A hard Brexit could cost Dutch pension funds hundreds of millions of euros to rearrange derivatives transactions currently cleared through London, consultancy Cardano has suggested.

Uncertainty about the outcome of the Brexit negotiations has triggered questions about the legal status of derivatives contracts after the deadline of March 2019.

“At the moment, pension funds are uncertain about where and when they must clear their contracts,” said Max Verheijen, head of financial markets at Cardano. “Pension funds must prepare for every scenario by concluding flexible clearing contracts.”

Any transfer of derivatives contracts between trading venues would be expensive, he said.

As London has the largest market for derivatives, pension funds’ transactions with investment banks are usually subject to British legislation.

Earlier this year, the Commission proposed that pension funds were made exempt from central clearing regulations, brought in under EMIR, until 2020. These require all derivatives trades to be conducted through a central clearing house.

Verheijen said: “If the current exemption from mandatory central clearing for pension funds until August 2018 were not to be extended, central clearing must take place in London, where clearing house LCH has a 95% market share for schemes that have already started central clearing.

“In case of a hard Brexit, the European Commission wants these contracts [to be] subject to European legislation, as it doesn’t want to be dependent on British legislation if a British clearing house goes bust.”

In this case, contracts with LCH would have to be transferred to central clearing parties based on the European mainland.

Thijs Aaten, managing director of the treasury centre of the €456bn asset manager APG, also expressed concerns about unexpected consequences of a hard Brexit for strongly regulated and complex derivatives transactions.

“Existing contracts must be honoured, but what if an existing transaction leads to a new one, for example through calling an option?” he said. “Would this be a new transaction and would it be subject to existing or new regulation?”

In his opinion, another problem would be mandatory ‘compression’ under EMIR legislation, which makes it compulsory to reduce a large number of transactions with the same bank to a smaller number of deals.

Aaten also warned of a lack of legal clarity about whether a compression would be a new or an existing trade, and to what legislation it would be subject.

Verheijen and Aaten both observed that British investment banks were preparing for both a ‘soft’ and a ‘hard’ Brexit and were setting up branches elsewhere in the EU.

Aaten said he knew banks that had rented office space in Amsterdam with the option of sub-letting if the need to move did not arise. However he declined to provide details.

“I keep a finger on the pulse and want to know whether I can continue a relationship with a British investment bank after March 2019,” he said.

In Verheijen’s opinion, pension funds should make sure they can conduct central clearing of derivatives both in London and on the European mainland, as concluding a contract usually takes between six and nine months.

“As we don’t know how the world looks after August 2018 and March 2019, we are already arranging flexible contracts with clearing members,” he said.

Meanwhile, The Bank of England said that around £26trn (€29trn) of outstanding uncleared derivatives contracts could be affected by a withdrawal of permission to conduct cross-border business after Brexit, according to a record of meetings of its financial policy committee that was published today.

The largest risks to the continuity of outstanding cross-border financial services contracts related to over-the-counter derivatives contracts and insurance contracts, the Bank noted. The committee had been informed by a representative of the UK’s Treasury department that it was considering all options for mitigating these risks.

Overall, the committee considered Brexit posed material risks to the provision of financial services to customers in both the UK and the EU.

“It would difficult, ahead of March 2019, for financial companies on their own to mitigate fully the risks of disruption to financial services,” the meeting record said. “Timely agreement on an implementation period would reduce risks to financial stability.”

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