Brexit: What does it mean for derivative contracts?

Brexit: What does it mean for derivative contracts?

Simon Leifer, partner at D2 Legal Technology, says financial firms should not underestimate the time and effort that will be needed to check their legal and derivatives contracts to ensure that they are not caught out by the effects of Britain's exit from the European Union.

The shockwaves from the result of the UK Referendum to leave the EU have continued to reverberate globally since it was announced on 24th June. Although the vote was no more than advisory, the UK Government has committed to honour it and therefore the prospect of the UK’s departure from the EU looks virtually certain to become a reality.

The financial markets can only now begin to estimate the financial costs of the UK’s departure. The immediate negative market reaction was to be expected and uncertainty is likely to persist for an unknown period of time. It is up to the UK to trigger Article 50 of The Lisbon Treaty in order to start the exit clock ticking and from that moment it will be certain that the UK will leave the EU no later than two years from that point in time.

So what are the immediate issues for existing legal contracts entered into by UK entities and in particular what about derivative contracts? Until the UK pulls the Article 50 trigger nothing will have changed and parties to a contract will be bound by exactly the same EU legislation as they were before the vote up until the actual moment of the UK’s exit from the EU. Prudence dictates that parties should be aware of what their contracts contain in case, for example, there are any termination provisions that could be triggered such as material adverse change or force majeure. Governing law provisions could be another area that might give rise to uncertainty because of the way these tie in to EU regulations.

On a more practical level parties will need to consider a number of other matters including but not limited to:
  • Insolvency - post Brexit current EU harmonised rules on insolvency will cease to apply for UK entities and therefore the recognition of UK insolvency proceedings may not be recognised across the EU
  • Collateral - the EU Collateral Directive will cease to apply and national insolvency rules may need to be adjusted to cope with issues such as the new margin reform rules applying to initial margin for uncleared derivatives
  • Descriptions of the “EU” will need to be checked and amended as necessary to ensure that they continue to work as originally intended
  • Deterioration of counterparty and own creditworthiness as a result of market uncertainty leading to increased margin requirements and / or increased transaction costs.

Ultimately, time needs to pass until some degree of certainty can resume in order to be able to determine what the landscape is likely to look like. As and when Article 50 is triggered then we will have much more certainty about the timetable and parties can plan what they need to do in an orderly way. So what should parties do in the meantime? Aside from keeping calm and carrying on, organisations should not underestimate the time and effort that will be needed to check their contracts to ensure that they are not caught out by the effects of Brexit.

Many firms have failed to ensure adequate filing and storage of their financial and non-financial contracts, never mind being on top of the important contractual terms contained within them, as shown by the “minimal” requirements of items such as the CFTC Data Recordkeeping & Reporting Requirements and the EBA’s required detailed records of financial contracts in relation to the BRRD.

Brexit may not happen until 2019 but if history tells us anything it is that lack of preparation generally for these types of events can have unintended material adverse consequences. Preparation is therefore key to ensuring an orderly management of key contracts and lack of preparation will only make it that much more difficult and costly for firms to navigate through the changes that Brexit will undoubtedly bring.

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