Baffled Credit Traders Call Their Lawyers as Brexit Clouds Swaps

  • U.K. leaving EU jeopardizes country’s central role in trading
  • Questions include role of British banks and euro clearing

The U.K.’s decision to leave the European Union is unnerving participants in the $12 trillion credit derivatives market.

Investors are concerned that British banks may become unable to trade credit-default swaps with EU counterparties, that U.K. clearinghouses may have to stop processing euro-denominated contracts and that collateral linked to the nation may be ineligible, according to law firms and banks. 

While the International Swaps & Derivatives Association has said it will work with dealers and investors to ensure the market functions safely, advisers are struggling to predict the impact of Britain’s exit from the 28-nation bloc before a deal is reached. The issue is one of a host of challenges that face U.K. Prime Minister Theresa May as she seeks to negotiate a new trading relationship with Europe.

“A lot will depend on the precise terms of the exit agreement that’s reached,” said Jonathan Haines, a partner at law firm Ashurst LLP in London. “We’ve had questions from banks seeking to understand the impact on them trading derivatives.”

British banks may have to set up subsidiaries in EU countries to trade default swaps with counterparties in the European Economic Area, Ashurst lawyers led by Haines wrote in a note to clients. 

For quick guide to bank passporting in Europe, click here.

Brexit raises “immediate issues for participants in the derivatives market” and the impact “will be substantial,” they wrote in the note.

The ability for U.K. clearinghouses to process euro-denominated trades may also be in jeopardy. The European Central Bank has previously tried to prevent trades in the currency from being cleared in the U.K., with a failed court case last year.

Linklaters LLP has advised clients to check for references to the EU in ISDA master agreements, which govern over-the-counter derivative transactions, according to Deepak Sitlani, a partner specializing in derivatives. The Credit Support Annex to the master agreement, for example, may only allow collateral originating from EU nations.

Collateral Checks

The contracts are expected to continue to be governed by New York or English law, according to Sitlani.

“In a slightly worried state, people are asking what they can do,” said Sitlani. “One thing is to look at your existing contracts and assess whether references to the EU will continue to be appropriate or whether they should specifically refer to the U.K. as well, for example in reference to eligible collateral.”

Still, the effect of Brexit on the global market for credit derivatives will be limited by the fact that many traders are based outside of Europe and so are less affected by changes within the EU. Furthermore, only a portion of contracts are in euros.

Lawyers at Allen & Overy LLP said that while they’re receiving “many queries” about whether Brexit warrants changes to documentation governing derivative trades, it’s difficult to make alterations before a deal is made.

“Until the terms and timing of the U.K.’s exit from the EU are clearer, there is not a great deal that can be done from a documentation perspective,” A&O said in a note to clients. “Any changes could conflict with any legislation designed to ensure continuity of contracts.”

Questions, Questions

HSBC Holdings Plc has told clients that sterling bonds can be delivered into settlement auctions for euro-denominated credit-default swaps and index trades, according to Michael Hampden-Turner, a default swaps specialist on the credit trading desk in London. The bank has received an increase in “general questions” from investors since the referendum, he said.

“People are concerned about the impact of Brexit on the U.K. credit derivative market,” said Hampden-Turner. “Investors are beginning to wonder what will happen if we start to see some U.K. distress and even defaults. We’re still in that phase where we’re getting overreactions to headlines, and that will probably last for another month at least.”

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