Impact of the referendum
Following the result of the vote in the UK referendum on 23 June 2016, there is some uncertainty about how the UK's exit from the European Union (EU) will impact derivatives transactions.
The UK will not leave the EU immediately and will continue to be part of the EU and remain a member for some time. Until then all EU legislation (including new EU laws) will continue to apply within the UK so there will be little that will fundamentally change in the short term. Indeed, following the vote, the Financial Conduct Authority (the FCA) confirmed in a statement on the EU Referendum result that firms must continue to abide by their obligations under UK law, including those derived from EU law, and continue with implementation plans for legislation that is still to come into effect.
The first step towards the UK leaving the EU is for the UK Government to notify the European Council of its intention to withdraw by invoking Article 50 of the Treaty on the European Union. This will then trigger a two year time period during which the UK will negotiate its exit from the EU.
The longer term impact of Brexit on derivatives regulation will very much depend on the new relationship that the UK has with the EU in the future, and there is much uncertainty surrounding this. Below we have set out the potential forms that this new relationship could take. Nevertheless, market participants may want to start planning for Brexit to identify the potential risks and opportunities and to mitigate the potential impact.
Although there should be no immediate impact on standard ISDA documentation, it is possible that post-Brexit changes may be required. Some technical amendments to documentation are likely to be required as well as a review of the standard ISDA representations and agreements. Particular clauses will need to be looked at more closely once the detail of any Brexit agreement is available.
The following areas in particular will need to be considered:
bespoke termination events;
standard termination events;
standard events of default;
bespoke events of default;
references to specific EU regulations or EU territory;
tax provisions: these could be affected if there is a change in the withholding tax treatment, for example; and
EU regulation relating to derivative transactions
Many laws governing how the derivatives markets operate in the EU come from EU directives and regulations. EU legislation which took the form of an EU directive will have been implemented into UK law by UK Acts of Parliament or UK Statutory Instruments. EU regulations (such as the European Market Infrastructure Regulation (EMIR) (and level 2 measures such as regulatory and implementing technical standards) are directly applicable in UK law without domestic implementing legislation and will cease to have effect when the UK leaves the EU, unless such laws are transposed into UK law to continue the effect of those EU regulations and level 2 measures. Although unlikely, if the UK Government were to repeal the European Communities Act 1972 (ECA), which provides the legal basis for the constitutional relationship between the UK and the EU, without replacement, then secondary legislation that is incorporated into UK law by the ECA would be likely to fall away, whilst any primary legislation would remain, causing gaps in legislation which would need to be addressed.
Consideration may also need to be given to market disruption wording and increased cost of hedging as well as ensuring that any Sovereign Succession Event language is carefully reviewed where the UK is a reference entity.
If Brexit were to trigger a deterioration in creditworthiness, there could of course be defaults or credit-related events. It does, though, seem unlikely that Brexit of itself would trigger an Event of Default or Termination Event under the 1992 or 2002 ISDA Master Agreements.
Finally, we would expect that legal opinions in support of close-out netting provisions and collateral posting will be subject to significant updating in order to reflect the new legal landscape.
The UK may decide to use continuity legislation to avoid a legal vacuum so that EU rules relating to financial services continue to apply in the UK for the time being post-Brexit. Maintaining equivalent rules would assist the UK in establishing that it satisfies "equivalence" standards that may be applicable.
EMIR: clearing and margining requirements
EMIR stipulates that financial counterparties and non-financial counterparties with derivatives activity over certain thresholds must clear certain OTC derivatives through a central counterparty (CCP) that is authorized or recognized under EMIR. It also requires counterparties to report their trades to a trade repository which registered by the European Securities and Markets Authority (ESMA) and to put in place certain risk mitigation techniques, including new margin requirements, in relation to uncleared derivatives. EMIR (and its associated delegated acts) is directly applicable in all EEA Member States so it will no longer apply if the UK leaves the EEA.
However, the clearing and margin requirements under EMIR are a result of the G20's commitment to increase transparency and reduce counterparty credit risk and operational risk in the derivatives market, and as a G20 participant the UK is obliged to meet these
global standards. The margin requirements follow the international framework established by the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commission (IOSCO) and the clearing requirements follow IOSCO's mandatory clearing requirements. It is therefore likely that in the event that the UK leaves the EEA the UK will ensure that it adopts these requirements wholesale.
Nevertheless, the UK would be regarded as a "third country" under EMIR and would need the European Commission to adopt an equivalence act under Article 13 in respect of the UK, which, if the UK adopts the requirements under EMIR without amendment, should be straightforward, although it would not be automatic and to date no equivalence decisions in respect of the margin requirements have been granted so it could take some time. If granted equivalence, UK counterparties would then be deemed to comply with the EMIR requirements by complying with the UK's equivalent requirements. In any event, the extraterritorial reach of the clearing and margin requirements under EMIR would mean that many UK counterparties would still need to comply with the EMIR requirements where they are transacting with an EEA counterparty.
MiFID II: trade execution and transaction reporting requirements
Under the directive and regulation replacing the Markets in Financial Instruments Directive (known as MiFID II), sufficiently liquid derivative trades that are subject to the clearing obligation under EMIR will need to be traded on a regulated market, multilateral trading facility (MTF) or a third country trading venue. In addition, MiFID II introduces more comprehensive transaction reporting requirements. MiFID II (which comes into force on 2 January 2018) will also introduce equivalence provisions whereby the European Commission can deem third countries equivalent so that, once registered with ESMA, firms can deal with professional eligible counterparties across the EU (but not retail clients).
Bank recovery and resolution
The Bank Recovery and Resolution Directive (Directive 2014/59/EU) (the BRRD) was implemented in the UK by means of amendments to the Banking Act 2009, and secondary legislation under it and it would therefore remain in place upon Brexit unless specifically amended or repealed.
If the UK is outside the EEA, the UK would need the European Commission to adopt an implementing act under Article 25 of EMIR determining that the legal and supervisory arrangements of the UK with regards to CCPs are equivalent, so that UK CCPs can apply to ESMA for recognition under EMIR, and continue to be able to offer their services to financial institutions based in the EU. Similarly, UK trade repositories may need to be recognized as third country trade repositories under EMIR in order for market participants to continue to report their trades to them in accordance with EMIR. A benefit of recognition under the EMIR third country regime is that CCPs that have been recognized under EMIR, will obtain qualifying CCP (QCCP) status across the EU under the Capital Requirements Regulation. This means that EU banks' exposures to these CCPs will be subject to a lower risk weighting in calculating their regulatory capital.
In addition, given that the BRRD implements the Financial Stability Board's (FSB) global principles on cross-border recognition of resolution actions, it is likely that the UK would seek to retain its existing legislation. However, the UK would need to ensure that the Credit Institutions (Reorganizationand Windingup) Regulations 2004 continues as it ensures the crossborder recognition of resolution actions.
Technically, upon Brexit, English law would become non-EEA law so EEA credit institutions which incur liabilities under English law, would need to include contractual recognition of bail-in clauses in their English law governed contracts, given that under Article 55 of the BRRD these need to be included in every in-scope contract that is governed by a law of a non-EEA country.
The EU Insolvency Regulations may cease to apply. These regulations deal with establishing the primacy of insolvency processes in relation to companies throughout the EU.
The UK has implemented into UK law the Model Law of the United Nations Commission on International Trade Law (UNCITRAL) on cross-border insolvency. The Model Law aims to provide a common international framework in which to deal more effectively with crossborder insolvencies, by enabling recognition of foreign insolvency proceedings and allowing for co-operation between foreign courts and foreign representatives. Only a limited number of EU Member States have implemented UNICITRAL, and there is at present little case law to indicate how the English courts will apply the provisions of UNCITRAL as implemented in UK law.
The Financial Collateral Arrangements (No. 2) Regulations 2003 (which were enacted as secondary legislation under the ECA so, if the ECA is repealed without replacement or saving provisions, it could potentially fall away) implement the Financial Collateral Directive which provides certain protections to financial collateral, arrangements such as those found in credit support documentation published by the International Swaps and Derivatives Association, Inc. (ISDA). If repealed, the extent to which a UK bank holding collateral relying on a financial collateral arrangement is still able to appropriate collateral and close out transactions with the usual protections provided for financial collateral arrangements will depend on the governing law of the security interest or title transfer arrangements and the location of the counterparty. Given the benefits of this legislation, we believe it is likely that the UK would look to re-enact these regulations into UK law.
Impact on UK collateral
Contractual choice of law and jurisdiction
Many OTC derivatives contracts are governed by English law and include a submission to the jurisdiction of the English courts, even if there are no UK counterparties. At present, all EU countries apply the EU rules on governing law embodied in Rome I and Rome II Regulations, which determine the law applicable to contractual and non-contractual obligations respectively (EC 593/2008 and EC 864/2007).
If the UK is no longer party to Rome I, English courts are still likely to continue to recognize the choice of other laws in commercial contracts. The position on choice of law to govern non-contractual claims (which is governed by Rome II) may be less clear. Courts in the remaining EU jurisdictions will continue to recognize the choice of English law in commercial contracts. This is because the Rome Regulations make no basic distinction between the laws of states inside and outside the EU: parties are free to choose either.
Choice of jurisdiction clauses would also continue to be recognized if post-Brexit the UK acceded to the 2005 Hague Convention on Choice of Court Agreements as an independent contracting state. (It is already subject to the Convention following the EU's accession in 2015.) This would result in reciprocal recognition between UK and EU Member States (except Denmark). Accession of countries to the Convention is not subject to the approval or agreement of existing signatories, but it is also not retrospective in effect. This means that the Convention applies only to choice of jurisdiction agreements concluded after the Convention comes into force in the country whose courts are identified in the clause. The clause must also be exclusive and, with limited exceptions, not one-sided.
It is possible that Brexit could adversely affect UK (and European or worldwide) economic conditions. This could trigger an increase in defaults and impact the creditworthiness of counterparties with exposure to the UK, which would make the cost of credit more expensive and could in turn lead to increased collateral requirements. Fluctuations or volatility may also increase mark-to-market exposures under existing derivatives contracts which could trigger obligations to post additional margin. If there is a decrease in the value of UK posted collateral such as sterling cash or gilts, counterparties would be required to post additional margin to cover the exposures.
What you can do now
The new relationship between the UK and the EU could take one (or a mixture of more than one) of the forms set out below.:
At the moment, there are many unknowns and it is difficult to assess the precise impact on derivatives transactions.
EEA / Single market access (e.g. Norway)
Bilateral agreements (e.g. Switzerland)
Free Trade Agreement (e.g. Canada)
Customs Union (covering goods not services) (e.g. Turkey)
Full exit from EU and reliance on WTO rules (default option).
Looking at the first three options, these will all involve - to a greater or lesser degree retaining or mirroring EU laws that apply to regulated businesses that want to be able to use passporting or equivalent arrangements to access EU markets. We would expect the UK Government will seek to preserve these arrangements as much as possible. For example, EEA members must enact EU laws into their own laws.
Third country regimes allow the EU to approve regulated entities to do business in the EU on the basis that their local rules are "equivalent" to EU rules. The easiest way to achieve equivalence is to enact applicable EU laws into the country's local law.
Bilateral agreements may give some more scope for flexibility in local law but again one would expect a degree of similarity between the local law and EU law in respect of the relevant regulated industry.
A customs union would give access to the EU Single Market in goods (in exchange for accepting the EU's external tariffs) but not access to markets in services, which would need to be separately negotiated.
Full exit would mean that the UK would be free to set local rules in respect of relevant regulated industry without concerns over equivalence, although the UK would still be obliged to satisfy its G20 commitments referred to above. It would also, obviously, mean that direct access to EU markets for those UK regulated entities would be unlikely to be available.
The derivatives market is an important market to the UK, and although we expect that the UK Government will be keen to ensure that many of the protections for derivatives transactions remain in place, and that the UK can continue to benefit from any cross-border arrangements. However, we also believe that every business should prepare and be ready to engage with Government to shape the impact of Brexit on their market. This preparation will be key to managing the risks and seizing the opportunities.
The clearing and margin requirements under EMIR have not fully come into force yet, however as it is likely the UK will adopt at least equivalent rules, counterparties should continue with their implementation plans to meet these requirements. Care may be needed to ensure that key definitions still work in existing transaction documentation, and an initial review of documentation may throw up potentially problematic clauses. Market participants will also need to keep abreast of any applicable changes to taxation laws.
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