A question that has been ignored, until very recently, is how firms will deal with cross-border derivative contracts when the UK leaves the EU in March 2019. Leaving the single market without either EEA membership or a trade agreement covering financial services will result in complications for existing derivative contracts.
With approximately £26 trillion of outstanding OTC derivatives contracts affected, the potential cliff-edge risk will cause extreme uncertainty that could send the market into disarray. Firms will need to mitigate contractual continuity risks, which is likely to involve the complex repapering exercise that will be required to move existing contracts to a (locally-licenced) EU entity.
The fate of future cross-border contracts lies in the hands of political negotiators managing the Withdrawal Agreement on the long-term relationship between the UK and the EU27. As a way of mitigating potential risks, an important element to the Withdrawal Agreement would be a transition period whereby lifecycle events would be enabled to continue until the proposed date of December 2020. However, due to the seemingly impenetrable fog in the channel, many firms have already started developing provisional plans for a more extreme Brexit. Firms have been encouraged to prepare for the worst case scenario, where no deal on market access is agreed between the UK and the EU27.
The European Commission issued a notice to stakeholders in February 2018, warning that withdrawal is “not just a matter for EU and national authorities but also for private parties”. It urges UK entities to prepare for a “no deal” Brexit as the UK will become a third country. If this is the case, the necessary maintenance of cross-border contracts will be unable to continue. The anticipated issues are expected to affect not only UK firms providing services to EU27 clients, but also EU27 entities providing financial services to clients located in the UK.
With the withdrawal date drawing closer by the day, affected firms and institutions are still either being held hostage by hope or are frozen in the headlights of the oncoming Brexit train. In the absence of a deus ex machina in the form of primary legislation, firms will have little choice but to begin the mammoth task of novation to a licensed EU entity. The scale and complexity of such a novation project should not be underestimated.
When transferring business to a licenced EU27 entity, UK firms will need to consider the different transfer methods:
Clifford Chance has suggested the possible statutory methods of transfer include Part VII FSMA and the EU cross-border mechanism. The main benefit of statutory methods is that they are automatic and do not open negotiation. Existing client contracts are included in the general transfer or merger of the business and therefore do not require individual novations (meaning there is no need for individual client consent).
Under a Part VII transfer, English courts are able to amend existing contracts making them fit for purpose for the transferee entity, clone contracts or split contracts (as long as the contracts are in the best interests of the customer). However, a drawback of this method is that it is only available to banks and not to investment firms (making up a significant proportion of UK entities looking to transfer business).
Part VII is a UK scheme and it is unclear whether it will be recognised in an international context and further schemes may need to be implemented in certain EU27 jurisdictions. There is currently no counterpart in European or Euro-national legislation and, with the withdrawal date soon to be upon us, there is likely not enough time for primary legislation to be passed.
Manual transfer methods
As statutory transfer methods need to be mandated by UK law, the more viable method is to transfer by novation. This will involve either transferring contracts internally to a branch located in a licenced EU27 state, or transferring contracts externally to another entity located in the EU27.
Transferring business branch-to-branch is likely to require less extensive due diligence tasks on existing contracts and changes to contracts can be made by notification. However, some elements of agreements, such as a change in branch or office, will still need formal consent from counterparties. This will be the case for derivatives contracts where there are tax implications for a change in booking location.
Formal and complete novation will be more intrusive to counterparties as consent will be required to novate their existing contracts to a EU27 entity. Additionally, transfer to an EU entity may trigger licensing requirements, as per below. Perhaps more consequentially, such life cycle events may bring legacy transactions into scope for margining requirements under EMIR.
Events triggering licensing requirements
In the absence of a relevant agreement, the legality of UK/EU contracts will be assessed on a jurisdiction by jurisdiction basis. Although the situation will differ depending on the type of contract in question, the following events are likely to trigger local licensing requirements:
- Option exercise – a licence may be required by the EU counterparty for certain asset types
- Rolling of an open position – both the UK and EU counterparties will require a licence (exemptions will apply for the EU counterparty)
- Material amendments – both the UK and EU counterparties will require a licence, however, these will be jurisdiction specific
- Novations – these will be subject to specific contract and jurisdiction analysis and will require extensive preparatory work
- Unwinds – both the UK and EU counterparties will require a licence (exemptions will apply for the EU counterparty)
- Portfolio compression by termination with no replacement – both the UK and EU counterparty will require a licence (exemptions will apply for the EU counterparty)
These events have been discussed in more detail in a previous DRS article.
Significant challenges to transfer by novation
Although the idea of transferring business to a licenced EU entity sounds like a silver bullet, it will take more than novation to kill the Brexit werewolf. There will be a number of logistical and operational issues with transferring by novation:
The scale of the task
As previously stated, approximately £26 trillion of OTC derivative contracts are expected to be affected by Brexit. The task of transferring, restructuring or terminating these contracts would be non-trivial at best.
In transferring or terminating contracts, firms can expect to face transactional and commercial difficulties such as:
- Changes in the entity’s business model or structure may compel counterparties to renegotiate contracts to secure better terms of their relationship with firms or the terms of individual transactions, which could negatively impact the firm
- The new EU entity may be subject to differentiated credit ratings requiring CVA adjustments and consequent quant arguments
- Netting and other efficiencies may be lost when collateral pools are split between entities
- Commercial terms and specific arrangements could all potentially change once the Pandora’s Box of negotiation is opened. Any changes to primary economic terms may have financial consequences
The transaction and documentation negotiations needed for Brexit are likely to have tax implications for UK firms as it will involve rebooking, transferring or merging entities. This could result in unexpected expenses and tax complications for both parties.
New clearing and margin requirements
If a transfer by novation provokes new clearing or margin requirements that currently come under the grandfathering arrangements under EMIR, clients may be unwilling to agree to a transfer. Novations will require previously uncleared or unmargined transactions to be cleared or margined, impacting both firms and their counterparties. A rush of demand for additional margin could significantly impact the market when firms and their counterparties try to find additional collateral.
There will be substantial financial implications for institutions transferring or receiving to or from the new entity. Transferring the bulk of existing contracts to a EU27 entity may impact capital requirements and lead to tax, accounting or operational complexities that may be hard for the entity to manage. These issues will be subject to exhaustive and likely expensive opinion and analysis.
Multiple parallel negotiations
Documentation packs and proposals will be sent to clients (each requiring individual attention and separate operational implementation). This will put a huge strain on, already stretched, legal and operational resources for counterparties who have business with multiple firms, creating vulnerable bottlenecks and delays.
Clients refusing to move
In transferring business to a EU27 entity, client contracts are subject to changes in economic terms, credit risk, splitting of collateral pools and netting sets, and potential tax implications. These issues are likely to make some counterparties unwilling or reluctant to consent to transfer business. Without client consent, firms will not be able to go ahead with the transfer of client contracts and may decide not to transfer in order to save the relationship with their clients.
Transferring all counterparty contracts from one business to another will be a complex task requiring documentary experience and in-depth process expertise. Many firms have already begun novation preparations, DRS is currently working on a number of novation projects. However, regulators have yet to provide any definite guidance and the regulatory future is wholly unmapped. There is currently no consistency on which legacy contracts or lifecycle events will be deemed as regulated activities (requiring a licence). In a Brexit context, firms engaging innovation projects or preparations are having to base their dealings on assumptions as to an uncertain future and necessarily indeterminate legal advice. Any regulatory changes or new regulatory guidance which differs from a firm’s assumptions could have negative consequences on their treatment of lifecycle events. Facing radical uncertainty, the likely prudential choice is transfer by novation pre-Brexit, whatever the final date may be.
As discussed previously, the ideal outcome of the current negotiations regarding Brexit would be the execution of a Withdrawal Agreement covering financial services. A rational and mutually beneficial outcome seems increasingly destined to be a casualty of Tory party civil war, and a crash-out Brexit looms ever larger on the horizon. Consequently, firms would be well advised to prepare for a no deal Brexit and not rely on a possible Withdrawal Agreement.
With the statutory mechanisms likely to be unsuitable for transferring business to a EU27 entity, transfer by novation is favourable. While this process is likely to be challenging, specialist assistance is ready and available. As always in regulatory change projects, time is of the essence, doubly so in the Brexit context where the timeline remains unclear. With the possible March 2019 withdrawal date fast approaching, it is imperative that UK and EU entities assess their derivative portfolio from the viewpoint of contractual continuity.
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