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Banking & Finance analysis: Nigel Dickinson, partner, and Victoria Nevins, associate, at Norton Rose Fulbright LLP discuss the potential implications of Brexit on the derivatives market
On 23 June 2016 the UK voted to leave the EU. This vote has had an immediate impact on derivatives transactions as a result of the current market uncertainty and volatility. Some of the immediate repercussions as a result of the decision to leave include:
The value of certain collateral assets has declined which in turn has triggered increased collateral posting obligations, increased haircuts and has resulted in certain assets becoming ineligible, in each case making derivatives trading more expensive.
The mark-to-market exposures under existing derivatives transactions have increased which has subsequently triggered a greater number of margin calls.
The credit ratings or creditworthiness of certain market participants have been negatively impacted by the vote. As a result, it may be more expensive for such market participants to enter into new derivatives transactions and to perform their obligations under their existing derivatives transactions. Market participants should also consider whether any credit deterioration of their counterparty has triggered any credit related termination events or events of default under their derivatives documentation.
As a result of the current market volatility, the financial pressures on certain market participants have increased creating a greater risk of them triggering certain events under their derivatives documentation (for example events of default, interest rate step-up, credit events and breach of financial covenants).
There are however not any immediate legal changes relating to financial regulations as a result of the vote. This was confirmed in statements from the UK Financial Conduct Authority and the governor of the Bank of England on 24 June 2016 and thus market participants continue to comply with their obligations under UK and EU law.
Presently there is still a great amount of uncertainty in respect of the specific terms of the UK’s exit from the EU and therefore it is difficult at this stage to comment meaningfully on the likely long-term effects of Brexit on derivatives transactions.
However, before the terms of any Brexit become clear, many market participants have started strategic reviews of their businesses. Part of these reviews include conducting a due diligence exercise on existing derivatives documentation to determine which of these contracts are likely to be affected by Brexit and whether any potential Brexit related risks can be addressed at this stage (for example market participants may consider amending unusual termination rights and any other unusual provisions in their derivatives documentation which may have been triggered by Brexit).
Until the specific details of the UK’s exit from the EU are available, it is uncertain whether the EU regulation will continue to apply to derivatives transactions. It is however likely that, until the legislation relating to derivatives transactions is repealed or amended, the UK government will, so far as practicable, pass a continuity order or savings provision in order to keep it in place.
There is not any immediate impact as a result of Brexit on the International Swaps and Derivatives Association (ISDA) Master Agreements or transactions that incorporate the terms set out in the ISDA definition booklets (assuming counterparties have not made unusual amendments to these Agreements and transactions). However, it is difficult to know the exact impact Brexit will have on the ISDA documentation until the UK’s departure from the EU is known.
We set out below some of the potential impacts of Brexit on certain provisions of the 1992 and 2002 ISDA Master Agreements and ISDA definitions booklets:
Brexit may result in a change in tax law which may trigger certain tax provisions under the ISDA Master Agreements.
There is a strong argument that Brexit will not impact the section 3 representations and section 4 agreements included in the ISDA Master Agreements, provided that the current UK and EU laws and regulations relating to derivatives transactions remain in place without any significant amendments. Agreements of particular interest to market participants post the vote have been Section 4(b) (Maintain Authorisations) and Section 4(c)(Comply with Laws).
With regards to the illegality and force majeure (in respect of the ISDA 2002 Master Agreement only) termination events it is not expected that Brexit would trigger such termination events as a result of a parties performance under an ISDA Master Agreement becoming illegal, impossible or impracticable.
All EU courts are required to give effect to the parties’ choice of law set out in section 13(a) pursuant to the EU Rome 1 and Rome 2 Regulations, irrespective of whether the contracting parties are located in a member state and whether the parties have chosen the law of an EU member state. If post-Brexit these Regulations were not to continue under English law, it is highly likely that the English courts would continue to respect the parties’ choice of English law in section 13(a). However, the position may be less clear with regard to the law governing non-contractual obligations as this is largely untested.
The relevant legislation to consider is Regulation (EU) 1215/2012 (Brussels 1 Recast). If post-Brexit this Regulation did not continue to apply in the UK, it is highly likely that the English courts would, under English common law, accept jurisdiction on the basis of the parties’ choice in Section 13(b). However, the analysis is more complex as to whether a non-chosen EU court declining jurisdiction in favour of the English courts or a court which is not a signatory to the Lugano Convention would also respect the parties’ choice in section 13(b); however there is a strong argument in these cases that the election by the parties of the English courts would be respected. Arbitration clauses which elect English law, seat and arbitration rules will remain unaffected by the post-Brexit regime.
There is no direct contractual impact in relation to transactions that incorporate the terms set out in the ISDA definitions booklets as a result of Brexit. There may however be market movements etc. that trigger certain provisions of the definition booklets (for example disruption events and rates and prices not being available)—market participants are therefore advised to monitor this carefully.
As mentioned above, the mark-to-market exposures under existing derivatives transactions will increase as a result of the current market uncertainty and volatility, which will, in turn, trigger additional margin calls and will result in derivatives transactions becoming more expensive. In addition, certain assets have deteriorated in value as a result of Brexit which will result in increased collateral posting obligations, increased haircuts and certain assets becoming ineligible which in turn may encourage market participants to use different types of collateral in the future.
In respect of cleared derivatives transactions, there is not any immediate impact, however this analysis may change once the post-Brexit regime is known.
If the UK was classified as a ‘third country’ for the purposes of EMIR and the UK no longer continued to benefit under the existing EU regime, it would need to negotiate equivalence agreements with the EU, US and other third country jurisdictions. Such discussions could be drawn out and there would be a period of uncertainty until the equivalence was granted. This would be problematic for UK central counterparties and UK trade repositories, as well as their clients.
Until the terms of the UK’s departure from the EU and of its new relationship with the EU are known, the potential upsides of Brexit in respect of derivatives transactions remain unclear.
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