More than six years after the range of IBOR scandals and a series of reform proposals the adoption of the “Regulation on indices used as benchmarks in financial instruments and financial contracts or to measure the performance of investment funds” (Benchmarks Regulation or BMR)1 marks a major step for financial institutions and their clients on what might be the most challenging and costly “road to compliance” ever since MiFiD was first introduced. Officially, the BMR entered into force on June 30, 2016 with the majority of its provisions applying from January 1, 2018 onwards, and it was seen as the EU response to the already known interbank offered rate (IBOR) “problem” – interest rates benchmarks have tremendous impact on financial markets’ decision making, and therefore having the same financial players benefitting from the markets also be the benchmark submitters can potentially lead to manipulations. Consequently, the BMR was introduced with the aim to restore investor and consumer’s confidence in the accuracy and stability of indices used to reference the price of financial instruments and financial contracts, as well as the measurement of the performance of investment funds.
The BMR calls on the European Commission and the European Securities and Markets Authority (ESMA) to develop and implement delegated acts, technical standards and guidelines in critical areas. These are of central importance to the system as they dictate how the BMR is to be implemented by competent authorities, administrators, contributors and users.2
On July 11, 2019, ESMA updated its BMR Q&As with regard to the euro short-term rate (€STR) and the commodity benchmark.3 ESMA’s Q&A aims to promote common, uniform and consistent supervisory approaches and practices in the day-to-day application of the BMR across the EU. On August 19, 2019 the private sector working group on euro risk-free rates has today published a report4 containing a set of operational and valuation recommendations addressing “…the impact of the transition from the euro overnight index average (EONIA) to the euro short-term rate (€STR)” (the Report).
The Report assesses the impacts of transition on various financial products and processes affected including covered secured (repos) and unsecured (cash accounts) cash products, financial instruments, investment funds, derivatives along with models referencing EONIA. In particular the Report emphasizes the need for market participants to prepare for the change from October 2, 2019 in EONIA’s publication from day T at 19:00 CET to the next business day i.e., T+1 at 9:15 CET as well as the discontinuation of EONIA on January 3, 2022. Market participants are equally encouraged to take note and prepare for the €STR publication time of 8:00 CET which was announced July 11, 2019. The Report marks a very useful publication even though it explicitly states that readers may need to retain their own counsel to assess how all highlighted impacts, which are not definitive, may affect specific market participants across various jurisdictions, asset classes, product and client types.
1. Contribution to the euro short-term rate (€STR)
€STR is a risk free interest rate that will replace EONIA. It was developed by a working group which was set-up by the European Central Bank (ECB). Due to its imminent launch on October 2, 20195, €STR raises urgent questions as to its applicability. In its most recent update, ESMA clarified that €STR is not based on “contributions of input data” as defined in Article 3(1)(8) of the BMR. Rather, the data is “exclusively based on borrowing transactions in euro conducted with financial counterparties that banks report to the ECB in accordance with Regulation (EU) No 1333/2014”6 (MMSR Regulation). The data is provided to the ECB for regulatory purposes rather than for determining the benchmark as required under Article 3 of the BMR. Therefore, banks providing the ECB with data under the MMSR Regulation are not classified as “supervised contributors”, so that the governance and control requirements applying to “supervised contributors” under Article 16 of the BMR do not apply to these banks.
2. The commodity benchmarks definition
ESMA further clarified that the definition of commodity benchmarks in relation to the BMR is not identical to that of commodity derivatives in relation to the Directive on Markets in Financial Instruments repealing Directive 2004/39/EC (MiFID II) and the Regulation on Markets in Financial Instruments (MiFIR). As opposed to the latter two legal acts, BMR makes multiple references to the commodity benchmark relating to physical or fungible assets, leading to ESMA defining the underlying asset of a commodity benchmark as a “fungible physical commodity”.7
Furthermore, on July 3, 2019, the ECB issued a letter to the heads of all Banking Union Supervised Institutions (BUSIs) categorized as significant credit institutions (SCIs).
3. The ECB’s “Dear CEO” letter8
The ECB, acting in its role at the helm of the Eurozone’s Banking Union’s Single Supervisory Mechanism (SSM), sent a letter to the CEOs of all BUSIs directly supervised by the ECB-SSM regarding the ongoing benchmark reforms and the transition from EONIA to €STR.
The highly prescriptive letter requires, among others, that SCIs’ senior managers and boards understand the risks associated with global benchmark reforms, notably in respect of the move towards €STR, and commence preparations regarding the BMR’s 2021 deadline for the transition to alternative “risk-free rates” or relevant reformed benchmark rates. To this end, SCIs must provide evidence to the ECB-SSM to show that their action plans as well as their agreements with counterparties are suitable to deal with upcoming developments (such as the EONIA to €STR transition, changes to EURIBOR and/or relevant benchmarks in any currency for contracts held).
Specifically, SCIs must provide a summary of key risks as well as an action plan containing proposals on how to mitigate those risks and addressing pricing issues and process changes. They must also implement contact points in charge of overseeing action plans – and all by July 31, 2019. Furthermore, by September 15, 2019, each SCI is required to submit a questionnaire relating to quantitative and qualitative fields to help the ECB determine how that SCI will be affected by benchmark reform.
How does this affect your business?
The BMR’s impact is wide reaching in relation to individual IBOR transition compliance let alone across the multiple different IBOR replacement efforts in various jurisdictions but equally across various asset classes and with client types. These all have documentation and non-documentation related workstreams. Even with centralized outreach programs, coordinated counsel and relevant fallback language drafting (which at present is not-cross asset class, cross-jurisdiction and client type but rather silo’ed in individual efforts of industry associations or bespoke firm specific drafting – even where such drafting comes from coordinated counsel) affected market participants may wish to consider that:
- The BMR-reforms require action for
affected financial services firms (and not just BUSIs) as well as
their clients across multiple workstreams. Some of these may be
specific to and within the responsibility of sell side financial
market participants and others will be specific to buy side actors
with a large majority, depending on type of product, client and
jurisdiction as well as governing law of documentation being a
matter where action is required from both sides. Some major
headline areas for focus include:
- Conducting a review of affected transactions and systems to assess the modifications to move to amendments on EONIA and other IBORs including change over in publication times and what this might mean for default settlement times – the Report advocates, and this may not resonate with all market participants or be feasible, longer settlement times for example moving EONIA-related derivatives9 and money market transactions from T+1 to a T+2 settlement and thus a potential difference between also payments of nominal and interest amounts. For investment funds the Report states that investment funds linked to EONIA that the T+1 publication will likely affect net asset value calculations and the redemption/subscription processes and that this could cause a shift in which EONIA calculation is referenced
- Designing and implementing new product approval processes for “risk free rate” and BMR compliant products for retail as well as wholesale clients and update communication and engagement strategies – the Report and other ECB statements, in keeping with other policymakers’ statements, advocates moving away from issuance of financial instruments linked to what will become legacy IBORs that go beyond the changeover period
- Undertaking client legal documentation upgrades to account for changes and “other” reforms across client but also investor facing documentation as well as any risk factor disclosures. Some of these “other” changes include introducing relevant language so as to cater for recent changes to EMIR or as a result of BREXIT but also ensuring, certainly for legacy OTC derivatives documentation and collateral documentation, that any changes do not trigger the application of mandatory margining and/or clearing (a number of supervisory authorities have yet to announce their “final state” supervisory expectations on this) as well as considering the availability of relief (where available) from adverse hedge accounting and other accounting impacts or in relation to the inadvertent trigger of tax implications if an amendment is deemed to be a significant modification or constitute rescission etc. In addition to the management of designing, implementing and delivering the legal drafting, affected parties will need to consider whether those changes require consent from counterparties and how best to obtain it as well as evidence that it has been obtained – in particular as the standard and methods permitted may be different by jurisdiction, client and product type
- Assessing internal and external infrastructure changes in particular amending systems, processes and models (including model approval timelines) across “front office” functions but equally relevant treasury, finance, risk and other control functions
- Assessing interactions with central counterparty clearing houses (CCPs) and discounting regimes – the Report sets out the recommended discounting switch date period for CCPs as March 31, 2020 to June 30, 2020
- Accounting for spread adjustments and any implications for payment mechanics, financial covenants, marking to market, impacts on hedging arrangements
- Managing conduct, legal and litigation/regulatory complaint risks (notably also consumer protection considerations) that may arise from the relevant changes
- Deciding when changes are to take effect
- Due to the tight turnaround times coinciding with European summer holidays, we recommend that SCIs start working on the aforementioned requirements as soon as possible, taking into account any new guidelines / requirements published by ESMA, the European Commission or the ECB in the near future.
- Other BUSIs classified as “lesser significant institutions” may be subject to indirect ECB-SSM or direct national supervision if the new requirements are “mirrored” at national level down the line. They will need to set up action plans and have evidence available to provide to the ECB-SSM and/or their national competent authorities. Benchmark-readiness is also important for firms that are in the EU but not in the Banking Union, as well as stakeholders dealing with relevant benchmark rates in non-euro currencies.
- As the deadlines for implementation are still subject to amendment and based on a variety of unpredictable factors, it is important for all BUSIs as well as the much wider body of affected non-BUSI financial services firms as well as relevant teams at buy-side market participants to closely cooperate with stakeholders and professional advisors.
Our Eurozone Hub lawyers are assisting a number of BUSIs in dealing with BMR-related supervisory dialogue and how this impacts workstreams beyond preparatory changes in policies and procedures but also on internal model remediation, contractual renegotiation/repapering and/or other forms of counterparty outreach programs. If you would like to receive further analysis on any other issues raised herein with regard to how to prepare in relation to documentation and non-documentation workstreams, please contact one of our Eurozone Hub key contacts.
1 Regulation (EU) 2016/1011 of the European Parliament and of the Council of 8 June 2016 on indices used as benchmarks in financial instruments and financial contracts or to measure the performance of investment funds and amending Directives 2008/48/EC and 2014/17/EU and Regulation (EU) No 596/2014, accessible here.↩
5 It is set to replace the euro overnight index average (EONIA) completely by the end of 2022.↩
9 Please see our special coverage on the impact on derivatives.↩
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