Hard Brexit Relief Welcome, But Detail Needed

ISDA Chief Executive Officer Scott O'Malia offers informal comments on important OTC derivatives issues in derivatiViews, reflecting ISDA's long-held commitment to making the market safer and more efficient.

There have been some recent positive signals from European Union (EU) authorities that action will be taken to mitigate disruption to EU 27 participants in the event of a hard Brexit. In particular, European officials have indicated that EU 27 firms will be temporarily able to continue accessing UK central counterparties (CCPs) following a no-deal scenario.

This reassurance is critical and welcome. Under the current framework, the UK would become a third country under EU law after Brexit, requiring its CCPs to apply for recognition from the European Securities and Markets Authority in order to continue providing clearing services to EU entities. However, the application process can’t begin until the UK has actually left the EU. If this occurs suddenly on March 29, 2019, without a withdrawal agreement or transition period in place, EU 27 firms could abruptly find themselves unable to act as clearing members at UK CCPs for a period of time.

EU counterparties would have little choice but to migrate the thousands of affected contracts to EU-recognized CCPs, which would result in punitive costs, significant operational challenges and likely disruption to markets. That’s if it’s even possible – a migration of this scale has never been attempted before, while substitutes are not available in the EU for all affected contracts.

Disruption is likely to be felt well in advance of the potential cliff-edge Brexit date. Faced with the prospect of suddenly being shut out of UK clearing houses, EU participants are likely to take costly and potentially irreversible mitigating actions – to the extent they can – months in advance of Brexit. In fact, UK CCPs will have to give prior notice to EU clearing members to ‘offboard’ in order to ensure they are compliant with EU law.

In a recent white paper, ISDA and six European trade associations recommended a series of steps that can be taken to address the risk of a cliff-edge Brexit. One of these is a temporary recognition regime that would allow services to continue as before, providing time for UK and EU firms to make the necessary arrangements, and for infrastructures to get the required applications and authorizations in place.

The UK has already announced that it plans to create temporary permissions and recognition regimes in the event of a no-deal Brexit. Comments from EU officials that something similar could be introduced in Europe are therefore important. But, while helpful, these comments are not on their own enough to prevent counterparties taking mitigating action ahead of March 29, 2019.

In order to fully reassure market participants, more certainty is required over what such a temporary regime would cover in the EU. This might include details about the temporary recognition mechanism, the time frame and any conditions. How would exposures to a UK CCP be treated for capital purposes during the time-limited recognition period, for instance? Would trades cleared at UK CCPs remain out of scope of EU bank bail-in rules, as they are today?

This clarity needs to emerge soon – ideally this month, but December at the latest. Market participants need time to adapt their strategies to prepare for a potential cliff-edge Brexit. Providing certainty now over the application and scope of any EU time-limited recognition regime will avoid the need for EU 27 participants to take action, and ensure markets continue to function efficiently and without disruption.

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