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FOR all the talk of banks deserting London as Britain’s departure from the EU looms, relatively little attention has been paid to the derivatives market. Yet this is a crucial area of business for British-based banks. The City handles a big chunk of the market, including 39% of the market in interest-rate derivatives alone, where global daily turnover averages $3trn. The rest of the EU accounts for just 9%. Brexit seems sure to cause significant disruption. Mark Carney, the governor of the Bank of England, recently warned that the very “legal validity” of pre-existing derivatives contracts could be put into question.
Brexit-related discussion of derivatives has tended to focus on the role of clearing-houses, which ensure that a contract can be honoured even if one side goes bust. Since the financial crisis, most countries have made it mandatory to clear derivatives trades. LCH, a clearing-house in London, clears over 50% of interest-rate swaps across all currencies; London houses clear 75% of swaps in euros and 97% of those in dollars. The EU has mooted the idea of forcing euro-denominated derivatives to be cleared within the EU, to ensure the euro zone’s financial stability. There is an obvious commercial incentive, too. On October 9th, Eurex, LCH’s largest continental competitor, based in Frankfurt, announced that it would allow banks to share in the profits from clearing. This brings its structure closer to LCH’s, in the hope banks will shift business away from it to Eurex.
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Yet about a quarter of derivatives contracts are not cleared—often because they predated the new rules. Such contracts are a worry. A “hard” Brexit, which more and more firms and even regulators feel they have to prepare for, implies a loss of the “passporting” rights that allow financial firms to do business across the EU. British-based banks would no longer automatically be licensed in the EU. They would lose the right to sign new derivatives contracts with European counterparties. And the status of their existing contracts would be thrown into doubt.
To be clear, not even the hardest of Brexits would void contracts at once. But derivatives contracts and portfolios are often adjusted. One method is “compression”, where some (or all) offsetting contracts are terminated and replaced with an equivalent derivative. Another is “novation”, where an existing contract is transferred to a different legal entity. Under the rules in six large EU member states analysed by the International Swaps and Derivatives Association (ISDA), a global trade body, novations and compressions would be considered regulated activities. Without a “passport” or an equivalence decision, these options would no longer be open to British counterparties. Unable to readjust their “legacy” portfolios left in London, EU firms would struggle to manage the risks.
Another option would be for banks to transfer all their pre-existing contracts to a legal entity within the EU. But Deepak Sitlani of Linklaters, a law firm, says such a step would mean the contracts would lose their “grandfathered” status. They would suddenly be subject to the clearing requirements, as well as new ones governing collateral. Besides being a short-term shock, this would raise costs in the long term.
The sheer logistical hurdles should not be underestimated, either. As Peter Werner of ISDA points out, novation requires the consent of all counterparties on any given contract. This could prove a nightmare: the Bank of England reckons tens of thousands of firms could be affected. And each contract must be rewritten: Allen & Overy, another law firm, has over the past few months been building an automated system to help in this mammoth task.
A simple solution that would avoid all these complications, notes a senior British official, would be a law, passed in Britain and in the rest of the EU, to grandfather pre-existing contracts. If broad enough it could encompass other sorts of contract too, such as those in insurance, which face similar problems. Alternatively, all these issues could be incorporated in the Brexit agreement. However, the chances of that seem ever slimmer. In the huge pile of outstanding issues the Brexit negotiations have to wade through, the fate of the derivatives markets is probably not near the top.