Author: Sharon Kimathi

Market participants are repapering and novating their current derivatives contracts to an EU27 subsidiary due to the ongoing uncertainty around Brexit – but are finding new issues every day.

In the absence of a third country regime (TCR) agreement, UK financial institutions are either novating, or considering novating derivatives books across to existing or newly-established European subsidiaries. “This may well end up as just a booking arrangement, with no longer-term implications to the City,” said Edmund Parker, global head of structured derivatives at Mayer Brown.

He believes there are many derivatives desks looking at novation as an option. “But it’s not clear if it’s just for booking purposes and the infrastructure will still sit here, or not,” he said.

The real number of personnel relocating to continental Europe from London has decreased from its initial predicted figure of 10,000 people, to roughly over 540 to date since Brexit – but the process is far from over.

A regulatory specialist at an information provider feels that sellside firms are cautious about opening up their legal agreements to novate or renegotiate due to both costs and grandfathering. “They are hesitant simply because they don’t want to jump the gun and novate to an EU27 entity, which incurs high legal costs,” she said.

Grandfathering

Firms are also fearful of the complications Brexit poses to their derivatives contracts, especially when it comes to the concept of grandfathering under the European Market Infrastructure Regulation (Emir).

“If you entered into a derivatives contract before Emir came into force, you would be considered in scope once you novated to an EU27 counterparty, and the notional amount of the contract would then count towards any Emir clearing thresholds,” said the regulatory specialist.

Market participants are working under the assumption that without the requisite piece of legislation or specific post-Brexit policies for swaps, then their grandfathered contracts would no longer be compliant.

See also: Brexit uncertainty creates rise in ManCos

Key Takeaways

• UK financial institutions are novating derivatives books across to existing or newly established European subsidiaries;
• Sellside firms are cautious about opening up their legal agreements to novate or renegotiate due to costs and grandfathering;
• Banks are cost-conscious and are looking at vendors, law firms and alternative legal services providers;
• The buyside needs to know if they are dealing with two entities with the same credit rating within their CSA or if they need to adjust that;
• It can take roughly four to six hours for one contract’s novation or repapering;
• Even finding the appropriate contract can be time-consuming;
• Market participants are working under the assumption that their grandfathered contracts would be non-compliant post-Brexit;
• Lifecycle events will also cause contractual continuity concerns.

The recent Brexit white paper also rules out passporting, but proposes an arrangement between passporting and TCR. At end of the transition period, this starting point would mean that the UK and EU will have identical rules and matching supervisory frameworks in all currently passported areas.

However, it also means that the EU and UK can diverge in their approaches, “but it will be in their joint interests to have common objectives for promoting financial stability and preventing regulatory arbitrage”, added Parker.

Time and money

“All banks are cost-conscious and are looking at vendors, law firms and alternative legal services providers like Axiom, or Thomson Reuters,” added the regulatory specialist. She notes that banks and large investment firms are in the early stages of making that determination and are in the midst of choosing the right staffing in-house, or more likely, via a legal services provider.

“They will try and keep costs down via using alternative legal services providers for simpler negotiations, and then use magic circle firms for more complex contracts,” said the regulatory specialist. That’s because renegotiating a derivatives contract will touch on various points, including tariffs, free movement of employees and supplier contracts.

“It depends on the counterparty for derivatives as it can be as easy as a bank moving their derivatives from London to Paris or Frankfurt – but even that can lead to more questions from the buyside’s standpoint,” she said. Investment firms will need to ask whether or not they are dealing with two entities with the same credit rating within their credit support annex (CSA), or if they need to adjust that CSA to reflect the new entity.

If the new transferee under the novation is in Paris, for example, but that entity is of a lower credit quality, “then the buyside will likely want different terms in their CSA in that scenario, like what the eligible collateral will be, or the minimum transfer,” said the regulatory specialist.

She predicts that such a task can take anyone up to four to six hours per day for one contract. “Then multiply that by the thousands of complex cases,” she said.

She notes that repapering can often lead to an assortment of problems. “Even minor things like getting to the right contact person or finding out that the original counterparty is no longer there,” she said. “Then you would need to know the right person to contact and that’ll lead to a back-and-forth, which takes a long time.”

The regulatory specialist’s clients are also concerned about incurring unnecessary costs or spending their budgets pre-emptively. “Especially if it turns out that they don’t need to novate their derivatives, for instance if they get their ideal scenario of equivalence,” she added.