With the UK looking to crash out of the European Union without striking a deal in 18 months’ time it is no surprise that traders are busy looking at the impact of Brexit on the derivatives market.
The International Swaps and Derivatives Association has examined the contractual certainty of derivatives trades.
As a matter of urgency, the lobby group was particularly concerned at the ability of banks and investment firms to perform existing contractual obligations for transactions between the European Union 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.
Good news for banks
According to ISDA chief executive, Scott O'Malia, the good news is that 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 European and UK entities won’t suddenly fall away after Brexit."
However, the ISDA head warned that 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 that jurisdiction.
“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,he cautioned.
“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.
Life cycle events could disrupt
O'Malia identified portfolio compression as one such event since it allows firms to reduce the size of their derivatives books by tearing up multiple trades and leaving target risk profile.
This concept is included in the European Market Infrastructure Regulation and MIFID as a key systemic risk-reduction measure.
Transitions from the books of record 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."