Brexit’s Impact on Derivative Contracts

On the heels of a historic and heated election, The UK announced it will be formally leaving the European Union as of January 31, 2020. Despite the landslide victory led by British Prime Minster Boris Johnson’s Conservative Party, there are still many obstacles to overcome before a withdrawal from the EU is finalized. Nevertheless, investors and financial analysts have many concerns about the impact Brexit will have on the derivatives industry, including fragmented markets and liquidity shortfalls.

Some of the most pressing concerns are as follows:

  1. Counterparty Creditworthiness: Counterparties’ creditworthiness may be adversely affected by Brexit. This could result in more expensive financing costs or additional collateral posting obligations. In an extreme scenario (rating downgrade), and termination rights could be triggered.

  2. Sovereign Downgrade: If the UK’s credit rating is downgraded, the creditworthiness of counterparties with UK exposures may be adversely affected.

  3. Exposure Fluctuations: Economic volatility may lead to new (or increased) mark to market exposures under derivative transactions resulting in new (or increased) collateral posting requirements.

  4. Collateral Valuation Fluctuations: Economic volatility, rating downgrades or currency fluctuations could lead to increased collateral posting requirements, especially if the value of UK collateral declines or if exposures in other currencies increase relative to sterling.

Impact on Derivatives Documentation

With over 900 member institutions from 71 countries, the International Swaps and Derivatives Association (ISDA) has worked to make the global derivatives markets safer and more efficient. Brexit presents some challenges as it relates to this area.

  1. ISDA Representations and Covenants: The representations and covenants under ISDA Master Agreement would be adversely affected by Brexit. Specific attention will need to be given to non-standard representations and covenants relating to EU/UK laws and regulations, creditworthiness, ratings and/or market conditions.

  2. Illegality Termination Event- 1992 ISDA Master Agreement: An Illegality Termination Event under the 1992 ISDA Master Agreement is triggered by an adoption or change in applicable law, as a result of which it becomes unlawful for a party to make/receive any payment or delivery or to comply with any other material provision of the ISDA Master Agreement in relation to the Transaction in question. Brexit can trigger Illegality Termination event.

  3. Force Majeure Termination Event: The Force Majeure Termination Event in the ISDA 2002 Master Agreement requires a force majeure or act of state which means that a party cannot make/receive payments or deliveries or comply with any other material provision of the ISDA Master Agreement in relation to the Transaction, or that it becomes impossible or impracticable to do so. It seems likely that a no-deal Brexit would constitute an ‘act of state’ for these purposes.

  4. Tax Event Termination Event: Broadly speaking, a Tax Event occurs when one party is required to make an additional payment, or the other party is required to receive a payment subject to a deduction, in respect of tax deducted or withheld from a payment as a result of, inter alia, a change in tax law (as defined in the ISDA Master Agreement) after the parties have entered into the Transaction.

    Following Brexit, there may be domestic law change in the UK and elsewhere, or the way in which existing domestic law applies may change, which could result in additional withholding tax on payments made in cross-border transactions. For example, the UK could use the opportunity to impose new withholding taxes, or a domestic law exemption from withholding tax in another jurisdiction may cease to apply to UK entities (by virtue of the fact that the UK has ceased to be an EU member state). The occurrence of a Tax Event in these circumstances will depend on the change in law or application in question (which in turn may depend on the outcome of the exit negotiations), and whether withholding tax would affect payments made on the underlying Transactions.

  5. ISDA’s Response to Brexit: ISDA released a statement that, in its view, Brexit “will not have an immediate impact on the legal certainty of existing derivatives contracts, nor will it require any immediate contractual change or action from counterparties. Once the UK government serves formal notice of its intention to withdraw, the UK will continue to remain a member of the EU for at least two years. During that time, existing European treaties, directives and regulations will remain in force.” ISDA has published a web page on the impact of Brexit on the ISDA Master Agreement that addresses several issues including: the choice of English law; the choice of English courts/arbitral tribunals as dispute forum; bank resolution issues; insolvency issues; and collateral issues.

Extracting Insights from Contracts

The impact of Brexit on OTC derivatives is still not entirely clear. But whatever the outcome, companies will have to review their contracts to effectively prepare for what changes it may bring. This review includes negotiated terms and provisions available in contracts such as governing law, currencies, jurisdiction, payments terms, and change of law, etc.

Traditional tools utilize pre-defined criteria, dependent upon metadata which will fail to keep pace with the unpredictable nature of Brexit. Manual reviews are even worse; they are typically slow, limited, and expensive one-off reviews that are likely out-of-date before they are even completed. That’s why Innodata believes its contract extraction and analytics platform is so powerful; it fundamentally changes how companies can approach contract review for Brexit. docAnalytics™ is not dependent upon metadata, instead it is a hybrid approach of artificial intelligence and machine learning with human review by trained legal experts, and it provides the capabilities for either the business user or legal group to find answers fast.

Click here to learn more about our contract extraction and analytics platform.

Darian Schwartz

Darian Schwartz- Senior Business Development Executive

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