Leaving the United Kingdom from the EU will no longer allow the use of the European passport to provide the various banking and financial services (lending, financing, trading, asset and investment management and forward financial instrument contracts) from the United Kingdom to EU Member States and vice versa.
The issue is particularly problematic for market contracts using master agreements, which constitute the contractual framework for several underlying relationships that can amount to several billion outstanding amounts depending on the counterparties. We will focus here on the fate of derivative contracts that represent the name
What future for derivatives master agreements?
Derivative transactions are entered into through contracts (called confirmations). These contracts may either be concluded separately, each with its own specific features, or as part of a more global contract called the Framework Agreement (the notion of “framework contract” is provided for in article 1111 of the Civil Code). The most commonly used framework agreements in international relations are the ISDA framework agreements under English law.
However, particularly in EU-UK post-Brexit relations, these operations will be affected. Indeed, if the transactions could have been validly concluded on the date of their conclusion, certain events inherent in the life of the said underlying contracts will raise questions as to the need to have an authorisation in order to carry out the latter and potentially, therefore, an impossibility to carry out these services in the absence of such authorisation.
In practice, there has been a migration of activities from the United Kingdom to France, reflected in the contractual form of transfers of Framework Conventions outside the United Kingdom through “novation” agreements.
These Novations Agreements under English law make it possible to transfer operations from one entity (London) to another (EU) entity in order to obtain its approval. Under French law, it is also possible to transfer contracts from one party to another by several contractual procedures similar, but not in every respect, to English law.
Several mechanisms therefore exist in French law, only here novation and assignment, the most commonly used, are discussed:
the novation that can be assimilated to a substitution mechanism takes three forms: novation by change of creditor, novation by change of debtor and novation by change of obligation. In all cases, novation extinguishes existing obligations between the parties to the original contract and creates new ones. As the obligations are distinct, it leads to the discontinuity of the contracts and potentially to the impossibility of continuing them under previous conditions.
the assignment that can be assimilated to a transfer also exists in three forms: the assignment of receivables, the assignment of liabilities and the assignment of contracts on forward financial instruments. Unlike novation, assignment does not create any discontinuity and obligations therefore continue to exist but between different parties.
In any event, the continuity or discontinuity of contracts will have fundamentally different consequences, in particular:
In addition to the possibilities offered by French law, some authorities have, within the framework of Brexit, proposed an innovative solution, one providing for a so-called “replication” contract, i.e. a contract replicating in the same way the transactions concluded between an entity in the United Kingdom and a counterparty in the EU between two other entities.
While this mechanism seems, in theory, very profitable, the technical nature of the process makes drafting and negotiation as delicate as renegotiating a model that is already known to all market participants.
It is therefore necessary to take the measure of each of the solutions offered in the market and to study them on a case-by-case basis. It is therefore not possible at present under positive law without intervention (provided for in particular in France) by the legislator to state that derivatives contracts will continue to exist and will be executed smoothly after Brexit.
Is Brexit a pretext for contract renegotiation?
The transfer of operations will obviously create in view of the levers that European entities now have to renegotiate contracts on financial futures instruments. In particular, the law and jurisdiction applicable to the Framework Convention must be chosen. To this end, ISDA published in 2018 two new ISDA Framework Conventions, one governed by Irish law and the other by French law, allowing future international relations between the EU and the United Kingdom to be tailor-made.
But the renegotiation will not stop with these clauses alone, it will be necessary to consider the relevance of a “simple” transfer or the necessity when transferring operations:
to audit the portfolios of current and future operations,
to establish the typology of the contractual documentation used,
to analyse the regulatory, accounting and tax impacts related to the choice of transfer method,
to analyse the conditions for recognition (recognition of netting agreements and collateral agreements) and enforcement of contracts abroad, and
to allocate the material and human resources necessary for the renegotiation of these contracts on forward financial instruments and their management following the transfer.
In addition to negotiating the applicable law and/or jurisdiction, the transfer of transactions may also provide an opportunity to renegotiate certain other legal or financial parameters such as:
the eligible and calculation currencies,
the benchmark indices,
The special case of derivatives cleared in a clearing house “CCP”?
Clearing in a clearing house involves the use of a mechanism under continental civil law that allows the extinction of reciprocal obligations between two parties. It is the clearing house that calculates derivative exposures and is responsible for clearing transactions. CCPs are governed by internal rulebook regulations validated/registered by market authorities.
Under the terms of the CCP regulation to which counterparties adhere, the provision of financial collateral between the parties (initial and/or variation margins) to secure exposures incurred under derivatives contracts is sometimes provided for in clearing contracts, in particular for OTC derivatives cleared in chambers.
In the absence of a post-Brexit agreement, the English CCPs will no longer have an authorisation to carry out the clearing.
A proposal for a European regulation on CCPs incorporating the founding provisions of the EMIR regulation now distinguishes between three categories of CCPs:
CCPs of non-systemic importance,
systemically important CCPs, and
systemically important CCPs whose size is considered too large to be subject to the conditions of other systemically important CCPs.
CCPs deemed to be of systemic importance will only be able to provide their services in the EU under very strict conditions defined by the proposed Regulation.
Nevertheless, CCPs whose systemic importance is considered too high will not be able to benefit from the same recognition conditions as those for systemically important CCPs, but may nevertheless apply for accreditation. However, it will remain open to the European institutions (in particular the Commission or ESMA) not to grant this accreditation to certain CCPs.
In conclusion, Brexit will provide an opportunity to review all contractual documentation relating to derivatives and other framework contracts (repos – loans). The timing is nevertheless questionable because other important projects are underway (updating benchmarks, updating prospectuses), a real strategic analysis (costs/risks) of future operations is necessary, inertia is not a solution!
1] See ISDA’s work on taxation during the Brexit.
2] Proposal for a Regulation of the European Parliament and of the Council of 13 June 2017 amending Regulation (EU) No 1095/2010 establishing a European Supervisory Authority (European Securities and Markets Authority) and amending Regulation (EU) No 648/2012 as regards the authorisation procedures for central counterparties and participating authorities, as well as the conditions for the recognition of third-country CCPs: EMIR REFIT.