Has the UK’s vote in favour of Brexit had any immediate impact on derivatives transactions?
On 23 June 2016 the UK voted to leave the EU. As a result of this vote there are not any immediate legal changes that need to be made to the financial regulations which regulate derivatives transactions in the UK. This was confirmed in statements from the UK Financial Conduct Authority and the Governor of the Bank of England on 24 June 2016 and therefore market participants should continue to comply with their obligations under UK and EU law.
This vote has however had an immediate impact on derivatives transactions as a result of current market volatility. Some of the immediate consequences of the UK’s decision to leave on derivatives transactions include:
(i) Decline in market value of certain collateral assets. 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.
(ii) Mark-to-market exposures increased. The mark-to-market exposures under existing derivatives transactions have increased which has subsequently triggered a greater number of margin calls.
(iii) Decline in credit ratings of certain counterparties. The credit ratings/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 applicable to such counterparty under their derivatives documentation.
(iv) Trigger Events. 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).
What do you think will be the long-term effects of Brexit on derivatives?
Presently the specific terms of the UK’s exit from the EU are not known and therefore it is not possible at this stage to comment meaningfully on the likely long-term effects of Brexit on derivatives transactions.
However, before the terms of any Brexit are published, 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 not known whether the EU regulation will continue to apply to derivatives transactions in the UK. It is however likely that, until the legislation relating to derivatives transactions in the UK 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.
What impact will there be on ISDA documents?
There is not any immediate impact as a result of Brexit on the 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 not possible 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:
- Section 2(d) (Deduction or Withholding for Tax): Brexit may result in a change in tax law which may trigger certain tax provisions under the ISDA Master Agreements.
- Section 3 (Representations) and Section 4 (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 following the vote have been Section 4(b) (Maintain Authorisations) and Section 4(c)(Comply with Laws)
- Section 5 (Events of Default and Termination Events): With regards to the illegality termination event and the force majeure termination event (in respect of the ISDA 2002 Master Agreement only) 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
- Section 13(a) (Governing law): English courts are required to give effect to the parties’ choice of law set out in section 13(a) pursuant to EU Regulation No. 593/2008 (Rome I Regulation) and EU Regulation No. 864/2007 (Rome II Regulation), 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, under the common law or any replacement regime, the English courts would continue to respect the parties’ choice of English law in section 13(a). However, the position is less clear with regard to the law governing non-contractual obligations
- Section 13(b) (Jurisdiction and Arbitration): The relevant legislation is EU Regulation No. 1215/2012 (Brussels Recast Regulation). 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 or any replacement regime, accept jurisdiction on the basis of the parties’ choice in Section 13(b). Whether a court outside the UK would respect the parties’ choice in section 13(b) and decline jurisdiction in favour of the English courts is a question of the local law of that court; however the expectation is that the submission by the parties to the jurisdiction of the English courts would continue to be respected by courts in EU Member States and in countries signatory to the Lugano Convention post-Brexit. As arbitration falls outside the scope of the Brussels Recast Regulation, arbitration clauses that elect English law, seat and arbitration rules will not be affected by Brexit.
- ISDA Definitions Booklets: 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.
Will there be an impact on the posting of collateral?
As mentioned above, the mark-to-market exposures under existing derivatives transactions will increase as a result of current market 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 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.
What will the effect be on clearing? Will the UK suffer if it is deemed a “third country” under EMIR?
Cleared Derivatives Transactions
There is not any immediate impact on cleared derivatives transactions, however this analysis may be subject to change once the post-Brexit regime is known.
EMIR – “third country” classification
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.
Are there any potential upsides of Brexit for derivatives?
Brexit may result in an increase in certain types of derivatives transactions (for example, hedging transactions and currency swap transactions) which allow market participants to manage their exposure to Brexit however, until the terms of the UK’s departure from the EU and of its new relationship with the EU are known, it is not possible to comment meaningfully on the potential upsides of Brexit in respect of derivatives transactions.
This post was published by LexisPSL Banking & Finance on August 4, 2016.