It is way too early to determine the impact on the OTC derivatives world but London is in danger of losing its edge if negotiations do not go their way. Lynn Strongin Dodds reports.
Derivatives as well as other financial markets have calmed down after the initial shock of Brexit but uncertainty will continue to linger overhead until negotiations with the European Union begin. In the meantime both sell and buy-side firms will have to continue laying the foundations for both Level 3 European Market Infrastructure Regulation (EMIR) in 2017 and the completely separate MiFID II reporting requirements which has been delayed until January of 2018.
As Steve Grob, director of group strategy for Fidessa notes, “Until Article 50 is invoked and we actually exit, the UK is still as much a part of Europe as it was before the referendum which means that all the regulation passed by the European Parliament such as EMIR and MiFID, will apply and be enacted into law.’
Equally as important is that the legislation like so many EU rules is derived from international standards set by bodies including the G20, Basel Committee and Financial Stability Board, according to James Doyle, partner in the international debt capital markets team at Hogan Lovells. “Also, the influence the FCA and the UK civil service have had on EU institutions and regulations has been profound. A lot of the measures have been based on English law.”
The Financial Conduct Authority (FCA) has supported this by stating 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.’ Read statement.
The wheels have already started to turn with mandatory clearing of European interest rate swaps making its debut on 21 June by category one firms which include the most sophisticated users of derivatives such as banks and brokers that are members of EMIR-approved clearing houses. The instruments covered are the most liquid type of swaps which are denominated in G4 currencies, specifically – fixed-to-float interest rate swaps, also known as plain vanilla swaps; float-to-float or basis swaps; forward rate agreements; and overnight index swaps.
The next wave – category two firms or financial institutions, such as large buy-side firms and alternative investment funds, which hold swap positions in excess of €8 billion are slated for 21 December 2016. Last but not least are those firms with a low level of activity in interest rate swaps and fall into category three, will have more time before they need to comply with the clearing mandate as ESMA is currently consulting on a proposed delay of this deadline from 2017 to 2019.
As for the legality of the contracts, the FIA commented that the UK leaving the EU will not have any impact on the legal certainty of existing contracts. “Given the importance of the UK derivatives markets, the strong likelihood is that the UK government will be focused on ensuring that current protections for derivatives and collateral arrangements continue in effect and that cross-border trading is not adversely affected,” it stated.
“With some notable exceptions, derivatives documentation is generally based on English or New York law and we expect that will continue to apply to a large number of financial contracts even if we Brexit,” says James Doyle of Hogan Lovells.
“With some notable exceptions, derivatives documentation is generally based on English or New York law and we expect that will continue to apply to a large number of financial contracts even if we Brexit,” says Doyle.
However, divorces are never simple and extricating itself from Europe will be a particularly painful process for the UK government. The exact timing is also clouding the issues. While new Prime Minister Theresa May made it clear she will not press the Article 50 button until 2017 a firm date has not been set which has led to speculation that this could either mean early next year or at the end when the fate of the respective French and German elections is sealed.
There is also a debate among the UK legal fraternity as to whether Brexit is binding after Article 50 is triggered. This would, according to experts give the UK more leverage in exit negotiations although this may be wishful thinking. The general consensus in Brussels is that Britain would need the approval of all other 27 member states to reverse Article 50.
The result is that battle lines are not yet firmly being drawn in the sand but there is jockeying for position behind the scenes and a great deal of conjecture. This is not surprising given that there is a lot of play for – around €1 trn euros are exchanged in Britain every day while the turnover for interest rate derivatives, such as forward rate agreements, swaps, and options is €927 bn euros per day, according to Brussels based think tank Bruegel.
The capital city houses four of the world’s clearing behemoths – LCH.Clearnet (LCH), which owned by the London Stock Exchange Group, Intercontinental Exchange (ICE), the London Metal Exchange and the CME Group.Data from the Bank of International Settlements shows that together they account for roughly 70% of the business while the nearest competitor, Paris, holds just 11 %.
The French, German and Dutch are already rubbing their hands in anticipation. LCH and ICE have clearing house licences in France and the Netherlands, respectively while the latter also clears some euro-denominated credit and foreign-exchange products through its US clearinghouse. However, moving all of their UK operations will be a monumental undertaking while duplicating London’s home grown legal, insolvency and bankruptcy infrastructure will also not be an easy task.
As Grob puts it, “You can’t magically pick up the infrastructure in London and plonk people down into Paris and Frankfurt. The bigger problem is that contracts are based on English law and the British system and you cannot replicate that overnight.”
“Although London has the infrastructure and talent, they may have to consider repositioning if passporting is not granted,” says Vishal Vedi, banking partner of Deloitte. “However, a bank that is based in London with no presence in the European Union could have to establish another entity in the region to serve its customers. We may also see firms move and ‘outsource ‘some of their services back to London.”
However, over time, some market participants are expected to make the move. “Although London has the infrastructure and talent, they may have to consider repositioning if passporting is not granted,” says Vishal Vedi, banking partner of Deloitte. “However, a bank that is based in London with no presence in the European Union could have to establish another entity in the region to serve its customers. We may also see firms move and ‘outsource ‘some of their services back to London.”
The scenario will hinge on the agreement reached and which model the UK opts for. They range from the Norway deal –passporting into the eurozone but with freedom of movement of people – which looks unlikely given immigration was at the heart of the Brexit campaign – or the WTO model espoused by New Zealand, Australia, China and the US whereby they are not part of the single market and people cannot easily move from one country to the other.
In the clearing world, central counterparties will also need to gain equivalency which allows financial firms from outside the EU to offer trading, brokerage and underwriting services to European institutional clients, as long as the regulatory regime where they are based is deemed “equivalent” to that of the EU. US clearinghouses were just given the greenlight but it took around four years of political wranglings and lengthy negotiations with EU policymakers.
The European Central Bank has tried to wrest the activity away from London onto European shores in the past by arguing that euro clearing houses should be in the euro zone. However, the UK challenged this view last year and emerged victorious at the European Court of Justice’s General Court in Luxembourg which ruled that the country could continue as it was part of the eurozone.
That argument will no longer hold water but it is too early to determine the fate of the UK CCPs. “Clearing will be a political football,” says Christian Lee, head of the clearing, risk and regulatory practice at consultancy Catalyst. “There shouldn’t be any reason why UK clearinghouses need to relocate to Europe but politically there will be market pressure. Should there be a scenario where euro clearing is in one entity and sterling clearing is in the UK this will cause major inefficiency and additional cost.”
His colleague, Stephen Loosely, a partner at Catalyst notes “that the problem may solve itself if the Deutsche Börse and London Stock Exchange $27 bn merger goes through. The combined entity will own both LCH.Clearnet and Eurex and members will have opportunities to migrate the liquidity between the two.”
Chris Bates, founding director of Abide Financial, a global transaction reporting specialist, believes the UK could craft its own variation of the derivatives regulation. “I would see no reason for the FCA to create a whole new or structurally different regime but it could perhaps include some enhancements particularly in trade reporting. For example, there are a high number of trade repositories in the UK – four – and one question is do they need to be in Europe.”
Amol Dhargalkar, managing director at Chatham Financial, would also not be surprised to see some modifications particularly when it comes to changing to a one-sided from two sided reporting obligation. This would switch the focus to reporting compliance from trade matching which is more aligned to Dodd Frank.
Looking ahead, Dhargalkar believes that companies will look to re-evaluate their hedges and exposures in the UK. “Some of the questions that will be asked will be around the upfront and compliance costs involved. While the smaller companies may not have much choice around where and who they trade with, but the larger companies will be able to look at other jurisdictions.”
* Want more analysis? Listen to our Brexit Podcast Series or read a Q&A exploring the impact on CCP clearing for OTC derivatives here.
