On November 20, 2020, the working group on euro risk-free rates (the Euro Working Group) published two consultations on fallback rates to EURIBOR. Market participants were invited to provide their views on the potential events that could trigger fallback measures and the fallback rates based on the euro short-term rate (€STR) and spread adjustment methodologies. The results of the consultations show that market participants are not in agreement on all matters relating to transitioning from EURIBOR to €STR.
EURIBOR Fallback Trigger Events
The vast majority of respondents supported the inclusion of pre-cessation trigger events in contracts and instruments referencing EURIBOR. Almost all respondents (97%) agreed that fallbacks to risk free rates should be triggered by a public statement by the administrator (or the regulatory supervisor of the administrator) that it will permanently or indefinitely cease to provide EURIBOR. Market participants noted the need for consistency with the fallback trigger events defined by other industry bodies such as ISDA, the LMA and the ARRC.
In addition, the majority of respondents (81%) supported the inclusion of a fallback trigger event if an announcement is made that EURIBOR is no longer (or will no longer be) representative of the underlying market it purports to measure. However, some respondents highlighted the fact that ISDA currently does not include this trigger event in its EURIBOR documentation. This could lead to mismatches between provisions for cash products and provisions for derivatives. While it is likely that the Euro Working Group will officially recommend the inclusion of this pre-cessation trigger event, it remains unclear whether ISDA will amend its EURIBOR documentation accordingly.
€STR-based EURIBOR fallback rates
The Euro market is split on the fallback rate that should apply on cessation or pre-cessation of EURIBOR. The majority of respondents (58%) are in favor of a backward-looking rate in corporate lending while 40% of the respondents proposed a forward-looking rate. Those supporters of a forward-looking rate are in favor of applying a waterfall of fallbacks with a backward-looking rate being the second fallback in the waterfall structure. While no such forward-looking €STR rate has been developed, this proposal mirrors recommendations by the ARRC for US lending markets. A higher percentage of respondents (77%) agreed that a backward-looking rate would be the most appropriate fallback methodology for EURIBOR-linked debt securities. On this point, the respondents stressed the need for consistency between derivatives and other instruments, and identified that a backward-looking rate would best match ISDA’s fallbacks.
Almost all respondents (97%) agreed that the historical mean/median spread adjustment methodology would be the preferred approach for cash products, which is in line with the recommendations of other working groups and with ISDA’s fallbacks.
The Euro Working Group proposed a phased in approach to a spread adjustment. Pursuant to such a phased in approach, the spread adjustment will be set using the historical mean/median approach and used at the end of a one-year transitional period after the EURIBOR fallback takes effect. During the transitional period, the spread adjustment would be calculated using linear interpolation between the spot EURIBOR/€STR spread on the last date that the relevant EURIBOR is published and the spread that would apply after the end of the transitional period. This approach aims to mitigate against a possible “cliff effect” at the time the fallbacks takes effect if the spot EURIBOR/€STR spread at that time differs from the historical mean/median.
However, almost half of the respondents (46%) disagreed with this proposal, citing that the additional complexity would outweigh potential benefits, and that this approach would be inconsistent with ISDA’s approach for derivatives. Almost a third of respondents (29%) remained neutral, acknowledging both the advantages and disadvantages of such an approach. With responses being split with regard to such a phased-in approach, it will be interesting to see what approach the Euro Working Group recommends.
Market participants with EURIBOR-linked products should keep an eye out for developments in this area as it is possible that the recommendations of the Euro Working Group could diverge from those adopted by ISDA, the LMA and the ARRC. While there are no current plans to discontinue EURIBOR, the Euro Working Group intends to publish final recommendations for €STR-based fallbacks during the first quarter of 2021, “taking into account views expressed by stakeholders”.