On July 30, the Association of Financial Markets in Europe (AFME) and the International Swaps and Derivatives Association, Inc. (ISDA) released a paper outlining the challenges UK and EU firms will face in relation to legacy over-the-counter (OTC) derivative contracts following the United Kingdom’s departure from the European Union (Brexit).

Currently, UK firms use single-market EU passports to engage in regulated activities in other EU member states without the need for a local license; EU firms use similar passporting arrangements to conduct business in the United Kingdom. The paper identifies other problems for legacy OTC derivative contracts entered into using a passport prior to Brexit after the United Kingdom has left the European Union. For example, lifecycle events involved in the contract could give rise to local EU licensing requirements for UK firms and, therefore, UK firms may wish to transfer legacy contracts out of the United Kingdom and into the European Union. The paper addresses the question as to whether it will still be legally permissible to perform contractual obligations arising under such legacy OTC contracts, and if not, whether the contracts are still valid.

To reduce the severity of the risks identified, the paper recommends a transition period under the final withdrawal agreement made between the United Kingdom and the European Union (Withdrawal Agreement). The paper also recommends that the Withdrawal Agreement should contain appropriate provisions to facilitate the transfer or novation of legacy OTC contracts from a UK firm to an appropriately licensed EU firm. However, due to the political uncertainty surrounding the Brexit negotiations, firms should plan for Brexit, assuming that there will be no Withdrawal Agreement.

The paper considers the use of statutory mechanisms to facilitate the transfer of legacy OTC contracts without the need for consent of the counterparty to the contract. The paper provides many examples of such schemes; however, it also identifies that some may not always be suitable or appropriate.

The paper also explores the use of a transfer of legacy OTC contracts by novation. The paper states that this mechanism is not a ‘silver bullet’ as there are significant execution and timing challenges involved in a large-scale novation of OTC derivative contracts in favor of an entity in a different EU member state. Novation also requires the individual consent of the clients and counter-parties involved, which could be delayed or withheld for a variety of reasons.

AFME and ISDA state that they intend to develop and publish more concrete proposals to help facilitate the transfer or novation of legacy OTC contracts.

The paper is available here.