The International Swaps and Derivatives Association, Inc. (ISDA), the Association of German Banks (Bundesverband deutscher Banken), the Italian Financial Markets Intermediaries Association (Associazione Intermediari Mercati Finanziari), the Banking and Payments Federation Ireland (BPFI), the Danish Securities Dealers Association (Børsmæglerforening Danmark), the Dutch Banking Association (Nederlandse Vereniging van Banken) and the Swedish Securities Dealers Association (Svenska Fondhandlareföreningen) have jointly published a paper that warns of the disruptive impact of a ‘hard’ Brexit on derivatives markets.
The paper describes the cliff-edge risks and the European Union (EU) regulatory requirements that would apply to derivatives in the event of a ‘no deal’, and the immediate adverse impacts on EU 27 firms and EU 27 clients of UK entities. UK firms and UK clients of EU 27 entities would also be affected in some cases.
The issues arise because the UK will become a third country under EU law at the point it exits the EU, and this could occur suddenly if the UK leaves on March 29, 2019 without a withdrawal agreement and transition period in place. This would result in a variety of regulatory requirements that would immediately restrict the ability of EU 27 firms to transact derivatives with UK entities and infrastructures and could have a systemic impact.
For example, EU 27 counterparties would be unable to act as clearing members at UK central counterparties (CCPs) at the point the UK becomes a third country, and neither they nor their clients would be able to clear products subject to the EU clearing mandate until UK CCPs are recognized by the EU. The resulting migration of thousands of contracts to EU-recognized CCPs – if even possible – would result in higher costs and would pose significant operational challenges. A migration of this scale has never before been attempted.
The paper points out that EU law gives the EU or EU 27 national competent authorities the power to take mitigating action – for instance, by adopting equivalence decisions or approving applications for recognition. However, there is a risk that these actions would only be taken after the UK has left the EU and become a third country. The perceived risk of such a hiatus would be likely to cause severe market disruption months in advance of Brexit.
The industry groups have made several recommendations on steps that can be taken now to address the risk of a cliff-edge Brexit.
- In a no-deal scenario, the European Commission (EC) and other EU authorities should consider taking necessary steps in advance of Brexit to avoid a disruptive hiatus by ensuring that mitigating actions take effect from the date when the UK leaves the EU. This would include taking all available preparatory steps and, where possible, accepting applications and adopting advance formal decisions that take effect on that date.
- The European Securities and Markets Authority (ESMA) should consider working with relevant CCPs, trade repositories, credit rating agencies and benchmark administrators in advance of Brexit to facilitate applications for recognition, endorsement or registration in the event of a no-deal scenario. This is so that, to the extent possible, any decision on recognition, endorsement or registration can take effect from the date the UK leaves the EU.
- As part of its contingency planning for a no-deal scenario, the EC should consider proposing EU legislation adapting EU law in advance of Brexit to create a temporary regime deferring the impacts addressed by these mitigating actions and allowing time for necessary actions to be taken after Brexit. The UK has already announced that it plans to address these issues by creating temporary permissions and recognition regimes to minimize disruption to UK markets in a hard Brexit scenario.
- The EC, ESMA, the Single Resolution Board and EU 27 national competent authorities, in cooperation with the UK authorities, should consider taking all other actions available to them to eliminate or at least shorten any disruptive gap between Brexit and any mitigating action becoming effective.
- The EU should consider providing early transparency to market participants about the mitigating actions that the authorities expect to take, and any likely gap before those actions become effective after Brexit, so firms and their clients and counterparties can plan accordingly.
In the absence of transparency, market participants may be forced to take disruptive, risky, costly and potentially irreversible (and ultimately unnecessary) steps to mitigate adverse impacts (where mitigation of such impacts is possible) far in advance of Brexit.
The impact of these issues could be mitigated through a withdrawal agreement and transition period. Even then, there is a risk that similar issues to those discussed in the paper would arise at the end of that transition period, moving the ‘cliff edge’ to that date.