The failure of Germany and France to amend rules related to the treatment of some over-the-counter derivatives contracts ahead of the UK’s exit from the European Union could cause unnecessary stress to the European financial system, according to Mark Carney, governor of the Bank of England. Carney calls on European lawmakers to address the matter before October 31.
The UK central bank – which has micro- and macro-prudential oversight of the UK financial system, as well as resolution responsibilities for banks, insurers and financial market infrastructures – has warned for some time of the need to tackle Brexit transition risks associated with multi-trillion dollar, over-the-counter derivatives contracts. Britain’s new prime minister, Boris Johnson, has repeatedly stated his commitment to the UK leaving the EU with or without a trade deal by October 31.
During a wide-ranging interview with Central Banking, Carney says the EU authorities have already tackled one major danger, related to cleared derivatives – at least in the immediate future. “The big thing that has been resolved is for cleared derivatives contracts,” says Carney. “The European authorities have taken measures for temporary permissions for large financial market infrastructures, which is hugely important.”
EU institutions were given temporary access to London-based derivatives clearing services such as LCH, Ice Clear Europe and LME Clear until March 30, 2020.
Problems remain, however, with bilateral, non-cleared derivatives.
Lawyers say there’s no question about the legal enforceability of bilateral, uncleared financial contracts post-Brexit. But there is a problem related to the lack of recognition among some European jurisdictions – notably in the two largest eurozone economies – of so-called ‘lifecycle’ events.
Lifecycle events include amending the terms of trades as well as the ability to compress or cancel derivatives against similar positions, which are very common practices in the derivatives industry. Compression of trades is viewed as an important post-financial crisis technique for reducing operational risks related to derivatives positions.
“For bilateral, uncleared contracts, national legislation has taken care of this in some jurisdictions in Europe, but in a number of the big ones – Germany and France are the most obvious – they have not addressed it.,” says Carney. “The consequence of that is there is some risk.”
A lawyer at bank with a large derivatives operation in London says he is also concerned about the situation highlighted by Carney. He says there have been few signs of an effort to address discrepancies in Germany and France, although Nordic countries, Benelux nations and Italy have all taken steps to address the issues.
“A difference of opinion”
“We have a difference of opinion with the European authorities about the seriousness of this risk,” says Carney, adding it is “in Europe’s interest and also ours residually” to address this risk “more clearly”.
Carney questioned the wisdom of increasing operational risks in the event of a no-deal Brexit, and reiterated that the authorities in Germany and France may not have fully grasped the scale of the issue.
“We know some of the largest institutions in London, they perform tens if not hundreds of thousands of these lifecycle events in total on a weekly basis,” says Carney. “So having legal uncertainty or an inability to perform lifecycle events when lots of other things are going on and there is lots of volatility – which would happen with a no-deal Brexit in our view – is not sensible. You can debate the scale of the risks, but it is just not a sensible risk to take.”
Some European officials, notably those in France, would like to see legacy (and new) bilateral, non-cleared derivatives held between UK and EU counterparties moved from the UK to Europe via a process called novation. “That approach in France [on life events] is combined with an approach to encourage moves and make it easier to move,” says the lawyer at a large bank in London. “So I wouldn’t anticipate France providing any relief. It’s not really aligned with their priority of encouraging clients away from London.”
The authorities in Germany, meanwhile, do not appear to have engaged with market participants even to discuss the issue. “Germany has simply enabled the creation of a regime,” says the bank derivatives lawyer. “They’ve given the regulator the authority to provide relief but, in fact, that ability hasn’t been triggered.”
Asked if he expected European authorities to tackle the issue of derivatives lifecycle risks by the Brexit deadline of October 31, Carney replies: “It is very much in the interests of France and Germany to make some movement on that.”