The working group on euro risk-free rates, for which the European Central Bank (ECB) provides the secretariat, has published the paper “Guiding principles for fallback provisions in new contracts for euro-denominated cash products”.
The paper focuses on non-derivatives, or “cash products” and considers some main features of the legal frameworks and market practices for retail and wholesale cash products with contracts referencing euro benchmarks, outlines, at a high level, the main characteristics of existing fallbacks for typical, euro-denominated cash products, and proposes a set of guiding principles for fallback provisions in new contracts for such products that market participants may wish to consider.
As shown in the paper, cash products referencing the two most critical euro benchmarks, EURIBOR and EONIA, have different characteristics which, among other factors, contribute to the legal risks associated with a potential permanent alteration or cessation of EURIBOR and/or EONIA. Current euro benchmarks, in particular EURIBOR, are widely referenced in contracts entered into by households, natural persons and small and medium-sized enterprises.
As a consequence, ensuring consumer protection is a main priority for contracts referencing EURIBOR, such as some retail mortgages and retail loans. Moreover, the European legal framework for assets held by retail customers is composed of a mix of European and national laws. Despite the existence of a common European legislative framework, there are still major differences between retail contracts in different Member States as such contracts are predominantly governed by local law.
The use of fallback provisions in contracts was generally not required under EU law until January 2018, when the Benchmarks Regulation came into effect. Article 28 (2) of the Benchmarks Regulation requires supervised entities “to produce and maintain robust written plans setting out the actions that they would take in the event that a benchmark materially changes or ceases to be provided. Where feasible and appropriate, such plans shall nominate one or several alternative benchmarks that could be referenced to substitute the benchmarks no longer provided, indicating why such benchmarks would be suitable alternatives. The supervised entities shall, upon request, provide the relevant competent authority with those plans and any updates and shall reflect them in the contractual relationship with clients.”
Fallback provisions, where present, were often originally intended to address the temporary unavailability of EURIBOR or EONIA, such as a computer failure affecting the designated screen page or a temporary market disruption, instead of their permanent cessation. As a result, fallback language in many legacy contracts for cash products may not produce a commercially acceptable result for all parties as it may affect the economics of the product in the event of a permanent cessation of the relevant benchmark.
According to the same source, new fallback language should take into account the specific principles as set out in the paper: new contracts should include permanent cessation triggers, covering at least the following scenarios:
(a) A public statement by the EURIBOR/EONIA administrator that it will cease publishing EURIBOR/EONIA or will not be included in the register under Article 36 of the Benchmarks Regulation permanently or indefinitely (in circumstances where no successor administrator has been appointed or where there is no mandatory administration).
(b) A public statement by the FSMA that EURIBOR/EONIA has been or will be permanently or indefinitely discontinued.
Where appropriate in light of any applicable regulatory regime, consideration should be given to including a scenario where it is unlawful for certain relevant parties to the agreement (such as the issuer in the case of a bond) to use EURIBOR/EONIA.
Market participants should seek to use ESTER as the primary basis for a fallback rate, where this is considered appropriate and feasible. ESTER is a near risk-free rate which will be derived and set following a methodology which differs from the ones used for EONIA and EURIBOR, thus giving rise to inherent differences between the values of these benchmarks.
Notes
EURIBOR – Euro Interbank Offer Rate
EONIA – Euro Overnight Index Average
ESTER – Euro Short-Term Rate
For further information: Guiding principles for fallback provisions in new contracts for euro-denominated cash products