On 30 June 2021, the Dutch Authority for the Financial Markets (Autoriteit Financiële Markten, the AFM) published recommendations on how to mitigate risks around the introduction of new fees and/or including fallback options in contracts by banks, insurers and pension funds in the context of the benchmark transition (the Recommendations).
In its press release on the Recommendations, the AFM notes that Dutch financial institutions have made a considerable effort to transition to alternative, risk-free benchmarks in recent years, but that this transition has slowed down worldwide. Recently, the AFM together with the Dutch Central Bank (De Nederlandsche Bank, DNB) issued a joint statement to remind financial institutions of the need to speed up the transition. According to the AFM, the main cause of the delay has been that new fees are not being introduced quickly enough and/or fallback provisions have not yet been included in contracts. The AFM (again) urges the parties involved to take action to ensure they meet the deadline of 31 December 2021.
In the Recommendations, the AFM indicates that the EU Benchmarks Regulation (BMR) provides that existing financial instruments and contracts based on interest rate benchmarks based on interbank offered rates (IBORs) must be amended to reference alternative rates, or be provided with a fallback option, and new contracts must include robust fallback options. The AFM also notes that the requirements to have fallback options also applies to EURIBOR- and SARON-based contracts, but that a large number of contracts – including those referencing EURIBOR – do not yet contain sufficiently robust fallback options. In addition, the AFM and DNB have noted that newly issued contracts – in particular those referencing EURIBOR – do not always contain appropriate fallback provisions. The AFM points out that market participants have the primary responsibility for ensuring a smooth transition from IBORs to risk-free rates (RFRs). According to the AFM, the swiftest manner to do this is to reference RFRs instead of IBORs in all new financial instruments or contracts and to, where possible, close out existing in instruments referencing IBORs.
The AFM notes that all contracts currently referencing an IBOR should have appropriate fallback options in place. These fallback options should ideally include the following elements:
- a replacement rate (for instance €STR as a replacement for EONIA);
- a methodology to compute a term structure using overnight rates (the Working Group on Euro Risk-Free Rates has identified and analysed 4 forward looking term methodologies and 8 backward looking term methodologies in different publications);
- a methodology to compute the spread (the Working Group on Euro Risk-Free Rates has identified and analysed 4 types of spread adjustment methodologies);
- additional technical provisions (e.g. floors on referenced rates); and
- characterization of the trigger event (for instance a cessation or a representativeness trigger).
According to the AFM fallback language containing all of the elements listed above (so-called “hardwired” fallback language) is highly desirable to reduce risks and enhance transparency particularly for less knowledgeable counterparties or end-clients. Other options may be considered by benchmark users, but the language should always be sufficiently robust and a simple reference to future market practice is not considered to be appropriate.
The AFM emphasises the need for market participants to foster a harmonised transition to avoid market fragmentation, which would be caused by too many differences in fallback options used in the market. This could among other things lead to an increase in costs for transaction and holding instruments for financial institutions, which eventually could lead to higher costs for non-professional clients, as well as a lack of understanding by non-professional end clients with regard to the fallback options and impact on their financial positions. A harmonised transition can for example be achieved if market participants in discussions launched by relevant working groups, by adopting fallback provisions that are aligned with recommendations of working groups/industry associations, and by adhering to fallback protocols developed by industry associations.
Section 3 of the Recommendations contains a number of specific recommendations for market participants on:
- communication to clients and counterparties: there should be a communication plan in place and clients should be proactively informed on the need for repapering (in a comprehensive, understandable and tailored manner);
- internal governance: a dedicated team should be in place monitoring developments of the market and regulations, which regularly informs higher management of actions taken and challenges faced;
- contracts: market participants need to carefully evaluate how different types of instruments or contracts are affected by this transition, especially ‘tough’ legacy contracts (i.e. existing IBOR referencing contracts that are unable, before the end of 2021, to either convert to a non-IBOR rate or be amended to add fallback options). In addition, amendments to contracts should have minimal economic and legal impact for clients (in particular non-professional clients); and
- operational systems: the move to RFRs requires changes to operational systems to integrate characteristics of amended contracts and properties of fallback rates. The AFM notes that market participants should identify its operational systems that are linked to benchmarks and develop a good understanding of how the transition to RFRs their IT requirements. Where necessary, they should update their operational systems accordingly in order to ensure that those systems continue to function properly whenever a switch in the interest rates is realised.