Following the implementation of the EU Benchmark Regulation (“BMR”), the Euro Interbank Offered Rate (“EURIBOR”) was modified to a hybrid methodology that relies on a three-level waterfall that prioritises the use of real transaction data when available from a group of 18 quoting European banks. As a result, EURIBOR is considered compliant under the BMR, and its administrator, the European Money Markets Institute (“EMMI”), is authorized and registered under Article 34 of the BMR. Therefore, the use of EURIBOR is expected to continue, subject to periodic reassessment in accordance with the BMR, and the financial and capital markets do not need to transition to a replacement benchmark, as is the case with many other IBORs.
Nonetheless, in January 2019 and November 2019 the Working Group on Euro Risk-Free Rates (“Euro Working Group”) published general principles and recommendations to the market with respect to the inclusion of fallback provisions in contracts that reference EURIBOR, to mitigate the risks of a temporary or permanent cessation and to make these contracts future proof. This action was in line BMR requirements that EU supervised entities provide robust written plans to address the unavailability of benchmarks including EURIBOR and implement such plans in new contracts.
On the basis of these developments, the derivatives, bond, structured products, and loan markets in Europe each developed their own fallback provisions, including spread adjustments and other conforming contractual amendments, to contemplate a potential cessation of EURIBOR. For example, the recent ISDA IBOR Fallbacks Supplement to the 2006 Definitions (the “Fallbacks Supplement”) was published for OTC derivatives under New York law, English law and certain other laws but not German law OTC derivatives, so the market continues to produce IBOR fallback provisions that are responsive to German-law concerns.
As is the case in other jurisdiction, the fallback provisions that have developed in Europe, although addressing the same legal risk, vary across asset classes (and sometimes within asset classes, depending on the drafting entity or counsel), as well as from jurisdiction to jurisdiction (given the many different legal concepts in the Euro jurisdictions). This means there is not yet a uniform market standard in Europe and these differences in fallback provisions increase the risk of mismatches between linked instruments (i.e., loans and bonds and their related interest rate swaps) if publication of EURIBOR ceases, as well as litigation risks and related systematic market risks.
As a result of these market developments, the Euro Working Group published two consultations on 23 November 2020: a Public Consultation on EURIBOR Fallback Trigger Events and a Public Consultation on €STR-Based EURIBOR Fallback Rates. They also held a related roundtable meeting on 14 December 2020. The goal of the consultations is to seek consistency, to the extent possible and appropriate, among market participants when developing and introducing fallback provisions in different financial instruments and contracts. Ideally, EURIBOR fallbacks will be drafted in a way that would enable them to be introduced in as many contracts as practicable. If special characteristics of certain products or markets need to be recognised, recommendations for how best to differ from standard fallback provisions are expected to be included. The consultations close on 15 January 2021.
As is true in other fallback methodologies being developed globally, there are two key elements to benchmark cessation and robust fallback provisions: defining the cessation events that will trigger transition to a replacement rate (and any related required contract amendment) and defining the consequences of the trigger events. These are the two broad areas covered by the new consultations.
In the first consultation, the Euro Working Group consults on seven possible cessation events, including pre-cessation events relating to (a) a statement that the benchmark no longer is, or no longer will be, representative of its underlying market, and (b) a material modification of the EURIBOR calculation methodology. In the case of the latter, one of the two recommendations is to follow the approach seen in ISDA and LMA documents, and incorporate an acknowledgment that a material change in the EURIBOR methodology would not constitute an automatic trigger event, especially given that the BMR requires at least annual review of the methodology. With respect to the non-representativeness pre-cessation trigger (which the Fallback Supplement does not apply to EURIBOR floating rate options), the Euro Working Group highlighted to the market that under the existing BMR, regulators do not have the authority to make a statement that EURIBOR is no longer representative. The consultations asks market participants to comment on each of the proposed trigger events and to indicate whether all asset classes should use the same trigger events to the extent possible. The Euro Working Group emphasized that trigger events shall only apply from the point in time that EURIBOR no longer is available, and not from a cessation announcement.
In the second consultation, the Euro Working Group analysed backward and forward-looking €STR-based rates across a variety of product categories as potential fallbacks to EURIBOR, and concluded that the most appropriate EURIBOR fallback measure for global market participants would be based on backward-looking term structure methodology (as is the case in the Fallback Supplement). However, the Euro Working Group also acknowledged that there might be products or contracts where the rate needs to be known in advance. As a forward looking €STR term rate is not yet available, the Euro Working Group suggests that these products and contracts include a fallback waterfall structure comprising both forward-looking rates (first level) and backroad-looking rates (second level).
The second consultation also seeks market feedback on questions relating to a spread adjustment and calculation considerations, such as a transition period, compounding, and the use of rate floors. With respect to a spread adjustment, and in order to avoid a value transfer, the Euro Working Group recommends the use of a five-year historical median spread adjustment, in line with the recommendations of ISDA, the ARRC, and the Working Group on Sterling Risk-Free Reference Rates.
Finally, we note that the Euro Working Group discussed the proposed BMR amendment, which would empower the EU Commission to amend legacy contracts that do not stipulate suitable fallbacks. Because any exercise of this authority by the EU Commission would involve taking into account the recommendations of various risk-free rate working groups with respect to replacement rates, spread adjustments, and conforming changes, the new consultations are relevant to both legacy contracts and new instruments and contracts (which would not rely on a legislative solution).