On 23 June 2020 the UK Government announced that it will take legislative steps that could help deal with a narrow pool of ‘tough legacy’ contracts that cannot transition from LIBOR by the current deadline of end-2021. The legislative action is expected to give the FCA regulatory power to manage and direct any wind-down period prior to eventual LIBOR cessation in a way that protects consumers and/or ensures market integrity. This will be achieved by amending the Benchmarks Regulation 2016/1011 as implemented by the UK (the UK BMR).
As part of its anticipated powers it is envisaged that the FCA could introduce a “synthetic LIBOR” by directing a methodology change and requiring publication on the same screen as LIBOR currently appears to ensure protection of consumers and market integrity. Leaving aside the economic and mathematical challenges of developing a synthetic LIBOR, one of the issues that will arise in this scenario is the extent to which market participants can use a synthetic LIBOR.
The proposals do not mean that there is an end to or a relaxation of the current LIBOR transition flight path. In the Government’s announcement and the FCA’s subsequent announcement on 23 June 2020 emphasis is given to ensuring that the pool of contracts referring to LIBOR is reduced as far as possible. The FCA appear keen to ensure that the only contracts that remain to be transitioned by the end of 2021 are those that genuinely have no or only inappropriate alternatives and no realistic ability to renegotiate or amend. There is also recognition that a methodology change may be not feasible or would not protect consumers or market integrity. Therefore, regulatory action may not be able to address all issues or be practicable in all circumstances.
It also appears that the usage of a synthetic LIBOR could be limited to what are seen as ‘tough legacy’ contracts. This is not yet defined but some indication of what this means can be taken from the recommendations put forward by the Sterling Risk Free Rate Working Group (RFRWG) in its Tough Legacy report in May 2020. In that report the RFRWG’s conclusions were:
Derivatives: Many derivatives are unlikely to be regard as ‘tough legacy’. However, there is recognition that a derivative used to hedge an exposure that is in itself ‘tough legacy’ could fall within this categorisation. In addition, the response to the ISDA IBOR Fallback Protocol could also be determinative of whether further consideration is given to categorisation of derivatives as ‘tough legacy’. Nevertheless, it is recognised that there is a case for action to address tough legacy exposures in the derivative market.
Bonds: Market participants are being encouraged to transition legacy bonds. However, there is recognition that transition of the whole legacy LIBOR bond market is unlikely to be feasible in part because consent solicitation programmes take time and are costly processes. As such there is a case for action to address tough legacy exposures in the bond market.
Loans – syndicated and bilateral: There is recognition that some recent facility agreements have a ‘replacement of screen rate’ clause which sets outs a mechanism to agree a replacement screen rate upon the discontinuation of LIBOR. However, older legacy documentation do not have such mechanisms and either all party consent is required to amend the rate or the position defaults to lender’s cost of funds. This combined with the fact that in the bilateral loan markets there is less standardisation of documents means there is a case for action to address tough legacy exposures in the loan market.
Mortgages: Although there is only a small number of sterling LIBOR mortgage contracts, the terms of these contracts are wide ranging and there is no universally accepted standard wording used. These contracts are not expected to have wording that envisage a discontinuance of LIBOR. As such there is a case for action to address tough legacy mortgage exposures.
The developments in relation to a synthetic LIBOR will, no doubt, be closely followed not least because it has the potential to address some of the risks and issues that are currently being debated by various market participants in relation to the LIBOR transition by end of 2021. The FCA are expected to look for a balance to be struck between encouraging the discontinuance of LIBOR beyond the end of 2021 and addressing the issues in relation to ‘tough legacy’ contracts. However, until there is more clarity from the FCA it will be difficult for market participants to reach the conclusion that transition plans can be put on hold. Indeed the FCA have said in their recent FAQs that transition from LIBOR is still necessary and “Continued focus on transition remains both necessary and desirable for those who can remove their current reliance on LIBOR”.
Market participants can assist in identifying the real problem areas by continuing their transition efforts and mapping the LIBOR exposure to the relevant contractual terms. This can then help identify more precisely the contracts are that truly problematic and thereby ensuring the solution deployed by the FCA is optimum. To allow transition plans to stop creates a risk that getting counterparty engagement at a later date becomes harder particularly where the solution deployed by the FCA could result in a better position for a party that may be more willing to negotiate in the current state of uncertainty. In addition, there is no certainty that the solution deployed by the FCA will be adopted by other regulators globally and so cross-border risks could materialise, which may be capable of being addressed now in a more consistent manner by continued focus on LIBOR transition projects.