The past few weeks have been chaotic for both Brexit negotiations and U.K. politics overall. On January 15, 2019, British Prime Minister Theresa May’s Brexit plan succumbed to historic defeat in Parliament. Brexit watchers expected a defeat but the record margin of 432 votes against, and 202 votes for, was still shocking. On January 16, 2019, the Prime Minister narrowly survived a vote of no-confidence in her government. On Monday, she submitted to Parliament a Plan B for Brexit with a vote on such plan scheduled for tomorrow, January 29th. Against this backdrop of upheaval and uncertainty, derivatives markets must still function and, over the past few months, the European Commission ( the “EC” or the “Commission”) has taken steps to mitigate the negative impacts of a possible no-deal Brexit. Nevertheless, issues and market concerns remain.
No Deal Brexit and the Limits of EU Equivalence
If anything, recent activities in the U.K. have heightened expectations of a no-deal Brexit. For months now, investors and advisors, particularly those in the U.K., have been flagging concerns about the impact of Brexit on the derivatives industry, including fragmented markets and liquidity shortfalls.
Facing such risks to the multi-trillion-dollar derivatives market and attendant long-term impacts on its economy, the EC announced on December 12 that it would adopt an equivalence decision to address some, but not all, of the issues associated with a no-deal Brexit. The EC stated it will issue temporary licenses to clearinghouses, recognizing U.K. laws as “equivalent” to EU standards, to ensure that derivatives markets will continue to function with minimal disruption.
Without recognition or equivalence in a no-deal Brexit, EU clients would be cut off from London-based clearinghouses, including ICE Clear Europe, LCH Ltd., and London Metal Exchange’s LME Clear, which are among the most important global clearinghouses.
But the decision sets forth stringent conditions for granting such temporary “equivalence” and subsequent market access to EU customers. It requires that the European Securities and Markets Authority (“EMSA”) to have access to “all information requested” on an “on-going” basis. Under the decision, ESMA can share the information with the European Central Bank and continued clearing approval is dependent upon certain requirements being met.
In addition to the relief granted to U.K. clearinghouses, U.K.-based security depositories will get a 24-month reprieve as a part of the equivalence decision. The Commission also determined it would temporarily exempt investors clearing OTC derivatives from obligations under EMIR to allow them to move such trades from the U.K. to the EU without additional costs or a change of status.
Issues that Remain: Exchange Equivalence
Despite the positive outcomes of the equivalence decision, issues remain. The temporary equivalence that was granted to U.K.-based clearinghouses was not extended to U.K.-based exchanges. EU regulation defines exchange-traded derivatives as instruments traded on an EU-regulated market or on a recognized third-country venue. If the U.K. leaves with no deal, London-based markets would constitute unrecognized third-country venues. Without equivalence from the EC, a listed futures contract opened by a EU bank or corporation in London will be abruptly reclassified as an OTC derivative after March 29, 2019.
With such a reclassification, a user of such a contract would incur higher margin requirements and may be subject to tougher reporting obligations for a user that would normally be exempt from such activity. The distinction matters because of the different regimes that apply to listed and OTC derivatives – the trade details that have to be reported, for example, are different. In addition, determinations about which derivatives users have to clear their swaps are based on OTC notional thresholds; if exchange-traded contracts are added to these totals, some firms that do not currently clear may find they are suddenly required to do so. Trades used for hedging are exempt from this reclassification, as are small derivatives users that are not banks.
Further Relief is Not Forthcoming
Market watchers believe hopes for relief at this late stage may be in vain, especially considering the EC has been warning the market to prepare for over a year. As further evidenced by recent events, all Brexit-related negotiations have been intensely political, with the EC’s equivalence decision applying only to the most systemically pressing concerns instead of ensuring a whole market solution. As European and British regulators continue their conflict, market participants can only watch on wearily.
To find out more about this issue, read the related Client Alert.