EU Benchmarks Regulation (BMR) and its interaction with global LIBOR reform
Cheryl McGee Wallace, FSRR Centre of Excellence, PwC UK explores BMR and its interaction with global LIBOR reform. In the most general terms, the EU Benchmarks Regulation (BMR) introduces a common framework to ensure the accuracy and integrity of indices used as benchmarks in financial instruments and financial contracts, or to measure the performance of investment funds in the European Union (EU). Its impacts reverberate far beyond the borders of the EU.
BMR regulates benchmark administrators, contributors and EU-supervised users. The EU is among the first jurisdictions to impose a comprehensive, legally binding regulatory regime governing financial benchmarks. Prior to BMR, the UK regulated the administration of and contribution to eight specified benchmarks, including LIBOR. The UK regime did not regulate the use of benchmarks. BMR replaced the current UK rules applicable to LIBOR once the administrator, ICE Benchmarks Administration (IBA), was authorised in late April 2018.
BMR applied from 1 January 2018 with a transitional period of 42 months (from the entry into force date of 30 June 2016) for third country and pre-existing EU administrators to comply. EU-supervised users can continue to use benchmarks from these administrators until 1 January 2020 or until the administrator’s application is rejected. Although IBA is a pre-existing administration, it decided to apply early. IBA and its contributors are subject to BMR.
For those outside the EU, it is important to note how BMR differs from existing global standards. Published in 2013, the IOSCO Principles for Financial Benchmarks provide voluntary guidelines for global administrators on governance, methodology and accountability. In 2014, the Financial Stability Board’s Official Sector Steering Group published global recommendations to reform interest rate benchmarks, including the development of robust transaction-based reference rates. Although BMR is based on these non-binding global norms, the regulation is directly applicable in all EU Member States and legally binding on EU-supervised firms, including non-EU administrators who seek to offer their benchmarks for use in the EU. Moreover, administrators, contributors and EU-supervised users within the scope of BMR are subject to financial penalties for violation. Crucially, BMR is broader in scope than IOSCO in that it also imposes requirements on contributors and users, and includes any benchmark used to measure the performance of an investment fund in the EU.
BMR’s impact on LIBOR
BMR prohibits EU-supervised users from using a benchmark unless its administrator is approved by a national regulator in one of the EU Member States and appears on the benchmarks register maintained by the European Securities and Markets authority (ESMA), an EU supranational supervisory authority. Although BMR only covers benchmarks used in the EU, cessation or material changes to an EU benchmark, particularly a critical benchmark such as LIBOR, will have global implications.
Critical benchmarks, used as a reference in more than 500bn EUR of financial instruments, must meet the highest standards of integrity and accuracy and are thus subject to the strictest requirements in BMR.
BMR introduces six categories of benchmarks. LIBOR qualifies as both a critical and an interest rate benchmark. Its administrator IBA and its 20 panel bank contributors must comply with rules applicable to both categories, including periodic independent external audits.
Critical benchmarks, used as a reference in more than 500bn EUR of financial instruments, must meet the highest standards of integrity and accuracy and are thus subject to the strictest requirements in BMR. To date, only LIBOR, EURIBOR and EONIA have been designated as critical benchmarks. Under BMR Arts. 21 and 22, national regulators in the EU can compel the administration of and contribution to critical benchmarks for a limited period given their impact on financial stability.
Interest rate benchmarks are subject to a specific prioritisation of input data, i.e. contributor's transactions in the underlying market, observations of third party transactions, committed quotes, indicative quotes or expert judgments.
Under BMR, benchmarks must be representative of the underlying market or economic reality, based on verifiable input data and appropriate for the intended use. Permitted as a last resort, input data based on discretion and expert judgment is subject to enhanced procedural and control requirements.
An orderly transition to alternative reference rates requires time and careful preparation to unwind or renegotiate legacy instruments worth hundreds of billions of USD, GBP, EUR, JPY and CHF.
Since banks have shifted to other sources of lending, the underlying market for unsecured wholesale overnight lending, which LIBOR purports to measure, is less liquid. IBA is transitioning to a waterfall methodology for determining LIBOR which is based first on transaction where available, then transaction-derived data, and finally expert judgement if no other data is available. That means some contributors only provide input based on expert judgement. LIBOR’s 20 panel banks, who are subject to periodic external audit, are concerned about the legal and regulatory risks of contributing under the new regulatory framework, but contributors withdrawing from the LIBOR panel could cause systemic risk.
Transition timelines and scenarios
An orderly transition to alternative reference rates requires time and careful preparation to unwind or renegotiate legacy instruments worth hundreds of billions of USD, GBP, EUR, JPY and CHF. Firms should account for the different timescales in their IBOR change programs.
The UK regulator negotiated an agreement with LIBOR’s panel banks to continue contributions through the end of 2021. The target deadline for LIBOR transition applies to both EU and global users. However, BMR subjects EU-supervised users to tighter transition deadlines for EONIA and EURIBOR. Their administrator, EMMI, has until 1 Jan 2020 to be authorised.
Under BMR Art. 51(4), benchmarks that cannot comply with BMR can be used until the end of the transitional period 1 Jan 2020, to prevent breach or frustration of contract. Stated differently, a non-compliant benchmark can no longer be used in new instruments in the EU as of that date. EMMI has already announced that despite its attempts to reform EONIA’s methodology, the benchmark is not expected to meet BMR standards by the end of the transitional period in early 2020. While ECB plans to publish the Euro Short-Term Rate, ESTER, as of October 2019, questions remain whether that date provides EU-supervised users sufficient time to transition from EONIA before the regulatory deadline. As for EURIBOR, EMMI is still attempting to develop a BMR-compliant methodology. In addition to incorporating multiple transition deadlines, firms should consider scenario analysis of potential outcomes.
We have more analysis on global LIBOR reform on our dedicated websites BMR and LIBOR and will be at RiskMinds International in December hosting this topic.
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