Brexit update: cross-country recognition of derivative trading and infrastructure

07 March 2019

On a departure of the United Kingdom from the European Union on 29 March 2019 without a transition agreement (a hard Brexit), UK entities would, absent agreement to the contrary, lose:

  1. the benefit of equivalence arrangements agreed between the EU and the US regarding derivatives; and
  2. the existing broad rights of UK and EU27 firms to trade derivatives on markets in each other’s jurisdictions.

This means that UK firms trading on US markets would cease to comply with the UK’s post-Brexit implementation of the European Market Infrastructure Regulation (EMIR), while US firms trading derivatives in UK markets would cease to comply with Dodd Frank. At the same time, the broad rights of UK and EU27 firms to trade in each other’s jurisdictions will be lost unless replaced or extended (whether permanently or temporarily).

This note briefly describes the broad grandfathering arrangements that have now been agreed between the UK and the US to allow UK firms trading on US markets to comply with the UK’s post-Brexit implementation of EMIR and US firms trading derivatives in UK markets to comply with Dodd Frank. We also cover the lesser arrangements that have so far been put in place between the UK and the EU covering derivatives clearing and derivatives traded over exchanges.

Joint statement by UK and US authorities on continuity of derivatives trading and clearing post-Brexit

In a welcome move, on 25 February 2019 the relevant UK and US regulators made a joint statement agreeing to grandfather a broad range of existing EU-US arrangements regarding derivatives trading and infrastructure into the post-Brexit UK-US relationship.

Under the announcement, the regulators reconfirmed their mutual recognition of central counterparty clearing houses (CCPs) for cleared derivatives transactions, allowing US firms to treat derivatives cleared by UK CCPs as equivalent to those being cleared by a US CCP (and therefore compliant under Dodd-Frank), and vice versa. The importance of this was underlined by the regulators in their observation that around 97% of all interest rate derivatives that are cleared globally are cleared in London.

The US Commodity Futures Trading Commission (the CFTC) will grant UK firms the same reliefs currently given to EU firms, including those relating to introducing broker registration, swap data reporting, and the trading and clearing of inter-affiliate swaps. Further, the CFTC will prioritise other no action reliefs around matters such as margin requirements in order to avoid disruption.

The UK authorities have equally confirmed that US trading venues, firms and CCPs will be able to continue providing services in the UK. This will allow UK entities to comply with anticipated post-Brexit UK derivatives regulations.

The full text of the joint statement is here.

EU and UK: recognition of CCPs, but lack of full recognition of trading venues

By contrast, the arrangements between the UK and EU regarding derivatives traded over exchanges and trading venues post-Brexit remain limited, and a reduction from the current cross-border rights UK and EU27 firms enjoy. Notably, while the EU and the UK have recognised each other’s CCPs should a hard Brexit occur; they have not given full recognition of each other’s derivatives trading venues.

On 18 February 2019 the European Securities and Markets Authority (ESMA) announced that if a hard Brexit occurred, ESMA would temporarily recognise LCH Limited, ICE Clear Europe Limited and LME Clear Limited as able to provide their services in the EU. This removes a significant potential source of disruption in that EU27 firms will not be obliged to clear their derivatives with an EU clearing house even if the UK exits the EU on 29 March 2019 without a transition agreement. The ESMA announcement is here. We do, however, note that the EU’s proposed “Location Policy” regarding CCPs remains a particular concern for LCH Limited’s continued ability to clear euro-denominated derivatives for EU27 firms.

The UK has similarly avoided the cliff-edge risk on a hard Brexit for UK firms using EU CCPs by providing that EU CCPs will be able to provide services to UK firms for three years after exit day if they notify the Bank of England (BoE) of their intention to do so and are currently permitted to provide those services in the EU. If any EU CCP fails to notify the BoE then a temporary permission of one year will still be granted to allow for an orderly run-off of positions. The current list of third country CCPs that have notified the BoE of the intent to provide services is here.

The position relating to trading venues for derivatives is less settled.

On 26 February 2019 the UK Financial Conduct Authority (FCA) confirmed that it had recognised five EU securities and derivatives exchanges as recognised overseas investment exchanges (an ROIE), and that five more have applied for recognition. This does not amount to an equivalency determination, but allows the EU exchanges to continue to offer services in the UK. The relevant FCA webpage is here.

However, the EU and the UK have not agreed a full equivalency determination of each other’s exchanges or trading venues, and if this remains the case in a hard Brexit there would be two significant impacts for EU and UK firms, including UK firms trading on an ROIE:

  1.  firms that trade exchange-traded derivatives on exchanges that lack an equivalency determination will be treated as if they had entered into OTC derivatives, which could cause those entities to exceed thresholds for the use of OTC derivatives, such as the maximum volume of OTC derivatives that may be held before the derivatives clearing obligation applies; and
  2. firms under a mandatory trading obligation regarding OTC derivatives will be unable to meet that obligation by trading on exchanges or trading venues that lack an equivalency determination.

Given that many types of derivatives are predominantly traded on UK venues rather than the EU, operators of some UK venues are setting up affiliates in the EU27 to act as trading venues. It is likely though that as many UK and other third-country firms will not be participants in those EU venues, liquidity will be lower than on the UK venues.

Efforts are continuing to lobby for mutual recognition of derivative trading venues to avoid the above concerns, with ten industry associations writing to the European Commission on 1 March 2019 to urge the Commission to agree mutual recognition.