Today marks the publication of the long awaited euro short-term rate (€STR), which is set to gradually replace the euro overnight index average (EONIA) and serve as a fallback for the euro interbank offered rate (EURIBOR). From this day forward €STR will be published at 08:00 CET on every TARGET2 business day, and EONIA will be equal to €STR plus a fixed spread of 8.5 basis points. This means that EONIA will effectively be pegged against €STR until January 3, 2022, when EONIA ceases to apply. It is expected that liquidity will move from EONIA to €STR in the medium to long-term, as has been the case in other countries further ahead in the rate replacement game.
This changeover is happening due to the "Regulation on indices used as benchmarks in financial instruments" (Benchmarks Regulation or BMR)1, which entered into force on June 30, 2016, and has applied from January 1, 2018, onwards. The BMR's main aim is the restoration of investor and consumer confidence in the accuracy and stability of indices used to reference the price of financial instruments and contracts, as well as the measurement of the performance of investment funds.
Shortly after the BMR entered into force, the European Money Markets Institute (EMMI) and European Central Bank (ECB) determined that EONIA was not BMR compliant.2 This resulted in the decision to replace EONIA with €STR, a risk-free interest rate based on unsecured overnight money market transactions, the counterparties to which include banks, money market funds, investment or pension funds and other financial participants such as central banks. €STR was developed by a working group set up by the ECB and will be administered by the ECB in accordance with the Money Market Statistical Reporting Regulation, transposing the International Organization of Securities Commissions' principles wherever relevant and appropriate.3
Not only will €STR be replacing EONIA; it will also serve as the fallback rate for EURIBOR, which is currently being reformed to meet BMR requirements. Whilst EURIBOR will not be replaced in the near future, its dependency on private sector activity and the uncertainty surrounding its long-term BMR compliancy mean that its continuity is not guaranteed. Given that contracts amounting to roughly €100 trillion are linked to EURIBOR4, as opposed to the €13.7 trillion linked to EONIA (of which only €3.7 trillion will be outstanding by 3 January 2022)5, €STR's function as a fallback rate is perhaps even more crucial than its role as a replacement rate.
The introduction of €STR has raised a number of questions, specifically in relation to contracts referencing EONIA or EURIBOR maturing after 2020 and new contracts referencing €STR or EURIBOR. To provide further clarity, the European Securities and Markets Authority (ESMA) and ECB have issued several guidelines dealing with various aspects of the upcoming transition.6 Notably, on July 16 the ECB issued a report in conjunction with trade associations and a number of law firms7 which contained non-binding guidelines on how best to transition from EONIA to €STR (the Legal Action Plan)8, and on September 25, 2019, the ECB's second roundtable on euro risk-free rates (the Roundtable) took place in Frankfurt.9 At the Roundtable, the consensus from the €STR Working Group was that all was in place for €STR's publication, especially given €STR's recent performance during its first stress test the week prior to the second roundtable, and that all market participants should take action as soon as possible. However, of the many issues discussed (such as the recalibration of €STR, practical measures relating to the 2019 and 2022 transitions, the transition's impact on accounting and risk management, and €STR's liquidity), the Legal Action Plan was the focal point from a lawyer's perspective.
Therefore, this update will mainly focus on issues relating to the Legal Action Plan as discussed during the Roundtable, specifically in terms of contracts transitioning from EONIA to €STR. Its most important recommendations for counterparties to contracts referencing EONIA are set out below:
- Market participants should not include any reference to EONIA in new contracts entered into after October 2, 2019, as well as new or legacy contracts maturing after January 3, 2022, but where the aforementioned is unavoidable, the contracts must include robust fallback provisions. Legacy contracts maturing after January 3, 2022, additionally require cancellation or restructuring so that they refer to €STR rather than EONIA.
- Market participants should use standard market documentation where feasible.
- The EONIA fallback rate means €STR plus the aforementioned spread of 0.085% (Fallback Rate).
- With regard to the discounting switch date (the date on which €STR should be used to create discounting curves for derivate contracts), it is recommended that CCPs switch around the same date (also referred to as the "big bang") with bilateral parties following suit.
- In terms of collateral remuneration, it must be kept in mind that the impact of EONIA on the derivatives market is mainly concerned with EONIA as the price alignment rate for credit support annex (CSA) contracts i.e. the collateralization of individual derivative contracts. There will be a transition from the use of EONIA to €STR for both the construction of discounting curves and the compensation rate. Against this background, it is recommended that (i) clean discounting (i.e. no different indices used for one set of CSA agreements with a central counterparty and a client) is used, and that (ii) €STR should be kept flat and cash payments should be made to account for the economic value difference. If this is not possible, then the first step should be to move to the Fallback Rate, after which time a move to €STR flat should be made whenever possible.
- New and legacy over-the-counter derivative transactions using 2006 International Swaps and Derivatives Association (ISDA) Definitions will be able to use the ISDA Benchmarks Supplement to aid the implementation of the Legal Action Plan. The Fallback Rate will be "hardwired" into the ISDA Benchmarks Supplement and therefore the affected contract, unless agreed otherwise.
- Where the ISDA Benchmark Supplement is not incorporated into legacy OTC derivative transactions, EONIA's cessation trigger events should be incorporated and references to EONIA under legacy trades should be amended to the Fallback Rate.
- At the Roundtable, it was suggested that ISDA should consider updating the 2006 ISDA Definitions to include a specific "EONIA cessation event" trigger, and this was indeed included in a new supplement to the 2006 ISDA Definitions published yesterday, October 1, 2019.10
- The sponsors of new and legacy derivative transactions under European master agreements (EMAs) should include fallback provisions regarding EONIA's cessation. For new EMAs, the use of standard sponsor documentation language is recommended where the sponsor has issued benchmark trigger events or fallback provisions similar to the ISDA Benchmark Supplement.
- New and legacy derivative and cash collateral agreements should similarly use fallback provisions, and more generally, relevant market associations should work with members to enhance the contractual robustness of new collateral agreements. For legacy agreements, this is especially important from a legal, operational and valuation standpoint.
- The transaction of secured cash products should occur solely on a fixed-rate basis ("classic repo"), and where €STR is referenced in new loan contracts, it must be determined whether any compensation mechanism is required.
- New and legacy cash contracts (loans, bonds, floating rate notes etc.) that mature after January 3, 2022, or fall within the scope of the BMR should include fallback provisions. As a significant number of short-term cash contracts will roll over by that date, new issuances should refer to €STR rather than EONIA as soon as this is feasible. Those that do not mature prior to January 3, 2022 will need to be amended or cancelled.
- Counterparties to syndicated loans (both new and legacy) are advised to use standard loan market association (LMA) documentation language, as this will most likely be adapted in order to facilitate easy adjustment to rate changes. For non-syndicated cash products, the ECB's working group outlines two alternative fallback languages, the wording of which should be adapted to take into account requirements such as asset classes, interactions with derivative contracts, and governing law and jurisdiction.11
Derivative & cash collateral agreements
- Market associations (ISDA, the International Capital Market Association, the International Securities Lending Association and sponsors of European master agreements) are recommended to develop solutions to enhance the robustness of new collateral agreements and work with their members to develop new documents and/or protocols.
The continental crunch
Beyond the Eurozone, benchmark reform is leading to assets of around US$400 trillion across currencies including the British pound, Japanese yen, Swiss franc, euro and US dollar migrating towards almost risk-free rates.12 Out of all its siblings, €STR is the youngest and least developed − in great part due to the dual reformation/replacement of two benchmarks as well as the fragmentation of economies (e.g. different credit risks of sovereign bonds).
Thus, whilst €STR has some catching up to do, it does benefit from having several forerunners from which it may glean information. However, it must be remembered that there are several notable differences between the euro and other currencies, such as (i) the fact that fallbacks in derivatives markets use backward-looking versions of risk free rates, whereas €STR (as EURIBOR's fallback) may use both, and (ii) that with regard to some contract types (e.g. futures), EURIBOR and €STR are theoretically alternatives, meaning that the liquidity of one may be inversely proportional to that of the other, and indeed, that EURIBOR's continued existence may hamper €STR's liquidity.
How does this affect your business?
From a practical perspective, derivative transactions are significantly better equipped to deal with the transition than cash products: ISDA generally works with market participants to find solutions before amending their standard language − used by most participants − in one fell swoop. Therefore, market participants dealing with these types of transactions may not necessarily be required to amend contracts individually.
Those dealing with cash products will find that most contracts will roll over by 2022, and that fallback language for new contracts will be available from the LMA or ECB. Any legacy agreement reaching maturity after EONIA's expiration date must, however, be renegotiated on a bilateral basis.
However, whether agreements need to be amended or not, it is crucial to analyze every single contract referencing EONIA and EURIBOR and, where necessary, enter into bilateral negotiations with counterparties as early as possible in order to avoid any unpleasant surprises – particularly where changes require high levels of or unanimous consent (e.g. legacy books in the cash bond market). Whilst the required amendments are influenced by a variety of factors, such as contract type, underlying product type and the date the contract was or is being entered into, analyzing whether fallback provisions and clarification language are required is a must.
Furthermore, companies should keep an eye on the following events: (i) the first €STR floating rate bond transaction, which will be undertaken by the European Investment Bank next week; (ii) new publications by ISDA, which will hold a EURIBOR and Euro LIBOR supplemental consultation in the near future; (iii) any agreement the ECB reaches with CCPs in relation to the coordinated discounting switch, which will probably take place around June 2020; and (iv) further ECB comments on developing and enhancing a liquid €STR published before the end of 2019.
Close cooperation with market bodies and professional advisors is required in order to be aware of all risks and steps that can be taken to mitigate these risks − commencing with the formulation of appropriate fallback provisions. For now, stakeholders would do well to keep an eye on €STR as it takes its first steps into this strange new world.
Our Eurozone Hub lawyers are assisting a number of BUSIs in dealing with BMR-related supervisory dialogue and how this impacts workstreams beyond preparatory changes in policies and procedures, and also on internal model remediation, contractual renegotiation/repapering and/or other forms of counterparty outreach programs. If you would like to receive further analysis on any other issues raised herein with regard to how to prepare in relation to documentation and non-documentation workstreams, please contact one of our Eurozone Hub key contacts.
1 Regulation (EU) 2016/1011 of the European Parliament and of the Council of 8 June, 2016, on indices used as benchmarks in financial instruments and financial contracts or to measure the performance of investment funds and amending Directives 2008/48/EC and 2014/17/EU and Regulation (EU) No 596/2014, accessible here.↩
2 EURIBOR was also held not to be BMR-complaint. Its reform by EMMI was recently approved.↩
7 Law firms which are members of the subgroup on contractual robustness. ↩
11 Annex 1 (new contracts) or annex 2 (legacy contracts) of the ECB'S "Third public consultation by the working group on euro risk-free rates on the EONIA to €STR Legal Action Plan" dated May 15, 2019, available here.↩
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