Back to the future and beyond
08 January 2019
Michael Huertas of Dentons discusses the uncertainty and challenges around Brexit
Image: Shutterstock
Looking back in time, 1986 was not only a remarkable a year for an evolving European securities lending market but also for Great Britain as the UK leader on European integration. Skip forward 30 years to 2016, and the Brexit referendum started what has for some time now been the UK’s rather difficult journey of leaving the European Union. Almost 1,000 days since that referendum and with less than 100 days until exit date, time is rather tight.
What’s ahead?
As the EU faces a tough year of Brexit challenges, it also faces a shift in the EU political executive and supervisory policymakers. A new first-time Romanian presidency of the Consilium, representing the helm of EU executive governments, took up its role on 1 January 2019 and will contribute to the debate on deciding on Brexit. A new set of members of the European Parliament will be voted in following the May EU Parliamentary elections, and a new European Commission will guide financial services regulatory policy as well as a possible Capital Markets Union 2.0 reboot and finalisation of Banking Union, Pillar III.
That sense of change is also being at the level of EU financial services supervisory authorities, who started the year by strengthening calls for greater supervisory convergence in the EU27. As the UK begins to diverge, greater powers for the ECB and the European Supervisory Authorities (ESAs) will focus on the conduct of business supervision and on-site inspection as well as greater and direct oversight in respect of financial services firms as well as market infrastructure providers.
Moreover, many non-bank financial services providers undertaking ‘bank-like activity’ may find they are under greater scrutiny as shadow banking and increased reporting is back on the agenda.
Reporting is likely to be a familiar topic for most firms affected by the Securities Financing Transactions Regulation (SFTR), which itself has been partly delayed by Brexit. This is partly due to technical discussions on revisions to European Market Infrastructure Regulation (EMIR). The European Commission has now set out the final seven commission delegated regulations, which include clarity around regulatory reporting start dates and clearer timelines so firms can focus on other forward-proofing of arrangements as phased reporting obligations come in place.
For many, that has also meant picking up the pace on Brexit-proofing legal entity structures as well as documentation. This trend is likely to continue, not only due to supervisory pressure from the European Central Bank (ECB) and the ESAs, who each published further updates to prescriptive Supervisory Principles on Relocations (SPoRs), but also because the securities lending market, not having fully found a consensus on whether the bulk of pre-crisis documented financial transactions need to be repapered and how to document new post-Brexit transactions on the first day of trading and notably from where.
While there is talk of the ESAs and/or the ECB potentially getting powers to issue no-action relief letters or similar measures, the mood is—as with SFTR-compliance—that firms need to prepare and work towards compliance by a specific date that is set by the supervisor and do so in a manner that meets the SPoRs.
Any equivalence measures granted to permit access from the UK’s new status as a third-country are very much conditional and can be withdrawn.
Work still to be done
An area where further action is required is still around contractual continuity for existing contracts as well as the documentation terms for future financial market transactions—and thus securities financing transactions. The term ‘contractual continuity’ in itself encompasses many concepts as well as concerns under one hat. Chief among them is the risk that, post-Brexit contracts, and obligations thereunder, will not be able to be performed or disputes enforced without amendment to existing terms or documentation architecture. Some of that may be alleviated by moving contracts to the new and expanded EU27 legal entities from contractual counterparties historically in the UK or other third-countries, but other issues also present themselves in need of a solution.
On the assumption that existing contracts will not benefit from grandfathering, there is no panacea to contractual continuity and the resulting repapering that would be needed to move potentially multiple millions of terms and conditions. Concerns remain of how to deal with optionality that exists in various master agreements across asset classes and transaction types. Add to that the bespoke nature of bilateral contracts, cross-default provisions and the paper headache becomes clearly in need of operational heavy-lifting. Solutions may start with a document/risk exposure analysis, involve novation or other permitted means of transfers but will require perhaps greater and more frequent inter-institutional cooperation amongst market participants and dialogue with supervisors.
Securities lending documentation is certainly not spared. While the International Swaps and Derivatives Association (ISDA) has moved ahead of other industry associations to publish updated guides on model clauses in arbitration and new master agreements that are subject to governing law of an EU Member State and/or enforcement in the EU27 Member States, some association are yet to respond. The absence from standardisation is worrying as firms may come up with their own solutions, some of which may not be interoperable across the market or suitable for existing arrangements. Existing documentation also needs to be revised to see if it suits firms’ new post-Brexit operating models, the SPoRs or other supervisory expectations and priorities of the relevant EU27 authorities. EU-level and national supervisors can easily police compliance by reference to existing as well as new post-Brexit contractual documentation on top of policies and procedures.
All of this has a potential impact on liquidity as well as pricing during what many predict, including the International Securities Lending Association, to be markets of ongoing heightened volatility. This may not cause a repeat of the 1968 Paper Crisis, but settlement failure or digital deadlock is a concern and there is no indication how market supervisors might or even would coordinate (temporary) market suspensions or trading restriction. The ECB has already announced that 2019 will be a year of increased on-site inspections, market-wide liquidity stress tests, a deep dive focus on liquidity models and generally testing of the resilience of market-based financing channels as well as the quality of collateral arrangements.
ISDA has exercised first-mover advantage in ensuring that the new French and Irish Master Agreements work without completely overhauling a sound and trusted architecture. The agreements also work on the premise of collateral being located in the EU27 and interoperable with legally robust and enforceable security interests. The association has communicated standardised concepts for designated replacement entities and other fallbacks. In terms of immediate pressures, beyond what may sound like a broken record to some, many firms need to do more and do so quickly. Repapering exercises take time and even longer without appropriate legal and operational support. If industry associations are silent or not leading on certain issues then repapering also needs extensive coordination with peers beyond wider contractual counterparties.
The only constant certainty is uncertainty
SFTR compliance, Capital Requirements Directive V/Capital Requirements Regulation and a range of International Financial Reporting Standards are on the agenda for most EU financial services. Other more recent reforms such as the second Markets in Financial Instruments Directive/Markets in Financial Instruments Regulation, the Benchmark Regulation, as well as the Short Selling Regulation, are all in supervisors sights.
What is more, 2019 might mark 30 years since the fall of Communism in Eastern Europe and 20 years since the introduction of the Euro, but Brexit’s culmination has been a further catalyst. It has united the EU27 while dividing Britain. What this could mean is that within the EU27 the amount of goodwill for Whitehall’s warring factions is growing ever less regardless of who might be in Number 10.
So too is the likelihood of the EU providing the UK with further assurances or interpretations of the current withdrawal agreement, which the EU has already approved, let alone an indication on the future state of financial services deal, which can only be discussed if Westminster approves the withdrawal agreement. If you thought the negotiations till now have been tough, any discussion on the future financial services deal could be a whole lot tougher and certainly different—why would the EU need to do a deal if larger businesses (including those from outside of the UK) are already moving of have plans to move?
Furthermore, if the UK does somehow decide to stop the clock on the 29 March’s exit date and/or go a step further and withdraw the Article 50 Notice and, thus, somehow stay, then all the spent efforts and extended assistance from the EU27 to the UK may still pose a problem. This could be met with a renegotiation of some legacy terms that Thatcher secured in the early 1980s, including the cash-back rebate.
Irrespective of whether Brexit does eventually materialise into what some hope is a Big Bang two for a global island nation. In the meantime, all of this presents the potential for even greater uncertainty, especially as the EU could have a very different parliament and commission in place during this year.
What’s ahead?
As the EU faces a tough year of Brexit challenges, it also faces a shift in the EU political executive and supervisory policymakers. A new first-time Romanian presidency of the Consilium, representing the helm of EU executive governments, took up its role on 1 January 2019 and will contribute to the debate on deciding on Brexit. A new set of members of the European Parliament will be voted in following the May EU Parliamentary elections, and a new European Commission will guide financial services regulatory policy as well as a possible Capital Markets Union 2.0 reboot and finalisation of Banking Union, Pillar III.
That sense of change is also being at the level of EU financial services supervisory authorities, who started the year by strengthening calls for greater supervisory convergence in the EU27. As the UK begins to diverge, greater powers for the ECB and the European Supervisory Authorities (ESAs) will focus on the conduct of business supervision and on-site inspection as well as greater and direct oversight in respect of financial services firms as well as market infrastructure providers.
Moreover, many non-bank financial services providers undertaking ‘bank-like activity’ may find they are under greater scrutiny as shadow banking and increased reporting is back on the agenda.
Reporting is likely to be a familiar topic for most firms affected by the Securities Financing Transactions Regulation (SFTR), which itself has been partly delayed by Brexit. This is partly due to technical discussions on revisions to European Market Infrastructure Regulation (EMIR). The European Commission has now set out the final seven commission delegated regulations, which include clarity around regulatory reporting start dates and clearer timelines so firms can focus on other forward-proofing of arrangements as phased reporting obligations come in place.
For many, that has also meant picking up the pace on Brexit-proofing legal entity structures as well as documentation. This trend is likely to continue, not only due to supervisory pressure from the European Central Bank (ECB) and the ESAs, who each published further updates to prescriptive Supervisory Principles on Relocations (SPoRs), but also because the securities lending market, not having fully found a consensus on whether the bulk of pre-crisis documented financial transactions need to be repapered and how to document new post-Brexit transactions on the first day of trading and notably from where.
While there is talk of the ESAs and/or the ECB potentially getting powers to issue no-action relief letters or similar measures, the mood is—as with SFTR-compliance—that firms need to prepare and work towards compliance by a specific date that is set by the supervisor and do so in a manner that meets the SPoRs.
Any equivalence measures granted to permit access from the UK’s new status as a third-country are very much conditional and can be withdrawn.
Work still to be done
An area where further action is required is still around contractual continuity for existing contracts as well as the documentation terms for future financial market transactions—and thus securities financing transactions. The term ‘contractual continuity’ in itself encompasses many concepts as well as concerns under one hat. Chief among them is the risk that, post-Brexit contracts, and obligations thereunder, will not be able to be performed or disputes enforced without amendment to existing terms or documentation architecture. Some of that may be alleviated by moving contracts to the new and expanded EU27 legal entities from contractual counterparties historically in the UK or other third-countries, but other issues also present themselves in need of a solution.
On the assumption that existing contracts will not benefit from grandfathering, there is no panacea to contractual continuity and the resulting repapering that would be needed to move potentially multiple millions of terms and conditions. Concerns remain of how to deal with optionality that exists in various master agreements across asset classes and transaction types. Add to that the bespoke nature of bilateral contracts, cross-default provisions and the paper headache becomes clearly in need of operational heavy-lifting. Solutions may start with a document/risk exposure analysis, involve novation or other permitted means of transfers but will require perhaps greater and more frequent inter-institutional cooperation amongst market participants and dialogue with supervisors.
Securities lending documentation is certainly not spared. While the International Swaps and Derivatives Association (ISDA) has moved ahead of other industry associations to publish updated guides on model clauses in arbitration and new master agreements that are subject to governing law of an EU Member State and/or enforcement in the EU27 Member States, some association are yet to respond. The absence from standardisation is worrying as firms may come up with their own solutions, some of which may not be interoperable across the market or suitable for existing arrangements. Existing documentation also needs to be revised to see if it suits firms’ new post-Brexit operating models, the SPoRs or other supervisory expectations and priorities of the relevant EU27 authorities. EU-level and national supervisors can easily police compliance by reference to existing as well as new post-Brexit contractual documentation on top of policies and procedures.
All of this has a potential impact on liquidity as well as pricing during what many predict, including the International Securities Lending Association, to be markets of ongoing heightened volatility. This may not cause a repeat of the 1968 Paper Crisis, but settlement failure or digital deadlock is a concern and there is no indication how market supervisors might or even would coordinate (temporary) market suspensions or trading restriction. The ECB has already announced that 2019 will be a year of increased on-site inspections, market-wide liquidity stress tests, a deep dive focus on liquidity models and generally testing of the resilience of market-based financing channels as well as the quality of collateral arrangements.
ISDA has exercised first-mover advantage in ensuring that the new French and Irish Master Agreements work without completely overhauling a sound and trusted architecture. The agreements also work on the premise of collateral being located in the EU27 and interoperable with legally robust and enforceable security interests. The association has communicated standardised concepts for designated replacement entities and other fallbacks. In terms of immediate pressures, beyond what may sound like a broken record to some, many firms need to do more and do so quickly. Repapering exercises take time and even longer without appropriate legal and operational support. If industry associations are silent or not leading on certain issues then repapering also needs extensive coordination with peers beyond wider contractual counterparties.
The only constant certainty is uncertainty
SFTR compliance, Capital Requirements Directive V/Capital Requirements Regulation and a range of International Financial Reporting Standards are on the agenda for most EU financial services. Other more recent reforms such as the second Markets in Financial Instruments Directive/Markets in Financial Instruments Regulation, the Benchmark Regulation, as well as the Short Selling Regulation, are all in supervisors sights.
What is more, 2019 might mark 30 years since the fall of Communism in Eastern Europe and 20 years since the introduction of the Euro, but Brexit’s culmination has been a further catalyst. It has united the EU27 while dividing Britain. What this could mean is that within the EU27 the amount of goodwill for Whitehall’s warring factions is growing ever less regardless of who might be in Number 10.
So too is the likelihood of the EU providing the UK with further assurances or interpretations of the current withdrawal agreement, which the EU has already approved, let alone an indication on the future state of financial services deal, which can only be discussed if Westminster approves the withdrawal agreement. If you thought the negotiations till now have been tough, any discussion on the future financial services deal could be a whole lot tougher and certainly different—why would the EU need to do a deal if larger businesses (including those from outside of the UK) are already moving of have plans to move?
Furthermore, if the UK does somehow decide to stop the clock on the 29 March’s exit date and/or go a step further and withdraw the Article 50 Notice and, thus, somehow stay, then all the spent efforts and extended assistance from the EU27 to the UK may still pose a problem. This could be met with a renegotiation of some legacy terms that Thatcher secured in the early 1980s, including the cash-back rebate.
Irrespective of whether Brexit does eventually materialise into what some hope is a Big Bang two for a global island nation. In the meantime, all of this presents the potential for even greater uncertainty, especially as the EU could have a very different parliament and commission in place during this year.
NO FEE, NO RISK
100% ON RETURNS If you invest in only one securities finance news source this year, make sure it is your free subscription to Securities Finance Times
100% ON RETURNS If you invest in only one securities finance news source this year, make sure it is your free subscription to Securities Finance Times
