For derivative transactions that are relocated from the United Kingdom to the EEA or newly concluded there, in many cases new master agreements must be concluded between the involved parties. The total volume of European derivatives trading (measured by open gross notional amount) amounted to around €681 trillion at the end of 2019 as announced by the European Securities and Markets Authority (ESMA) (see here). Of this, 8 percent was accounted for by exchange-traded derivatives and 92 percent by over-the-counter (OTC) derivatives. According to the Bank of England, the open gross nominal amount of the non-clearable OTC derivative contracts affected by the Brexit is around £17 trillion between the EU and UK, of which £12 trillion is currently due to mature after 31 December 2020 (see here).
If financial service providers and their customers do not manage to cope with the restructuring and the flood of relocations in time, some hedges may no longer take place at all or only at greatly increased costs.
One of the most important adverse impacts will arise if UK Central Counter Parties (CCPs) are not recognized under EMIR at the end of the transition period. This would affect the ability of EU firms to remain as clearing members of those CCPs, would affect the ability of EU counterparties to continue to clear derivatives on those CCPs and would create huge operational challenges associated with migration of thousands of contracts and their related collateral to alternative CCPs (if this is feasible). This would assumingly give rise to higher costs, increased systemic risk and competition in global derivatives markets and CCPs, all of which would impede the access of EU firms and their clients and counterparties to these markets. In addition, without mitigating action, there might be a wide range of significant impacts on EU firms and EU clients and counterparties of UK firms.
Additional problems arise for EU seated non-financial companies trading commodity derivatives on British trading venues (LME and ICE Futures Europe), as the emergency measures of the EU Commission include British central counterparties and central securities depositories, but no trading venues. Non-financial companies are generally not subject to clearing and collateralization obligations under EMIR. Their OTC over-the-counter derivatives business serves both hedging and trading purposes and is not considered to pose a risk to financial stability below a certain threshold. Such a possibility was deliberately created to make these markets more liquid and thereby enable all companies to hedge commodity price risks. Directly affected by this are primarily raw material-intensive industries such as chemicals or energy, but indirectly also all others that hedge on these markets. Without this risk management, production costs would increase.
With Brexit, the British trading venues will become third country trading venues if they are not previously recognized by the EU Commission under MiFIR or at least Article 2a EMIR. However, the EU Commission has expressly rejected this timely recognition. As a result, commodity derivatives currently traded on the stock exchange will be classified as OTC derivatives under EMIR in future. If EMIR clearing thresholds are thereby exceeded, the non-financial companies concerned would be subject to clearing and collateralization obligations. The companies would then have to reduce their trading volume as a precautionary measure, relocate it to an EEA or recognized third country trading center or stop trading altogether. Possible consequences of such a mandatory restructuring could be a sinking liquidity and rising prices for these commodity derivatives. This in turn could cause some problems in the risk management of non-financial companies that use commodity derivatives in risk management. For enterprises, which trade derivatives on UK trading venues, for which no alternative in the EEA or a recognized third country provider exists, so that for the enterprises concerned trading would be more complex for certain derivatives.
In this regard, the European banking, insurance and securities supervisors EBA, EIOPA and ESMA published a final report (see here) with draft regulatory technical standards on 23 November 2020. The final report proposes to update the EU Commission’s Delegated Regulation on risk mitigation techniques for OTC derivative contracts that are not cleared by a CCP and this covers therefore also the aforementioned commodity OTC derivatives.
Specifically with regard to Brexit, the regulators are against a general grandfathering of legacy OTC derivative contracts between UK and European counterparties. However, under certain conditions it should be possible for UK counterparties to be exchanged by EU counterparties without the need for bilateral collateralization or clearing obligations. This is a temporary exception. Therefore, ESMA has also published a final report (see here) with new technical regulatory standards proposing temporary facilitations for Brexit-related novations of OTC derivative contracts.
Further, ESMA published a notification on 25 November 2020 (see here ). ESMA clarifies that it maintains the existing obligation for investment firms to trade certain derivatives on EU trading venues or on venues recognized as equivalent, even after the end of the transitional period on 31 December 2020. In its communication, ESMA acknowledges that this approach creates challenges for some EU counterparties particularly UK branches of EU investment firms. However, ESMA considers that EU counterparties can meet their obligations under the trading obligations for derivatives (DTO) by trading on EU trading venues or eligible trading venues in third countries, and this situation is primarily a consequence of the way the UK has chosen to implement the DTO.