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Habib Motani, partner and global head of the derivatives group at Clifford Chance LLP, and Carolyn Jackson, partner at Katten Muchin Rosenman UK LLP, and both P.R.I.M.E. Finance experts, discuss the impact of no-deal Brexit for derivative contracts and derivative market participants, both in the UK and the EU.
Habib Motani (HM): I am tempted to respond ‘resources’ but I suppose resource is not a challenge for contracts but a challenge for those entering into contracts. Those who have a business of entering into derivatives contracts are undoubtedly seeing their resources stretched very thin as they identify the businesses potentially affected, evaluate the potential effects, develop their strategy for addressing the potential effects and implement it, while at the same time reading, evaluating and understanding the truckloads of new legislative and regulatory publications coming out of not just the UK but also EU27 authorities too. Keeping on top of what legal and regulatory changes are proposed and addressing their impact is a massive, massive challenge, and of course this is still subject to exactly what deal is done, if any, between the UK and the EU.
For a sell side institution, you can break the analysis down into two broad buckets:
Let's start with existing contracts, that is contracts that are outstanding on the date of the UK's exit from the EU. You might think why should Brexit affect contracts that have already been entered into? Surely all that needs to happen is for the contracts to be performed by both parties and for them to gracefully mature? It's not so simple I'm afraid.
The question is whether, post Brexit, doing the things that you will need to do in order to perform the contract (the so-called ‘lifecycle events’) will require regulatory licences or approvals. For example, if pre-Brexit you are a UK institution which sold a physically settled share option out of your London office to a counterparty that is in the EU27, and your counterparty exercises the option post Brexit, can you settle the exercised option by selling the shares to your counterparty for the exercise price. Isn't selling shares a regulated activity? Fortunately, it looks like most EU27 jurisdictions are looking to see this sort of performance of an existing contract as not triggering a new licensing requirement. But it's a country by country question. There isn't an EU wide answer to this, so depending on where your counterparties are, you need to check each and every jurisdiction. Of course the same goes for an EU27 institution with a UK counterparty, although we know the UK is being accommodating.
But it's not just a question of performing existing contracts. What if the counterparty wants to modify the existing contract. Say you have provided an over the counter (OTC) interest rate swap with a $10m notional and the counterparty wants to reduce it to a $5m of notional. That change isn't performing. It's a material amendment. It's effectively the cancellation of the old trade and its replacement by a new one. But do you need a licence to enter into that? And even if you don't, is the amended trade now caught by mandatory margining requirements or mandatory clearing requirements?
Issues are not limited to OTC derivatives. If you have a securitised derivatives programme that has been approved by the UK competent authority and say it is listed on London, today you can passport it to other EU countries to enable you to market your product in those countries. But a programme approved in London post-Brexit will not be passportable in the same way, so you will need to look for another solution to enable you to market in the EU27.
With new contracts the issue is very much the question of will you need an EU27 license to carry on that business, and let's turn to how market participants are addressing this.
In the case of a UK legal entity, even where it already had EU27 branches, the regulatory basis on which, the EU27 branches have been operating has been a passporting of the institutions UK authorisation, and this will not be possible post a hard Brexit. Here strategies have varied. Some have determined to use existing EU27 legal entities as their main EU operating vehicle going forward on the basis that new business will be written through that entity, but leaving the pre-existing business in the UK entity to run off. Others have sought to turn their existing UK entity into a part of an existing or newly established EU entity through use of mechanisms such as a legally sanctioned cross border merger. These have been significant exercises taking many months to achieve. The proposed principal EU27 entity has needed to acquire new licences (if newly established) or extend existing licences (if an existing entity). The regulators in the relevant EU27 jurisdiction have wanted to ensure that the new operating centre has the appropriate capability to undertake the relevant business going forward.
Where the plan has been newly to use an EU27 entity going forward, it has not simply been a question of ensuring it has the appropriate licences, regulatory capital, senior management, risk management and other operational capabilities. There has also been a question of the documentation it will use going forward. For example, if the entity will hold client money, the relevant client money rules often require specific disclosures in the contract and the rules in the new jurisdiction may be different from those in the UK. Similarly, if the EU27 entity is going to use English law contracts going forward, that raises the issue of the need for including provision recognising the resolution powers such as bail-in or resolution stays, of its (new) home regulator–previously an English law governed contract has not caused an issue even for non-UK entities as English law has been an EU law, but that will cease to be the case on Brexit.
In short, market participants have for many reasons been engaged in what for many have been a significant exercise in re-orienting their business mode to enable them to continue dealing with EU27 counterparties post Brexit.
HM: The main issue that market participants have been seeking to address, if pre-Brexit they have been operating their business primarily out of the UK, is how to put themselves in a position to continue dealing post-Brexit with their EU27 counterparties. Similarly EU27 based institutions have needed to consider how to continue dealing with UK counterparties. What this has largely led to is institutions changing the operating centre, and in many cases the legal entity, through which they face the relevant counterparties. Exactly how this has been done has varied and has been very much driven by the starting point.
Where an institution is an EU27 entity that has been operating out of its London branch, the strategy in many cases has been to relocate its business operations so as to operate at least its EU27 facing business out of an EU27 office, usually the country of the head office. Although the EU facing business has been key, in many cases it has made sense for even non-EU facing business to operate going forward primarily from that EU27 base. As a legal entity organisational matter, this has been the more straightforward situation. Changing from one branch to another has generally not required a corporate re-organisation.
Carolyn Jackson (CJ): As the Brexit date of 29 March 2019 looms nearer, the European Commission, the European Securities and Markets Authority (ESMA) and the European Economic Area (EEA) member states have begun to implement or are considering implementing draft legislation to avoid the ‘cliff-edge’ impact of a no-deal Brexit on contract continuity and clearing for derivatives contracts. Such proposed or actual legislative measures, however, are generally limited in scope and temporary. Further, to date no measures have been proposed that would permit UK firms that provide direct electronic access (DEA) to EEA trading venues, or are own account dealing firms that have DEA to EEA trading venues or that trade derivatives subject to an EEA mandatory clearing requirement to continue their activities. Nor have any measures been provided to permit any UK entity currently fulfilling their reporting obligations under the European Market Infrastructure Regulation (EU) 648/2012 (EMIR) by reporting to an EEA trade repository to continue to do so. Even if such additional measures are ultimately in place before 29 March 2019, they too will most likely be temporary. Thus, UK participants that will want to continue to enter into derivatives contracts with EEA counterparties beyond these temporary no-deal Brexit grace periods will most likely need to restructure their businesses during such time period to include an establishment in the EEA.
A no-deal Brexit will result in UK firms no longer being able to ‘passport’ the provision of investment activities and services into the EEA under the revised and restated Markets in Financial Instruments Directive 2004/39/EC (MiFID II) and banking services under the Capital Requirements Directive 2013/36/EU (CRD IV), either on a cross-border basis or through establishing a branch in the relevant EEA jurisdiction. The applicable passported investment activities and services include dealing on own account in derivatives while acting as a market maker, being a member of an EEA regulated market or multilateral trading facility (MTF), having direct electronic access to an EEA trading venue, applying a high-frequency algorithmic trading technique or executing client orders. On the occurrence of a no-deal Brexit, any UK firm currently relying on a passport into an EEA jurisdiction will need to determine if it can continue its cross-border derivatives activities and services without becoming authorised. Such determination must be made for each of the 30 EEA jurisdictions in which it conducts its activities or services, as each jurisdiction has its own national implementation of MiFID II. Authorisation generally requires setting up at least a branch, but many EEA jurisdictions require a local subsidiary. Once a UK entity has set up an establishment in one EEA jurisdiction, it could then take advantage of the MiFID II passporting regime to minimise its EEA presence.
As mentioned above, many of the EEA jurisdictions are considering or have passed legislative measures to enable UK derivatives participants to be able to continue to conduct derivatives activities with counterparties in their jurisdiction without being authorised in their jurisdiction upon the occurrence of a no-deal Brexit. However, the relief granted can differ from member state to member state. Some jurisdictions are limiting the relief to only permit UK participants to continue to perform on existing derivative contractual obligations for existing clients; some are permitting UK participants to enter into new transactions, as well as perform ‘life-cycle’ actions on existing contracts (option exercise, rolling open positions, unwinds, compression, etc.) with both existing and new clients; some provide relief to contracts with per se professional clients and eligible counterparties only; and some jurisdictions are not providing any relief. All such relief is temporary, however, with none currently extending beyond two years, meaning that at some point a UK entity wanting to continue its derivatives activities into the EEA will need to establish a new entity in at least one Member State and become authorised.
UK derivative markets participants continuing to enter into derivatives with one or more of the EEA jurisdictions must also determine how they will be able to comply with the clearing and reporting obligations under EMIR as well as the trading obligation under MiFID II. One of the greatest concerns for the derivatives marketplace arising under a no-deal Brexit has been whether EEA counterparties could continue clearing derivatives on a UK central counterparty (CCP). On 18 February 2019, ESMA adopted recognition decisions for the following three UK CCPs—LCH Limited, ICE Clear Europe Limited and LME Clear Limited. These recognition decisions followed the 19 December 2018 Implementing Decision by the European Commission whereby it granted an equivalence decision on the regulatory framework applicable to UK CCPs. The equivalence and recognition decisions are temporary and will end on the one-year anniversary of a no-deal Brexit. Thus, if the equivalence and recognition decisions are not renewed, EEA clearing members may be required to restructure their existing clearing arrangements to clear on EEA CCPs.
Unlike the relief granted to ensure contract continuity and clearing following a no-deal Brexit, although temporary and in some cases limited, no relief has been granted for UK participants in regards to EMIR reporting and MiFID II trading obligations. Indeed, ESMA and the FCA have instructed trade repositories to assume that there will be a no-deal Brexit and plan accordingly. Following a no-deal Brexit, any UK firm currently reporting its derivatives transactions to an EEA trade repository will be required to report them to a UK trade repository. Not only will any new trades be required to be reported to the UK trade repository, but any changes to any existing open transactions as well. Even if an EEA trade repository is able to set-up an affiliate in the UK, the process will involve new contractual relationships between the UK firms and the UK trade repository as well as the onboarding of open transactions into the UK trade repository.
Similarly, no relief has been granted by any EEA authority to enable UK firms that provide DEA to EEA trading venues or those that deal on own account that have DEA to EEA trading venues to continue such trading operations in derivatives. Additionally, UK firms that trade a derivative subject to an EEA mandatory clearing obligation will not be able to comply with the obligation to trade such derivative on an EEA trading venue if such derivative is also subject to a UK mandatory clearing obligations, as the UK rules will require it to be traded on a UK trading venue. Absent any relief from the EEA authorities, such UK firms will have to cease their applicable trading activities until they have been able to restructure their operations to include an EEA affiliate.
CJ: The implications for EU derivatives market participants of a no-deal Brexit will in some ways be reciprocal to the impact on UK derivatives market participants, although the impact should be softer because only the laws of one jurisdiction rather than thirty need to be considered, the longer transition periods under the UK’s Temporary Permissions and Recognitions Regimes and the UK’s Overseas Person Exclusion. Therefore, it is possible that fewer EEA member firms that would want to continue to enter into derivatives contracts with UK counterparties will be required to restructure their businesses to include an establishment in the UK within the next year following a no-deal Brexit.
Should a no-deal Brexit occur, just as UK firms will have lost the right to passport into the EEA, EEA firms will lose the right to passport their investment activities and services into the UK. To prepare for such eventuality, the UK has passed the EEA Passport Rights (Amendment, etc., and Transitional Provisions) (EU Exit) Regulations 2018, which introduces a temporary permission regime (Temporary Permissions Regime) to enable EEA firms to continue to conduct derivatives activity, among other regulated activities, in the UK for a limited period of up to three years after exit day. HM Treasury has the authority to extend this period by 12-month increments. EEA firms that want to participate in the regime must either send an application for UK authorisation or a notice of their intent to participate by 28 March 2019 to either the Financial Conduct Authority (for investment firms) or the Prudential Regulatory Authority (for credit institutions). While participating in the regime, an EEA firm will be notified of a three‑month period during which they must submit their application for authorisation to the appropriate UK regulator. Additionally, the UK government is making provisions through a draft statutory instrument, the Financial Services Contracts (Transitional and Saving Provisions) (EU Exit) Regulations 2019, to enable those EEA firms that either cannot or do not choose to participate in the Temporary Permissions Regime to continue to service existing derivatives contracts with existing clients.
EEA firms wanting to continue their derivatives activity in the UK only have to consider the regulation of one jurisdiction, unlike their counterparts in the UK seeking to continue to conduct derivatives activities in the EEA, which must consider 30 different jurisdictions. In addition, some EEA firms may be able to avail themselves of the UK’s Overseas Person Exclusion (OPE). The OPE enables a third-country firm to provide investment activities and services into the UK, provided such activities and services are not provided from an establishment in the UK and are either conducted with or through a UK authorised person or are through a “legitimate approach” (essentially requiring any end client to meet certain sophistication hurdles). While the UK is a part of the EEA, it is currently best practice for an EEA firm to passport in, whether or not it can rely on the OPE, because of the regulatory certainty it provides. However, many EEA entities without an establishment in the UK that had previously passported into the UK under MiFID II are currently considering whether they can continue their derivatives activities in the UK without becoming authorised in reliance upon the OPE. Those that can rely upon the OPE will not have to restructure their business to set up a UK establishment to continue conducting their regulated derivatives activities in the UK.
Similar to the Temporary Permission Regimes for investment firms and credit institutions, the UK has implemented the CCP Regulations to provide a temporary recognition regime to enable EU CCPs to continue clearing for UK counterparties for up to three years after a no‑deal Brexit.
As mentioned above, the FCA has informed UK trade repositories to prepare for a no-deal Brexit. Thus, any EEA firm currently reporting its derivatives transactions to a UK trade repository will be required to report to a EEA trade repository following a no-deal Brexit. Not only will any new trades be required to be reported to the EEA trade repository but also any changes to any existing transactions. Even if UK trade repositories are able to set up affiliates in the EEA, the process will involve new contractual relationships between the EEA firms and the EEA affiliate trade repository as well as the onboarding of open transactions into the EEA trade repository.
As with the EEA, the UK regulatory authorities have provided no relief to enable EEA firms that provide DEA to UK trading venues or those that deal on own account that have DEA to UK trading venues to continue such trading operations in derivatives following a no-deal Brexit. Additionally, EEA firms that trade a derivative subject to a UK mandatory clearing obligation will not be able to comply with the obligation to trade such derivative on a UK trading venue if such derivative is also subject to an EEA mandatory clearing obligation, as the EEA rules will require it to be traded on an EEA trading venue. Absent any relief from the UK authorities, such EEA firms will have to cease their applicable trading activities until they have been able to restructure their operations to include a UK affiliate.
Interviewed by Emma Millington.
The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor.
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