Overnight sensation: ISDA publishes new definitions to facilitate transition from EONIA

• United Kingdom

• Financial services and markets regulation
• The future of funds - Derivatives
• Financial services

17-02-2020

On Friday 14 February 2020, the International Swaps and Derivatives Association, Inc. (“ISDA”) published the ISDA Collateral Agreement Interest Rate Definitions (the “Collateral Rate Definitions”). The Collateral Rate Definitions allow parties to incorporate standard definitions of overnight interest rates into their ISDA collateral agreements.

The Collateral Rate Definitions have been produced by ISDA in the context of efforts to transition markets from interbank offered rates (“IBORs”) to alternative risk-free rates (“RFRs”) and wider benchmark reforms. For background information regarding the cessation of IBORs and the development of RFRs, see our previous briefing “Buy-side perspective: IBOR transition and derivatives”.

Benchmark reform in the euro market

The reform of two widely used interest rate benchmarks is taking place in the euro market. The interest rates subject to these reforms are:

0. the Euro Overnight Index Average Rate (“EONIA”); and
0. the Euro Interbank Offered Rate (“EURIBOR”). 

The reforms to EONIA and EURIBOR are required because neither interest rate complies with the requirements of the EU Benchmarks Regulation (the “BMR”). The BMR was introduced in order to ensure the accuracy, robustness and integrity of benchmarks. In order to achieve this, the BMR created requirements in respect of the processes used to determine benchmarks such as EONIA and EURIBOR.

Certain EU supervised entities will be prohibited from using critical benchmarks that do not comply with the requirements of the BMR after 31 December 2021. Whereas efforts are underway to reform EURIBOR ahead of this deadline in order to ensure that it complies with the BMR, EONIA will be discontinued and replaced.   

The end of EONIA

On 13 September 2018, the Working Group on Euro Risk-Free Rates (the “Euro Working Group”) (an industry led group established in 2018 to identify a RFR for the euro market and to guide transition to the selected RFR) recommended that the Euro Short Term Rate (“€STR”) be the RFR for the euro market and that €STR should replace EONIA as the market’s overnight rate (see press release  “Private sector working group on euro risk-free rates recommends ESTER as euro risk-free rate”). Later, on 14 March 2019, the Euro Working Group recommended that market participants begin to gradually replace their use of EONIA with the use of €STR (see press release “Working group on euro risk-free rates recommends transition path from EONIA to €STR and €STR-based forward-looking term structure methodology”).

Following recommendations made by the Euro Working Group, the European Money Market Institute (“EMMI”) (the administrator of EONIA) announced on 31 May 2019 that EONIA will be discontinued on 3 January 2022. This date is intended to act as an incentive for the market to fully adopt €STR as the replacement to EONIA (see “Recommendations for EONIA of the Working Group on euro risk-free rates”).

In order to further facilitate this transition, EONIA was reformed to become a tracker benchmark for €STR on 1 October 2019 and is now calculated by EMMI using a reformed determination methodology and revised governance framework.

The rise of €STR

€STR, first published on 2 October 2019, is the rate of interest reflecting the borrowing costs of euro area banks in the wholesale unsecured overnight market and is produced by the European Central Bank. €STR is regarded as a more accurate and robust rate than EONIA for a number of reasons, summarised in the table below:

The Collateral Rate Definitions: Transitioning from EONIA to €STR

The Collateral Rate Definitions were developed in response to a recommendation made by the Euro Working Group in its “EONIA to €STR Legal Action Plan” published on 16 July 2019 (the “Action Plan”).

In the Action Plan, the Euro Working Group recommended that new agreements which specify EONIA as the interest rate payable in respect of euro cash collateral incorporate robust fallback language. The Action Plan also recommended that ISDA develop a mechanism to update legacy collateral agreements for derivatives transactions to include robust fallback language.

Effect of the Collateral Rate Definitions

The Collateral Rate Definitions provide that, on 3 January 2022 (or any prior date on which it is announced that EONIA will cease to be available), references to EONIA contained in collateral agreements that incorporate the Collateral Rate Definitions will be replaced by references to €STR plus a spread of 0.085 per cent (“Modified €STR”). Modified €STR mirrors the existing EMMI methodology for the calculation for EONIA (referred to above). 

The Collateral Rate Definitions also provide fallbacks that apply if either €STR or Modified €STR cease to be available.

Version control

ISDA may update the Collateral Rate Definitions from time to time, for example in order to include fallback language applicable to additional interest rates. If parties incorporate the Collateral Rate Definitions into their collateral agreements, unless otherwise specified, the version incorporated will be the version published by ISDA on the day immediately preceding the date on which the collateral agreement is executed.

If the parties wish to apply the version of the Collateral Rate Definitions in place from time to time, they can provide for this expressly in the collateral agreement. Alternatively, the parties can apply the override mechanism contained in the Collateral Rate Definitions. The override mechanism can be applied to either a particular interest rate or to all rates. If the override mechanism is applied, the fallbacks contained in the latest version of the Collateral Rate Definitions will be applied regardless of when the collateral agreement was executed.

Negative interest rates

The Collateral Rate Definitions specify that the incorporation of the Collateral Rate Definitions will not affect the application of the ISDA 2014 Collateral Agreement Negative Interest Rate Protocol (the “Negative Interest Rate Protocol”) to collateral agreements. In particular, the Collateral Rate Definitions clarify that the specification of Modified €STR as the applicable interest rate will not amount to a “Spread Provision” for the purposes of the Negative Interest Rate Protocol. The inclusion of a Spread Provision in a collateral agreement can mean that the agreement falls outside of the scope of the Negative Interest Rate Protocol.

Points to consider

Parties should consider whether it is appropriate to continue to include EONIA as the interest rate for euro denominated cash in their collateral agreements given that this rate will only continue to be available for a limited time. Where EONIA is specified, parties should consider incorporating the Collateral Rate Definitions into their collateral agreements if they wish to transition to Modified €STR when EONIA ceases to be available.

Firms with legacy references to EONIA in their collateral agreements should ensure that those references are replaced with references to €STR, Modified €STR or another suitable  successor rate prior to 3 January 2022. The fallback provisions in the Collateral Rate Definitions offer firms a standardised way of achieving this. Firms should however consider carefully whether the fallbacks, including those that will apply to €STR are appropriate for them. In particular, firms should consider the commercial impact of any amendments to their cash collateral interest rates, including the possibility of the transfer of any economic value that might occur as a consequence of a change to the applicable interest rate.

The Collateral Rate Definitions offer a means of complying with the recommendations of Euro Working Group in relation to robust fallback language for euro cash interest rates. Although the recommendations of the Euro Working Group are not legally binding, they do represent the prevailing market consensus and widespread adoption of the Collateral Rate Definitions, perhaps driven by the sell-side, might therefore be expected.  

How Eversheds Sutherland can assist

Eversheds Sutherland, together with alternative, legal and compliance provider Konexo can guide firms through all of the steps needed to transition from IBORs to RFRs and wider benchmark reforms, including in relation to their legacy derivatives portfolio and future trading arrangements.

0. Developing a strategy - Together Eversheds Sutherland and Konexo can work with you to develop project plans and offer strategic advice at each stage of the transition process.
0. Keeping you updated - Eversheds Sutherland participates in numerous industry working groups and is therefore aware of the latest market developments. We can also work with you to ensure that that you are up-to-date with product developments and industry documentation initiatives and trends.
0. Training your team - We can offer tailored training to relevant teams within your business.
0. Efficient tech solutions - The firm offers AI solutions as a cost and time efficient way of identifying references to IBORs within contracts.
0. Helping you keep track - We can also develop reports to help firms track progress.
0. Helping you communicate with your clients effectively - We can also develop a client communication strategy (including documentation that can be used for client education).
0. Global cross-product coverage - Eversheds Sutherland has a global presence in all of the major financial markets across all major products (including cash and derivatives) and offers buy-side firms a joined up solution across all products.

For more information regarding how we can help with IBOR transition, please see our brochure “Making It Plain Sailing – We can help you navigate through the end of IBORs”.