EU Benchmark Regulation amended to include a statutory replacement rate mechanism for LIBOR

Summary

On 12 February 2021, delegated regulation 2021/168 (the Amending Regulation) was published in the Official Journal of the European Union, amending the EU Benchmark Regulation (the EU BMR) and EU EMIR. Among other things, the Amending Regulation gives the European Commission (the Commission) the power to mandate the use of a designated replacement rate (a Replacement Rate) for any critical or third-country benchmark that is to be discontinued, is no longer representative, or is no longer authorised for use in the EU (an Outgoing Benchmark).

The amendments are based on a proposal (the Proposal) published in July 2020. However, following industry and member state feedback, the original Proposal has been extensively amended. In particular, the new Replacement Rate provisions are broader than those set out in the Proposal, and apply to:

• EU law-governed contracts and MiFID II financial instruments (including transferable securities, UCITS and derivative contracts) that reference a benchmark; and
• non-EU law-governed contracts that reference a benchmark, where the contracting parties are EU entities and the applicable jurisdiction does not provide for the orderly wind-down of the benchmark in question.

The Amending Regulation also makes further changes to the EU BMR, to:

• extend the third-country transitional period until the end of 2023, with an option for a
  further two-year extension if necessary; and
• exclude from its scope designated spot foreign exchange rates of a third-country currency
  that is not freely transferable.

Finally, a somewhat last-minute provision amends EU EMIR to clarify the scope of recently introduced regulatory relief from clearing and margining obligations where legacy transactions are amended to account for benchmark reform in line with the requirements of Article 28(2) of the EU BMR.

The amendments are discussed in more detail below.

Replacement rate regime

Scope

EU law contracts and financial instruments: As set out in a new Article 23a under the EU BMR (not to be confused with the proposed Article 23A under the UK BMR, discussed in this briefing), the Replacement Rate provisions apply to any EU law-governed contract or MiFID II financial instrument that references an Outgoing Benchmark. This scope is (helpfully) broader than originally proposed, and extends significantly beyond the remit of the EU BMR itself. For example, under the original Proposal, loan agreements were out of scope, while loan-linked derivatives were in scope. Under the wider scope set out in the Amending Regulation, both loans and their linked derivatives will be amended to reference Replacement Rates. Furthermore, the original Proposal only extended to contracts entered into by EU supervised entities, a limitation which has been removed from the Amending Regulation.

Non-EU law contracts: The provisions also purport to apply to non-EU law-governed contracts, but only where all of the contracting parties are EU entities and, importantly, where the law of the applicable jurisdiction does not provide for the orderly wind-down of the Outgoing Benchmark. This carve-out was not part of the original Proposal and appears to have been introduced to address market concerns around the interaction of multiple legislative regimes.

Legacy contracts only: The Replacement Rate provisions only apply to contracts and financial instruments that reference the Outgoing Benchmark on the date on which the Replacement Rate is designated. Where master agreements, such as the ISDA Master Agreement, are in scope, the recitals to the Amending Regulation make clear that the Replacement Rate will only apply to transactions entered into prior to its designation, even though transactions entered into thereafter are part of the same contract.

In-scope benchmarks: In-scope benchmarks include (i) benchmarks that have been designated as critical under the EU BMR (such as EURIBOR), and (ii) third-country benchmarks, the cessation of which would disrupt the functioning of the EU financial system (such as LIBOR).

Opt-out: Contracts under which the parties have agreed a different fallback rate, whether before or after a Replacement Rate is designated, fall outside the scope of the Replacement Rate regime. extend the third-country transitional period until the end of 2023, with an option for a further two-year extension if necessary; and exclude from its scope designated spot foreign exchange rates of a third-country currency that is not freely transferable.

No "suitable" fallbacks or "tough legacy": A Replacement Rate will only replace an Outgoing Benchmark in contracts and financial instruments which either (i) do not contain any fallback provisions, or (ii) do not contain "suitable" fallback provisions (so-called "tough legacy" contracts).

In the Amending Regulation the meaning of "suitable" is determined by reference to what would constitute an "unsuitable" fallback. These are deemed to be:

1. fallbacks that do not provide for a permanent replacement of the Outgoing Benchmark; 
2. fallbacks that require third-party consent, where consent has been denied; and 
3. fallbacks that provide for a replacement rate which no longer reflects or significantly diverges from the underlying market or the economic reality that the Outgoing Benchmark is intended to measure, where its application could have an adverse impact on financial stability.

Limb 3 above is intended to address situations where, for example, there has been a significant widening of the spread between an Outgoing Benchmark and its specified contractual fallback rate over time, or where the contractual fallback provisions would change the basis of the contract or instrument from a variable rate to a fixed rate (as is likely to be the case for many in- scope floating rate notes). The determination under limb 3 would be made at the relevant member state level, on the basis of a horizontal assessment of a specific type of contractual arrangement (such as floating rate notes), and not on a case-by-case basis. The process of assessing a particular type of contract or financial instrument would commence upon receipt by the relevant competent authority of an objection to the contractual fallback rate by one of the contracting parties. The parties would be free to opt out of using the Replacement Rate if they agreed on a suitable fallback rate before cessation of the Outgoing Benchmark.

Trigger Events

New Article 23b sets out the events (Trigger Events) which activate the Commission's power to designate a Replacement Rate. These are:

1. public confirmation by the competent authority for the Outgoing Benchmark's administrator that the capability of the Outgoing Benchmark no longer reflects the underlying market or economic reality;
2. public confirmation by or on behalf of the Outgoing Benchmark's administrator that the Outgoing Benchmark, or certain currencies and/or tenors thereof is/are to be permanently or indefinitely discontinued, where there is no successor administrator; 
3. public confirmation by the competent authority for the Outgoing Benchmark's administrator, or any entity with insolvency or resolution authority over the administrator, that the Outgoing Benchmark, or certain currencies and/or tenors thereof is/are to be permanently or indefinitely discontinued, where there is no successor administrator; or 
4. withdrawal or suspension of (i) the administrator's authorisation or recognition under the EU BMR, or (ii) the Outgoing Benchmark's endorsement under the EU BMR, where there is no successor administrator and the administrator intends to permanently or indefinitely discontinue the Outgoing Benchmark or certain currencies and/or tenors thereof.

Aside from the fourth Trigger Event described above, which is specific to the EU BMR, the Trigger Events remain broadly in line with those proposed in the current corresponding draft US legislation. In addition, the inclusion of a "pre-cessation" trigger is consistent with the FCA's proposed "synthetic LIBOR" approach. This consistency, combined with the carve-out discussed at Non-EU law contracts above, will help to mitigate market concerns around the concurrent development of three different, potentially conflicting, regimes across the EU, the UK and the US.

Consultation followed by implementing act

After the occurrence of a Trigger Event, the Commission is obliged to conduct a public consultation in relation to the terms of a new implementing act. The terms of new implementing act will include: 

• details of the Replacement Rate(s) and the date from which it/they will apply;
• the spread adjustment (including the calculation method) to be applied to the Replacement Rate; and
• any "essential conforming changes" that are reasonably necessary for the use of the Replacement Rate (which might be expected to include, for example, changes to calculation
  periods and/or the introduction of a lookback or lockout period).

While not obliged to follow official recommendations made by central banks and working groups, the Commission must take these, and any recommendations of the Outgoing Benchmark's administrator, into consideration. It is therefore reasonable to assume that any Replacement Rate selected by the Commission should be in line with official recommendations where available – for example, SONIA plus a spread for GBP LIBOR, SOFR plus a spread for USD LIBOR, and so on.

National competent authority (NCA) powers

For an Outgoing Benchmark that is recognised as being critical in the EU member state in which the majority of its contributors are based, the relevant NCA also has the power to designate a Replacement Rate upon the occurrence of a Trigger Event. Before making an announcement that would constitute a pre-cessation trigger, the NCA must be satisfied that the remedial powers available under the EU BMR are not sufficient to restore representativeness.

Extension of third-country transitional regime

Extension of transitional provisions: Current third-country transitional provisions under the EU BMR permit EU supervised entities to continue to use third-country benchmarks until the end of 2021, irrespective of whether they are on the ESMA register. The Amending Regulation extends this period to the end of 2023. However, to avoid regulatory arbitrage, the extension is not available to EU administrators that relocate to a third country in the intervening period.

Under certain circumstances (see Further EU BMR review below), the Commission can extend the transitional provisions further, to the end of 2025. This would be in line with the UK BMR transitional provisions (assuming that the Financial Services Bill is adopted in its current form).

You can read more about the Financial Services Bill in our briefing.

Further EU BMR Review: Under the Amending Regulation, the Commission is required to report on the scope of the EU BMR by 15 June 2023, focusing particularly on the shortcomings of the third-country authorisation regime (which have been well-documented in the market) and whether the regulation's general scope should be narrowed. If the report indicates that it is necessary, the transitional provisions may be extended further by the Commission to the end of 2025, to provide more time to address issues raised in the report. As with the exchange rate exemptions (described below), any such extension would be subject to European Parliament and Council approval. Under the Amending Regulation, the European Parliament and the Council have a specific power to revoke the Commission's authority to extend the exemption at any time.

Exemption of certain third-country spot FX benchmarks

Under the Amending Regulation, the Commission has the authority to exempt certain third-country spot foreign exchange benchmarks (TC FX Rates) from the EU BMR. In order to be eligible for exemption, a TC FX Rate must (i) reference a spot exchange rate of a third-country currency that is not freely convertible, and (ii) be used on a frequent, systematic and regular basis to hedge against adverse foreign exchange movements. This is a significant deviation from the original Proposal, which specifically required the use of a TC FX Rate by EU supervised entities in derivative contracts in order for it to be eligible for exemption.

As very few jurisdictions regulate spot exchange rates, the existing "equivalence", "endorsement" and "recognition" routes to authorisation under the EU BMR are not available for TC FX Rates. Accordingly, without appropriate exemptions, EU supervised entities will no longer be permitted to reference TC FX Rates (other than those produced by central banks) in relevant contracts after 31 December 2023, when the existing third-country transitional provisions are scheduled to expire (also see Extension of third-country transitional regime below).

The Commission will consult on which TC FX Rates should be exempted by the end of 2022 and will adopt delegated legislation listing the exempted rates by 15 June 2023, just six months before the scheduled expiry of the transitional provisions. The list will then be updated as necessary.

The European Parliament and the Council have a right of veto in respect of any proposed exemption and have up to six months from notification to disagree, potentially taking the approval timeline very close to the scheduled expiry of the transitional provisions (although also see Further EU BMR Review above). As with the third-country transitional provisions discussed above, the European Parliament and the Council have a specific power to revoke the Commission's power to exempt TC FX Rates at any time.

Clarification of relief from clearing and margining obligations under EU EMIR

Recent changes to EU EMIR introduced by the EU CCP Recovery and Resolution Regulation were intended to clarify that legacy derivative transactions that are not subject to clearing or margining obligations under EU EMIR will not become subject to such requirements where they are amended solely to ensure compliance with Article 28(2) of the EU BMR (which requires EU supervised entities to include fallback provisions for discontinued or amended benchmarks in their contractual documentation).

The amendments took effect on 11 February 2021, but are not considered to be sufficiently broad to cover the full range of amendments that may need to be made by market participants. The Amending Regulation therefore amends new Article 13a of EU EMIR to make clear that derivative transactions that (i) are not currently subject to clearing or margining requirements under EU EMIR, and (ii) are amended or novated for the sole purpose of replacing a reference benchmark or introducing fallback provisions in relation to a reference benchmark, will not become subject to new clearing and/or margining obligations as a result of such amendments.

Next steps

The Amending Regulation entered into force and applies from 13 February 2021, making it the first of the three major "tough legacy" proposals to take effect. The proposed US legislation is still in the early stages of development, and is potentially subject to challenge on the grounds that it is unconstitutional. In the UK, the FCA has indicated that its proposed legislative solution to the problem of tough legacy contracts may not take effect until summer, although further FCA consultations are expected this quarter. Until all of these regimes are finalised, it is unclear how they will interact. 

Away from tough legacy, market participants will welcome the prospect of a further report on the EU BMR next year, and will hope that it finally provides a workable third-country authorisation regime, while simultaneously reducing the overall scope of what many consider to be an overly broad regulation that is markedly out of step with comparable jurisdictions.

Authors: Mike Logie and Kirsty McAllister-Jones.