Derivatives Contracts Will Not Be Void Post-Brexit

There’s a lot of speculation and second guessing about the final form of Brexit and the impact on financial services. But on one thing we can be pretty certain: existing cross-border derivatives contracts between counterparties in the UK and the other 27 European Union (EU) member states will not suddenly become null and void after Brexit. In fact, parties should be able to continue to perform on their contractual obligations – including payments, settlements and collateral transfers – as before, irrespective of the form of the UK’s withdrawal from the EU.

Does that mean there’ll be no impact at all? No. As we flagged in an earlier post, legal analysis conducted by ISDA on six jurisdictions – France, Germany, Italy, the Netherlands, Spain and the UK – shows that some activities that may arise during the life of a typical derivatives trade might be affected. These activities, which include novations, some types of portfolio compression, the rolling of open positions and material amendments, could be classed as a regulated activity, requiring local permissions.

Assuming passporting between the UK and the EU 27 ceases to be available after Brexit, and firms do not have local permissions, then it could become more challenging for those activities to take place between the UK and the EU 27 – although the exact impact differs from country to country. Absent an exemption or an equivalence determination, it could mean that firms choose to transfer outstanding contracts to a locally authorized subsidiary in the relevant jurisdiction in order for those activities to take place without interruption, or otherwise seek a local license.

Either would be time consuming and no small undertaking. But it’s important that the two issues aren’t confused – difficulty in performing some activities like novations and compression is not the same as an inability to make payments or settlements. It doesn’t mean existing cross-border contracts would become invalid after Brexit. It does mean that all parties to EU 27/UK derivatives need to think about how their ability to manage positions might be affected post-Brexit.

This issue can be resolved as part of the withdrawal agreement, or otherwise through coordinated legislative action by the EU 27 and the UK that continues to allow all activities to be taken in relation to existing contracts. That would be equally beneficial to the EU 27 and the UK. For example, it will ensure that outstanding hedges between European pension funds and UK dealers, or between UK corporates and EU banks, can continue to be managed without interruption or the need to be transferred from one jurisdiction to another.

Now is the Time to Think About Benchmarks

With everything going on – implementation of MIFID II, Brexit negotiations and publication of the latest Basel measures – it’s difficult to look too much beyond 2018, let alone the end of 2021. That’s the date Andrew Bailey, chief executive of the UK’s Financial Conduct Authority, has said the regulator will no longer compel or persuade banks to make submissions to LIBOR (although panel banks have agreed to submit until then). But the task of transitioning from the IBORs to new risk-free rates (RFRs) is immense, and the industry can’t afford to kick the can down the road. Everyone needs to start thinking about what this means for them now.

There has been progress. Public-private sector working groups in the US, UK and Japan have already settled on their choice of RFRs, and have begun planning for transition. Europe also now has its own working group of public- and private-sector participants to consider the issue. But there are a whole host of challenges that need to be thought through by the industry – from dealing with possible value transfer and potential liquidity issues, to the requirement by certain investors for term fixings and the possible regulatory and capital implications of switching legacy trades to alternative RFRs. The scale of the task, both in terms of volume of outstanding contracts and the breadth of sectors affected, is unprecedented.

ISDA has decided to think about these issues now. Last month, we announced that we’re working on a comprehensive report that will consider how the IBORs are currently used across financial markets, including in derivatives, loans, bonds and mortgages. It will highlight likely challenges in any transition, and outline identified solutions. Central to the report will be global survey of buy- and sell-side firms, trade associations and infrastructure providers that will take place either side of the holidays.

The intention is to build on the work being done by the various public-private sector working groups, and to consider the issues on a global basis. We’re not saying this report will have all the answers – but it should at least identify the main issues and possible solutions. If you’re closely involved in benchmarks at your firm, then we would value your input.

Separately, work is continuing on an initiative to develop robust fallbacks for certain key IBORs. These two projects are often confused – which isn’t surprising as the issues and challenges are similar. In short, if the RFR initiatives are about encouraging a managed, orderly transition to RFRs with a possible deadline of end-2021, then the fallback work is meant to address what would happen for anyone yet to transition their positions if an IBOR ceases to be published as certain trigger events occur. Having a clearly defined fallback plan written into contracts will help minimize any disruption this might cause.

The ISDA working groups considering the issue have proposed using the relevant RFRs identified by the public-private sector initiatives where they are available. But many of the same challenges facing the transition work have emerged here too – how to minimize value transfer, how to treat the absence of term fixings, how to deal with the fact the IBORs reflect bank credit risk while RFRs do not.

The two initiatives are closely coordinated – many of the same participants, including ISDA, are involved in both. But the two are working to different timelines – a possible end-2021 date for transition, and ASAP for fallbacks. That could mean the solutions developed to address these challenges for fallbacks may differ to the solutions established for transition. All this is taking place against the backdrop of the European Union Benchmarks Regulation, which requires supervised entities to produce plans from January that set out the steps they will take in the event a benchmark ceases to be published. ISDA is currently working on a supplement to help participants meet this requirement.

ISDA will keep the industry updated on all of these initiatives throughout 2018. That’s when we expect the rubber to really hit the road, and for the challenges and solutions to be fleshed out. But market participants shouldn’t wait to start thinking about how a shift from the IBORs will affect them. Now is the time for each firm to comprehensively identify how they use the IBORs – to what extent is an IBOR-referenced rate paid or received on loans, bonds or derivatives, and to what degree is it used as a discount rate to determine liabilities? Only armed with this information will firms be in a good position to meet the challenges faced by these changes.


Monitoring of Basel Rules will be Critical

Publication of the latest package of capital requirements – often dubbed Basel IV – has been a long time coming. A year later than expected after a disagreement between European and US regulators over the level of an output floor, banks finally have clarity on the detail of the final framework.

There was little surprise about the output floor compromise – the 72.5% level was widely flagged in the media in advance. It remains to be seen whether this figure will ultimately mitigate the concerns of those European regulators who were worried about a reduction in risk sensitivity in the framework.

An impact study from the European Banking Authority (based on end-2015 data) indicated total Tier 1 minimum required capital would increase by 15.2% for European Union global systemically important banks (G-SIBs) on a weighted average basis. That compares with an average drop of 1.4% for G-SIBs globally, according to figures from the Basel Committee on Banking Supervision. However, that global figure masks a wide variation in impact, meaning there will be winners and losers. The Basel Committee estimates the total capital shortfall for G-SIBs is €85.7 billion.

Fortunately, there’s time to drill down closer into the impact, and to ensure those banks most active as intermediaries aren’t forced to pull back from providing liquidity. The Basel Committee has set out transitional arrangements that will enable the floor to be phased in over five years, and the clock starts counting down in 2022. Implementation of other parts of the framework will also occur in 2022.

This timing is important. Since the crisis, the largest global banks have raised over $1.5 trillion in new common equity Tier 1 capital. Further changes need to be very carefully monitored during the period until implementation to ensure capital levels don’t rise significantly and become out of synch with risks and returns. That would impact the ability of banks to provide financing, investment and risk management services to the real economy. Where anomalies are spotted, regulators must act to adjust the framework to the extent necessary.

This monitoring should also drill down to the business and product level. While a specific change may have a relatively muted effect on overall bank capital, the impact on a particular business can be much more severe. As a result, banks are more likely to pull out those businesses that are deemed uneconomic.

Take the leverage ratio as an example. Banks are required to count customer cash collateral held at central counterparties towards their leverage exposure and to ignore the exposure-reducing effect of initial margin. This has a negligible effect on overall bank capital, but it significantly increases the amount needed to support client clearing activities. Some banks have opted to scale back or withdraw from the client clearing business as a result, which runs counter to the objectives of the Group-of-20 nations to encourage central clearing.

While the Basel Committee has said it will continue to monitor the impact of the leverage ratio on client clearing, it is disappointing that the requirement has been left unchanged in the final package. National regulators and policy-makers such as the US Treasury and the European Commission have recognized this as an issue, and have already proposed alternative treatments. We think it’s important for the calibration to be globally consistent to prevent regulatory fragmentation and an unlevel playing field.

There were some welcome inclusions. There is a commitment to review the calibration of both the standardized and internal model approaches of the Fundamental Review of the Trading Book, and the implementation date is being extended to 2022. This will give regulators and the industry time to further develop new and largely untested elements, like the new eligibility test for trading desks to use internal models and the non-modellable risk factors framework, and to ensure the calibrations are appropriate. The credit valuation adjustment framework has also been recalibrated – although the new requirements should be fully tested before implementation to ensure the rules are proportionate and sensitive to risk.

Over the coming weeks, ISDA will work with members to review the entire text in detail. In the coming year, we will also provide input and impact analysis as national authorities look to transpose the rules into local regulation. ISDA is committed to ensuring we have a capital framework that is both safe and efficient.