On 23 June 2016, the UK electorate voted to leave the European Union in a so-called Brexit referendum. This historic decision raises significant challenges and potential opportunities for financial services activity within the UK and the European Union.
The consequences of the decision to leave the European Union will not be known for some time. In the short term, nothing has changed. The referendum result does not have automatic effect and the UK remains a member of the European Union and must continue to abide by European laws and regulations.
EU law will continue to apply in the United Kingdom throughout the exit negotiation process. Therefore, all existing EU laws and regulations will remain in full force and effect until the terms of the United Kingdom’s exit agreement have been concluded.
In order to effect the UK’s exit from the European Union, it is likely that the UK will enact an amendment to the primary legislation which governs its relationship with the European Union, the European Communities Act 1972. This would be accompanied by a decision on which elements of European law applicable in the UK should be repealed, amended or replaced. However, the UK’s legislative timetable will be dictated by its requirements under European law.
Thoughts for particular practice areas
We have considered some possible implications for areas of financial services activity and some high-level thoughts are set out below.
- There has been a general move towards a Capital Markets Union (CMU) across the EU. Depending on the method of exit, the Capital Markets Union rules (such as the new Prospectus Regulation) may not apply to the UK. This is likely to give rise to divergence in disclosure standards and document formats between the UK and the EU. This may lead to different forms of prospectus (or wrappers) to enable deals to be offered into the UK and the EU.
- Rules governing market conduct which are largely based on the Market Abuse Regulation1 (MAR) in relation to the civil law implications would also no longer apply to the UK unless the method of exit was such that these rules continued to apply. This may give rise to challenges in carrying out stabilisation activities in relation to securities to be admitted to trading in the UK and in the EU, as the parallel regimes may not be consistent with each other.
- Care will need to be taken with risk factors, both generally in relation to the UK exit and specifically where a business sector is particularly exposed to disruption as a result of ceasing to be an EU business.
- The majority of managers of European CLOs are based in London and comply with the European Risk Retention rules, either by acting as sponsor, or by establishing an entity to act as sponsor which has to be MiFID-regulated. Upon Brexit, unless there are saving provisions put in place, UK managers would no longer be eligible to act as sponsors. Unless deals are restructured to use originator risk retention techniques, this would create liquidity issues for existing deals with UK managers as they could not be purchased by European institutions and would prevent new deals being issued by UK managers to European institutions. Conversely, CLO managers that are based and regulated in other European countries will have an advantage. It is likely that deals could still be structured using the originator risk retention method, although these need to be analysed carefully on a case by case basis.
- The financial and economic volatility that is expected to stem from the referendum and Brexit may have an effect on the financial strength or perceived financial strength both of UK based counterparties to CLOs (hedging counterparties, account bank, custodians) but also to UK based borrowers of leveraged loans which form part of a CLO portfolio. Actual rating downgrades of counterparties and/or defaults in respect of underlying assets, if any, would have a negative effect on a CLO and returns to CLO investors.
- CLOs typically have a very prescriptive list of modifications that can be carried out by the Issuer without having to obtain the noteholder’s (and sometime other agent’s) consent. We would expect to add a reference to any changes required to comply with Brexit to be included in this list going forward so that the relevant CLO can be brought into line with any relevant legislation in due course.
- CLOs have very detailed risk factors in the offering documents and we would expect to include relevant risk factors on the possible outcomes of Brexit for CLOs in deals going forward.
- The preferential treatment for covered bonds in EU legislation is based on Article 52(4) of the Undertakings for the Collective Investment in Transferable Securities (UCITS) Directive. One of the main requirements is for the Issuer to be a credit institution with its registered office in the European Economic Area (EEA). Depending on the exit mechanism negotiated, UK covered bonds may no longer satisfy this requirement. This would put UK covered bonds at a competitive disadvantage to ones issued by credit institutions within the EEA.
- The financial and economic volatility issues could also impact UK housing markets, residential mortgages being the main assets in the cover pools for UK covered bonds. In addition, any rise in interest rates could also lead to an increase in asset defaults. Any fall in the performance of the assets in the cover pool could lead to downgrades and defaults.
- The UK would not benefit from any new framework for covered bonds coming out of the Capital Markets Union initiative unless the UK expressly opted to incorporate any amendments.
- UK covered bonds will, however, still be eligible collateral for Eurosystem operations as the Issuer can be in a G-10 country which would include the UK.
- UK-based derivatives businesses currently use EU financial services regulation to 'passport' their activities into other EEA member states and conversely EEA businesses established outside the UK do the same to offer services within the UK.
- There may be rating implications for derivatives businesses in the UK, either as a result of any downgrading of the UK’s own credit rating or as a result of the perceived impact of Brexit on financial institutions own businesses. This may trigger extensive collateralisation requirements or replacement obligations in relation to structured finance transactions.
- For contracts with base-currencies other than sterling, any fall in the value of sterling could increase the collateral requirements if sterling assets are worth less under those contracts.
- Standard ISDA documentation should not be affected by Brexit. However, businesses should review their documentation for any non-standard termination clauses.
- Much of the wider regulatory regime applicable to derivatives in the UK derives from EU legislation, including for example, the EMIR regime. It will depend on what is negotiated at the time of exit but it is likely that EMIR will continue to be relevant in the way that it is currently relevant to parties outside the EU. Also, the UK, as one of the main drivers behind the EMIR regime, is likely to seek to implement an equivalent regime.
- The draft Securitisation Regulation (STS) and the CMU are work in progress. Industry bodies such as ICMA will continue to work on their formulation. It is unclear how the Bank of England and its EU counterparts will relate to one another over the two-year withdrawal period.
- The current EU debate around regulation and risk retention will continue and will produce a regime that applies across the EU. The UK is likely to develop its own regime if the EU regime is no longer applicable post- Brexit, which may lead to costs of dual compliance but also opportunities to arbitrage the regimes.
- Just as for CLOs, we would expect to include relevant risk factors on the possible outcomes of Brexit for securitisations in deals going forward.
For so long as Article 50 of the Treaty of Lisbon 2009 is not triggered by the UK, and the withdrawal negotiation process has not formally commenced – and the method of withdrawal remaining unclear – discussions on the exact and precise repercussions of the Brexit referendum in financial markets are of necessity speculative. In the short term, nothing has changed and EU legislation remains applicable for all transactions.