories (the s.c. “EMIR”). From a general point of view, as the EMIR framework would cease to apply in principle in post-Brexit Britain, this would fundamentally hamper EU derivative market access for UK undertakings in case of a no-deal outcome.

More precisely, the issue that appears to be the most delicate is the one concerning clearing obligations. Pursuant to EMIR articles 4 and following unrelated counterparties to a derivative contract shall settle their transactions “in a CCP authorised […] or recognised under [the EMIR] and listed in the [relevant] register”. EMIR enables CCPs duly authorised by the competent domestic authorities of the Member States to operate on the European market, while providing a differentiated procedure for market access of third State-resident clearinghouses. In this respect, several detrimental consequences would be triggered by a hard Brexit. First of all, the loss of mutual recognition under EU law would ipso facto prevent British CCPs to clear euro-denominated swaps entered into by EU companies. Secondly, the inapplicability of EU legislation would cause the impossibility to take advantage of EU rules on British territory. Therefore, close out netting and clearing by UK clearinghouses could be adversely affected by claw-back rules of the domestic insolvency regime of a EU27-resident counterparty.

Another important regulatory issue as regards to market access relates to the loss of passporting rights for UK dealers in the European market (and vice-versa). Indeed, the immediate disapplication of the freedom of establishment and the free movement of financial services rules in case of a hard Brexit would rise the issue of the “regulatory equivalence” above. Hence, while it is not true that British undertakings would be prevented en bloc from acceding the internal market, the access of British financial services providers to the European market would still have be subject to a “sector-by-sector” evaluation by ESMA or other competent authorities[3].

As said, regulatory problems represent only one side of the coin. Other problems may arise in respect to the enforcement of OTC derivatives subject to English law; that is, due to the widespread use of ISDA master agreements, the vast majority of derivatives currently traded. Again, the sudden inapplicability of EU principles (such as those relating to costumer protection in financial services) in the British legal environment would contribute to the legal uncertainty of the system, hugely undermining investors’ trust in capital markets. This has driven the biggest UK-active financial institutions to start novating their contracts in force with important clients, to the detriment of the smaller ones.

The above represent, of course, only some of the legal issues that would arise in case of a no-deal Brexit. There are other important issues that authorities would certainly have to face, such as capitalisation requirements, transparency, monitoring and information exchange, payment systems operation etc.

In any case, as suggested by the Futures Industry Association (“FIA”) in its report “The Impact of a No-Deal Brexit on the Cleared Derivative Industry” dated December 2017, a solution to the issue of market access may be put in place by the market players themselves. Indeed, regulatory issues might be passed-by through the establishment by British CCPs of EU subsidiaries (the same applies vice-versa to EU-established clearinghouses wishing to have access to the British market). However, such an option postulates high costs, also in the light that there are neither precedents nor established commercial practices in matters of mass-transfer of portfolios.

On the other hand, in order to overcome the uncertainties related to English law, the private sector has started to react and search alternative solutions. In particular, European civil law jurisdiction (Germany and France above) have started developing their own contracts, reflecting the rules contained in their private law codes and regulations. Most importantly, between 2018 and 2019 the ISDA has published its new French law and Irish law documentation (both Master Agreements and ancillary collateral documents) in order to foster the financial hubs of Dublin and Paris.

Finally, however, it seems unlikely that in case of a no-deal Brexit every single issue would be addressed and solved timely by the competent authorities, thereby making market distortions or partial disruption inevitable. In the light of this, should a specific agreement on the UK’s withdrawal from the Union not be reached in time, grandfathering by the EU institutions or by the British administration themselves still seems to represent the best solution, even on temporary and unilateral basis.

[1] PARTINGTON Richard, UK and US agree post-Brexit derivatives trading deal, the Guardian (25 February 2019).

[2] https://www.isda.org/a/FAvEE/Brexit-Other-Cliff-Edge-Effects-Under-EU-Law-in-a-No-Deal-Scenario.pdf

[3] In this respect, see: TURNER David, Derivatives face Brexit risk, IPE (December 2018).