With considerable uncertainty over the future of the UK’s relationship with the European Union (EU) after the conclusion of the exit negotiations, financial institutions are in the midst of a complex risk assessment exercise. From the risk of lost passporting rights to understanding the potential triggers for contractual default and from currency fluctuation to ratings downgrades, the sheer scale of the impact assessment for the financial services industry (and the knock-on effect beyond) is daunting.
Yet with minimal contract digitisation, firms face manually locating, reviewing and repapering thousands of contracts. And this is just for Brexit. With the potential for other countries to leave the EU in the near future as well as further significant regulatory change possible in the US, firms look set to repeat this manual trawl through the contractual documentation again and again.
Worst versus best case
While prime minister Teresa May has announced that the financial services sector should be treated as a special case within Brexit negotiations, the fact is that two years from now the sector could be operating ‘business as usual’ or the UK could have lost its EU passporting rights and become an outcast from the global economy. There is simply no way of predicting where things will end up at this moment in time. Given the impending decision to trigger Article 50 at the end of March 2017, most financial services firms have been testing the potential impact of Brexit on current business operations – and that means looking at both best and worst case scenarios.
Passporting rights. For any institution relying on a UK branch to passport on a cross-border basis into EU member states, Brexit raises very significant concerns. Firms based in the Americas, Asia, Middle East and Africa are using multi-branch passporting to access the EU financial services market via a London branch. With absolutely no indication so far as to the potential decision of the EU regarding passporting – either in response to triggering Article 50 or during the Brexit negotiations – firms need to seriously consider the role of that London branch in the future. With potential implications on the selling of notes and financial instruments if that passport no longer applies, firms will need to amend platform architecture and also need to consider renegotiating thousands of contracts between counterparties.
Commodity delivery. Certain financial contracts – those that envisage some form of underlying commodity delivery – could also be affected if the UK comes out of the Customs Union as part of the Brexit negotiation (as has been mooted). Firms need to understand the specifics of each contract; for example, if commodities are being delivered either from the EU into the UK or vice versa, would the exit from the Customs Union affect those contracts? Could delays trigger defaults? What happens if the EU suddenly decides that items cannot be transported into the union without paying a tax tariff or fee? With no way of predicting the outcome of negotiations today, firms need to identify those contracts that could potentially be affected. This will require a granular deep dive of different types of transactions that banks may have from trade finance to commodity derivatives, and the specific nature of the contractual documentation governing them.
EU and UK law integration. It is only a couple of years since firms repapered derivatives documentation to include reference to the European Markets Infrastructure Regulation (EMIR). Yet as the UK and EU laws are disentangled over the next two years – and beyond – it is possible that EMIR will no longer be applicable in the UK, therefore requiring all of those previously amended contracts to be re-amended to remove references to EMIR. EMIR is just one example of a raft of EU regulation that has been passed in Brussels and integrated into UK law (and English law governed contracts) that has a direct impact on the way UK firms do business. UK firms are therefore likely to face another significant repapering exercise.
Currency risk. What is going to happen to contracts valued in euro or sterling, if either (or, indeed, both) currencies take a massive hit? Are firms going to look to hedge against that risk by moving to US dollars (USD)? The shift to USD may extend to collateral portfolios – an assessment of the risk associated with portfolios denominated in euro or sterling could encourage firms to start liquidating those assets and moving to USD.
Ratings downgrades. A post Brexit ratings downgrade (for UK and EU firms) could result in a domino effect across swathes of financial contracts, which are all interlinked by boilerplate cross default provisions. Obviously, any contract that includes a rating downgrade clause would be triggered but such an event could also trigger multiple cross default clauses from derivatives contracts to loan and project finance contracts – with almost potentially catastrophic consequences.
From relocating branches to repapering potentially thousands of contracts, firms face business changing decisions that, to be frank, cannot be accurately assessed without an in-depth understanding of the legal implications of Brexit negotiations on current contractual obligations. And this is the problem: while lawyers and experts need to look closely at contracts to even consider the potential risks associated with Brexit, most firms will struggle with the first step of locating all of the relevant contracts – after which the fuller assessment can be undertaken.
There are a few foresighted firms, however, that have embraced the digitisation of their paper contract portfolios, ensuring they are adequately stored and searchable to help with such exercises. Most firms only capture key economic terms, rather than the underlying contractual agreements and obligations. Without digital records, firms cannot use document and data discovery tools to fast track this process and therefore face manual and time consuming exercises even to identify those contracts that need to be repapered. Not to mention the increased costs associated with hiring more staff to conduct these reviews.
Firms need to think now about the best way to incorporate technology into their businesses to extract essential complex contractual information in a consumable, machine readable format that provides immediate insight into the legal and regulatory landscape, and immediate visibility of those toxic clauses within documents that could trigger an unintended event. For example, with a system that lists thresholds, offices traded from, whether or not early termination is switched on, the kind of collateral held (and in what base currency), an organisation can quickly and easily use data discovery tools to rapidly assess the changing landscape – and make the correct decisions in scenarios such as Brexit.
Whether or not two years will be long enough to repaper and stress test contracts – or even determine what needs to be addressed – remains moot. However, the onus is on firms to undertake a robust impact assessment exercise that looks at the worst case scenario, as soon as possible. What happens if the EU decides on 1 April that a firm can no longer passport from the UK into the EU? How will a firm service its clients? And from where with the least legal and contractual impact?
The likelihood is that Brexit is more than just one event. From another member state deciding to leave the EU to president Trump backtracking on Dodd-Frank, turbulent times lie ahead. Firms may have to undertake this impact assessment and contract repapering exercise again and again. Legal contract management is fast becoming a core component of scenario and disaster planning – without automation and digitisation, firms will struggle to be prepared for either a best or worst case situation.