Benchmarks such as Libor – London Interbank Offered Rate – underpin a vast range of financial contracts and transactions worldwide, from derivatives and bonds to credit cards and property loans. Libor-based contracts have a gross notional value of $240 trillion.
Changes to financial markets have also eroded the credibility of traditional benchmarks. As the role of non-bank institutions in managing liquidity has increased, interbank borrowing, on which most established benchmarks are supposed to be based, has plummeted.
Reliable and robust benchmarks
Regulators worldwide are urging financial institutions to adopt alternatives based on actual transactions. From end-2021, the UK’s Financial Services Authority will no longer require banks to make submissions for the calculation of Libor rates, which could result in an end to their publication.
The 2016 EU Benchmarks Regulation states that benchmarks must be reliable and robust, and underpinned by observable transactions in an active market determined by competitive supply and demand forces – which the euro-denominated benchmarks Eonia and Euribor no longer meet in their existing form.
The European Money Markets Institute (EMMI) has led efforts to convert Euribor into a compliant benchmark with a hybrid methodology using actual transactions where possible, but other market prices if necessary.
A private-sector working group convened by the EU authorities and Belgium’s Financial Services and Markets Authority, as lead supervisor of Eonia and Euribor, has selected Ester – Euro Short-Term Rate – as the benchmark risk-free rate. The ECB will publish €STR for the first time on October 2, 2019. The European Money Markets Institute (EMMI) has led efforts to convert Euribor into a compliant benchmark with a hybrid methodology using actual transactions where possible, but other market prices if necessary.
The Belgian regulator has now authorised EMMI as administrator of the revised Euribor, certifying it as compliant and eligible for use by EU-supervised entities after the Benchmarks Regulation’s transition period. Eonia is not dead yet, either; EMMI intends to apply to the FSMA for authorisation of Eonia in September. However, the jury is still out as to whether market participants will embrace the reformed Euribor and Eonia in the long term.
A new deadline to 2022
In this situation, the European Commission has decided the original 2020 deadline set by the Benchmark Directive is no longer feasible, and pushed back the end-date for Eonia and Euribor as benchmarks by two years to January 1, 2022.
The impending shift poses a significant challenge to the asset management community, which the Benchmark Regulation will require “to produce and maintain robust written plans setting out the actions they would take in the event that a benchmark materially changes or ceases to be provided”.
For new and existing contracts between a fund and a counterparty that reference a benchmark, asset managers must assess whether the benchmark in question will cease to exist and if so, when.
What about the existing contracts?
Existing contracts may have to be amended, since fallback provisions were generally not required under EU law until recently and anyway typically address only temporary unavailability of benchmarks, rather than their termination. New contracts will have to include permanent cessation triggers and benchmark replacement language.
Managers must also assess whether assets in which the fund invests have exposure to a benchmark that may disappear or be replaced. This could create legal uncertainty that needs to be reflected in risk management, and also affects the liquidity of the asset.
In addition, prospectuses and private placement memorandums will need to contain appropriate risk warnings. Asset managers must also consider that in economic terms, the new benchmarks will not be equivalent to their predecessors.
While the Commission has given an additional breathing space to make the necessary changes, with many aspects of the changeover still to be finalised, the industry has plenty of work ahead.
More news on the fund industry in supplement.