22 Oct 2018

Brexit: avoiding a cliff edge in financial services

With less than six months remaining until the UK leaves the European Union, there remains very significant uncertainty for Europe’s financial services industry. Although Brexit poses challenges to all sectors of the economy, the potential for disruption is particularly acute for the wholesale financial sector, due to the cross-border nature of much of its business.

Reaching a Withdrawal Agreement that includes a transition period should be the priority for all stakeholders involved. This is important to ensure an orderly withdrawal, preserve financial stability and avoid market disruption.

At the time of writing, there remains uncertainty about whether there will be such a transition period. In the absence of a Withdrawal Agreement, firms are implementing their contingency plans to ensure they will be able to continue to serve their clients. Firms have undertaken extensive planning and are taking steps to adapt their business to the UK’s withdrawal from the single market. However, there are a number of important cliff edge risks that industry cannot tackle alone.

We recently reiterated our concerns in a letter to Commission Vice-President Dombrovskis and urged the European Commission along with member states and regulators to provide certainty on the steps that will be taken to address these risks.

There are a number of cliff edge risks which urgently need addressing, including:

  1. 1.      Continued access to central counterparties

Brexit will have major implications for clearing. London-based central counterparties (CCPs) are currently responsible for clearing euro-denominated derivative transactions worth €100tns each year.

In the absence of transitional arrangements, or recognition under the European Market Infrastructure Regulation (EMIR), UK CCPs would no longer be authorised to perform clearing services under EU law and EU27 firms would no longer be able to satisfy their clearing obligations through a UK CCP. A solution is urgently required to ensure that there is no gap in the ability to access CCPs and to avoid increased capital requirements.

It has been suggested that EU27 banks could move positions to EU CCPs. However, this would be unrealistic in the limited time available, would involve systemic risk, and it is questionable whether the market alone could supply sufficient liquidity for such significant shifts of positions between CCPs. There is also currently no available alternative for clearing some products in the EU27.

There is a real risk that, in the absence of clarity on a solution, UK CCPs may have to start the process of delivering termination notices to their EU27 clearing participants as early as December to ensure that they will continue to comply with the law. This is likely to have a highly disruptive and adverse impact on firms, markets and end-users. Agreeing a legally sound solution, to avoid such a scenario, is required as a matter of urgency.

  1. 2.      Continued servicing of existing contracts

Following the UK’s departure from the single market, current passporting arrangements, which allow UK firms to serve clients across Europe, will cease. As a result, there is significant uncertainty about the ability of firms to continue to serve EU27 clients under existing contracts, particularly in relation to derivatives contracts. 

While firms should be able to continue to perform contractual obligations under existing contracts for OTC derivatives in most member states, it may not be possible to perform essential ‘lifecycle’ events. These include the exercise of options, transfers of collateral, unwinds or portfolio compression. Such lifecycle events occur frequently and the inability to perform them could impair the ability of banks and clients to manage exposures and risks, which is important to both to market participants and regulators.

Transferring legacy clients onto new contracts in advance of Brexit would also be hugely challenging, particularly in a “no deal” scenario. The scale of this exercise would be unprecedented and there is also the risk that clients and counterparties may delay or refuse consent to such a novation process. We recently explored these challenges in more detail in a joint paper with the International Swaps and Derivatives Association (ISDA). We believe that official sector action is required to address this risk and enable lifecycle events to continue to be performed.

  1. 3.      Cross-border data transfers

A third cliff edge risk is the significant uncertainty around the ability for firms to continue to transfer personal data between the UK and the EU27 post-Brexit. After leaving the EU, the UK will become a third country and, without a bilateral agreement, would fall outside the EU’s “safe data” zone under GDPR. This will make it more difficult for banks and other businesses to transfer data between the EU27 and the UK.

The ability to continue to transfer data is vital to support cross-border business. Firms may have a presence in several countries but will often manage certain functions such as HR or financial crime monitoring from a centralised location, as well as engaging with vendors and suppliers based in other member states. Therefore, cross-border data transfers are essential for maintaining day-to-day operations.

If the European Commission deems a third country to have an ‘adequate’ data protection framework in place, then data transfers between Europe and that third country can continue uninhibited. However, a full assessment could only happen after the UK has actually left the EU. We would like to see adequacy determinations initiated by the EU27 and the UK as soon as practicable ahead of the UK’s exit. We also urge the relevant authorities to commit to providing a temporary solution to ensure that there is no gap following the UK’s withdrawal given that the additional safeguards in the GDPR can be costly and lengthy to implement. You can find further detail in our briefing note on data transfers.

Clarity is urgently needed

In light of the ongoing uncertainty regarding the outcome of the Brexit negotiations, and a no deal Brexit remaining a possibility, firms require urgent clarity on actions that the European Commission, member states and regulators would take to minimise the impact on clients, consumers and financial stability. With little more than 5 months remaining, the time is now to provide clarity and reassurance.