EU benchmark drama set for cliffhanger end

Access to key FX rates due to be decided six months before potential cut-off

European Parliament
European Parliament: set June 15, 2023 date to decide on exclusions for FX rates

A long-running drama about the oversight of financial benchmarks within the European Union looks set for a nailbiting finish, with a flurry of crucial decisions now scheduled for mid-2023 – just six months before EU firms may be cut off from some third-country benchmarks, including important currency hedging rates.

The cut-off was originally set for the end of next year and could – in 2023 – be pushed back a further two years. That gives the market extra breathing space, which some are welcoming.

“The original third-country transitional period at the end of 2021 was going to be a real nightmare,” says a compliance head at one major dealer. “A large swath of third-country benchmarks have yet to be approved for use in the EU, so more time is useful.”

Others are preparing for the worst.

“Without any real change to the scope of that regime, I think we need to all anticipate a cliff edge at the end of 2023 for a significant number of third-country benchmarks,” said Anna Grainger, executive director for legal and compliance at Morgan Stanley, speaking at a December 7 event organised by the International Swaps and Derivatives Association.

The market now faces a long wait to find out which benchmarks will be affected, and when. A day after the Isda event, the European Parliament and Council of the European Union weighed in, setting a June 15, 2023 date for the European Commission to decide on exclusions for foreign exchange rates – as well as other classes of benchmarks – and whether the transition period should be pushed back to the end of 2025.

In doing so, legislators told the EC to analyse “the consequences of the far-reaching scope” of the regime on third-country administrators, and their EU customers.

The regime in question is the EU’s Benchmarks Regulation (BMR), introduced in 2018 to head off any repeat of the Libor scandal by subjecting benchmark contributors, creators and administrators to new standards on accuracy and integrity. Third-country benchmarks have to be authorised if they want to keep their EU customers, but were given until the end of next year to do so.  

The original third-country transitional period at the end of 2021 was going to be a real nightmare
Compliance head at one major dealer

Industry critics argue authorisation is currently too difficult. Three paths are available – equivalence, recognition and endorsement. Equivalence requires comparison of the BMR with applicable local regulations, but few third countries currently have their own set of benchmark rules. The second option, recognition, requires an administrator to set up an EU legal entity to perform oversight, which would be answerable to its host country regulator – an expensive and onerous undertaking. And the third requires the third-country administrator to pair up with an EU administrator that would become answerable for its non-EU benchmarks.

If third-country administrators decline to jump through these hoops, then European firms would be barred from using their benchmarks.

“We don’t think the third-country benchmark regime is really fit for purpose,” says Rick Sandilands, senior counsel for Europe at Isda. “It doesn’t work to protect users of these benchmarks, it actually has almost the opposite effect, in that if the benchmarks that are referenced in a contract are prohibited then it could expose them to risk.”

The Investment Association estimates there are 2.6 million benchmarks in use worldwide, but much of the industry’s pushback has focused on spot FX rates that form the basis for offshore hedging markets in Korean won, Taiwanese dollar and a number of other currencies.

According to analysis by the Global Financial Markets Association, around $931 billion in US dollar/Korean won trades could be attributed to EU entities in 2019, while the US dollar/Taiwanese dollar rate was referenced by EU firms in $585 billion of trades.

“You’ve had long enough”

The European Commission proposed a two-pronged fix in July this year, extending the transition period to 2023 – with the option of a further two-year delay – and carving out FX rates entirely if two conditions are met. The rate in question must not be freely convertible, and must be used “on a frequent, systematic and regular basis” by EU entities to settle FX hedges.

The compliance head at the large dealer argues a two-year extension to the transition period gives the market enough time to find solutions.

“At the end of 2023, if you’re a third-country index provider and you’re selling your indexes into Europe, then you’ve had long enough to be aware of the issues your clients may be facing – and if they don’t want to get their indexes authorised then they will have to pull out of the European market, and European entities will have to stop using them. 2023 is enough time for firms and benchmark providers to get a grip on this,” he says.

At this month’s Isda event, Morgan Stanley’s Grainger saw it differently, arguing an extension would not make it any easier for benchmark administrators to be authorised.  

“The proposal to extend those transitional provisions through to 2023, and possibly to 2025, will continue to mask [these] problem[s]. It’s really fortunate for all of us that we’re not facing this cliff edge at the end of 2021 anymore, but as an industry, I still don’t think we know how many third-country benchmarks we use, and we can’t really understand what their impact is going to be until those transitional provisions expire,” she said.

We would have preferred this proposal not to be in there
Rick Sandilands, Isda

And the FX exclusion is causing some head-scratching. In a letter to the EC, Joanna Perkins, chief executive of the Financial Markets Law Committee, argued the “frequent, systematic and regular” carve-out was too vague and would be difficult to enforce.

Isda’s Sandilands makes a similar case: “We would have preferred this proposal not to be in there,” he says. “By their nature, a lot of non-EU benchmarks are not widely used, but that doesn’t mean they’re not important to the companies that need them. The European Commission will hopefully take a pragmatic approach to its designation power, and look at the impact on the people who need that benchmark rather than asking whether it’s broadly used in the European Union by a lot of people.”

The amendments from the Council of the EU and the European Parliament hold out the prospect of more far-reaching change. By the mid-2023 deadline, the EC is told to do three things: create a list of spot FX benchmarks that would be eligible for exclusion from authorisation; review the scope of the regime as it relates to third-country benchmark administrators and the potential impact on their EU users of those benchmarks; and decide whether to extend the transition period by a further two years.

In issuing their marching orders, the EU’s co-legislators strike a critical tone. They note that, when drawing up the BMR, policymakers had expected other countries to follow suit with their own, similar benchmark regimes, thereby opening the door to a raft of equivalence decisions. A lack of progress on this front has opened up a “disparity in scope between the regulatory regime for financial benchmarks in the Union and in third countries” and a threat to the EU’s benchmark users.

It’s not clear where this leaves the BMR as it applies to non-EU benchmarks – and it is not scheduled to get any clearer until six months before the transition period is due to expire. At that point, benchmark users in the EU will find out, all at once, which FX rates will be excluded from the regime, whether whole classes of other benchmarks will also be excluded, and whether the rules will be applied from the end of 2023, or the end of 2025.

Speaking at the Isda event, one day prior to the release of the parliament and council amendments, David Henry Doyle, European head of government affairs and public policy at S&P Global, argued the proposed exclusion for selected FX rates was an admission the third-country benchmark regime had failed – and that further revisions and exemptions to the rules would only undermine their original justification.

“The idea that the EU will just introduce exemptions when they feel like it is a bit of a slippery slope, because you then have potential for actually going against the principles that you set yourself at the beginning of the BMR process,” he says.

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