A well-known and still-unsolved uncertainty for UK parties to derivative contracts with EU27 counterparties in the event of a hard Brexit is whether amending or doing routine novation (“compression”) of such contracts might contravene local laws in the EU27 country concerned about transacting derivatives business (at the moment, the MiFID II passport makes this a non-point). ISDA has commissioned legal opinions in the major EU27 countries, and of course the answers are not always entirely clear or consistent. The ISDA Q&A has more. One solution of sorts is for the UK party to novate its affected derivatives to an EU27 affiliate via a FSMA Part VII transfer: this works so long as the counterparty’s local law recognises the effect of a Part VII order. Barclays is doing this (see Finbrief) to novate some of its ones to its Irish subsidiary. However, that route is not open to many as FSMA section 106(1)(a) requires a deposit-taking business to be transferred, and many parties do not have one. For the rest, it would involve the tedious and time- and resource-consuming process of manually “repapering” them.
But besides this, if the counterparty is an EU27 FC or NFC+, there is another problem. If the contract was done before the clearing and margining rules became applicable to it, it does not, as it stands, have to be cleared through a CCP nor margined. But what would the position be if the UK party novated its position to an EU27 affiliate: would that novation trigger the clearing or margining rules? Readers will remember (see FinBrief) that EMIR article 4 imposes a clearing obligation on institutions which enter into or novate relevant derivatives contracts after the date when clearing starts to apply, and so clearly it would trigger any clearing obligation: hence ESMA’s decision to issue RTS which, if we have a hard Brexit, will create a 12 month window for trades to be novated to an EU27 counterparty without triggering the clearing obligation. This left the margining requirement under Article 11(3) unaffected, and on Thursday the ESAs issued further draft RTS which, in a parallel fashion, create a 12 month window. The market had wanted all legacy swaps with UK counterparties to be exempt from these requirements altogether, but the ESAs considered that this would have gone beyond its their mandate, and the EC has refused to respond to the UK’s temporary permissions regime, so the market is now faced with having to undergo a massive repapering exercise.
And is it a total solution? Not so, as this week’s Risk.net reports that the novation may mean that any counterparty which is currently applying hedge accounting treatment would have problems continuing to do so post-novation (hedged swaps are perfectly offset, and any price swings do not show up in the profit and loss reports: if you cannot hedge account, then you can get unwanted volatility in your P&L).
Head of Knowledge Management (Finance and Projects)
Mark Daley joined DLA Piper in 2015 after over thirty years’ experience as a debt finance lawyer in private practice in London and Hong Kong.