Welcome to our December 2020 issue of the Risk-Free Rates (RFR) Regulatory Round-up - LIBOR. This issue summarises the important announcements there have been in the last few weeks that have clarified the timetable of transition away from LIBOR. The announcements have reinforced the global nature of this transition and the complex inter-relation between the different bodies involved.
Transition timetable becomes clearer
ICE Benchmark Administrator
At the end of November, ICE Benchmark Administration (IBA), the regulated and authorised administrator of LIBOR, announced it will launch consultations in early December on its intention to cease the publication of the following:
- Immediately following the LIBOR publication on 31 December 2021
- GBP LIBOR - all tenors (overnight, 1 week, 1, 2, 3, 6 and 12 months)
- EUR LIBOR - all tenors (overnight, 1 week, 1, 2, 3, 6 and 12 months)
- CHF LIBOR - all tenors (spot next, 1 week, 1, 2, 3, 6 and 12 months)
- JPY LIBOR - all tenors (spot next, 1 week, 1, 2, 3, 6 and 12 months)
- USD LIBOR - 1 week and 2 months tenors
- Immediately following the LIBOR publication on 30 June 2023.
- USD LIBOR - tenors for overnight and 1, 3, 6 and 12 months
The ICE consultation (PDF 606 KB) was launched on 4 December with a closing date of 25 January 2021.
Regulatory responses - UK
These announcements set off a chain of announcements from regulators, emphasising that the IBA announcements should not be read as the LIBOR benchmark ceasing or being unrepresentative for the purposes of the ISDA fallback protocols.
For non-USD LIBORs, the FCA set out its potential approach to the use of new powers under the Financial Services Bill to ensure an orderly wind-down of LIBOR, including two consultations on:
- How it would use the proposed new powers to require continued publication of critical benchmarks on the basis of a changed methodology in certain circumstances
- The circumstances in which those powers would potentially become relevant
The FCA made it clear in the announcement that there would be a case for using the proposed new powers to require a change to the LIBOR methodology where:
- LIBOR currency-tenor settings are widely used in outstanding contracts and/or instruments that cannot practicably be transitioned away from the benchmark rate by actions or agreements by or between the contracting counterparties themselves (“tough legacy” contracts)
- Using the powers would contribute to protecting consumers or preserving market integrity
- The preferred inputs to a new methodology of the types it has proposed are available to the LIBOR administrator
The FCA envisages the methodology change to produce a “synthetic LIBOR” rate would be a forward-looking term RFR based on the overnight RFR already chosen by the national working group for the relevant currency (for example, SONIA for sterling, SOFR for US dollar and TONA for Japanese yen) plus a credit spread, calculated in the same way as ISDA.
In practice, this will mean for non-USD LIBORs that the FCA is unlikely to use its powers to require continued publication of euro and Swiss franc LIBORs at the time these panels are proposed to cease. Euro and Swiss franc LIBOR have a much smaller “tough legacy” populations. The FCA is still considering its use of powers for the more heavily-used yen settings, but it is likely to use its powers for the most heavily-used sterling tenors.
In a further statement on 30 November, the FCA emphasised that it will consider how the exercise of its powers could best be coordinated with any measures being taken in other jurisdictions where a benchmark is heavily used. Under this approach, the FCA would, for instance, consider how any limitations on new use it applies after end-2021 could be best coordinated with any appropriate measures taken in the US in the case of USD LIBOR.
Regulatory Responses - US
The US authorities were quick to highlight that this likely extension of the deadline for the major USD LIBOR tenors would allow most legacy USD contracts to mature before LIBOR ceases. However, they emphasised that, to facilitate the movement away from LIBOR, firms should cease issuing new contracts referencing USD LIBOR as soon as possible and, apart from very limited circumstances, by 31 December 2021.
Implications of the announcements
Firms should examine the implications of these announcements on their transition plans. The deadlines have not changed for non-USD LIBOR referencing products, but firms can gain more comfort that there is likely to be a tough legacy solution in the form of a synthetic LIBOR for those GBP LIBOR referencing products that are impossible to transition. However, regulators continue to emphasise that pro-active transition away from LIBOR is the only way that parties can have economic certainty and control over their contractual terms when LIBOR ceases or is no longer representative.
Alongside the consultations referenced above, the FCA plans to consult further in Q2 2021 on its proposed policy approach to use its power under the UK Benchmark Regulation (subject to the Financial Services Bill being enacted) to prohibit some or all new use of LIBOR by supervised entities.
For USD LIBOR referencing products, firms have been given more time to transition their legacy books. However, supervisory scrutiny is likely to increase over transition plans, especially around the continued issuance of new products referencing USD LIBOR. Firms will also now need to consider operational issues such as system updates to allow two cessation events and the impacts on multi-currency products.
In the meantime, regulators and working groups continue to issue guidance and updates to help firms with active transitions, which we list below.
Sterling market developments
Transition in sterling non-linear derivatives
The Sterling RFR working group published a published a paper (PDF 732 KB) providing considerations on how a non-linear derivatives market based on a RFR could be structured using compounded-in-arrears SONIA. This paper will help all non-linear derivatives market participants and end-users to meet the Working Group's target milestone for market participants to cease by end Q2/Q3 2021 the creation of new GBP LIBOR linked non-linear derivatives expiring after 2021 (except for risk management of existing positions). The Working Group's view is that a fully-functioning SONIA-referencing non-linear derivatives market could potentially exist on terms like those found in ISDA's IBOR fallbacks protocol and supplement.
FCA updated Q&As on conduct risk during LIBOR transition
The FCA has updated its Q&As on Conduct Risk during LIBOR transition, which it first published in November 2019.
The first update addresses how firms can fairly and actively transition existing customers from LIBOR, when the spread between LIBOR and SONIA will vary - a topic that has arisen due to the volatility in the spread between LIBOR and SONIA in the spring of this year. The FCA recounts its previous advice that LIBOR transition should not be used to move customers with continuing contracts to replacement rates that are expected to be higher than LIBOR would have been, but it emphasises that it is up to firms and their customers to determine when and how to transition. They should factor the costs, risks and benefits of any options, and the information available to them at the time. However, the FCA states that where firms are dealing with counterparties who may not be fully able to assess fair terms, firms may wish to consider other conversion mechanisms. For example, firms may consider whether it is appropriate to use contractual arrangements which see the last reset before end-2021 being based on LIBOR, before moving to an alternative rate thereafter.
The second update addresses whether LIBOR contracts can be converted to Bank of England Base Rate plus an appropriate spread, rather than SONIA with an appropriate spread, given that some counterparties may be more familiar with the Bank Rate. The FCA again emphasises that LIBOR discontinuation should not be used to move customers with continuing contracts to replacement rates that are expected to be higher than LIBOR would have been. And given that Bank Rate has tended to be higher than SONIA, the FCA would expect firms to take this into account, for example by a corresponding reduction in the spread added to Bank Rate, compared with the spread that would be added to SONIA. Firms will need to be able to demonstrate how their approach to choosing that spread is fair to the customer.
Euro market developments
EU “tough legacy” developments
On 30 November, the European Parliament and Council agreed the amendments proposed by the European Commission in July 2020 to amend the EU Benchmark regulation. The amendments allow the Commission to designate a replacement benchmark covering all references to a widely-used reference rate that is phased out, i.e. LIBOR, when necessary for avoiding disruption in EU financial markets. However, it was emphasised by the Commission that it is still in market participants' best interests actively to transition to alternative reference rates. The agreed amendment will apply immediately after its publication in the Official Journal.
Fallbacks for EURIBOR
On 23 November, the Euro Working Group on RFRs published two public consultations on fallbacks to EURIBOR. In one (PDF 770 KB), stakeholders are invited to provide their views on fallback rates based on the euro short-term rate (€STR) and spread adjustment methodologies in order to produce the most suitable EURIBOR fallback measures per asset class. In the second, stakeholders are invited to give their views on potential events that could trigger such fallback measures. The deadline for responses is 15 January 2021, with a final recommendation on both topics expected to be published in Q1 2021.
US dollar market developments
Following the announcements on USD LIBOR referenced above, the Alternative Reference Rates Committee (ARRC) released a guide (PDF 468 KB) on the announcements, which also gives updates on the setting of the spread adjustment and the ARRC's legislative proposal with New York State.
On 6 November, US regulators issued an inter-agency statement re-iterating that they do not endorse a specific replacement rate following the LIBOR cessation after 2021. Banks may use any reference rate for loans that they determine appropriate for their funding models and customer needs; also, banks should include language in lending contracts that provides for using a robust fallback rate if the initial reference rate is discontinued. Key highlights are:
- All banks should have risk management processes in place, commensurate with the size and complexity of their exposures, to identify and mitigate their LIBOR transition risks.
- Examiners will not criticise banks solely for using a reference rate, including a credit-sensitive rate, other than the secured overnight financing rate (SOFR), for loans.
On 25 November, the ARRC released conventions (PDF 241 KB) for using SOFR in arrears, both daily simple SOFR and daily compounded SOFR in arrears, in bilateral business loans. The recommended conventions address both new loans that are originated using SOFR and legacy loans that “fall back” from LIBOR to SOFR upon LIBOR cessation. The conventions are similar to the ARRC's recommended conventions for using SOFR in arrears in syndicated business loans. The ARRC also released FAQs for Business Loans Hardwired Fallback Language (PDF 174 KB).
Other market developments
On 11 November, the Swiss Financial Market Supervisory Authority (FINMA) published its 2020 Risk Monitor, which identifies key risks facing supervised institutions and attracting its supervisory attention. Among seven principal risks identified as emerging in the year of COVID-19, FINMA evaluates the risks emanating from a disorderly abolition of LIBOR benchmark interest rates as decreasing.
On 30 November, the Japanese Benchmarks working group released the results of the second consultation on the appropriate choice and usage of Japanese Yen interest rate benchmarks. Industry consensus was with the recommendations of the working group, in particular a waterfall structure for replacement benchmarks of term reference rates, overnight RFR compounding (fixing in arrears). Industry consensus for the spread adjustment methodology was the historical median approach over a five-year lookback period as it maintains consistency with other currencies and ISDA's approach.