Overview
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) 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.
Recent developments
On July 11, 2019, ESMA updated its BMR Q&As with regard to
the euro short-term rate (€STR) and the
commodity benchmark. 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 report 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, 2019, €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” (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”.
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” letter
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 derivatives 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
- Conducting a review of affected
- 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.
Footnotes
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.↩
2 For further background reading and materials please
refer to our slides from our “Replacing IBORs: Roundtable
Frankfurt” available here. ↩
3 ESMA’s Questions and Answers on the Benchmarks
Regulation (BMR) dated July 11, 2019, page accessible here.↩
5 It is set to replace the euro overnight index
average (EONIA) completely by the end of 2022.↩
6 ESMA’s Questions and Answers on the Benchmarks
Regulation (BMR) dated July 11, 2019, page 7, accessible here.↩
7 ESMA’s Questions and Answers on the Benchmarks
Regulation (BMR) dated July 11, 2019, page 21, accessible here.↩
8 ldquo;ECB-SSM issues: Dear CEO letter on state of
preparation of interest rate benchmark reforms and use of risk-free
rates” dated July 8, 2019, accessible here.↩
9 Please see our special coverage on the impact on
derivatives.↩
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