Andrew Hoffman and Leanne Ingledew Prudential Regulation Authority 20 Moorgate London EC2R 6DA Cp19_15@bankofengland.co.uk 14 th August 2015 Dear Leanne and Andrew, CP19/15: Contractual stays in financial contracts governed by third-country law The British Bankers Association ( BBA ) welcomes the opportunity to respond to the above consultation. The BBA is the leading trade association for the UK banking sector with 200 member banks headquartered in over 50 countries with operations in 180 jurisdictions worldwide. The members of the BBA have supported the UK and international authorities in their work to limit the risk of contagion in the event of bank failure and recognise the role of stays as an important aspect of this. As the consultation paper states, the stay provisions under the Banking Act 2009 and the Bank Recovery & Resolution Directive ( BRRD ) are necessarily limited in their geographical scope. For this reason, the BBA welcomed the announcement that the Financial Stability Board ( FSB ) intended to issue guidelines to promote cross-border recognition of resolution actions and the suggestion that FSB jurisdictions should work towards the adoption of statutory cross-border recognition frameworks. Contractual solutions to recognition should therefore be regarded as interim arrangements for a limited set of contracts and as complementary to statutory frameworks. The Bank of England ( the Bank ) has clearly taken a leadership role in the development and promotion of the ISDA Resolution Stay Protocol ( ISDA Stay Protocol ) and other similar industry initiatives. The paper notes the coordinated work by a number of FSB member countries to require firms to incorporate recognition of domestic stay regimes into financial contracts when these are governed by foreign law. Incorporation of such recognition was successfully implemented between G-18 dealers last year, largely because the requirement and timing was co-ordinated globally. This covered the majority of the uncleared derivatives documented under ISDA Master Agreements. The proposals in the consultation would result in the UK moving ahead of other jurisdictions, which would significantly increase the operational costs of implementation as well as harming the competitiveness of UK headquartered banks and their overseas subsidiaries. The 2014 G-18 global exercise also worked as it only required the main trading entities in the impacted groups to adhere to the ISDA Stay Protocol. This was based on a proportionate view of the costs and benefits of the exercise. It does not appear that any such reasonable and proportionate view is being taken on the scope, with even the smallest entities being required to adhere under the proposed rules. Given the volume of derivative exposure that is cleared, already subject to the ISDA Stay Protocol or already documented under English governing law, there is a very small tail of potential exposures subject to the Banking Act 2009 stay provisions. The risk from this tail will be further reduced with the implementation of margin for uncleared derivatives. Overall, the consultation paper proposal involves significant cost compared to this minimal exposure.
2 Throughout this response, it should be borne in mind that when the cleared swap population is aggregated with the swap volume covered by the existing adherence to the ISDA Stay Protocol amongst the G-18, over 90% of outstanding swap exposure is already covered. What the PRA is now focused on relates solely to the residuum. We should keep in mind the potential cost/benefit analysis of these proposals in foreclosing a potential issue with respect to a small part of this residuum, particularly since it is acknowledged that contractual provisions are an interim solution to achieving cross-border recognition of resolution actions. As such, we encourage the PRA to adopt a proportional approach. For example, consideration should be given to the adoption of a two-step de minimis threshold test for excluding certain counterparty exposures, perhaps in terms of a combination of number of transactions under a master agreement and level of exposure as denoted by counterparty type (e.g. NFC- 1 or a third-country entity equivalent). In summary our response identifies the following key points for consideration: the extremely broad geographic scope is likely to have a detrimental impact on the competitiveness of third-country subsidiaries of UK headquartered groups that is not proportional to the benefits of the rules for those that will be resolved without reference to the UK special resolution regime; the timing of implementation should be coordinated across countries that are also seeking to implement proposals similar to this consultation. This would ensure uniform standards across different jurisdictions and promote international harmonisation in an efficient manner. This in turn would have the effect of enhanced client awareness and better acceptance of the proposed changes to contractual terms in a transparent, efficient and standardised manner; and the final rules should provide precise definitions of the financial contracts subject to the provisions and identify which of those would be relevant for a temporary stay under the Banking Act 2009 (this would exclude for example overnight, cash-market and demand rights under financial contracts). In particular, the rules should provide a definition of securities to limit what might be an inadvertent extension of the rules to a very broad range of securities and related contracts which contain termination rights. They should provide transitional relief to permit non-eea central counterparties ( CCPs ) to be considered recognised (and therefore excluded) in any period before a third-country equivalence decision, and subsequent CCP recognition decision, has been taken by the European Commission. Geographical scope of the rule The extremely broad geographical and entity scope of the proposals is a matter of concern for our members. The impact of the UK implementing the contractual stay rules ahead of most other non- EEA markets is particularly concerning in relation to the proposed inclusion of the non-eea credit institutions, investment firms or financial institutions that are subsidiaries of UK authorised institutions. In addition to the general concerns raised in this letter about the proposed scope of the rule, we do not think there is justification for imposing this with respect to affiliates expected to be resolved on a standalone basis in a multiple point of entry strategy. The imposition of any such requirement will be extremely damaging to the business of such subsidiaries given there will be no equivalent requirement imposed on local competitors at the same time. As drafted, the rules require subsidiaries that are credit institutions, financial institutions and investment firms located in any non-eea jurisdiction to renegotiate contracts with clients to non-eea governing law contracts so as to include an agreement to only exercise termination rights to the extent they could under the UK resolution regime. However, in the case of a North American or 1 The obligations of EMIR are applied to entities and their counterparties on a proportional basis. EMIR therefore provides a framework to classify participants in the EU OTC derivatives markets, specifically: financial counterparties ( FC ), non-financial counterparties ( NFC ) and third-country entities ( TCE ). NFCs are further divided into NFC+ (whose OTC derivative contracts exceed a prescribed clearing threshold) and NFC- (whose OTC derivative contracts fall below such a clearing threshold).
3 Asian subsidiary in a multiple point of entry group structure, the entity they are trading with will not (unless the resolution strategy was to change) be resolved by the UK resolution authority and so the UK special resolution regime and whatever it mandates will be irrelevant to the relationship between the parties. Aside from the detrimental competitive impact on the subsidiaries of UK headquartered banks there is considerable volume and complexity of regulatory requirements that require banks to agree new or amended documentation with their clients. We would expect a number of challenges in ensuring client adherence, including number of competing regulatory demands, ability to continue trading with local competitors, reluctance on the part of asset managers to give up rights on resolution and difficultly in explaining UK rules to non UK customers. Given that a failure to agree revised documentation would prohibit new derivative contracts being written, this would have the impact of reducing competitiveness and/or restricting client access to risk management and investment solutions. Compounding the problem is the fact that the rule as drafted prohibits the relevant subsidiary from creating any new obligations under a financial arrangement that is governed by the law of a thirdcountry unless the recognition clause is added. For these non-eea subsidiaries, the overwhelming majority of contracts may be third-country law governed for example, US subsidiaries will be transacting almost entirely on the basis of New York law. As outlined above, client adherence will be very challenging and the fact that this requirement would apply to the majority of the non-eea affiliates contracts means that the consequences of the proposed rules for non-eea subsidiaries could be severe. Furthermore, if not already the case, in due course the third-country in question will likely implement equivalent requirements and these third-country entities will then be subject to parallel but contradictory regulatory requirements and an obligation to renegotiate contracts once again with clients, albeit on different contractual terms and with a different acknowledgement. For the above it has been assumed that for the purposes of the draft rules third-country governing law is taken to mean non-eea. It would be helpful if the final drafting of rule 2.1 made this clear as well as the meaning of laws of the UK in rule 2.2(1) which is inconsistent with the ISDA Stay Protocol that opts in to the laws of England & Wales. In addition to the above, it is noted that paragraph 1.3 of the consultation could be read as implying that the rules will be applied extraterritorially to non-uk groups. Specifically, the reference to regardless of their location could suggest that the provisions extend to financial holding companies and mixed financial holding companies that are incorporated outside of the UK. As this can surely not be the intention we assume that Section 192B FSMA ensures that qualifying parent undertakings have to be UK incorporated, and would appreciate confirmation of this. Contracts to which the requirement applies Notwithstanding our concerns with the geographic scope of the requirement, the proposed rule identifies a broadly appropriate set of financial contracts which should include the contractual terms. There are a number of areas of concern to the members of the BBA. First, the definition of financial arrangements in part 1.4 of the proposed rules encompasses financial contracts which in turn includes securities contracts. Paragraph 2.5 of the consultation indicates that securities contracts includes: i) contracts for the purchase, sale or loan of a security, a group or index of securities; ii) options on a security or group or index of securities; and iii) repurchase or reverse purchase transactions on any such security, group or index. Without clarification and in the absence of a statutory definition of securities, however, the term would apply to a broad variety of debt, equity and hybrid securities, shares, bonds and notes that contain early termination provisions. For example, securities underwriting and purchase agreements typically include termination or market out provisions enabling the underwriters or managers to terminate the agreement if certain market or issuer related events occur after the date the agreement is signed. We do not believe it is the PRA s intention to capture such agreements. Also, cash trading in securities is typically governed by a bank's terms and conditions of business which are a one way notification of terms, with acceptance implied by trading. So requiring an explicit confirmation of agreement from
4 counterparties would be problematic for trades which usually settle delivery verses payment. The final rules should clarify that electronic settlement can be deemed as counterparty agreement under paragraph 2.2 of the rules and that written agreement is not required. A further point in relation to the definition of securities is that the laws of some jurisdictions, for example the US Securities Act, deem guarantees to be securities. There is therefore the risk that guarantees in such markets would be caught if and to the extent that they contain termination rights. It is difficult to believe that the application of the rules to such a broad range of securities and related contracts is intended. Accordingly, it would be helpful if the PRA could clarify that such general securities contracts and guarantees are not intended to be caught by the proposed rules. It is important that the market has full clarity on what is meant by a material amendment made to the substantive terms of a relevant obligation (see paragraph 2.8 of the consultation) and we therefore encourage the PRA to consider how the final rule can address this. Furthermore, whilst we fully support the exemptions set out in paragraph 2.6 of the consultation, we are concerned that as currently drafted the rule would only exempt some and not all non-eea financial market infrastructure ( FMI ). In particular, we are concerned that the reference in paragraph 2.6 to recognised central counterparties could be interpreted as only capturing those non-eea central counterparties that have been recognised under Article 25 of EMIR. Given the significant delay in the European Commission making third-country equivalence decisions under Article 25 of EMIR, we are concerned that a significant number of non-eea central counterparties will not be considered recognised at the time the proposed PRA rule comes into force. This is likely to result in implementation challenges for firms comparable to those being faced with the implementation of Article 55 of the BRRD because, as the PRA is aware, contracts with non-eea FMI are expected to be the most problematic and difficult in terms of obtaining the FMI's agreement to amend such contracts due to the standard nature of their terms. UK firms are unlikely to be able to achieve this through bilateral negotiations. The BBA therefore strongly encourages the PRA to review the scope of the exclusion to address this problem and, at a minimum, provide a transitional provision to allow non-eea central counterparties to be considered recognised (and therefore excluded) in any period before a third-country equivalence decision, and subsequent CCP recognition decision, has been taken. Notwithstanding this, the proposed approach to new obligations is supported. Finally, we would welcome confirmation that the definition of termination rights for the purposes of the draft rules is consistent with similar terminology (Default Right) used in the ISDA Stay Protocol. Timing and structure of transitional provisions As regards the proposed timing of the rules, we note that the consultation paper pays regard to the complexities of compliance and seeks to mitigate these through transitional arrangements. Whilst this is welcome, the proposed arrangements do not offset the material challenges of compliance. First, the ISDA Stay Protocol worked because it was imposed on all participants at the same time. If the requirement is imposed on UK banks before it is imposed on most others then counterparties/client will have less incentive to agree to adhere to the ISDA Stay Protocol (this assumes it will satisfy the PRA rule), harming the competitive position of UK banks as they try to achieve compliance with a requirement no other regulator has yet implemented. This problem will be particularly acute outside the EEA where local standalone subsidiaries of UK parents will be out of line with local market requirements. Thus international coordination of implementation timeframes at the regulatory level is absolutely necessary to ensure that UK banks are not unnecessarily disadvantaged. This applies to both the commencement date for the overall regime and possibility of staggering implementation by product type. A globally-coordinated approach would increase the level of client awareness of the requirements and assist firms in achieving compliance and would therefore be the BBA s strong preference. At the very least, alignment of the implementation of the PRA rules with those expected in the US would ameliorate a number of the implementation challenges outlined in our response.
5 The second issue on the timing relates to the sequencing of this requirement with all of the other documentation-related projects that are currently occurring. The stays recognition requirement is very similar to the requirement in Article 55 which, under the current timetable, must be complied with by 1 st January 2016; notwithstanding the major operational challenge for banks given the seemingly inadvertently broad range of contracts within scope and short implementation timeframe. As firms will wish to sequence client outreach on both matters at the same time, this calls into question whether it will be practically possible for firms to take advantage of the proposed staggered implementation deadlines for the contractual stay rule. The effectiveness of the proposed transitional arrangements will also be impacted by the implementation timelines adopted by other countries. Ultimately, the BBA believes that the introduction of the stays requirement should be coordinated via the FSB. As noted elsewhere, this is the best way in which to achieve awareness and support for the initiative. Notwithstanding this and consistent with our comments above, we recommend that the final stage of implementation should only capture any remaining contracts which are NFC+ and exclude those which are NFC- or equivalent or, should the proposed two-step de minimis threshold test be acceptable, those counterparties. As a final point regarding implementation, it would be welcome if the PRA was to commit to reviewing the ISDA Stay Protocol, as may be amended, and equivalent industry initiatives to cover other financial arrangements as they emerge to assess the extent to which they can be deemed as providing a safe harbour for the purposes of the final PRA rules. Any official guidance and policy statements by the PRA that makes clear that it will consider an entity to have satisfied the conditions of the UK rules for any financial arrangements subject to the terms of the ISDA Stay Protocol or equivalent will promote broad adherence and allow compliance in a standardised, efficient and transparent fashion. Operational Costs As noted above, we would welcome guidance from the PRA that adherence to the ISDA Stay Protocol would be deemed a safe harbour. A consequence of the UK moving ahead of other jurisdictions is that the firms to which the PRA rules apply will bear a proportionally greater share of the burden of educating clients globally as to the reasons for the rules and the mechanics of the ISDA Stay Protocol, which is a complex document. Greater coordination of the implementation of the rules would spread the costs of outreach and education over a much broader population of firms thereby reducing the costs for firms subject to the PRA rules. This should be not overlooked by the cost-benefit analysis. Consideration of the impact of the proposals should also include an assessment of the costs for overseas clients in taking legal advice. It is not clear this client cost can be justified when they trade with an institution that will not fall under the UK authorities upon resolution or if their trading activity is immaterial to the resolution of the institution. Other Matters The proposal in section 3 to revisit requirements for record keeping once the final EBA RTS under BRRD Article 71(8) comes into effect is welcome. The approach to be taken in the interim described by paragraph 3.3 seems appropriate. Paragraph 1.14 explains the proposed approach to the enforcement of the new rules. This describes that the Bank and PRA will both monitor the effect of the rules on the activities of firms and will, if necessary, take steps to address any gaps. This will be by either a PRA supervisory requirement or Bank requirement to remove an impediment to resolution. It should go without saying that firms will expect to see coordination between the Bank and the PRA in this regard. The consultation paper is not clear that, should a firm fail to comply with the rules, this will be treated as a breach of PRA rules
6 and that the relevant financial arrangement would remain binding and enforceable. This should be clarified. In summary, therefore, whilst the BBA supports the underlying objectives of the proposals we strongly encourage the PRA to reconsider the geographic scope and to discuss with partners, through the FSB, how implementation and compliance could be coordinated internationally in an efficient manner that promotes awareness and understanding of the complex requirements. The BBA would be happy to assist the PRA in this and on any other matter related to the implementation of the final contractual stay rules. Yours sincerely, Adam Cull, Senior Director, International & Financial Policy adam.cull@bba.org.uk +44 (0)20 7216 8867