Yesterday’s announcement that the compliance deadline for the European Benchmarks Regulation (BMR) has been moved back by two years to 31 December 2021 is hugely welcome news for the industry. Market participants now have an extra two years to work through what will be an immensely complex transition to new or reformed benchmarks for all EU financial contracts.
AFME (along with the Euro RFR Working Group and several other trade associations such as GFMA, ISDA, FIA and EMTA) had strongly argued in favour of an extension for both critical as well as non-critical benchmarks.
The BMR has a number of high-level objectives, particularly around improved governance and the quality of the data that is used to calculate benchmarks, and it is having a major impact on European financial markets.
Due to the high number of transactions linked to them, EURIBOR and EONIA (Euro Interbank Offered Rate) and EONIA (Euro OverNight Index Average) have been defined as ‘critical benchmarks’ under the BMR. According to the ECB, there is an estimated €22 trillion of EONIA-linked derivatives contracts in existence and €109 trillion linked to EURIBOR. But neither EONIA, nor EURIBOR currently meet the requirements of the BMR and given the huge volume of financial contracts affected, achieving a changeover to rates which do comply will be a mammoth undertaking.
This was an issue that prompted considerable discussion at AFME’s Spanish Funding Conference earlier this month, as the capital markets industry grappled with how to tackle the challenge. In his keynote address, Sebastián Albella, Chairman of the CNMV (Spanish Securities Markets Commission), pointed out that in Spain alone one in four mortgage contracts is linked to EURIBOR.
The days of submission-based rates have been numbered since the onset of the financial crisis and the LIBOR rate-rigging scandal, which resulted in a global drive to reform IBORs of all kinds. The loss of public trust in the veracity of LIBOR, in particular, made it clear that maintaining the status quo was not an option. Since then, many banks have (for understandable reasons) become increasingly reluctant to continue submitting the data used to calculate IBORs. And, lastly, the underlying volume of EURIBOR and EONIA-based transactions has also been declining. These are all factors that have undermined the depth and representativeness of the data.
But while the case for reform may be clear, the sheer number and variety of financial contracts linked to EURIBOR and EONIA means reform will be immensely complex. And while good progress is being made, much also remains to be done.
The approach being taken combines both replacement and reform. For EONIA-based contracts, the European Money Market Institute (EMMI), the body which administers both EONIA and EURIBOR, has already announced it has ceased its efforts to reform EONIA. Subsequently, the ECB’s Euro risk free rates (RFR) Working Group announced that ESTER (Euro Short-Term Rate) will be the new designated risk-free rate to replace EONIA. EONIA-backed securities will transition to ESTER, which will also become a fall back rate in EURIBOR-based contracts. However actual ESTER data does not exist yet, and may not be available until October 2019. As an interim measure, the ECB has begun publishing “pre-ESTER” data, which will give market participants an opportunity to acclimatise to the new ESTER rate.
For EURIBOR, the plan is for reform not replacement, and these reforming efforts have significant regulatory backing; indeed Sebastián Albella said it was ‘crucial’. Mikael Stenström of the ECB, also at AFME’s conference earlier this month, confirmed that he expects a positive outcome for those efforts. EMMI is expected to file for authorisation of a reformed version of EURIBOR by the second quarter of this year; this is expected to change the calculation of EURIBOR to a ‘hybrid methodology’ that relies not just on submissions but also on real transaction data (supplemented by other market data where necessary).
Third Country benchmarks
Additionally, third country benchmarks (rates which are produced outside of the EU), are another big area of concern. Despite their misleading ‘non-critical’ labelling under the Regulation, third country benchmarks such as non-EU Foreign Exchange spot rates are widely used by EU financial firms and corporates in hedging commercial activities and investments abroad.
At present there remains considerable uncertainty about whether many third country benchmark administrators can or will become BMR compliant via the available third country routes, which could create significant disruption for market participants. The two year delay will provide a vital opportunity to review the third country regime under the BMR Review clause. This will make it possible to rectify unintended consequences and enable viable solutions to be found.
Continuing progress on reform
While this two year delay does offer some much needed breathing space, it will be important to maintain momentum on reform and avoid complacency. As Mikael Stenström remarked, the success of these reforms will depend on each and every market user – whether from a large or small institution – being engaged in these issues: reviewing their contracts, making provisions and engaging in the consultation processes around the reforms. We will be continuing our engagement on these issues over the coming period.