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- The Bank of England has warned of a possible financial crunch in the derivatives markets in the event of a hard Brexit.
- The central bank believes that up to £29 trillion ($38 trillion) of uncleared over-the-counter (OTC) derivative contracts could effectively cease to function.
- That’s because the UK has committed to a post-Brexit implementation period, but the EU has not yet done so.
- European derivative markets are linked heavily between the UK and the rest of the continent.
A major financial crunch on contracts worth almost £30 trillion ($39.7 trillion) could be on the horizon in March next year, the Bank of England warned on Wednesday.
The UK’s central bank used its latest Financial Stability Report – which looks at the risks to the safety of the UK economy and the global financial system – to warn that Britain’s impending exit from the European Union could have a huge impact on over-the-counter derivative markets.
Derivative markets allow those in the financial system to trade assets that derive their value from elsewhere. Credit swaps and options are among the most common forms of derivatives.
European derivative markets are linked heavily between the UK and the rest of the continent, and the bank argued that if a fix cannot be found to allow that cross border trade to continue after Brexit, trillions of pounds worth of such contracts could effectively cease to function.
“UK and EEA parties may no longer have the necessary permissions to service certain uncleared over-the-counter (OTC) derivative contracts with parties in the other jurisdiction,” the bank’s financial stability report said.
“Amending existing contracts and/or undertaking other ‘lifecycle events’ could constitute regulated activities in some EEA member states and in the UK. Such lifecycle events include: rolling open positions, exercising options and trade compression. Lifecycle events are common in servicing derivative contracts. Some – such as trade compression – may be required by regulators
The value of such contracts, the bank said, could be as much as £29 trillion ($38 trillion).
“Based on latest data, this could affect around a quarter of contracts entered into by parties in both the UK and EEA, with a notional value of around £29 trillion, of which around £16 trillion matures after March 2019.”
So far during Brexit negotiations, the UK has committed to an implementation period for changes in financial rules, but the European Commission has not done so.
“The UK Government has committed to legislate, if necessary, to allow EEA counterparties to continue servicing contracts with UK entities (through a temporary permissions regime and additional legislation if required),” the report said.
“EU authorities have not announced an intention to enable UK counterparties to continue servicing contracts with counterparties in the EEA.”
If EU authorities ultimately fail to agree to such measures, the bank’s worries about derivatives could materialise.
The Bank of England’s warning comes amid growing tensions between UK and EU financial authorities. Earlier this week, the European Banking Association argued that UK banks are not prepared for a no deal Brexit.
“Firms cannot take for granted that they continue to operate as at present nor can they rely on as yet unrealised political agreements or public policy interventions,” Andrea Enria, the EBA’s chair said, warning that banks need to “speed up” their preparations for a cliff-edge EU exit.
The Bank of England on Wednesday reassured markets that it believes UK lenders could survive a hard Brexit, or what it calls a “disorderly Brexit” – saying that it “continues to judge that the UK banking system could support the real economy through a disorderly Brexit.”