December 7, 2018.Fitch Ratings
Interim solutions and contingency planning with respect to derivatives and insurance claims are reducing some significant risks a “no-deal” Brexit would present to the European financial services sector, Fitch Ratings says in a new report. However, without greater clarity on the scope, conditions and timing of prospective measures, some uncertainty remains on how losing cross-border authorisation would affect financial institutions (FIs).
The Brexit process has a range of potential outcomes and no single scenario has a high probability, in our view. A critical issue in a disorderly “no-deal” scenario would be the loss of EU “passporting” rights, which authorise UK FIs to transact with EU clients.
Recent proposals for EU27 counterparties to access UK trading venues, and national legislation in some EU27 states giving UK FIs temporary authorisation, reduce the risk that a full lapse of EU authorisation would leave issuers unable to perform on some insurance claims and derivative contracts.
For cleared derivatives, the European Commission’s pledge to provide UK central counterparties (CCPs) with temporary conditional authorisation would buy time for UK CCPs to gain permanent EU authorisation, or for EU27 counterparties to close out and rebook contracts to EU27 venues (although this could be operationally and legally burdensome).
While the legal consensus is that performance on most existing uncleared derivatives would be unaffected by a loss of EU authorisation, concerns could arise if certain derivative life-cycle events occurred when authorisation had been lost. UK FIs may be able to fall back on authorisation by individual EU member states (France’s National Assembly will consider such a proposal this month). European supervisors have proposed a one-year exemption for clearing and bilateral margining obligations if UK FIs novate legacy contracts to EU27 group entities or third-party EU27 counterparties.
If fully implemented, the solutions proposed for uncleared derivatives should also reduce risks for structured finance transactions involving EU27 issuers with UK swap counterparties. However, if not fully mitigated, life-cycle events could cause early termination events, leaving structured finance issuers owing termination payments, which could cause substantial liquidity stress if they are out of the money and mark-to-market payments are large.
All Fitch-rated UK insurers are enacting contingency plans for ongoing claim payments after Brexit, for example by obtaining new business licences or transferring claims on legacy policies to an EU27-based subsidiary (Lloyd’s of London is transferring all EEA business to Lloyd’s Brussels by end-2020). Nevertheless, the European Insurance and Occupational Pensions Authority estimates that 9.1 million policyholders may face uncertainty and delays in receiving payments. Potential legislation by individual EU member states giving temporary authorisation to UK FIs is likely to clear much of any remaining residual risk.
We discuss these issues in our Special Report, “No-Deal Brexit: Derivatives Disruption Unlikely”, published today and available at www.fitchratings.com or by clicking on the link above.