On 24 July 2020, the European Commission published proposed amendments to the EU Benchmarks Regulation (BMR) which came into force in January 2018, subject to a 2-year transitional or grace period, and imposes requirements on administrators, regulated users of and contributors to, benchmarks.
On 27 November 2019, the 2-year transitional period was extended, until 31 December 2021, for critical and third-country benchmarks. A Fund, as a regulated user, is required to use only those benchmarks which are included on the EU benchmarks register maintained by ESMA. During the extended transitional period (until end December 2021), third-country benchmarks may continue, subject to conditions, to be used by Funds. At the end of the extended transitional period, the BMR will limit Funds to using: (i) benchmarks provided by an EU authorised administrator, (ii) benchmarks that have undergone an equivalence/recognition/endorsement procedure and been entered on ESMA’s register for third-country benchmarks (the BMR Third-Country Regime), or (iii) subject to conditions, legacy use of third-country benchmarks.
The proposed BMR amendments published by the Commission in July provide for:
- an exemption under the BMR for third-country foreign exchange spot rates; and
- the designation, by the Commission, of a statutory replacement rate for a benchmark whose cessation would result in financial instability in the EU e.g. LIBOR.
New exemption under the BMR for foreign exchange spot rates
A spot FX rate used to determine the pay-out due under a forward or swap agreement offered by an EU entity and traded on an EU market constitutes ‘use’ of the spot FX rate under the BMR which brings the offer of forwards and swaps by the EU entity within scope of the BMR. As of 31 December 2021 (the end of the third-country/critical benchmark transitional period), reference to spot FX rates in EU-traded currency forwards or swaps will no longer be permitted. As the EU is the only jurisdiction to regulate spot FX rates, the BMR Third-Country Regime could not be relied on to access such rates. The EU is therefore proposing an amendment to the BMR to ensure continued access by EU supervised entities to currency rates administered outside the EU after the end of the extended BMR transitional period on 31 December 2021. While industry was hopeful that the EU’s solution may have resulted in a more general exemption for third-country benchmarks from the provisions of the BMR, this is not what is proposed under the BMR amendments published in July. Instead, the proposal is for a targeted modification of the scope of the BMR to exempt FX spot rates which will enable EU entities to continue referencing third-country spot exchange rates for non-convertible currencies on EU based forward contracts.
Statutory designation of a replacement rate for a benchmark whose cessation would result in financial instability in the EU
As discussed in our November 2019 briefing, Brexit & UK Benchmarks, the coincidence of Brexit and the cessation of LIBOR has the potential to severely impact Irish Funds’ access to LIBOR replacement rates introduced following its cessation.
At the end of the UK’s transitional period under the UK/EU Withdrawal Agreement on 31 December 2020, LIBOR will become a non-critical, third-country benchmark under the BMR. Under the BMR, access to non-critical, third-country benchmarks by EU regulated entities, including Irish UCITS and Central Bank regulated AIFs (Funds), is limited to where the use of such benchmarks commenced on or before 31 December 2021. After this date, Funds will be prevented from commencing to use non-critical, third-country benchmarks, such as LIBOR and/or any of its replacement or successor’s rates, which do not comply with the BMR Third-Country Regime.
The continuation of LIBOR beyond the end of 2021 is not guaranteed and significant efforts are underway to identify replacement rates prior to its cessation. Working groups have been established by central banks in various currency areas to recommend IBOR fall-back rates that would apply in the event of legacy use of LIBOR as at the date of its permanent cessation.
However, even once these replacement rates are available, it will be difficult to amend all existing use of LIBOR in the short period of time before it is expected to be discontinued. There are also a significant number of legacy contracts that contain references to LIBOR and cannot be renegotiated (so-called ‘tough legacy’ contracts). And, as a result of Brexit, any new use of the LIBOR replacement rates, after the extended BMR transitional period ends on 31 December 2021, will be subject to the requirement for the replacement rate to be included on ESMA’s register in compliance with the BMR Third-Country Regime.
EU Solution
The EU’s proposed BMR amendments seek to provide a solution by empowering the Commission to designate a statutory successor for a benchmark whose cessation would result in financial instability in the EU and where no suitable contractual fall-back provisions exist. Under the proposed power, the Commission would have the ability to designate LIBOR replacement rates to take the place of LIBOR “irrespective of where the are authorised and published”. In designating a replacement rate, the Commission would take into account the recommendations of the IBOR alternative reference rate working groups. The replacement rates would, by operation of law, replace all references to use of LIBOR by a Fund or other EU regulated entity. In order to benefit from the statutory replacement rate, use of LIBOR must be pending at the time the designation enters into force. Hence, only legacy users of LIBOR, as at the date of its statutory replacement by the EU, may avail of the LIBOR replacement rate.
The following highlights a possible flow of events following implementation of the above EU solution which could resolve the issue of access to LIBOR replacement rates for a Fund which, as at the end of the BMR critical/third-country transitional period, uses LIBOR to measure its performance:
- 31 December 2020:
- UK/EU Withdrawal Agreement transitional period ends;
- 1 January 2021:
- LIBOR is a non-critical, third-country benchmark and its use in the EU is dependent on the BMR non-critical/third-country transitional provisions;
- 31 December 2021:
- BMR non-critical/third-country transitional period ends;
- no new use of unauthorised non-critical/third-country benchmarks permitted in the EU after this date;
- (Possibly Post) 31 December 2021
- Effective date for cessation of LIBOR clarified and replacement rates available; and
- EU designates statutory replacement rates and references to use of LIBOR by EU regulated entities is replaced, by operation of law, with designated LIBOR successor rates.
Next Steps
The Commission’s proposal leaves no doubt as to the immediacty of the issues created by the coincidence of the cessation of LIBOR and the end of the UK/EU Withdrawal Agremeent transitional period. While no effective date has been fixed for the BMR amendments, the Commission’s FAQ accompanying its proposal notes that ‘The powers would be triggered as soon as the effective date for the cessation becomes clear’. Stakeholders can expect prompt progress of the Commission’s proposal through the legislative process to allow for timely implementation of the EU’s solution to the issues as outlined.
Contact Us
If you have any queries on the issues discussed in this article, please contact the Asset Management & Investment Funds team or your usual William Fry contact.
Contributed by Nessa Joyce
