Reference interest rates play a central role on the financial markets. They are widely used across a range of financial products, including loans, deposits, securities and derivatives. Concerns about the sustainability of the existing reference rates following global rate-rigging scandals have led to a reform process. The reform is aimed at creating new, nearly risk-free reference rates (RFRs) as an alternative to current interbank offered rates (IBORs). In Europe, the process is occurring within a wider reform under the EU Benchmarks Regulation (BMR) which introduced new requirements for the reference rates administrators, contributors and supervised entities which use the rates. A special private sector working group (WG) was formed with the task to shape the path toward new euro benchmarks, by identifying and recommending alternative risk-free rates and considering best practices for contracts. WG was set up by the European Central Bank (ECB) along with the Belgian Financial Services and Markets Authority (FSMA), the European Securities and Markets Authority (ESMA) and the European Commission (EC).
The beginning of October will bring big changes for euro area benchmarks rates. As of 2 October 2019, ECB will publish its new euro short term rate €STR. €STR was recommended by WG as the new overnight euro rate which should be used as an alternative for all products that currently reference EONIA or EURIBOR. At the same time, the methodology for calculating the current euro overnight index average rate (EONIA) will be changed – it will essentially follow €STR methodology, with a plan to be permanently discontinued at the end of 2021. This is an important milestone in the reform process and requires banks and other users of benchmark rates to take adequate adjustment steps. This year also marks an approval of the extension of the deadline for full implementation of BMR until end of 2021, which was granted due to immensely complex transition process. Market participants in the EU are already taking significant transition steps, while the process is equally important for the participants outside of the EU as their contracts with clients are largely reliant on the same existing benchmarks.
Main euro benchmarks
Currently, two most critical euro benchmarks are EONIA and EURIBOR. EONIA is mostly used as a reference rate in financial instruments – sport contracts and overnight index swaps, but also as a discounting curve for collateralized euro cash flows, including those using EURIBOR as a primary rate. The total notional amount of contracts using EONIA exceeds EUR 100 trillion. EURIBOR underpins more than EUR 180,000 billion worth contracts and more than EUR 1,000 billion worth of retail mortgages. EURIBOR is by far dominant benchmark in the SEE region and ex-YU countries, in both retail and wholesale markets. Other reference rates, such as LIBOR are less present. Each of these benchmarks is profoundly affected by the reform.
Although reform is ongoing for quite some time, it is still a work in progress and all development details are not yet known for all benchmarks. While EONIA will be replaced with the new benchmark €STR, a new (hybrid) calculation methodology is gradually being implemented for EURIBOR. European Money Markets Institute (EMMI) has been authorized in July as an administrator of EURIBOR and is now working towards completing the implementation of new EURIBOR methodology by the end of 2019. The desire to keep EURIBOR alive has been largely driven by its prominent role in the European mortgage sector. LIBOR is moving toward new rates published by central banks depending on the jurisdiction.
Private contract solutions
The reform process has many implications and it will affect all users of the reference rates, irrespective of the location. This includes banks, market infrastructure providers, investors, corporates, consumers and others. WG and other institutions have produced various guidelines and action plans to help users to navigate through the transition. The process of adjustment to the rates reform is largely based on the private contract solutions, which requires active steps on the side of market participants. While support and involvement of the relevant public authorities is underlined as critical, there are generally no specific regulatory or legislative solutions that would deal with the adjustment of contracts. The topic has been discussed by various industry bodies and associations, including Loan Market Association (LMA) for syndicated loans and International Swaps and Derivatives Association (ISDA) for financial derivatives, each of which has produced certain standardized model clauses in their areas. Market participants are, however, urged to pay attention to consistency among products, especially in related contracts and to ensure local law compliance.
Steps to take
There are various short and long-term steps that market participants will need to take to ensure a smooth transition, depending on the relevant benchmark. Recommended steps can be summarized broadly as follows:
Identifying affected products
The first step market participants should take is identifying the scope of potentially affected contracts. This includes considering current documents and identifying affected product areas, what reference rates are used and how existing reference rates and fallback provisions work. Although language may vary across individual contracts, reference rates and fallback provisions for specific product types are often based on a similar approach. This will likely require distinguishing between retail and wholesale products and products based on standardized documents (such as LMA or ISDA contracts) and those based on local banks` model contracts.
Systemic strategy and plan (road map)
Systemic outreach strategy and production of an action plan is emphasized as essential for the successful transition. Such plans are already required in the EU by BMR – specifically, Article 28(2) requires supervised entities to produce and maintain robust written plans setting out actions that they would take in the event that an existing benchmark materially changes or is permanently ceased. The market participants can rely in this respect on the guidelines produced by WG and other relevant entities. The steps will take time and costs and it is advisable to make assessments in advance. Contractual terms will regulate which party bears the cost, while consumer protection rules typically allow charging consumers only those costs that are clearly set out in the contract.
Immediate steps concerning EONIA
Due to the change of the methodology for EONIA from 2 October 2019, market participants will need make technical adjustments, including adaptation of IT systems, to cope with the new T+1 publication time of the rate.
Implementing fallback provisions
The reform has created a need for the users to implement fallback replacement rate provisions in their new and legacy contracts that could apply in case of a material change to, or cessation of, the existing reference rates. For euro products, it is helpful to follow a guide on fallbacks published by WG in January 2019. Fallback provisions are also formally required by BMR in EU – ESMA clarified in its Q&As that supervised entities are required to reflect transition plans in the contracts with clients entered into after 1 January 2018.
Legacy agreements usually have certain fallback clauses. However, these were typically drafted for the temporary unavailability of benchmark rates, e.g. due to a system disruption – thus they are not a suitable solution for the permanent cessation of the rates. The existing provisions are also not consistent and the type of documentation and the governing law of contracts varies. Application of the existing provisions would likely produce unintended economic results, such as turning a floating rate into fixed, or increasing the rate substantially for the borrower and may be susceptible to challenge under contract interpretation rules. On the other hand, many local law governed contracts in SEE do not contain fallback provisions at all (or even a definition of the relevant reference rate), which leaves it open for a potential wave of disputes and court interpretation on what happens to such contracts once the agreed rate is no longer available or is materially changed. As far as EURIBOR is concerned, this may raise questions if reformed EURIBOR will be in line with what the parties agreed or if its change will be economically substantial in a sense that it no longer constitutes the same intended rate, despite the same name and data source. This is especially the case if a change of tenor occurs e.g. from 6 or 12 month EURIBOR to an overnight rate.
It is, therefore, a general guideline to stop using legacy fallback provisions and focus efforts on timely developing and implementing new robust fallback replacement rate provisions in contracts that would enable a workable transition. Keeping the contracts in the current form and continuing to sign new contracts with the existing reference rates, such as EURIBOR or EONIA, without robust fallback provisions, carries real economic and legal risks.
At the moment, fallback rate recommended for EONIA is €STR + 8.5 b.p spread. For EURIBOR, WG is working currently on identifying a recommended fallback based on €STR. Although fallback provisions for EURIBOR and other benchmarks are likely to continue to evolve as the reform progresses, it is generally recommended to start working with the new fallback rates instead of delaying the process in order to avoid a compounding effect of the issues generated by the existing fallback provisions (or lack thereof).
Local laws have to be considered in this respect to minimize litigation, regulatory and reputational risks especially in retail contracts which are subject to special, more stringent requirements under the consumer protection laws. The consumer protection laws generally require that reference interest rates have to be clear, accessible, objective and verifiable at all times. Reference rates have to be published on the creditor’s website and visible in its business premises. In certain SEE countries, consumer laws emphasize that reference rate may not be impacted by unilateral will of any of the parties. Most importantly, interest rates cannot be changed without client’s consent. Such rules will have to be considered when drafting the fallback clauses and planning the process of their implementation. Under local laws, replacement rates would need to reflect basic principles of contract law (such as principles of ‘equivalence of mutual obligations’, ‘equality of the parties’, ‘determinability of an obligation’, ‘fairness’ and similar.).
If the parties do not reach an agreement until the cessation or material change of the existing reference rates, the outcome of the validity of the interest rate provision or the entire agreement will depend on the general contract law rules applied by the court in the litigation proceeding. This would be a very challenging scenario veiled in uncertainty. Local contract law rules in ex-YU countries contain certain statutory fallback interest rates for the cases when interest is agreed but its amount is not determined. These are, however, primarily intended for the cases when interest is not determinable from the outset and could run counter the parties’ intention if applied in case of the subsequent unavailability of the agreed rate. Considering volume of involved contracts and all legal, economic and social implications of the topic, it is reasonable to expect that the courts would tend to preserve the agreements. However,, other possible legal scenarios cannot be excluded. Factual background and formal procedural rules would be assessed in each case, therefore it is hard to imagine a uniform approach at the moment. It is notable from the recent court cases regarding Swiss francs currency disputes in ex-YU countries that court practice may significantly vary and that, in retail segment, protection of consumers is a significant factor in the court reasoning.
The process of amending the primary reference rate or insertion of fallback provisions may also impact security documents. The need for their amendments and re-registration should be carefully considered in the context of local law rules in each jurisdiction to balance between the need to preserve accurate and valid security and to keep the original ranking.
Keeping clients informed
Since the clients’ knowledge about the rates reform and fallback provisions varies significantly, clients should be provided with timely and precise information. This is particularly important for retail contracts in which EURIBOR dominates as a reference rate. Consumers need to be properly informed on rationale and operation of changes and fallback provisions, so that they can understand the approach and react in an informed manner. This particularly applies to explaining the conversion methodology, so that clients can understand why a reference rate is changed or why a spread adjustment is needed. This should assist in gaining trust and co-operation in the amending process and also help to avoid potential regulatory consequences in case of inadequate communication.
Liaising with industry organizations and regulators
Engaging with other market participants, trade associations and working groups to discuss best practices and use of standardized solutions should help to facilitate the transition. This would also increase transparency and consistency of offered provisions, which should contribute to greater buy-in by the clients. As support from the relevant public authorities remains crucial, it is advisable for the supervised entities to seek their opinions in cases of doubt, especially in retail contracts.
Considering looming deadlines, sheer number of involved contracts and the scale of potential losses in case of inadequate transition management, there is clearly no space for let-up in efforts. Get ready in time.