Although we are reluctant to contribute to the now well-established industry of Brexit crystal ball-gazing, there are a number of documentation issues in which there is at least enough certainty to formulate the questions; definitive answers will attend the daily twists and turns of politics. These issues include: the future status of trade lifecycle events, cross-border cooperation in recovery, resolution and insolvency processes, passporting rights into and from the EU, the use of Benchmarks and choice of governing law and jurisdiction. For each of these areas, in a series of short notes we shall focus on potential deficiencies in current market-standard documentation as well as tracking future developments.
The most material in terms of size and problematic potency is the status of future post-trade lifecycle events. Almost immediately following the June 2016 referendum, a legion of legal firms rushed to pronounce on the post-Brexit continuing validity and robustness of the ISDA, LMA, GMSLA and other market-standard documents. They were (and are) incontrovertibly and obviously correct with respect to the payment and settlement obligations for “legacy” contracts. The initial and unanimous analysis concluded that, subject to future change or anomalous local implementations of MifID 2, payment and settlement of existing derivative trades will be unaffected by any likely Brexit scenario. It was only in late 2017 that attention turned to the panoply of events that might occur beyond settlement. Absent an equivalency decision, immediately post-Brexit, the UK becomes a third-country under MiFID 2. In the (it seems increasingly likely) situation where the UK loses passporting rights, the legality of new UK/EU trades will have to be assessed on a jurisdiction by jurisdiction basis. There is a long list of, hitherto noncontroversial, events which have the potential to convert legacy trades into new transactions, potentially bringing them under the aegis of the MiFID 2 shield.
Although the situation differs with respect to activity, location and precise capacity; in the absence of primary legislation or MifID 2 equivalence, the following events are likely to require national authorisation/licence in each of the applicable EU member states:
The situation differs with respect to activity, location and precise capacity:
- Option exercise- the EU counterparty may require a licence for certain asset types
- Rolling of an open position- a regulated activity for which the UK counterparty will require a licence. EU counterparty will require a licence, although exemptions may apply
- Material amendments- both UK and EU counterparties may require a licence. Jurisdiction-specific with respect to materiality
- Novations- subject to specific case and jurisdiction analysis. Legacy EU entity > new EU entity with no change to the UK party, licence likely required by the UK party. Legacy UK entity > new UK entity with no change to the EU entity, licence required by EU entity and new UK entity. Other novation structures are likely to require at least a licence for the EU counterparty
- Unwinds- a regulated activity for which the UK counterparty will require a licence. EU counterparty will require a licence, although exemptions may apply
- Portfolio Compression by termination with no replacement- a regulated activity for which the UK counterparty will require a licence. EU counterparty will require a licence, although exemptions may apply
- Portfolio Compression by termination with no replacement- a regulated activity (excepting the Netherlands) for which both parties would require a licence. The EU parties may refer to the MiFIR portfolio compression mandate
These events may take place many times during a given trade’s life and far from being true electives, are typically mandated by contract or by regulation. Article 14 of the Delegated Regulation on Clearing Thresholds obliges all counterparties with 500 or more OTC derivative contracts to, at least biannually, analyse the possibility of and engage in Portfolio Compression. In the wider sphere of cross-border contractual commitments, Brexit-imposed illegality is unlikely to be a robust defence in a damages claim for non-performance.
Although belated, the problem is now recognised and has been the subject of jeremiads from the BoE and FCA alike. The questions are clear, the answers less so. From the top down, three possible solutions exist:
- Life cycle event authorisations are included in the final terms of exit “divorce bill”. The final terms will require ratification by all EU countries, and are therefore subject to narrow political interest and subsequent “hijack” by countries for which the issues are less material. Other significant questions of equally mutual interest are currently stymied by the negotiating teams’ inability to square the Brexit circle.
- UK and EU national regulators work in parallel to authorise life cycle events in their respective countries. This approach would be promising if it were a simple issue of ESMA et al. working in tandem with the UK regulators- shared expertise and a history of cooperation would ensure consistency and cohesion. Unfortunately, once the UK is classed as a third country under MiFID 2, the majority of lifecycle events are regulated by national rather than pan-European regulators. Although uniformity of application and implementation seems unlikely, work in parallel with regulators of the five or six larger economies would cover the vast majority of affected contracts.
- Counterparties bilaterally amend contracts to allow for life cycle events. Even if facilitated by a protocol mechanism, this option would require vast resources in time and treasure from institutions already punch-drunk from preceding rounds of regulatory reform and currently committed to the challenges implementing and negotiating existing regulations.
These solutions range from highly unlikely to well-nigh impossible and (transition periods notwithstanding) all are subject to a very tight timetable. While adult intervention is to be hoped for, given the almost complete lack of high-level Brexit progress to date, market participants should be forgiven for not holding their breath. Although the worst case bilateral amendment scenario seems inconceivable, so did Brexit in many quarters. In the spirit of hoping for the best, but planning for the worst; market participants should begin risk and resource analyses to prepare for a possible large-scale repapering exercise.
 Legacy transactions between regulated UK and EU investment firms are estimated to total £20trn., approx.one quarter of both UK and EU non-cleared OTC contracts. Note, that though substantial, this notional figure is not subject to duration weighting
 Note- the Netherlands is sui generis in regard to “third country” novations. The UK counterparty is likely to require a licence when novating out of the Netherlands, including to a newly third country UK entity
 A requirement that is virtually certain to be reproduced in the post-Brexit UK EMIR (unfortunately already dubbed “BREMIR”)