Derivatives update: One Step Closer to Obligatory Contractual Stays on Termination Rights
In our February 2015 alerter, we considered ISDA's 2014 Resolution Stay Protocol (the Protocol), and noted that entities which are not "systemically important financial institutions" (SIFIs) are not expected to adhere until regulations had been introduced to mandate contractual stays on termination rights in financial contracts.
This briefing considers the UK Prudential Regulation Authority's (PRA's) May 2015 Consultation Paper on "Contractual stays in financial contracts governed by third-country law", which sets out the proposed regulations which will result in non-SIFIs being required to sign up to the Protocol or some other form of contractual stay.
We also provide an update on the industry efforts to extend the Protocol to repo and stock lending agreements.
PRA May 2015 Consultation Paper
The proposals in the Consultation Paper include:
- A new rule to be inserted into the PRA Rulebook requiring the parties to contractually ensure that "financial arrangements" governed by non-EEA law are subject to the same stays on termination rights as would have existed had the financial arrangements been governed by the laws of the United Kingdom.
- The rule will apply to PRA-authorised UK banks, building societies, PRA-designated UK investment firms, as well as their qualifying parent undertakings. Parent undertakings also have an obligation to ensure that their subsidiaries that are credit institutions, investment firms or financial institutions comply (irrespective of the location of those subsidiaries).
- "Financial Arrangements" will be defined to include "derivatives" as defined in EMIR, "financial contracts" as defined in Directive 2014/59/EU of the European Parliament and of the Council of 15 May 2014 establishing a framework for the recovery and resolution of credit institutions and investment firms (the BRRD) and any master agreement relating to contracts for the sale, purchase or delivery of any currency (e.g. IFEMA, FEOMA etc.).
- The rule will operate by prohibiting the covered firms from creating new obligations or materially amending existing obligations under financial arrangements that are governed by non-EEA law, unless the counterparty has agreed in writing to be subject to the UK resolution stays.
- The implementation date for the rule is expected to be staggered depending on the type of counterparty the authorised institution is dealing with as follows:
- 1 January 2016 – credit institutions and investment firms
- 1 July 2016 – asset managers (and the funds they manage), insurers and other counterparties that act on an agency basis
- 1 January 2017 – all other counterparties (save for "excluded persons" as defined in the Banking Act 2009, which include central counterparties and central banks)
The consultation period closes on 26 August 2015.
The PRA estimates that up to 20% of affected firms' contracts will require amendment, and they anticipate parties making use of contractual mechanisms such as the Protocol to effect the necessary changes.
The draft rules set out in the Consultation Paper appear to depart from the Protocol slightly, in that the rules, like the BRRD, do not extend to credit support arrangements, whereas the Protocol does.
Ramifications for non-SIFIs
Regulators were always aware that it was not realistic to expect non-SIFIs to adhere voluntarily to the Protocol. By mandating compliance for regulated firms under the new rule, the PRA is proposing to address this issue by requiring that no new transactions may be entered into (and that existing transactions may not be rolled over by bilateral amendment) unless the contractual stay language is incorporated into the relevant contract. In deference to the fact that some counterparties (particularly asset managers) may need to consult with clients before consenting to the required amending language, the deadline for compliance for non-financial institutions has been extended beyond 1 January 2016.
The proposed rules will only apply to contracts which are governed by non-EEA law. ISDA Master Agreements, Global Master Repurchase Agreements etc. which are governed by English law will not be affected by these new rules: instead, BRRD itself (through the implementing legislation in each Member State) imposes contractual stays on termination rights in financial contracts that are governed by EEA laws, including English law.
Extension of 2014 ISDA Resolution Stay Protocol to repo and stock-lending
Relevant industry bodies have been considering how best to embrace the repo and stock lending markets. In the past few months, that initiative has moved forward and a solution has been adopted whereby the Protocol is to be extended to apply to commonly used repo and stock lending master agreements entered into between systemically important banks. Draft documents are being produced and progress will be made over the summer months.