Whether or not a transition deal is reached by March 30, 2019, Brexit raises questions about disruption risk in cross-border contracts that involve regulated activities. This risk exists for issuers across all sectors where counterparties have relied on passporting rights to perform cross-border activities between the EU27 and the U.K. (see "Countdown to Brexit: No Deal Moving Into Sight," Oct. 30, 2018). For structured finance issuers, Brexit raises questions relating to counterparty and operational risks, particularly in instances where there are cross-border derivative exposures. In a scenario where no plan for the U.K.'s orderly withdrawal from the EU is agreed, the implication of Brexit on such derivatives would crystallize on March 30. We understand U.K. derivative dealers are implementing contingency plans to mitigate this risk--particularly by transferring affected contracts to EU27 affiliates--and would have more time to execute these measures if a transition period is agreed with the EU. In this report, S&P Global Ratings analyzes some potential effects of Brexit on the operational and counterparty risks in rated structured finance transactions, and lists the transactions where we believe these risk factors are most relevant.

In our view, the operational and counterparty risks resulting from Brexit, particularly for cross-border derivatives, could have a significantly larger ratings impact than our expectations for deterioration in the credit quality of the securitized assets (see "Countdown To Brexit: A Disruptive Brexit Would Mean Increased Losses In U.K. ABS And RMBS Transactions But 'AAA' Ratings Will Be Stable," Sept. 5, 2018). U.K.-incorporated financial institutions (which include U.K. subsidiaries of foreign groups) have typically relied on passporting rights to enter into derivative contracts with EU-domiciled structured finance issuers. Post-Brexit and any associated transition period, we expect that U.K. banks will lose these passporting rights. The U.K. government is legislating to allow the continued performance of lifecycle events on uncleared derivative obligations with EU-domiciled financial institutions for a temporary period following a no-deal Brexit. This should allow more time to implement action plans to mitigate the loss of passporting rights in the U.K. However, in the EU, the focus of reciprocal legislation relates to cleared derivatives for which the European Commission has said it will adopt measures to avoid disruption in central clearing and depositary services, and uncleared derivatives for which the European Securities and Markets Authority has proposed some temporary exemption under European Market Infrastructure Regulation (EMIR; see below). The European Commission has indicated that it does not expect to explore further legislative solutions for uncleared derivatives, which are commonly used in structured finance transactions, but some countries are legislating to address these issues at a national level. Post-Brexit, in the absence of an agreement on these matters at the EU level or an "equivalence decision" by the European Commission, local regulations in some EU member states might prevent certain EU counterparties from performing lifecycle events on uncleared derivatives with U.K. entities. Therefore, we expect that U.K. counterparties' loss of passporting rights will probably prevent some EU structured finance issuers from entering into new derivative contracts with them, and may affect their ability to perform certain servicing functions on existing contracts. Without mitigating actions by the affected counterparties, we believe this could result in contract terminations, which could have significant ratings implications for affected structured finance transactions.

Administrative Key Transaction Parties And Bank Account Providers Pose Low Disruption Risk

U.K. financial institutions participate in structured finance transactions with EU domiciled issuers in different transaction roles, such as paying agents, cash managers, bank account providers, and trustees. To the extent any transaction party could experience interruption to such services due to a loss of passporting rights, there could be a ratings impact if it were to result in disruption or delays to transaction cash flows. However, we understand that administrative roles are not all reliant on passporting rights, and issuers would, in any event, generally have the ability to novate these agreements to other counterparties without significant costs.

Cross-Border Derivatives Present The Largest Disruption Risk

In our view, absent any mitigating actions, the largest potential for disruption risk in structured finance transactions would apply to EU-based issuers that have a U.K.-based derivative counterparty. The appendix to this article provides a list of these issuers, split by asset class and counterparty.

We understand that counterparties will generally be able to continue to make payments and post collateral on existing agreements after Brexit. However, structured finance issuers are particularly sensitive to any risk of termination of derivative contracts (which support the ratings on many structured finance transactions). Derivative contracts typically contain a provision allowing for termination of the derivative in the event that performance becomes illegal. If the counterparty's loss of passporting rights were to constitute a case of illegality, triggering a termination event under applicable swap documentation, the issuer may owe senior termination payments to the counterparty, depending on the mark-to-market value of the swap (i.e., if the issuer is out-of-the-money when the swap is terminated). This could present substantial liquidity risks to issuers and result in significant ratings volatility; it is possible that if issuers owe large mark-to-market payments to counterparties, highly rated structured finance securities could default. Our current assumption is that illegality termination events would not occur as a result of Brexit. However, we understand there is a risk that certain "lifecycle" events (such as material amendments to existing contract terms) could be viewed as entry into a new derivative transaction and, as such, require authorization from national regulators. In the absence of such authorizations, U.K. counterparties may be unable to execute relevant events (a possible example could be amendments required to reflect new benchmark provisions in connection with the phase-out of IBORs, if a relevant regulator construed such amendments as entry into a new derivative transaction). If agreements are terminated or cannot deal with lifecycle events, there could be a significant negative ratings impact on affected transactions.

For covered bonds, the dual recourse nature of the rated obligations would further mitigate any liquidity risk in our view. For commercial mortgage backed securities transactions, the majority of the derivative exposure is to interest rate caps, which have been paid upfront and, as such, would not require the issuer to make a termination payment even if an illegality termination event occurred. However, these derivative agreements could face future lifecycle events, which could result in the loss or reduced effectiveness of the hedges for these transactions.

Implementation Of Brexit Contingency Plans Mitigates Lifecycle Risk

We observe that, as part of their Brexit contingency planning, many U.K. market participants are transferring their swaps to EU regulated affiliates, generally through a novation process, which would help to alleviate the risk of difficulties in servicing existing agreements through lifecycle events (see "Countdown To Brexit: Financial Institutions Are Past The Point Of No Return," Oct. 11, 2018). Most derivatives in structured finance transactions are uncleared, and the issuer is generally exempt from posting margin. To help facilitate the transfer of existing contracts, EU authorities have proposed exemptions from EMIR clearing and bilateral collateral posting requirements that may otherwise have been triggered by such novations of over-the-counter derivative agreements. We believe the novation of agreements would generally mitigate the risks to continuity in the servicing of existing contracts.

Certain U.K. entities are transferring uncleared derivatives to EU affiliates through a court process, and these transfers are generally well advanced. Other transfers require the consent of each counterparty, and the extent of client engagement will be an important factor in determining what proportion is completed by March 29, 2019. We believe there is a risk that some of these transfers may not be completed prior to March 30, 2019.

As part of our surveillance of rated transactions, we would expect to be notified of these amendments as soon as practicable so that we can assess the potential impact on our outstanding ratings. Our analysis would consider if the rating of the new counterparty is commensurate with the assigned ratings on the supported securities (see "Counterparty Risk Framework Methodology And Assumptions," June 25, 2013 and "Counterparty Risk Analysis In Covered Bonds," Dec. 21, 2015). In the event that transaction parties request S&P Global Ratings to confirm that the contract novation will not, in and of itself, cause us to lower, withdraw, or qualify our current ratings (such requests are typically referred to as rating agency confirmations [RACs]), we always reserve the right to decline to provide a RAC, notwithstanding the presence of a RAC requirement in a transaction document (see "Standard & Poor's Clarifies Its Approach To Requests For Rating Agency Confirmation On Structured Finance Transactions," May 18, 2012).

Brexit Unlikely To Have Any Immediate Ratings Impact On Structured Finance Transactions

We will continue to monitor how cross-border counterparty risks may evolve in structured finance transactions post-Brexit. We understand that U.K. counterparties will generally be able to make payments and post collateral under existing contracts with EU issuers entered into pre-Brexit, and therefore do not currently expect ratings impact on EU structured finance transactions. However, we note that structured finance issuers are particularly sensitive to liquidity risks if a derivative contract were to be terminated due to illegality. We also understand that, in the absence of mitigating actions, U.K. counterparties of EU issuers may face difficulties in making material amendments to existing contracts. We believe it is premature to take any rating action as a result of these potential restrictions, but will closely follow any developments in this space.

Related Criteria

• Counterparty Risk Framework Methodology And Assumptions, June 25, 2013
• Counterparty Risk Analysis In Covered Bonds, Dec. 21, 2015

Related Research

• Credit Conditions EMEA: Bracing For Turbulence, Nov. 29, 2018
• Countdown To Brexit: No Deal Moving Into Sight, Oct. 30, 2018
• Countdown To Brexit: Financial Institutions Are Past The Point Of No Return, Oct. 11, 2018
• Countdown To Brexit: A Disruptive Brexit Would Mean Increased Losses In U.K. ABS And RMBS Transactions But 'AAA' Ratings Will Be Stable, Sept. 5, 2018
• Standard & Poor's Clarifies Its Approach To Requests For Rating Agency Confirmation On Structured Finance Transactions, May 18, 2012

Appendix

Table 1