The Brexit End Game

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.

As we approach the sharp end of the Brexit process, a bit more clarity has emerged on how cross-border derivatives business between UK and EU participants will work. Last week, UK chancellor Rishi Sunak announced a series of unilateral equivalence decisions, meant to ensure some level of continuity for UK entities trading with EU firms after the end of the Brexit transition period on December 31, 2020. But there are still some glaring gaps that haven’t been addressed by either the UK or EU, including equivalence for trading venues.

This is a big deal, because a lack of equivalence would exacerbate liquidity fragmentation at a time when markets would likely be facing considerable uncertainty resulting from Brexit. Given the rules on trading venues in the EU and UK are virtually identical, we think equivalence is justified – and very necessary.

Without equivalence, an EU and UK firm would find it challenging to trade a derivative that is subject to both the EU and UK trading obligations, because the EU derivatives trading obligation (DTO) would require the transaction to be executed on an EU-recognized trading venue, and the UK DTO would require execution to take place on a UK-recognized venue. The only option for EU and UK counterparties would be to trade in-scope derivatives on US swap execution facilities, which are recognized by both jurisdictions. However, this comes with several operational and practical challenges that might make this impossible for some.

A similar conflict would emerge when an EU entity trades derivatives through its UK branch with a UK counterparty, and vice versa. These conflicts would create an impossible situation for banks, asset managers, pension funds and corporates that trade with counterparties in the other jurisdiction.

However, the challenge is more acute for EU entities trading through a UK branch. Under UK rules, the UK DTO would apply after the transition when an EU firm trades in-scope derivatives through its UK branch with a UK or EU counterparty, and can also be read as applying to trades with third-country parties – even though the EU DTO would apply to those trades as well. Under EU rules, in contrast, only the UK DTO would apply if the EU branch of a UK firm trades with a UK or third-country counterparty, except in limited circumstances.

There are some possible workarounds that could partially mitigate the duplication – and we’ve highlighted these in a recent paper. For instance, the rules could be changed so the DTO does not apply to business conducted through overseas branches with local firms in the branch jurisdiction or with third-country entities. Changes could also be made to the scope of the DTO to avoid overlap – for instance, the EU might decide there is insufficient liquidity in sterling interest rate swaps to warrant being subject to an EU trading obligation. However, none of these solutions fully resolve that problem, and further action and cooperation by EU and UK regulators would be needed in a number of these cases.

We strongly believe that equivalence is the best and most complete way of dealing with this issue from the point of view of both EU and UK counterparties.

Both EU and UK authorities have taken action in one important area: recognition of central counterparties (CCPs). Last week’s announcement by the UK included equivalence for CCPs established in the European Economic Area (EEA), which follows the adoption of temporary equivalence for UK CCPs by the European Commission in September. Given the systemic implications of shifting cleared positions from one CCP to another, achieving clarity on this point was critical.

The UK announcement also included an important measure that will enable UK firms to continue treating derivatives traded on EEA regulated markets as exchange-traded contracts rather than over-the-counter derivatives. Without this, smaller UK financial institutions and non-financial corporates currently exempt from the clearing mandate could have suddenly breached the clearing threshold due to their exchange-traded derivatives exposures. We urge EU authorities to take a similar step in the interests of EU small financial institutions and non-financial corporates.

Brexit will inevitably result in changes in how derivatives are traded on a cross-border basis between EU and UK entities. But a lack of equivalence for trading venues would only lead to a lack of efficiency, fragmentation and operational costs, for very little benefit. The UK chancellor did not rule out further equivalence decisions if similar action is taken by the EU. But the clock is ticking until the end of December – the time for action is now.

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