A decision by the United Kingdom to leave the European Union could be a bad thing for the derivatives markets. But from a legal standpoint there isn’t a lot that can be done about it in advance, and the existing Master Agreement for derivatives needs no change. Those are the key points in a recent memorandum on the prospect of Brexit available on the website of the international law firm Allen & Overy.
The Bad News
London is, at least “arguably,” the most important center for over-the-counter derivatives activity both in the EU itself and around the globe. Further, it is a critical intersection where the EU meets the rest of the world. Businesses from the rest of the globe set up a local branch in the United Kingdom and then use it as a “passport” to the broader European Economic Area and its derivatives market.
Furthermore, even with regard to a derivatives transaction that doesn’t involve any UK party:
- Many deals are governed by English law and involve submission to the jurisdiction of English courts;
- Key infrastructure elements, such as central counterparties may be established in the UK;
- The contracts may be referenced in GBP or UK assets, or GBP and UK assets may be used as collateral.
The memo provides several reasons for believing that the Brexit will lead to negative consequences, among them deterioration in counterparty creditworthiness, changes in exposures, and a decline in the value of the above mentioned UK linked collateral. It repeatedly acknowledges along the way that the “form and detail of any post-Brexit regime” is as yet unknown, so the true impact cannot yet be definitively expressed. Still…. If businesses with a lot of exposure to the UK economy do become less credit worthy, even at best entry into new derivatives positions or even the maintenance of existing positions for those businesses becomes a trickier and more costly matter than at present.
At worst, the move could trigger termination rights with regard to credit-impaired counterparties.
The Good News
In their lawyerly way, the folks at Allen & Overy have “given some thought to whether Brexit would have a material impact on the operation of agreements based on the standard ISDA Master Agreements.” But, this is the good news in their report, they think not. The documentation should hold up.
The effects of Brexit will not render performance under the existing Master Agreement unlawful, impossible, or impracticable. Thus, they will not trigger “force majeure” terminations. The credit-related terminations that might occur would be such as could be accommodated within the existing ISDA structure.
English law will continue to be an attractive choice for the governing-law clauses of derivatives contracts even after a Brexit, because “the certainty, stability and predictability of English law” will remain in place, as will “the commerciality and expertise of the English courts.”
Relatedly: it seems likely to Allen & Overy that the authorities in the UK will want the EU directives and regulations that pertain to derivatives to continue to have effect after the Brexit, at least until some post-Brexit regime has been negotiated, a process that “could take several years.”
Over time, presumably, a consequence of Brexit would be that the regulations in the UK governing derivatives will start to diverge from the EU rules. This will leave some parties with two compliance burdens where they now have one.
Also, the UK itself will lose some of its leverage, its influence on relevant EU financial services regulations, which could leave firms headquartered there at a competitive disadvantage.
So, what does Allen & Overy recommend to its clients in the derivatives markets, doing business in London and elsewhere? It specifically declines to recommend that they enter into any “specific clauses addressing a Brexit scenario in new derivatives and collateral arrangements” since such clauses “would likely be difficult to draft and negotiate and would have limited benefit.”
But it does suggest that clients review their existing contracts and arrangements to determine which positions are most likely to be affected, how, and whether it is possible to mitigate the risks.
Allen Overy refers readers to a separate paper on the possible tax consequences of a Brexit.