Brexit and Contractual Certainty



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’s been a lot of recent focus on the impact of Brexit on the derivatives market. That’s no surprise. Derivatives are widely used by companies across Europe to create certainty and stability in their business, and to manage their risk.

ISDA has spent a lot of time looking at the contractual certainty of derivatives trades, and recently conducted analysis on one specific part of this issue: the ability of banks and investment firms to perform existing contractual obligations under transactions between the 27 European Union (EU) member states and UK counterparties that were entered into before Brexit. This analysis focused on six jurisdictions – France, Germany, Italy, the Netherlands, Spain and the UK.

The good news is that the analysis shows there is unlikely to be any impact on the performance of contractual obligations on existing trades – which includes payments, settlements, transfer of collateral and the exercise of pre-agreed options. That’s an important point: cross-border trades between EU 27 and UK entities won’t all of a sudden fall away after Brexit. However, certain events or actions that occur during the lifecycle of a transaction, and which are outside of contractual obligations, could be affected – although the exact impact differs country to country, based on the law of the applicable jurisdiction (EU 27 member state or UK).

For instance, a novation, certain types of portfolio compression, the rolling of an open position (extending the maturity of a trade), material amendments and some types of unwind may be classed as a regulated activity. That means that, without passporting rights under the Markets in Financial Instruments Directive (MIFID), investment firms, credit institutions and branches would either need to rely on an equivalence decision or an exemption, or obtain a local license in the relevant jurisdiction in order to continue to perform these lifecycle events. That could be time-consuming and pose a significant operational burden on firms, which could potentially result in disruption to financial markets.

These types of lifecycle events are frequent, and allow counterparties to manage their exposures and risk. Portfolio compression, for instance, allows firms to reduce the size of their derivatives books by tearing up multiple trades and leaving target risk profile – a concept included in the European Market Infrastructure Regulation and MIFID as a key systemic risk-reduction measure. Transitions from the IBORs would also require an amendment of contracts.

Given the significant volume of derivatives trades between counterparties in the EU 27 and the UK– and the fact that these lifecycle events are common and required by regulations in some cases – it’s critical that firms in both the EU and the UK are able to carry out the full range of actions that have been agreed between. It’s clearly in everyone’s interest – whether they are located in Munich, Milan or Manchester – that performance of these lifecycle events on existing cross-border trades isn’t interrupted post-Brexit.

As a result, we think it’s important that provisions are put in place that allow EU and UK counterparties to manage their transactions after Brexit. We would encourage policy-makers to consider all available options now, including coordinated legislative action, insertion of language into a separation agreement, or ultimately wording within the EU-UK withdrawal agreement that allows entities to continue to perform a wide range of lifecycle events. This isn’t about winners or losers. It’s about ensuring the safety and efficiency of this market post-Brexit for both EU and UK counterparties.

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