The European Banking Authority and Bank of England are urging one another to act quickly to avoid a calamitous melt down of European OTC swap contracts before the Brexit deadline. While their statements stirred up fear, the practical realities are less dramatic.
Over the last few weeks, the FIFA World Cup has captivated sports audiences across the globe. Within asset management and banking, a new sport has emerged in recent months – Brexit Gazing. It involves players making predictions with varying levels of accuracy about the post-Brexit industry. No players can claim victory or defeat in Brexit Gazing, since the final rules remain unfinished and we won’t be able to tally the final score for years from now – yet popularity keeps rising.
Competition recently hit a fever pitch after the European Banking Authority (EBA) and Bank of England (BoE) demanded the other party take action to avoid a calamity relating to existing over-the-counter (OTC) derivative contracts between EU and UK parties. Top Brexit Gazers predict market turmoil which everyone is powerless to control. The more pragmatic assessment however is much less exciting and acknowledges built in market contingencies. Here are five OTC derivative Brexit Gazing predictions deserving of the red card!
“Most OTC contracts will be void come March 2019”
International Swap Dealers Association (ISDA), the trade body that governs the global OTC markets. has repeatedly stated that it expects legal obligations for existing contracts to continue post-Brexit. The standard ISDA contracts contain continuity clauses already. The industry might need to review certain life cycle events against local country rules, but, deal or no deal, the OTC market will not collapse.
ISDA has been working hard to ensure adequacy of contractual contingencies regardless of the outcome of Brexit negotiations. They recently published Irish and French law versions of their Master Agreements intended to provide options to counterparties who prefer to trade under EU law with European court jurisdiction clauses post-Brexit. English law will become a third-country law after the UK withdraws from the EU, but Irish law is quite similar to English law, and the new agreements reduce the steps required in settling a contractual dispute with an EU/EEA counterparty.
The £29 Trillion OTC Fallacy
Several outlets reported that more than £29 trillion worth of derivative contracts would be at risk because of a “no deal” Brexit. It’s a staggering number, however, there are many technical issues with the measure. £29 trillion is often referenced as the outstanding notional contract values, but notional contract amounts are rarely a true reflection of the size of counterparty risk. That’s because gains and losses are determined by how much the asset underpinning the contract value fluctuates and not by the actual size of the derivative contract. The measure of value at risk is normally calculated utilizing mark to market values which are normally multiple times smaller in value. Also, about half of that total will expire prior to the March 2019 Brexit deadline. Finally, many contracts will hedge or net against one another further reducing net exposure amounts.
The OTC swap and derivative markets are truly global however, London plays a key role as a central hub of activity. Banks and asset managers from all over the world contract with one another using London-based counterparties under generally accepted global ISDA documentation and protocols under the rule of English law. This has been the case for several decades.
Any decision to explicitly force migration of OTC activity from the UK would be costly, inefficient, and have global negative reverberations. As such, in lieu of the UK radically altering its rules, it is likely that for the foreseeable future much of the current OTC activity can remain where it is. Both EMIR (in the EU) and Dodd Frank (in the US) rules include the concept of “third country equivalency” so broadly the current activity should be capable of continuing in the UK post-Brexit.
A Global Issue
Much of the OTC activity in London is conducted for non-EU counterparties. London Clearing House, part of the London Stock Exchange Group, clears more than 90 percent of euro-denominated interest rate swaps. This activity is not solely conducted for EU-based counterparts, in fact, there are many non-EU that conduct their EU-based OTC and clearing activity in London. As such, there are many stakeholders beyond the divorcing couple that would be heavily impacted. Any resolution must be globally acceptable. The global OTC derivative industry cannot and will not be materially disrupted, especially when all parties have legal contingencies available to mitigate the worst-case scenarios from playing out.
“OTC Contracts Risk Becoming Worthless”
Some are concerned that OTC contracts would become worthless post-Brexit. Again, this is simply not true. The majority of OTC derivative contracts in scope may legally be closed out with the required notice period provided to the counterparty. Parties are free to unwind (at loss or profit depending on status of contract). For new contracts, EU stakeholders might re-contract with the UK or other non-EU entity using cleared EMIR contracts to mitigate future risks. There are means within existing rule-sets to manage risk of this highly globalized business.