Beyond Brexit: Derivatives Deal a Glimpse into the UK’s Future?

As we inch closer to Brexit day with no deal in sight, financial regulators across the world are looking to mitigate the worst impacts. Market access accommodations intend to ensure continuity of financial activity to and from the UK. A recently penned deal between the UK and US aims to help smooth that transition in derivatives trading. It also highlights once more the critical importance of London as a global financial hub, which has no intention of letting Brexit weaken its position.

Last week, US and UK policymakers – the US Commodity Futures Trading Commission (CFTC), the Bank of England (BoE), and the UK’s Financial Conduct Authority (FCA) –  published a joint statement addressing the continuity of derivatives trading and clearing in a post-Brexit world. The interconnectedness and interdependence of New York and London as financial centers are crucially important for the global derivatives markets. Until this agreement, uncertainty loomed over the over-the-counter (OTC) derivatives market whose value was most recently estimated by the Bank of International Settlements (BIS) at $595 trillion –more than half of which are derivatives contracts from US companies traded into the UK. The BIS also said London and New York host 80% of OTC derivatives contracts.

The OTC derivatives market is essential for companies from several industries to hedge against market risks, so it is crucial to the global economy that London and New York can continue business as usual post-Brexit.

The comments of the signatories to the deal also highlight its significance. Mark Carney, Governor of the BoE, said of the agreement:

“Derivatives can seem far removed from the everyday concerns of households and businesses, but they are essential for everyone to save and invest with confidence. As host of the world’s largest and most sophisticated derivative markets, the US and UK have special responsibilities to keep their markets resilient, efficient and open. The measures we are announcing today will do that.”

Christopher Giancarlo, Chairman of the CFTC, reiterated how important London is in the context of the global trading infrastructure:

 “London is, and will remain, a global center for derivatives trading and clearing. Given the long-established cooperation between the CFTC and the Bank of England, the Financial Conduct Authority, and Her Majesty’s Treasury, I am pleased to announce these important measures. They provide a bridge over Brexit through a durable regulatory framework upon which the thriving derivatives market between the United Kingdom and the United States may continue and endure.”

The agreement looks to coordinate the UK and US on three measures by the end of March 2019 (Brexit’s current deadline):

  1. Continued supervisory cooperation through an updated memoranda of understanding (MoU)
  2. Extension of existing CFTC relief and comparability for the UK through no-action letters
  3. Confirmation of UK equivalence for the US and vice versa

Each of these measures provide assurance to UK and US central counterparties (CCPs) who conduct business in the opposite territory that the current arrangements where they are deemed equivalent will continue to be recognized post-Brexit. This, in turn, provides continuity to banks, asset managers, and others who use CCP services in London and New York.

UK makes post-divorce plans 

The departure of the UK from the EU is often described as a “divorce” as the two long standing partners go their separate ways. In this dynamic, the UK is looking to come out the other side with goals: (a) arrange the terms of departure from the EU (b) create new relationships with trading partners whom they currently transact with as an EU member state.

The UK is already working towards building legal, commercial, and regulatory relationships with global partners for life outside the EU. The fact that the UK will be free from the EU regulatory approval process means that it may be able to frame a nimbler regulatory environment for itself. The recent bilateral agreement with the US on derivatives is indicative of the types of deals the UK will look to strike going forward to protect their central role in global financial markets.

Other recent examples of the UK forging ties with partners beyond the EU include the signing of a mutual recognition of funds (MRF) agreement with Hong Kong in late 2018. Additionally, the UK has taken a leading role through its Global Financial Innovation Network (GFIN). The FCA-lead initiative, which has been dubbed a “global regulatory sandbox,” initially launched in August 2018 and involves the collaboration of 29 organizations across the world. The GFIN cohort includes 11 national regulators and aims to support the advancement and deployment of innovative technology in financial services. This will be an interesting space to watch as it could indicate whether the UK enjoys first mover advantage in becoming a fintech hub for global entities wishing to enter the heavily regulated financial services sector.

Proponents of Brexit suggest global projects, such as the GFIN, are where the UK can benefit from its separation from the EU. However, opponents say leaving the largest trading bloc on the globe reduces bargaining power and market access opportunities. Both the Hong Kong MRF and the GFIN could provide a short-term bell of how successful (or not) the UK will be in forging global ties in a post-Brexit world.