Banks warned on holes in EU’s proposed Brexit relief

Potential EC, French and German no-deal relief is expected to be short-lived and incomplete

No-deal brexit

  • The UK and EU27 governments approved a Brexit Withdrawal Agreement on November 25, but the UK parliament could reject the deal.
  • In the meantime, market participants do not know what regime will apply once the UK leaves the EU in March next year: there may be no deal, and no transition period.
  • European authorities have indicated they will consider temporary relief in the event of a no-deal outcome, to avoid London clearing houses ejecting EU members at the end of 2018.
  • However, the details may still be too sparse for CCPs and their members to feel comfortable.
  • Non-cleared trades were excluded from the relief. The question is whether parties to existing EU-UK trades can keep using ‘lifecycle events’ such as compression – and, if not, whether novating them to the continent will trigger clearing and margining requirements.
  • Europe’s supervisory authorities have issued proposals to ease the novation of contracts from UK to EU entities, but policy on lifecycle events is being left to individual member states.
  • Existing French law allows some lifecycle events such as compression, for example, but is less clear on anything that changes the economic terms of a trade.

There may be 28 signatures on the Withdrawal Agreement, but swaps market participants are being warned to continue preparing for legal obstacles in trades between European Union and UK counterparties in the event of a no-deal Brexit. That’s despite moves from EU rulemakers to soften the blow.

The European Commission, European Securities and Markets Authority (Esma) and national authorities in France and Germany have all announced initiatives in recent weeks aimed at avoiding market disruption on April 1, 2019 if the UK leaves the EU without a withdrawal agreement. Some of these focus on the cliff-edge risk facing cleared trades – in a no-deal outcome, EU entities would be barred from using clearing houses in London – while others address the less dramatic questions of whether existing non-cleared trades need to be moved to the continent and, if so, how they would be treated by regulators.

In all cases, there is a danger the relief could be counterproductive.

“It is questionable if this [relief] is good for the market,” says Michael Huertas, a partner at law firm Dentons in Frankfurt. “The moment we have this hope that we have more time, people are lulled into a false sense of security that they don’t need to do anything.”

On November 23, Esma released a statement welcoming an earlier EC contingency plan – from November 13 – which included a proposal for “temporary and conditional equivalence decisions” to ensure European firms can still access UK clearing houses and trade depositaries after March 29 next year. Esma said it had “already started engaging” with UK central counterparties (CCPs).

The most urgent concern among market participants is that the combination of the European Market Infrastructure Regulation (Emir) and LCH’s own rulebook would prevent EU27 members using the UK-based clearer after a no-deal Brexit. Because its rules require it to give a three-month notice period when off-boarding members, LCH might have to start serving cancellation notices before end-2018.

LCH intends to apply for whatever temporary relief is on offer, but a spokesperson for the clearing house declined to say whether the EC and Esma statements provided enough reassurance at this stage to avoid off-boarding clients from the end of December.

“What are the conditions that the EC communication talks about, what is the duration of the temporary equivalence assessment? These are some important areas of uncertainty remaining. [The authorities] have obviously set out publicly that they want to address this issue, but in order to do that, we think there will need to be more certainty provided very shortly,” says Oliver Moullin, a managing director focused on Brexit at the Association for Financial Markets in Europe (Afme).

A clearing expert at an EU27 bank agrees, saying: “If I were a clearing house, I would be positively disposed, but I’m not sure I’ve seen enough yet to say I can definitely rely on what I’ve been told.”

The message from public bodies is they don’t see the necessity to move all euro clearing business from London to the continent now
Oliver Wagner, German Association of Foreign Banks

Although the EC action plan refers only to derivatives, a spokesperson for Esma says any temporary equivalence regime would cover all cleared products available on UK CCPs. That would include cash equities and cleared repo agreements.

However, the clearing expert suggests the EC reference to derivatives alone may have been deliberate, because there are good reasons why European authorities would want to encourage cleared repo trades backed by eurozone government bonds to relocate to a eurozone jurisdiction. LCH already started clearing German and Belgian government bond repo in Paris last year, to add to its existing offering of French, Italian and Spanish bonds.

“If you are talking about government bond repo, you are talking about one of the primary tools of monetary stability, so there is a much bigger case for repo clearing of euro products being within the EU27 – and globally, securities clearing tends to be a domestic business,” says the clearing expert.

But he points out that failing to provide any relief for repo clearing would also force EU members to clear sterling repo in the EU27, which is counter-intuitive and runs against the general principle that government bond trades should be cleared in the home currency jurisdiction.

Long-term plan

The French Autorité de contrôle prudentiel et de resolution (ACPR) held a conference on November 23 which was dominated by discussions of Brexit implications. Marc Peronne, a partner in charge of the financial regulation practice at the Paris office of Linklaters, says national supervisors as well as speakers from Esma emphasised their desire to avoid serious disruption to derivatives markets on April 1.

Emmanuelle Assouan, deputy director for financial market infrastructures at the Banque de France, told the conference the clearing conundrum was regarded as a potential “systemic risk”, and Peronne says French regulators believe there is no viable EU27 alternative to absorb the full volumes of interest rate swaps involving European clients from LCH in the near term.

Frankfurt’s Eurex might disagree with that assessment, but the official line is that any migration of business should not be rushed.

“The message from public bodies is they don’t see the necessity to move all euro clearing business from London to the continent now. They fear that would be too fast, and there could be a risk of financial instability,” says Oliver Wagner, managing director at the German Association of Foreign Banks (VAB).

However, because clearing rules are contained within Emir, they can only be changed through a decision at the EU level approved by all the co-legislators – unlike directives, where individual nations have to introduce their own version of the rules, the text of European regulation is binding for all members.

Several member states, especially France, have long proclaimed their desire to see clearing for European clients revert to the EU27 after Brexit. This means any relief is likely to be short-lived, and may not extend as long as the proposed UK no-deal temporary permissions regime, which is intended to run until December 2020 – when the transition period under the Withdrawal Agreement is provisionally supposed to end.

The standard notice period for the EC to withdraw an equivalence decision is just 30 days, although the EU is now discussing extending this to six months to manage the post-Brexit relationship with the UK more effectively.

“Even if the 30-day revocation is moved out to six months, that’s still not a long time for moving away from CCPs. You are still at a moment’s notice to having to switch your business model away from the UK over into another jurisdiction. A prudent or pessimistic risk manager would be looking at what is the worst-case scenario, as opposed to hoping a number of outcomes will all pan out well,” says Huertas at Dentons.

François Villeroy de Galhau

At the November 23 ACPR conference, François Villeroy de Galhau, governor of the Banque de France, suggested any temporary relief from Emir in the event of a no-deal Brexit should be “not much more than a year”. He also wanted the relief to be “tied to a strict timetable” for the adoption of revisions to Emir – known as Emir II – that will introduce a new equivalence mechanism based on the systemic importance of the third-country CCP. Foreign clearing houses that have systemic significance for Europe – called tier two in the draft legislation – would be subject to direct supervision by European regulators under Emir II, as well as their home jurisdiction.

The clearing expert suggests it would make sense to tie the end of the relief period directly to the passage of Emir II and the completion of EC assessments of UK clearing houses under that new regulation. Hence the CCPs and their members would know at the end of the relief period what their permanent regime will look like, and the EC would know whether or not it is actually necessary to force the clearing of specific products to transfer into the EU27.

“You have a lot of dollar-denominated commodities at LME: is that really a systemic issue for Europe? I think that would be open to question, and the same with sterling futures on Ice, for example. Emir II will enable them to do that analysis at that level of granularity – that would be a constructive way forward,” says the clearing expert.

Non-cleared questions

The issues facing non-cleared trades are more technical, and less dramatic. Lawyers believe even a no-deal Brexit would not threaten the enforceability of trades between UK and EU counterparties, but have been warning for months that the rules of some member states would make it impossible to carry out certain routine, lifecycle acts – such as compression, unwinds, or amending some terms of a trade.

To continue managing these positions as they do presently, therefore, parties may have to move them to the continent. The standard way to achieve this is via novation, but because novation involves closing out each existing trade and replacing it with a new one, there is a question about whether the new trades would be caught by clearing and margining rules that came into effect after the old trade was executed.

Europe’s supervisory authorities have now published a brace of proposals that would shield novations from these two rules, but only in a no-deal Brexit (see box: You’re stuck in an odd position…). The more fundamental question of whether lifecycle events on EU-UK trades are permissible post-Brexit – and therefore whether trades need to move at all – is being treated as a question for each member state.

In its action plan, the EC argued: “There does not appear to be any generalised problem of contract performance in the case of a no-deal scenario.” It acknowledged that certain lifecycle events may require authorisation or exemption, but instructed market participants to “continue preparing for this situation by transferring contracts and seeking the relevant authorisations”.

Some have done so. On November 30, reported that Barclays and UBS have set in train a process through which a court would sanction the transfer of derivatives en masse to European entities, without going through the hassle and uncertainty of novation. In theory, those plans could still be arrested if an EU-UK deal emerges.

Oliver Moullin

Moullin at Afme accepts non-cleared swaps do not present the same cliff-edge risk as CCP off-boarding, but warns questions relating to lifecycle events could mount up quickly after April 1.

“Our view is that there should also be action taken in relation to non-cleared derivatives contracts, to enable lifecycle events to continue. Lifecycle events will occur frequently on an ongoing basis, and we feel there is a need to clarify that they will be able to continue, for firms to be able to continue their risk management under their existing contracts,” he says.

Engaging in non-cleared trades is defined as an investment service in the second Markets in Financial Instruments Directive (Mifid II). As a directive, there is more leeway for national legislation to tackle Brexit-related problems and the loss of Mifid II passporting rights for UK entities in other EU countries.

“As it’s all to do with European passporting, European regulation would be preferable,” says VAB’s Wagner. However, Moullin at Afme says the EC seems to have concluded member-states should address the question individually. Market participants are therefore encouraging other countries to follow the lead set by French and German national lawmakers, who are preparing draft laws that would in each case allow local regulators to take steps to mitigate market disruption after March 29 next year.

Peronne at Linklaters says French clients were initially advised to take a conservative approach and move their UK swaps business into the EU27, because there is limited French case law to help decide what activities might or might not fall foul of local supervisors.

However, the Haut Comité Juridique de la Place Financière de Paris, a consultative committee that consists of representatives from the ACPR and Autorité des Marchés Financiers, as well as senior lawyers, published a report on the impact of a no-deal Brexit in October. This suggested lifecycle events on existing non-cleared trades would not constitute an investment service requiring a French licence under the local implementation of Mifid II as long as they did not involve a “significant amendment” to the transaction. Compression, collateral transfers, contract unwinds and options exercises would all fall below this threshold, and could therefore take place on a UK derivatives book with French clients.

By contrast, based on the case law that exists, the HCJPFP concluded activities such as novations or changes to maturity or nominal value would require a licence, and there is a grey area – described as lifecycle events that would amount to “renegotiating the economic terms” of a trade – which would need to be reviewed on a case-by case basis.

“These are the areas where the new law could alleviate concerns in the market – to set a clearer and more objective distinction between what is allowed, and what is not allowed,” says Peronne at Linklaters.

The French Senate passed the no-deal Brexit law in early November, but the exact details of any relief for non-cleared swaps users will only be contained in subsequent rule-making.

“The French parliament has allowed the government to take the steps necessary to ‘ensure that market contracts can continue through a hard Brexit’. What this tells us is that derivatives contracts and the issues a hard Brexit would raise in this respect are on the radar of the French government, and they will take some measures to probably allow UK banks that have a book of derivatives with French clients to keep them,” says Peronne.

But he emphasises the French government’s appetite to offer swaps users comfort beyond the HCJPFP report will be tempered by its desire to draw more activity to Paris. That will potentially limit both the timeline and the extent of the relief granted.

There are similar concerns around the measures that were attached by the German Federal Finance Ministry as an appendix to a tax law change on November 20. The draft would amend the German banking act to let the local regulator, Bafin, craft a temporary permissions regime in the absence of any EU-wide solution. As with the French relief, there is no detail yet on what that regime might look like.

“A lot of things are possible, but if you start to work through the mechanics of this, you realise it offers respite on a case-by-case basis, which Bafin is in the lead to take decisions on. In the advice we give clients, we say nothing is certain until the dust has finally settled,” says Huertas at Dentons.

Wagner at VAB says it is not just “poker-playing” by regulators that should impel banks to continue their no-deal preparations: “It is not only the supervisors, but also the banks’ clients who are asking for more comfort and certainty.”

Huertas agrees with that sentiment, and says there is little good will left in the EU27 to expend energy on preserving the status of the UK financial sector. He warns that the longer the uncertainty persists, the more European clients will request that their swaps portfolios are moved into the EU27 as a precaution. “The more people move, the [more the] need to have access to the London ecosystem is reduced,” he notes.

Editing by Duncan Wood

“You’re stuck in an odd position…”

Europe’s supervisory authorities (ESAs) have proposed two regulatory technical standards in the past month, which would protect existing trades from clearing and margining requirements if they were novated to EU27 entities in the event of a no-deal Brexit. But some market participants believe the conditional relief could encourage banks to sit on their hands for now.

“The RTSs are helpful, but only if there’s a hard [no-deal] Brexit. It’s definitely incentivising a wait-and-see approach,” says a US bank legal expert.

The time-limited exemption from bilateral margin requirements on novated trades – published on November 29 – accompanies an earlier proposal offering similar relief from the clearing obligation. The new RTS would provide a 12-month exemption from non-cleared margin rules on grandfathered legacy contracts that are transferred from London to EU27 entities – but only if the UK crashes out of the EU without a withdrawal agreement.

The ESAs said in a joint statement that counterparties can begin repapering contracts ahead of the application date, and make novation conditional upon a no-deal Brexit, given the conditional application of the two amending regulations on margining and the clearing obligation.

“I don’t think you can make a novation conditional on a hard [no-deal] Brexit – you either novate or you don’t. It’s unclear what happens if you make the move before a hard Brexit happens. You’re stuck in an odd position whereby if you wait, you get grandfathering relief, but if you go early, you don’t,” the legal expert says.

The earlier RTS, published on November 8, would grant a 12-month reprieve from the clearing obligation for novated trades. For some, the brace of proposals are an important piece of the Brexit planning jigsaw.

“This helps a lot,” says a margin manager at one European bank. “I’m sure the UK regulator will say the same.”

Even in the event of a no-deal Brexit, however, exemption from clearing and bilateral margin rules that are written into the European Market Infrastructure Regulation may only address part of the problem. Novated swaps may also pose an accounting headache. Because the novation process replaces a legacy swap with a new instrument, it also breaks any hedge accounting arrangement previously in place. This means the new swap must be redesignated as a hedge for the underlying risk, potentially creating accounting inefficiencies if pricing has diverged from a theoretical perfect hedge.

Novation of swaps to another legal entity, even within the same group, can also carry longer-term costs. If trades are moved to a smaller European subsidiary, with less capital and higher funding costs, the bank’s valuation of the trade could materially change. Even if trades are moved to an entity with an identical funding profile, a client’s portfolio could suddenly be split across two entities, potentially hiking costs on each if netting opportunities are reduced.

Despite such concerns, the ESAs have no plan to issue further regulatory forbearance.

“As regards non-centrally cleared OTC derivative contracts, these two measures will be the only regulatory measures the ESAs intend to propose to help address the legal uncertainty raised by the withdrawal of the UK from the EU and to ensure a level-playing field between EU counterparties,” the ESAs said in a joint statement.

The problem, according to one industry lawyer, is that many of those issues lie outside the remit of the supervisory authorities.

“Esma and other European authorities are very sensitive not to go beyond their authority. An awful lot of issues the industry is complaining about are not within Esma’s remit, but determining what is subject to the clearing obligation and what is subject to collateralisation are within its remit. This is Esma doing what it can do to help, but there’s a lot more needed that isn’t within its power,” says the lawyer.

Both draft RTSs for Brexit-driven novations have been submitted to the EC for endorsement, and are subject to approval by the European Parliament and European Council.

Reporting by Helen Bartholomew

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