Cooperation in Derivatives in a No-Deal Brexit Environment

With the date for the United Kingdom to leave the European Union rapidly approaching, several recent developments concerning derivatives (both legal and political) are likely to be of interest to UK and EU27 counterparties. In this note, we will address guidance provided by European and British authorities concerning the transition as well as feedback circulated by industry associations like the International Swaps and Derivatives Association (ISDA) and the Futures Industry Association (FIA).

Legal/Regulatory Developments

Regulatory authorities reach informal cooperation agreements for sharing of information and CCP access

In anticipation of a hard (no deal) Brexit, the European Securities and Markets Authority (ESMA) has published several recent announcements concerning its plans for managing the impact on the financial markets.

In order to ensure continued market supervision, ESMA has announced the conclusion of two Memorandums of Understanding (MoUs) with the the UK's Financial Conduct Authority (FCA).  The first MoU concerns the exchange of information regarding credit rating agencies and trade repositories (TRs), and the second is a multilateral MoU between individual regulators in the EU and the FCA covering the sharing of information with regard to market surveillance, investment services and asset management activities. While not formal or binding, the MoUs are an indication that counterparties should expect an ongoing unified approach to the regulation of markets and financial services between the UK and the EU, at least where their respective regulatory authorities are concerned.

Separately, ESMA has concluded MoUs with the Bank of England² that aim to ensure continued access to central counterparties (CCPs) and the central securities depositary (CSD) located in the UK. Absent a withdrawal agreement, UK CCPs will no longer be permitted to provide clearing services to EU counterparties in accordance with the European Market Infrastructure Regulation (EMIR),³ unless the CCP is recognized under Article 25 of EMIR (which establishes an equivalence regime for nonmember state CCPs). Recognition is subject to several conditions (including a cooperation agreement between ESMA and the nonmember state's regulatory authorities), but technically cannot be sought until the UK exits the EU, creating a risk that clearing services will be disrupted. Nonetheless, it appears that ESMA is moving forward and intends for recognition decisions to be made in time for exit day. It is important to note that this MoU does not guarantee such decisions will be made by March 29 and therefore does not ensure continued access to UK CCPs following Brexit.

ESMA releases guidance for complying with certain EMIR requirements post-Brexit

Perhaps of more practical application for CCPs is ESMA’s guidance⁴ regarding a host of EMIR requirements pertaining to derivatives that will be affected by the United Kingdom’s withdrawal from the European Union. The guidance addresses steps to be taken by EU and UK counterparties as well as CCPs regarding trade reporting, reconciliation, record-keeping, data access, portability and aggregation.

Upon exit day, the various obligations of EU counterparties regarding derivatives transactions under EMIR will no longer apply to UK entities. Operating on the assumption that no withdrawal agreement will be put in place, ESMA has set forth instructions for disengaging UK counterparties from EMIR's requirements.

For example, with regard to trade reporting, once UK counterparties are no longer required to report their positions to EU TRs *(entities that collect and maintain records of all derivatives contracts), all reporting of outstanding transactions between EU and UK counterparties will cease as of March 29 insofar as concerns the UK counterparty; EU TRs will need to indicate the termination of the UK reports within one month of Brexit. By implication, beginning on March 29 and subject to whatever may be provided for under the MoU concluded between ESMA and the FCA (see above), EU authorities will have zero visibility as to the outstanding derivatives contracts with UK counterparties, making it impossible for ESMA to know the notional values or concentration of risk at any given moment in the derivatives markets.

Likewise, all record-keeping requirements under EMIR will cease to apply to UK counterparties, unless the UK TRs are recognized by ESMA under EMIR’s equivalence regime for nonmember states. If no equivalence determination is made, record-keeping requirements will cease to apply to UK TRs and records of UK-UK and UK-EU27 trades will be terminated. For derivatives contracts executed in the EU with UK counterparties, inter-TR reconciliation will no longer take place. Additionally, UK TRs will no longer have access to EU27 data unless the TR is recognized under EMIR’s equivalence regime. (It is worth noting that an equivalence determination would normally entail the UK and EU entering into cooperation and date-sharing arrangements as well as the adoption of an implementing act by the European Commission, although it remains to be seen whether exceptions will be made to the formalities prescribed by EMIR’s equivalence regime in the event of a hard Brexit.)  Finally, the relevant UK TR will need to ensure the portability of data post-Brexit so that any derivatives subject to EMIR’s Article 9 reporting requirement may be transferred to EU TRs in accordance with the waterfall set forth in the guidance provided by ESMA.

UK readies legislation to replace EU laws and regulations

With regard to the UK, the FCA has published an extensive proposal of changes that will need to be made to its handbook and the binding technical standards that reference EU legislation.⁵ Given the breadth of the changes and the gap in legislation that would be created in the event of a hard Brexit, the Treasury has drafted legislation granting regulators the authority to make transitional provisions connected to financial services legislation. The draft legislation also augments the supervisory authority of the FCA and the Bank of England/Prudential Regulatory Authority regarding UK counterparties in order to ensure a smooth transition.

The UK intends to onshore the Markets in Financial Instruments Directive (MiFID 2) and EMIR regimes for transaction reporting. Similarly to ESMA, the FCA has recently published guidance⁶ as it relates to the new reporting scheme, which system is to be based on ESMA's Financial Instrument Reference Data System (FIRDS). UK firms and venues have been instructed to begin testing the new FCA FIRDS beginning Feb. 21 in preparation for a full transition the weekend of March 31. UK TRs will have to begin reporting transactions on their venue by European Economic Area (EEA) firms that will subsequently not have an obligation to report to the FCA. The same would not apply to UK branches of EEA firms, which should be reporting to the FCA post-Brexit.

Broadly speaking, the message to derive from these announcements by ESMA and the FCA is that the EU and UK governments and regulatory authorities are making every effort to minimize potential disruption to the financial services industry in the event of a hard Brexit. The FCA has published a wealth of information⁷ concerning the transition and the government is working steadily toward putting in place the necessary legislation before exit day in the absence of a withdrawal agreement. Nevertheless, it is difficult to anticipate how such a transition, if it is to occur, might unfold in real time, and (as further discussed below) other critical issues remain unresolved.

Industry Associations Voice Market Concerns

Both ISDA and the FIA have urged that equivalence decisions be expedited for UK trading venues, citing the risk that if these markets are not recognized, CCPs may be unable to comply with obligations under EMIR and the Markets in Financial Instruments Regulation (MiFIR).⁸

The MiFIR⁹ imposed a trading obligation on EU counterparties such that certain classes of derivatives must be executed on regulated markets. Third-country markets may be recognized as equivalent under Article 28(4) of MiFIR, or alternatively, individual member states may grant authorization under Title III of the amended MiFID 2¹⁰. Absent either of the foregoing, EU CCPs would not be able to access UK markets as a source of liquidity for the purpose of complying with the trading obligation under MiFIR. Given the significant number of UK trading facilities currently authorized to trade derivatives that are subject to the clearing obligation, a loss of access to these liquidity sources could be problematic.

Further complicating matters, EMIR requires certain CCPs to clear certain classes of over-the-counter (OTC) derivatives subject to a clearing threshold. Based on the definition set forth in EMIR, any derivatives contract concluded on a UK market that is not a “regulated market” within the definition of Directive 2004/39/EC (the Markets in Financial Instruments Directive, since amended by MiFID 2) shall qualify as an OTC derivative. Consequently, derivatives that would have been considered exchange-traded derivatives will suddenly be considered OTC derivatives, impacting the ability of CCPs to determine whether or not they have met the clearing threshold under EMIR. 

Conclusion

Based on the foregoing concerns, ISDA and the FIA are urging the European Commission to move quickly to adopt equivalence decisions regarding UK trading venues. It will be interesting to see if, following the announcements concerning CCP access, similar announcements regarding UK markets are issued in the coming weeks.

² https://www.esma.europa.eu/sites/default/files/library/esma71-99-1107_esma_agrees_no-deal_brexit_mous_with_the_bank_of_england_for_recognition_of_uk_ccps_and_the_uk_csd_0.pdf

³ https://eur-lex.europa.eu/legal-content/EN/TXT/HTML/?uri=CELEX:32012R0648&from=EN

⁴ https://www.esma.europa.eu/sites/default/files/library/esma70-151-1997_statement_brexit_emir_data.pdf

⁵ https://www.fca.org.uk/publication/consultation/cp18-28.pdf

⁶ https://www.fca.org.uk/markets/market-data-regimes/fca-firds-and-transaction-reporting

⁷ https://www.fca.org.uk/news/statements/brexit-what-we-expect-firms-now#annex

⁸ https://eur-lex.europa.eu/legal-content/EN/TXT/HTML/?uri=CELEX:32014R0600&from=EN

⁹ https://eur-lex.europa.eu/legal-content/EN/TXT/HTML/?uri=CELEX:32014R0600&from=EN

¹⁰ https://eur-lex.europa.eu/legal-content/EN/TXT/HTML/?uri=CELEX:32014L0065&from=FR