Benchmark regulation: Commission proposes (i) mandatory replacements for discontinued IBOR rates and (ii) exemption for non-EU FX rates

Summary

On 24 July 2020, the European Commission (Commission) published a proposal (Proposal) to amend the EU Benchmark Regulation (BMR) to give the Commission powers to mandate the use of a statutory replacement rate (SRR) in relevant contracts if a major benchmark used in the EU, such as LIBOR, is discontinued or becomes unrepresentative of its underlying market. 

Under the Proposal, the relevant SRR would automatically replace the outgoing benchmark by operation of law in all contracts which are (i) in scope of the BMR (meaning that loan agreements would be excluded, but loan-linked agreements, such as hedging transactions, could be in scope) and (ii) entered into by one or more BMR "supervised entities", where the contract contains no suitable fallback provisions (so-called tough legacy contracts). The Commission would also request EU member states to implement similar provisions under domestic legislation, to cover tough legacy contracts that are governed by the laws of that jurisdiction and entered into by non-supervised entities. The Commission's approach to tough legacy contracts, if adopted by the Council of the EU and the European Parliament, will be sweeping, and on its face will overlap and could conflict in certain circumstances with the UK Financial Conduct Authority's (FCA) proposed "synthetic LIBOR" approach to tough legacy contracts and the ARRC's proposed legislative solution to tough legacy USD LIBOR contracts under New York law. More information on the FCA's proposed powers and the ARRC's legislative proposal is available in our briefing here.

Separately, but as part of the same legislative Proposal, the Commission proposes to exclude from the scope of the BMR certain non-EU spot exchange rates which are referenced in non-deliverable forwards and swaps.

Background

The Proposal follows a recently completed fulsome review of the BMR by the Commission. Financial markets participants and trade bodies had hoped that the review would lead to a limitation on the broad scope of the BMR and, in particular, to amendments to the unwieldy and onerous third-country benchmark regime. Instead, the Proposal rather narrowly seeks to exempt only certain non-EU spot exchange rates from the BMR. The Proposal also very broadly seeks to use the BMR as the basis for the EU's legislative fix to the tough legacy contract issue.

Statutory replacements for discontinued or unrepresentative rates

LIBOR discontinuation or unrepresentativeness

The FCA confirmed in 2017 that it will no longer compel panel banks to submit data for the calculation of LIBOR beyond 31 December 2021 and, aside from the publication of any currency/tenor combinations under the FCA's "synthetic LIBOR" proposals, LIBOR is expected to be discontinued at some point thereafter. As a result, market-wide initiatives are in place to incorporate appropriate fallback provisions into LIBOR-referencing contracts. However, as the Proposal notes, given the relatively short timeframe for incorporating these fallback provisions, the huge breadth and range of contracts that reference LIBOR, and (for certain contracts) the challenges associated with obtaining the necessary approval from all parties to incorporate fallback provisions or transition to alternative reference rates, there will inevitably be a significant stock of LIBOR-referencing contracts that have not been amended to incorporate appropriate fallback provisions or transition to alternative reference rates by the time LIBOR is discontinued. 

Divergence with UK approach

According to the Proposal, the original approach chosen by the Commission to manage tough legacy contracts was aligned with that recently announced by the UK government. Under the UK's proposed approach, there are plans to confer powers on the FCA to mandate the publication of a "synthetic" LIBOR for certain currency/tenor combinations for use in tough legacy contracts if (i) that particular currency/tenor combination becomes unrepresentative of its underlying market, and (ii) representativeness will not be restored. However, according to the Proposal, several limitations to this approach have since come to light, as articulated by the FCA itself. The limitations include that it may not be possible or practical to publish the relevant replacement rate across all currency/tenor combinations and that "synthetic LIBOR" might not be appropriate for all products and agreements. However, it may be that the Commission's proposed approach does not produce the best outcome in every scenario either.

Designation of a statutory replacement rate

The Proposal would give the Commission the authority to designate SRRs to replace LIBOR and any other major benchmark used in the EU which is discontinued or becomes unrepresentative. In designating an SRR, the Commission would take into account the recommendations of official risk-free rate working groups that have been established to determine the most appropriate fallback rates for a range of IBORs and other reference rates. Presumably, this process should lead the Commission to designate the same successor rate for a given LIBOR currency as that designated or recommended by the relevant working groups or regulators in other jurisdictions, but the Commission would not be bound by such and therefore could potentially diverge.

Trigger events

Designation of an SRR would be triggered by the occurrence of any of the following "trigger events":

• a public statement by or on behalf of the administrator of a benchmark announcing that it has ceased or will cease to provide the benchmark permanently or indefinitely where there is no successor administrator;
• a public statement by the relevant competent authority or other relevant body that the administrator of a benchmark has ceased or will cease to provide the benchmark permanently or indefinitely where there is no successor administrator; or
• a public statement by the regulatory authority competent for the authorisation of the administrator of the benchmark announcing that the benchmark is no longer representative of the underlying market or economic reality on a permanent and irremediable basis.

The trigger events are consistent with the terminology of the BMR and, mercifully for market participants, are substantially the same as those proposed for the ARRC's proposed legislative solution, and the "unrepresentativeness" trigger is consistent with the FCA's "synthetic LIBOR" approach.

Contracts in scope

Under the Proposal, following the occurrence of one of the above-described trigger events, SRRs would replace outgoing rates by operation of law for "financial instruments, financial contracts and measurements of the performance of an investment fund" which "contain no suitable fallback provisions". On its face, the Proposal applies to relevant contracts and instruments, regardless of whether the governing law is that of an EU member state or otherwise.

The former terms are all as defined in the BMR; therefore, the Proposal only applies to those limited set of instruments and contracts which are currently in scope of the BMR, where at least one party is an EU supervised entity. Therefore, by way of example, a security issued by an EU supervised entity linked to a LIBOR rate and listed on an EU regulated market or MTF would be in scope of the Proposal; whereas a security having identical terms save for being unlisted would not be in scope. As discussed below, the Proposal makes no mention of excluding non-EU law governed instruments and contracts, but on its face applies to all BMR in-scope instruments and contracts – regardless of governing law - so long as at least one of the counterparties is a BMR "supervised entity". 

Importantly, loan agreements, not being covered by the relevant BMR definitions, would not be amended under the new rules. Therefore, in order to avoid hedging mismatches and to ensure consistency across portfolios, market participants will need to closely monitor which of their contracts have been amended by operation of law pursuant to the new BMR provisions, and which need to be amended by other means.

The Proposal envisions that the application of an SRR could effectively be extended through the enactment of similar domestic legislation by each EU member state, to cover contracts that are (i) entered into between entities which are not subject to the BMR, and (ii) governed by the laws of the relevant member state. This gives rise to the possibility of a patchwork of legislation across the EU if such domestic laws are not substantially the same across member states.

The draft amendments to the BMR set out in the Proposal do not define "suitable fallback provisions" for purposes of determining to which instruments and contracts the terms of the Proposal would apply. However, the broader Proposal does include a summary table of the proposed rules which provides useful detail, as set out in the Annex to this briefing. According to the table, instruments and contracts which do not include "suitable fallback provisions", and therefore would automatically switch from the relevant LIBOR rate to the relevant SRR on a trigger event, are:

1. legacy contracts that contain no contractual fallback benchmarks;
2. legacy contracts that only contain fallback provisions to accommodate a temporary suspension of a benchmark whose cessation would result in significant disruption in the functioning of financial markets in the EU; and
3. legacy contracts that contain a fallback that references the benchmarks mentioned under (2) (e.g. last quoted fixing of the above benchmarks).

It remains to be seen whether the Commission will publish further guidance on what types of contract are to be in scope of the Proposal – for example, possibly to more closely align with the detailed legislative proposal of the ARRC.

Replacement by "operation of law"

Under the Proposal, SRRs would automatically replace outgoing rates in in-scope contracts following a trigger event, "by operation of law". As noted above, the Proposal is not limited to relevant contracts and instruments which are governed by the laws of EU member states, but also appears to encompass contracts governed by non-EU laws, such as English and New York law. This could give rise to conflicts scenarios where firms are subject to different LIBOR tough legacy regimes – for example the UK "synthetic LIBOR" approach or the US ARRC's proposed approach. It is possible that firms could get pulled into a cross-jurisdictional tug of war and/or encounter possible hedge mismatches, particularly if the Commission were to designate a different replacement rate than that adopted by the FCA or other relevant authority.

Proposed exemption of designated FX rates

The Proposal also recommends inserting a new exemption category into Article 2 of the BMR, covering designated non-EU FX benchmarks listed in a new delegated act thereunder. 

Without such exemptions, EU supervised entities will no longer be permitted to reference non-EU FX benchmarks (other than those produced by central banks) in certain contracts after 31 December 2021, unless the rates have been authorised via the "equivalence, "endorsement" or "recognition" routes available under the BMR. As very few jurisdictions regulate spot exchange rates, the Proposal notes that these entry routes are not feasible for such rates and that exemptions are therefore required. 

In order to be exempted, a benchmark must fulfil the following criteria:

1. it must refer to a spot exchange rate of a non-EU currency that is not freely convertible;
2. it must be used by supervised entities on a frequent, systematic and regular basis in derivative contracts for hedging against third-country currency volatility; and
3. it must be used as a settlement rate to calculate the pay-out of the derivative contract referred to at 2 above in a currency other than the currency with limited convertibility referred to at  1 above.

National competent authorities of supervised entities using an exempted rate are required to report to the Commission and to ESMA at least every two years on the number of derivative contracts using that rate for hedging against non-EU currency volatility.

Conclusion

The non-EU FX exemption is a welcome amendment to the BMR, albeit more limited in scope than some market participants and trade bodies were hoping. 

On the other hand, the proposal to impose mandatory SRRs in replacement of outgoing LIBOR rates by operation of law, first under the BMR and then via EU member state domestic legislation for a broader range of contracts, will spark confusion and uncertainty as firms seek to plan their tough legacy strategies. Matters will be complicated yet further by the exclusion of contracts which are not within scope of the BMR, including loan agreements which may be intrinsically linked to derivative transactions which are within scope. As with other tough legacy proposals, while the new rules could potentially provide helpful tools for remediating pools of LIBOR-linked contracts following the discontinuation of LIBOR, market participants can for the time being only achieve certainty with regard to the financial effect of LIBOR cessation through active transition.

Authors: Alex Biles, Mike Logie, and Kirsty McAllister-Jones

Annex