Joshua Price (White & Case, London) co-authored this article

With less than four months to go until Brexit, the UK and EU have agreed a withdrawal agreement at a political level. However, if this agreement is not passed by the UK parliament, there is a risk that the UK could crash out of the bloc without a deal which could have a devastating impact on about £41 trillion worth of derivatives contracts.

That's because European banks could lose access to LCH, a unit of the London Stock Exchange (LSE), which clears about 90 percent of Euro-denominated interest-rate swaps.

Brexit will shatter the ecosystem for settling derivatives contracts that has been protected by pan- European regulations, such as MiFID and EMIR, which allow EEA firms to enjoy easy access to UK trading venues and central counterparties (CCPs) like LCH. Trading venues include regulated markets, multilateral trading facilities (MTFs) and organised trading facilities (OTFs).

MiFID grants regulated markets, such as the LSE and Germany's Frankfurt Stock Exchange, mutual access rights to participants across the EEA.

MiFID also gives MTF operators such as Eurex Repo in Germany, and OTF operators passporting rights, allowing them to provide their services across the EEA. EMIR allow CCPs, such as LCH and Germany's Eurex market, access rights to provide clearing services across the EEA.

Currently, most members of these trading venues and CCPs tend to be authorised investment firms or credit institutions because these types of entities possess the necessary resources and sophistication to engage in on-venue trading and clearing activities.

This existing regulatory system means trading venues and CCPs do not have to set up a fully capitalised entity in each EEA Member State in which they wish to operate in, thereby reducing the legal and regulatory burden. Supporting this framework are provisions that prevent individual Member States from putting in place arbitrary barriers to entry into their financial markets. Therefore, MiFID and EMIR create a single market across the EEA that allows trading venues and CCPs established in one Member State to provide trading and clearing services across the EEA.

The Brexit effect — a 'third-country'

If the UK exits the EU on 29 March 2019 with no EU/UK reciprocal transitional period or other relevant arrangements in place, UK trading venues and CCPs will cease to be authorised or recognised entities under EU legislation and, as a result, will no longer benefit from market access and passporting rights prescribed under MiFID and EMIR.

After Brexit, UK trading venues will become so-called 'third-country' firms. There are existing third-country frameworks under EU legislation, but these are not comprehensive whole market measures and are within the full discretion of EU institutions.

Under MiFIR 'third-country' firms can register with the European Securities and Markets Authority (ESMA) in order to provide investment services across the EEA. But before any such registration can occur, the European Commission (EC) must have made an equivalence decision relating to the relevant third country. This process is detailed and time-consuming.

Recent examples of third-country equivalence tests in other areas of EU legislation demonstrate that this can take several years (e.g., in the derivatives sector). The outline political declaration of the future relationship between the EU and UK notes that both parties will commence equivalence assessments as soon as possible, endeavoring to conclude these before the end of June 2020. If there is a no deal Brexit, the UK will introduce a temporary permissions regime to mitigate the licensing risk for incoming firms. The EC has made indications that it may also introduce steps to mitigate against similar risks, particularly relating to clearing.

Any MiFIR equivalence decision would allow UK firms to provide investment services to non-retail clients across the EEA without having to incorporate a new legal entity. Importantly, this would cover trading venues, such as MTFs and OTFs, but would not cover the operators of regulated markets, as this activity does not fall within the definition of 'investment services.'

In the absence of an equivalence decision, UK trading venues need to consider whether the provision of their services to EEA firms would be regarded as an investment service or activity under MiFID or a regulated activity in each Member State of their EEA clients. As regulated markets would not benefit from any equivalence decision, they would need to consider the national licencing (or exemptions) in each relevant individual EEA Member State.

From a trading perspective, there are arguments that a non-EEA trading venue may not be performing an investment service or regulated activity in the EEA by just having members that are EEA firms. This often depends on number of factors, such as the nature of the trade, marketing activities of the venue and its physical presence in EEA. This is based on arguments that the characteristic place of performance of the venue's activities is outside the EEA. The interpretation of the characteristic place of performance ultimately comes down to the relevant EEA Member State's national interpretation of what lies within and outside the scope of its national licencing requirements.

After Brexit, as UK trading venues will no longer benefit from mutual access and passporting rights under MiFID, they will not be able to provide trading services into the EEA. Therefore, UK trading venues face a potential licencing risk if they continue to provide services to EEA members. This is because the provision of trading venue services to a member that is incorporated in an EEA Member State could be seen as providing such services into that Member State and within the scope of EU (and/or national) authorisation requirements.

UK trading venues are taking a number of steps to address market access issues. For example, the London Metal Exchange (LME)—a recognised investment exchange in the UK—has published details of its Brexit planning on its website. The LME is seeking regulatory licences or exemptions in EEA jurisdictions in which its members are located and is anticipating receiving licences or exemptions needed to provide access to EEA firms so they can continue trading on the LME. Bloomberg has expressed concerns around its ability to service EEA members from its UK MTF and has established a new entity in the Netherlands. It has also applied for authorisation under MiFID as an MTF in order to maintain access to EEA single market and service EEA members.

Without an EU/UK transitional period or EU Commission equivalence decision on UK trading venues (as well as something covering regulated markets), EEA firms are unlikely to be able to be members of the UK trading venue, unless the UK trading venue has itself obtained the relevant licences or exemptions from the particular EEA Member States.

If the relevant measures are not in place at the point of Brexit—or after any transitional period—EEA firms face being cut off from large pools of liquidity and potentially increased trading and hedging costs. UK trading venues will face limited access, if any, to EEA markets and a decreased client base, unless they establish an EEA authorised entity or obtain the relevant national licences/exemptions.

Where next for CCPs?

UK CCPs will become third-country CCPs after Brexit. Under EMIR, a CCP established in a third country may provide clearing services to clearing members or trading venues established in the EU only where that CCP is recognised by ESMA. This provision effectively prohibits non-EEA CCPs providing clearing services to EEA firms, unless they have ESMA recognition.

Post-Brexit, in order for UK CCPs to obtain recognition, the EC will need to adopt an implementing act in relation to the UK. For its part, the UK CCP must be appropriately authorised in the UK, there must be a cooperation agreement in place between ESMA and the UK regulators, and there must be equivalent anti-money laundering requirements in the UK. The UK CCPs are already authorised from a UK perspective, and there are equivalent anti-money laundering requirements in the UK. Therefore, whether UK CCPs will become recognised will be down to the EC and ESMA.

Until a UK CCP is recognised by the ESMA, it will no longer be able to provide services to EEA clearing members. Therefore, in respect of derivatives subject to the EU's mandatory clearing obligation (e.g., G4 interest-rate swaps), EEA clearing members will need to close out their positions with UK CCPs prior to Brexit and then open new positions with an authorised EEA, or third-country recognised CCP.

Without EU pre-emptive actions and decisions relating to recognition of UK CCPs at the point of Brexit, this will involve a huge repapering exercise that is unlikely to be completed before 29 March 2019. Further, EEA firms face potential market volatility given that a large part of the European market will be attempting do the same thing at the same time. There is also the issue around market capacity amid reports that for interest-rate swaps, Eurex—a possible destination for some EEA firms—only clears nine currencies compared to LCH's 21. For swaps denominated in Hungarian forints and Czech koruna, for example, EEA members currently using LCH would have to go to the US, where CME Clearing (a recognised CCP) matches LCH's currency sets.

For derivatives which are not subject to mandatory clearing, but which firms wish to put up for clearing, EEA firms can continue to access UK CCPs through UK clearing members. Where EEA firms are themselves acting for their own clients, they would then need to access UK CCPs through indirect clearing arrangements with the UK clearing members. Such arrangements would be permissible under EMIR, however, UK clearing members in such arrangements would have to consider their own EEA licencing position vis-à-vis their EEA clients or counterparties.

UK CCPs are taking a number of steps to mitigate market access issues for EEA firms. LME Clear has noted that it is possible for clients of an LME member to enter into a back-to-back exchange-traded derivative contract with its client under their terms of business. This contract is not a client contract under the LME rules, but the arrangement may qualify as an indirect clearing arrangement for the purposes of MiFIR. As LME will be facing a UK or non-EEA clearing member, it will not need to worry about the jurisdiction of the clearing member's client, so it will not be acting in breach of Article 25(1) of EMIR. There have been some indications that the EC is prepared to put in place time-limited equivalence for UK CCPs, in the event of a no deal Brexit to mitigate against the risks discussed above. This appears to be a more limited version of the UK's temporary permissions regime. Whilst this is welcomed and may provide some further breathing room for market participants, it does not deal with the fundamental underlying issues on a long-term basis and may only serve to kick the can down the regulatory road.

EEA firms, UK venues and CCPs face a potentially daunting prospect. EEA firms may be forced off UK financial market infrastructure prior to Brexit so that these trading venues and CCPs do not breach EU laws—which will lead to loss of significant business. EEA firms also face the expensive and time-consuming prospect of trying to move billions (and, in some cases, trillions) of euros in notional values worth of derivatives positions from UK trading venues and CCPs to EEA (or certain non-EU) recognised trading venues or CCPs.

This is likely to have a substantial impact on volatility and pricing and may create market risks. Without an EU/UK transitional period (and in the longer term, agreement covering financial services) or unilateral decisions made by the EU, the UK and EU face the prospect of significant market disruptions and widespread breaches of rules by large parts of the market.

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