Welcome to the autumn 2019 edition of our semi-annual newsletter for corporate treasurers, chief financial officers and corporate general counsel in which we highlight key topical issues in the financial markets and explore their implications from a corporate perspective.
In this edition, we continue our series on global interest rate reform. The transition away from LIBOR is gaining traction as the focus increasingly shifts towards the practical implementation of new risk-free rates, with significant steps being taken across the financial markets. Reforms in the euro area have also made significant progress, with developments in EURIBOR, STR and EONIA.
We take a closer look at two topical areas environmental, social and governance (ESG) issues and blockchain and other distributed ledger technology (DLT). On ESG and climate risk, there is increasing attention on the development of global policies, alongside growth and development in ESG-linked financial products. DLT's development continues as practical applications of this technology materialise, and accordingly contribute to the evolution of finance and broader digitisation of the economy.
Lastly, we consider the impact of recent and upcoming regulatory change. Three months into the new regime introduced by the Prospectus Regulation, we examine what has changed. We also look at the changes to EMIR introduced in June 2019, and scan ahead to more changes to EMIR taking effect in June 2020.
We hope you find this edition helpful in considering the implications of these key developments in practice. We would be pleased to discuss further any queries or comments which any of the articles may raise.
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Finance Insights | Autumn 2019
LIBOR
Practical implementation becoming a reality
With just over two years remaining to the end of 2021, beyond which the FCA has stated it will not compel panel banks to submit to LIBOR, the transition away from LIBOR is gaining traction.
The adoption of risk-free rates in the floating rate note ("FRN") and securitisation markets has shown promising momentum, with significant issuance over the last eighteen months in the new risk-free rates (SONIA in place of GBP LIBOR and SOFR instead of USD LIBOR). In the SONIA FRN market, a standard set of market conventions has been quick to develop, despite initial concerns that the absence of a forward term structure would cause difficulty. Under these conventions, the overnight rate is compounded over an observation period, with a short "lag" (or "lookback") period (typically five days) between the observation period and interest period allowing parties to calculate the interest rate ahead of the payment date. Whilst issuance in the new risk-free rates has been dominated by financial institutions and supranationals, there are signs that corporate issuers will be well placed to follow.
A significant milestone was reached in the loan markets in September 2019 when the LMA published two new draft compounded risk-free rate facilities agreements (one for compounded SONIA and one for compounded SOFR). These are structured on the basis of the concepts of an observation period, lag time and interest period, similar in approach to the conventions in the SONIA FRN market, in order to calculate a compounded risk-free rate a few days ahead of an interest payment date. Published as exposure drafts, they are intended to facilitate awareness of the issues involved with
this approach and are subject to revision as market practice settles. Summer 2019 also saw another milestone in the loan markets, with the first signature by a corporate of a bilateral daily compounded SONIA loan facility.
Whilst efforts continue to develop term risk-free rates for certain, more limited use cases, regulators have urged market participants not to wait for term rates but to engage with interest rate reform and consider the risk-free rate products available.
The transition of legacy products is on-going. A number of FRN issuers in the UK have now successfully undertaken consent solicitation processes seeking bondholder approval for a transition from LIBOR to SONIA. In the loan market, the LMA recently published an exposure draft reference rate selection agreement for use in transitioning legacy loan transactions from LIBOR to risk-free rates as part of an amendment process.
In 2020, ISDA is expected to publish a supplement to the 2006 ISDA Definitions to include fallbacks to the term and spread adjusted RFR on permanent cessation of certain IBORs, including LIBOR. Discussions continue on implementation of a pre-cessation trigger based on a regulatory determination of unrepresentativeness following an inconclusive ISDA consultation on this point. ISDA has also published definitions for new risk-free rates (such as SOFR and STR).
As the transition away from LIBOR gathers speed, the focus is increasingly shifting towards the practical implementation of new risk-free rate products.
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Finance Insights | Autumn 2019
STR
Significant developments in euro interest rate reform
Over the last six months we have seen significant progress in interest rate reform in the euro area. The methodology for existing rates, EURIBOR and EONIA, has been changed, and STR, the new euro overnight rate, has been published.
Supporting the euro area's dual rate approach, the methodology for EURIBOR has been reformed by its administrator, the European Money Markets Institute ("EMMI"), and authorisation under the European Benchmarks Regulation ("EBR") was obtained in July 2019. The new hybrid methodology is currently being phased in and is expected to be fully implemented by year end. Despite the expected continued publication of EURIBOR, the working group on euro risk-free rates (the "Euro RFR WG") has highlighted the importance of fallbacks for EURIBOR and is considering potential STR-based fallbacks.
In accordance with its March 2019 announcement, the ECB published STR for the first time on 2 October 2019. This reflected trading on the previous day, calculation being on a T+1 basis. The arrival of STR was welcomed, with the EIB and Landeskreditbank Baden-Wuerttemberg Foerderbank moving swiftly to support the new rate, announcing floating rate notes referencing STR ahead of its debut.
Simultaneously, EMMI, which also administers EONIA, implemented revisions to the EONIA calculation methodology, shifting the rate to STR plus a fixed spread of 8.5 basis points. This follows EMMI's announcement in 2018 that EONIA was unlikely to meet the requirements of the EBR and
recommendations of the Euro RFR WG that EONIA should be modified in this way to facilitate transition to STR. Also in line with the Euro RFR WG recommendations, EMMI announced that EONIA will be discontinued on 3 January 2022.
The changes to EONIA are likely to be particularly relevant in the context of euro swingline loans, overnight index swaps, securities financing transactions and interest on euro cash collateral under credit support agreements, and may lead to drafting changes in finance documentation which otherwise would have referred to EONIA. ISDA is currently preparing definitions of EONIA and STR for use in credit support agreements and is considering how to facilitate the amendment of existing credit support agreements which reference EONIA. The LMA has published a guidance note which includes drafting suggestions for STR for use in LMA facility agreements incorporating a euro swingline, and is keeping under review market practice on this point as it develops.
EONIA is also used to calculate price alignment interest (interest on cash collateral) and for discounting (valuation) in the context of cleared swaps. Clearing houses LCH and Eurex have announced plans to move from EONIA to STR during 2020. Both proposals would see a shift to STR "flat", with no adjustment spread applied and, instead, a cash compensation payment made at the time of transition.
With these developments, reforms in the euro area are now well underway and the practical implications for participants active in this market are unfolding.
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ESG
More green growth
ESG and climate risk continue to remain high on the agenda of public and private sector actors alike, with increasing attention on the development of global policies and the growth of ESG-linked financial products.
In September 2019, the IMF published a literature review of the roles macroeconomic and financial policies can play in climate change mitigation. It suggests that although energy policy and variants of carbon pricing policies have been the focus, other complementary policies will likely be needed. These may include:
>fiscal policy tools, which should be at the forefront for fiscal policies to achieve real climate change mitigation and secure low-carbon public infrastructure by enabling the cost of climate change to be properly accounted for;
>financial policy tools, which can help achieve private investments in green productive capital, infrastructure and R&D; and
>monetary policy tools, to ensure that central banks' balance sheets accurately reflect climate risks by pricing the risk in their portfolios and operations.
At the inaugural Task Force on Climate-Related Financial Disclosures ("TCFD") Summit in Tokyo in October 2019, Mark Carney updated on the TCFD voluntary disclosure standard's use and emphasised the importance of bringing resilience against climate risks into the heart of financial decisionmaking by making climate disclosure comprehensive and transforming climate risk management. He noted the growing demand for and development of increasingly sophisticated disclosures under TCFD, and the need for common taxonomies to identify environmental out-performance which
are not limited to a binary of green or brown, but which factor in the various shades of green and brown. For example, while wind farms may be classified as "green" and coal as "brown", natural gas is not in the same category as either. Over the next few years, market participants should accordingly expect:
>the quantity and quality of disclosures to increase;
>disclosure metrics to be refined, to make them decision-useful;
>to be required to spread knowledge on how to assess strategic resilience; and
>to consider how to disclose the extent to which portfolios are ready for the transition to net zero.
Alongside these developments, the Green and Sustainable Bond market continues to grow and develop. Issuances are predicted to reach USD180-220 billion by the end of 2019, compared to USD169 billion in 2018. The first European Sustainable Bonds where payment terms of each series are dependent on achieving sustainable development goals were issued recently by Enel, the European energy company, with Linklaters advising. This is significant in the European market as previously payment terms have not been linked to use of proceeds in this way. In the case of this triple series issuance, a coupon step-up will be introduced to each of the three series issued if the company does not meet its sustainable development goals relating to affordable clean energy (in relation to the first two series) and climate action (in relation to the third series).
Corporates can continue to expect a policy and regulatory environment which places increasing influence on the importance of (truly) green factors, alongside innovative ways of raising capital.
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Blockchain
Driving efficiencies in finance
Over the last two years, business sentiment towards blockchain and other types of distributed ledger technology ("DLT") has ranged from one extreme to the other. 2017 saw the peak of over-expectation, amid claims that blockchain would revolutionise almost all aspects of the economy. A wave of disillusionment swiftly followed, as practical and legal challenges were brought to the fore. Now, we appear to be in a new phase of measured optimism, where practical DLT applications are materialising, but are often narrower in their scope than originally proclaimed.
Three use cases relevant to corporates are worth highlighting in particular.
>In payments, the creation of new digital coins, such as Facebook's proposed digital currency Libra, could potentially force corporates to accept alternative means of payment for goods or services. There remain significant regulatory barriers to this reality. Conversely, several corporate groups have already adopted DLT solutions to assist with treasury management and avoid external payment rails for internal value movements.
>DLT and smart contracts may also be used to assist with collateral management processes. Digital Asset, for example, has developed a tool to streamline the process of creating and maintaining security interests over assets held or evidenced on a DLT platform, which Linklaters has considered from an English law perspective.
>Raising capital through the issuance of digital tokens via a DLT platform could benefit issuers by streamlining fundraising processes, enhancing visibility and allowing for the automation of corporate actions. This year, the London Stock Exchange participated in the first tokenised equity offering by a UK company, facilitated by Linklaters' strategic partner Nivaura, and blockchain bonds have been piloted by the World Bank, Socit Gnrale and Santander among others. These developments are, however, still relatively nascent. To trade and service natively digital securities, new infrastructure is required, including novel solutions for custody and payment. This could involve significant buildout costs. It remains to be seen whether such investment is justified or if improvements to existing market infrastructure will prove more cost-effective.
Fundamental legal questions underpin many of these applications. Questions around, for example, whether it is possible to own digital or crypto assets and transfer title to them via a DLT platform remain open to debate. To help resolve some of these uncertainties, the UK Jurisdiction Taskforce is working towards producing an authoritative legal statement as to the status of DLT and smart contracts under English law, with assistance from Linklaters.
Whether or not DLT ultimately fulfils all aspirations, there is no denying its success in driving a broader digitalisation of the economy. It is now viewed as one among a range of tools, including document negotiation platforms and artificial intelligence, contributing to the evolution (if not revolution) of finance.
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Finance Insights | Autumn 2019
Prospectus Regulation
Shock of the new?
Having entered into force in 2017, the Prospectus Regulation became applicable in its entirety on 21 July 2019, repealing the Prospectus Directive and overhauling the pan European prospectus regime that it had established.
The Prospectus Regulation heralded a number of innovations, from the universal registration document, to a proportionate prospectus regime to cater to the financing needs of SMEs, to simplified prospectuses for "secondary issuance". But three months into the new regime, what, if anything, has changed?
Many debt issuers, seeking to benefit from grandfathering, updated their issuance programmes before 21 July. The number of prospectuses approved post 21 July has therefore been lower than usual. Nonetheless, some broad themes in relation to the approval process under the Prospectus Regulation are emerging, as we explore below.
Continuity is broadly maintained regarding prospectus content requirements, with some notable exceptions. New content requirements include requirements to specify the legal entity identifier of issuers, the website of issuers (if any), and the use of and estimated net amount of proceeds (now extended to wholesale non-equity securities). The prospectus must now include hyperlinks to all documents incorporated in it by reference, and these hyperlinks must remain functional for ten years. Approved prospectuses must also remain available on websites for at least ten years.
The Prospectus Regulation introduced detailed provisions governing risk factor disclosure, fleshed out by ESMA Guidelines. Risk factors are required to be presented in a limited number of categories, with the most material factors in each category presented first. Materiality is to be assessed by determining the probability of occurrence and expected magnitude of negative impact. The Guidelines encourage competent authorities to challenge non-compliant risk factor disclosure and there is evidence that competent authorities are already following the Guidelines, although technically they will not apply until December 2019. Market participant feedback on risk factor review under the Prospectus Regulation has been mixed. But early indications in the vanilla debt space are that, where issuers have taken time to review and update their risk factors, in line with the Guidelines, disruption to the prospectus review process has been limited.
As part of ongoing efforts to modernise the prospectus regime, the Prospectus Regulation has introduced a requirement for competent authorities to provide data to ESMA to allow ESMA to create a centralised, searchable, free to access storage mechanism for prospectuses. Competent authorities are likely to push this obligation onto issuers which will, in turn, increase issuers' compliance costs. Competent authorities and issuers alike have currently been granted a temporary reprieve from this requirement however, as system issues mean that ESMA will not require the full set of data to be collected until mid-2020.
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Finance Insights | Autumn 2019
EMIR
Reporting changes affecting NFC-s ahead
As discussed in our Spring edition, EMIR has been amended as part of the European Commission's REFIT programme, with some changes taking effect in June 2019. Non-financial counterparties ("NFCs") that wished to be classified as NFC-s for the purposes of the clearing and margining provisions of EMIR needed to re-calculate whether their OTC derivative positions were below the clearing thresholds as at 17 June 2019. Changes in the scope of the clearing obligation for NFC+s below the clearing threshold for a particular asset class, and a new exemption from clearing for so-called "small FCs", also apply by reference to those calculations.
Further important changes for NFCs related to reporting of derivatives. If certain conditions are satisfied, it is now possible for NFCs to obtain an exemption from reporting intra-group derivative transactions.
More changes flowing from the REFIT amendments are now on the horizon. From 18 June 2020, financial counterparties ("FCs") entering into OTC derivatives with NFC-s are required to report the transactions on behalf of the NFC- ("mandatory reporting"), unless the NFC- elects in advance to make its own report. While the introduction of mandatory reporting by FCs will be welcome to many NFC-s, the implications of the change will need to be analysed by each NFC-. In particular, the following points should be considered.
Where an NFC- currently relies on a delegated reporting arrangement with the FCs it contracts with, those arrangements will need amending or terminating going forward (and consideration also needs to be given to reporting of modifications and terminations of existing transactions outstanding at 18 June 2020). Since an NFC- is required
under EMIR to provide the FC with certain information to facilitate mandatory reporting by the FC, the FC is likely to want an agreement in place as regards the information to be provided. ISDA and other trade associations are developing a new Master Regulatory Reporting Agreement to replace the existing ISDA/FIA form of Delegated Reporting Agreement.
Mandatory reporting will not necessarily apply to all transactions it does not apply to exchange-traded derivatives, nor where an NFC- enters into any intra-group transactions that are not exempted from reporting. It would also not be applicable following a no-deal Brexit, nor is it likely to apply after any transition period has lapsed, where a UK NFC- enters into derivatives with an EU FC. The UK NFC- would need to report under EMIR as onshored, and mandatory reporting under UK EMIR would not apply to the EU FC.
Where mandatory reporting applies, the NFC- may still want access to the data that has been reported on its behalf, for risk-monitoring and reconciliation purposes. The NFC- is likely to need an account with the relevant trade repository to do so.
Given the need for changes to existing reporting arrangements, NFC-s can expect to see requests for amendments to those arrangements from their FC counterparties in the coming months, ahead of the June 2020 application date for mandatory reporting.
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Finance Insights | Autumn 2019
Contact us
UK
Philip Spittal Partner, Head of Global Loans, Banking Tel: +44 20 7456 4656 [email protected]
James Martin Partner, Banking Tel: +44 20 7456 4430 [email protected]
Ian Callaghan Partner, Banking Tel: +44 20 7456 5304 [email protected]
Mirthe van Kesteren Partner, Banking Tel: +44 20 7456 5446 [email protected]
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November 2019
Ben Dulieu Partner, Equity and Debt Markets Tel: +44 20 7456 3353 [email protected]
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Oliver Edwards Partner, Banking Tel: +44 20 7456 4463 [email protected]
Christopher Williams Counsel, Banking Tel: +44 20 7456 5091 [email protected]
Richard Levy Partner, Equity and Debt Markets Tel: +44 20 7456 5594 [email protected]
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November 2019
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