AFME and ISDA: loss of EU passporting after Brexit a threat to OTC derivatives, novation uncertain

As we have said previously, we do not believe Brexit will make it illegal for firms to perform contractual obligations under existing contracts in most (if not all) Member States, and thus should not affect the legal validity of existing transactions.

However, if performance of lifecycle events on existing contracts between UK and EU-27 market participants is not legally permissible following Brexit, this is likely to impair the ability of UK and EU-27 counterparties to existing contracts to manage their exposures and risks.

Thus, the loss of EU financial passporting rights after Brexit will have implications for cross-border OTC derivatives contracts between UK and EU-27 firms and their EU-27 and UK clients and counterparties respectively where those firms currently rely on an EU passport to trade cross-border in the EU-27 or the UK. Similar issues may also arise in relation to OTC derivatives contracts between some EU-27 firms operating through a branch in the UK and their EU-27 clients and counterparties to the extent that the EU passport is no longer available in relation to continuing activities of the UK branches after Brexit.

—

The only alternative for many firms with respect to legacy contracts affected by these uncertainties is to seek the individual consent of each client or counterparty to the transfer of the rights and obligations of the UK firm under the relevant contracts to its EU-27 affiliate (the mechanism known as ‘novation’) in advance of Brexit. Firms have already carried out significant preparatory work on their novation projects and, in many cases, have already begun their outreach to clients and counterparties.

However, their progress in completing their novation projects is being affected by extrinsic factors outside their control, including possible regulatory actions (due to local law being unclear on whether authorization would be required) adversely affecting firms’ assumptions about the treatment of lifecycle events and client cooperation and agreement. There are significant practical execution and timing challenges to completing such an exercise before Brexit, not least because of the scale and complexity of the process and because there are many reasons why clients may delay or even refuse their consent to a novation.