THE TICKING CLOCK.
Jannah Patchay, Managing Director, Markets Evolution looks at the ramifications of Brexit on the OTC market.
Like winter, Brexit is coming. Eighteen months is not a long time in the world of financial markets; industry participants can barely implement a new piece of European regulation in that timeframe, let alone successfully execute their unmooring from the single market.
As to what lies beyond the relatively certain, legally well-understood (if somewhat prone to over-enthusiastic regulation), peaceful waters of that great harbour – well, nobody quite knows. And again, 18 months is not a long time in which to plan and embark upon a voyage into the unknown.
Narrowing the focus somewhat, specifically to the challenges facing OTC derivatives markets, does not improve the outlook. By April 2019, the UK will no longer be in the European Union (barring some as yet unforeseen and momentous – and potentially catastrophic – political event).
There are two potential scenarios. Either the UK and the remaining EU 27 will have defined and agreed the terms for a transitional arrangement, or else they won’t, and there will be a cliff-edge, whereupon we all tumble off into an unknown world and the abyss. In the latter eventuality, it is quite possible that the state of OTC derivatives markets will be a minor concern, compared to the massive shocks to the real economy. However, it is perhaps more likely that the significance of these markets will become increasingly recognised, in the absence of legal certainty.
Realistically, thrashing out a full-blown transitional agreement, governing every aspect of interstate commerce between the UK and the EU 27 (with freedom of movement thrown in for good measure) will be difficult by the 2019 deadline. The most likely outcome would be that any transitional arrangement reflected, in large part, the current status quo, albeit on a time-limited basis and would give all parties more breathing space to negotiate the real agreement.
This would though be a politically unpalatable result for many. Those committed to the Brexit project would perceive it as remaining by stealth. It also has the effect of merely extending, rather than alleviating, the heightened state of uncertainty in which business must carry on. It is probably about time that we started thinking about what a hard Brexit might look like, for OTC derivatives at least, and the picture is not a pretty one.
The different roads upon exit
Upon its abrupt exit from the EU, the UK would become a ‘third country’ from a legal perspective. In the financial services world, there are three options. Firstly, a firm could set up a subsidiary in an EU member state, have it authorised locally, and then use its passporting ability (as an EU-authorised firm) to provide services to clients in other member states as well. This requires a separately capitalised balance sheet, and a physical base of operations in the relevant member state – a token shopfront won’t do. Every bank currently operating out of London is considering this option.
Secondly, the firm could establish multiple branches in several member states, obtaining local authorisation for each. This avoids the need for separate capitalisation, and enables the firm to retain its base of operations outside the EU. However, it is clunky and expensive to manage from a regulatory compliance perspective (the firm would need expertise in the local regulatory regime of each member state in which it set up a branch).
Last but not least is the possibility of providing services on a cross-border basis. This requires a closer look at each member state’s provisions in local law, as there is no harmonising regime, at the EU level, for the provision of cross-border services. This is for good reason – it would defeat the purpose of the equivalence regime. Unfortunately, member states are extremely variable in their appetite for cross-border service provision.
For example, The UK’s Financial Conduct Authority’s (FCA) Overseas Persons Exemption creates a fairly liberal open market regime, subject to some restrictions on solicitation of clients and the nature of clients. Other member states’ approaches range from the middle ground (local regulatory permission required, but well short of full authorisation) to completely closed (full authorisation required to provide any in-scope services).
A combination of having a London nexus, alongside relaxed enforcement and lack of regulatory scrutiny in this area has meant that, until now, most firms have operated in blissful ignorance of the true constraints on their ability to provide cross-border services. This is all changing, with the advent not only of Brexit, but also MiFID II, which broadens the scope of activities and services that would be impacted.
As previously alluded, there is, of course, a potential silver bullet in the form of equivalence. An equivalence determination for the UK would mean that the European Commission accepts the UK’s regulatory regime as being sufficiently similar and robust, in terms of both rules and enforcement capability, such that it may be treated on an even footing with the EU. Given the FCA’s key role in defining much of the post-crisis financial regulatory agenda, and its record of going above and beyond what is required in gold plating key EU regulatory measures, this should be a no-brainer.
In practice, an equivalence determination would allow UK firms to continue providing financial services into the EU. Crucially, according to the EU’s own principles for determining equivalence, it would also need to be fully reciprocal, meaning that EU firms could continue freely providing those same financial services into the UK. Politically, there would need to be an appetite from both sides but this dependency could also create barriers to equivalence.
The EU is motivated by a desire not only to preserve the integrity of the single market, but also to firmly demonstrate the disadvantages of exiting it. The UK government, on the other hand, needs to show that Brexit means Brexit, and also to make good on its promises of leading the world through open financial markets – a pledge which presumably, at a minimum, means something a bit different to what we have now.
And what does all this mean, in practice, for market participants and their OTC derivatives contracts? Given the countdown has begun, many firms are not waiting to see what will happen with respect to transitional arrangements. There simply isn’t enough time. They are instead turning their attention and increasing efforts in understanding the multitude of client contracts in place, seeking to future-proof new business whilst ensuring continuity for existing contracts.
This means that change is happening now. It has begun, and in the absence of clear leadership and direction from above, it will take its own shape from the multitude of individual corporate structures and operating models that seek to preserve themselves in a post-Brexit European landscape.