On February 13, 2021, the European Union’s (EU) amendments to the Benchmarks Regulation (2016/1011) (the Amended BMR) came into force, which provides a legislative fix for the cessation of LIBOR in legacy contracts. The Amended BMR gives the European Commission (the Commission) the power to replace critical benchmarks and other relevant benchmarks if their termination would significantly disrupt or otherwise affect the functioning of the financial markets in the EU.
How does it work?
The Amended BMR permits the Commission to adopt implementing acts to designate a replacement risk-free rate for a particular benchmark. These acts would specify the replacement benchmark, the spread adjustment (designed to eliminate possible value transfer caused by the lack of a credit risk element in the replacement risk-free rates), any corresponding conforming changes necessary for the use of the replacement benchmark and the date from which the replacement benchmark will apply to legacy contracts.
When selecting a replacement rate, the Commission is required to take into account recommendations of the relevant central bank, alternative reference rate working group (e.g. the ARRC and Working Group on Sterling Risk-Free Reference Rates) and other stakeholders including the competent authority of the benchmark administrator and the European Securities and Markets Authority.
Which benchmarks are covered?
The Commission’s powers extend to critical benchmarks and other EU benchmarks where the cessation thereof would significantly disrupt the functioning of EU financial markets. The Commission is also empowered to designate replacement rates for third-country benchmarks where their cessation would significantly disrupt the functioning of the EU financial markets or pose a systemic risk to the EU financial system.
When can the Commission exercise its powers?
The Commission is permitted to exercise its powers under the Amended BMR if any one of the following events has occurred:
- the competent authority for the administrator of the relevant benchmark issues a public statement or publishes information in which it is announced that that benchmark no longer reflects the underlying market or economic reality;
- the administrator of the benchmark or competent authority for that administrator issues a public statement or publishes information in which it is announced that that administrator will commence the orderly wind-down of that benchmark or will permanently or indefinitely cease to provide that benchmark, certain tenors or certain currencies thereof; and
- the competent authority for the administrator of that benchmark withdraws or suspends the authorisation of the administrator or requires the cessation of the endorsement of the administrator.
Which contracts are covered?
- The Amended BMR applies to any contract or financial instrument that references a benchmark, and is subject to (a) the law of a Member State of the EU or (b) a third country where the law does not provide for the orderly wind-down of a benchmark (provided that all parties to such a contract are established in the EU). Whilst this gives the Amended BMR extraterritorial scope, it would not prevail over another country’s own legislation. Given that, among others, the UK and U.S. are both pursuing legislative fixes (as discussed in our previous blog posts here and here), this significantly reduces the risk of competition between the EU’s legislative solution and that of other key jurisdictions.
- If the Commission designates a replacement rate under the Amended BMR, that replacement rate will only replace references to that benchmark in contracts and financial instruments if they contain no fallback provisions or no suitable fallback provisions. For these purposes, fallback provisions will be deemed unsuitable if they do not provide for a permanent replacement benchmark, if consent is required from (and has been denied by) third parties, or if the replacement benchmark under the fallbacks no longer reflect the underlying market or economic reality and its application could have an adverse impact on financial stability. This addresses the concerns of many market participants and industry groups that parties’ freely negotiated fallbacks could be overridden by the Commission’s legislative powers.
The EU’s legislative solution is a welcomed development in LIBOR transition efforts and provides much needed certainty for market participants with ‘tough legacy’ LIBOR-referencing contracts. However, the decision to implement automatic changes to the benchmarks of these ‘tough legacy’ contracts does give rise to the risk of winners and losers, as value neutrality may be hard to ensure. Furthermore, the replacement rates are unlikely to represent the economic bargains that the parties would have struck had they actively amended their contracts.
In addition, there is the risk of creating mismatches between different parts of a portfolio, as some products may move to the statutory successor rate and others may be amended bilaterally. In light of this, market participants are urged to not sit back and rely on the legislative fix, but to amend their LIBOR-referencing contracts wherever possible, to ensure that their contracts accurately reflect their bargains.