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January 21, 2019

The working group on euro risk-free rates published a paper on the guiding principles for fallback provisions in new contracts for euro-denominated cash products. This working group is an industry-led group established in 2018 by ECB, the Belgian Financial Services and Markets Authority (FSMA), ESMA, and EC. Its main tasks are to identify and recommend the risk-free rates to serve as a basis for an alternative to the current benchmarks used in a variety of financial instruments and contracts in the euro area. The paper offers an overview of the legal frameworks and market practices applicable to cash products, such as mortgages, loans and bonds, that reference EURIBOR and EONIA, with a focus on fallback clauses.

The paper emphasizes that it is important for market participants to prepare for the transition to risk-free rates. During 2019, the working group intends to recommend more detailed fallback language to be used in legacy and new euro-denominated contracts. In addition, the working group will consider best practices for contracts to ensure that new contracts are robust and resilient to the possible material alteration or cessation of the underlying benchmark.

Major reference interest rates play a pivotal role in the global financial system. They are widely used in contracts for derivatives, loans, and securities. They are also used by market participants to value financial instruments and by investment funds as benchmarks for assessing their performance, among other things. Declining activity in the underlying interbank unsecured funding markets and challenges to the sustainability of panels contributing to these benchmark rates pose potentially serious risks to individual users of the rates and to the financial system more broadly. Therefore, in 2014, FSB had published its report on reforming major interest rate benchmarks, which sets out a series of recommendations to strengthen the existing benchmarks by underpinning them, to the greatest extent possible, with real transaction data and to develop alternative, nearly risk-free reference rates.

In addition, Principle 13 of the “Principles for Financial Benchmarks,” which were published by IOSCO, states that users should be encouraged to take steps to make sure that contracts or other financial instruments that reference a benchmark have robust fallback provisions in the event of material change to, or cessation of, the referenced benchmark. Moreover, IOSCO also published a statement on matters to consider in the use of financial benchmarks, including contingency planning, particularly for scenarios in which a benchmark is no longer available. In Europe, the Benchmarks Regulation recently introduced new requirements for benchmark administrators, supervised contributors, and supervised entities using benchmarks, including requirements for the use of fallback provisions in contracts.

At the request of the FSB’s Official Sector Steering Group, the International Swaps and Derivatives Association, Inc. (ISDA) is considering fallbacks for derivatives referencing EUR LIBOR, EURIBOR and other key interest rate benchmarks (ISDA IBOR fallbacks). In addition, ISDA has recently published the ISDA Benchmarks Supplement, which market participants may incorporate to provide primary fallbacks for derivatives in the event of cessation of an index until such time as the ISDA IBOR fallbacks are incorporated into the terms of transactions (upon which the ISDA Benchmarks Supplement provisions will be subordinated to the ISDA IBOR fallbacks in relation to the relevant IBOR). The ISDA Benchmarks Supplement also provides primary fallbacks in the event that a benchmark is not authorized or fails to maintain authorization under the EU Benchmarks Regulation, resulting in the parties to the relevant transaction (or the calculation agent, if different) being prohibited from performing their obligations under that transaction.


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Keywords: Europe, EU, Banking, Securities, Fallback Provisions, RFR, Euro-denominated Cash Products, Interest Rate Benchmark, FSB, IOSCO, ECB

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