Easing transition: FCA announces LIBOR cessation date

June 2021 | FEATURE | BANKING & FINANCE

Financier Worldwide Magazine

June 2021 Issue

The transition away from the London Inter-Bank Offered Rate (LIBOR) has been a long and laborious process. However, on 5 March 2021, the UK Financial Conduct Authority (FCA) finally announced the dates by which panel banks’ submissions for any LIBOR will stop and LIBOR will no longer be representative.

Established in 1986, LIBOR has long been one of the most important rates in the global finance industry. In addition to deciding the price of transactions, the rate was considered a measure of trust and reflects the confidence that banks have in each other. Under the LIBOR system, the British Bankers’ Association (BBA) and later the Intercontinental Exchange Inc (ICE) would confirm with banks on a daily basis at what rate they were able to borrow unsecured from other banks.

Since the rates submitted are estimates rather than based on actual transactions, there was scope for LIBOR manipulation. A series of high-profile cases saw complicit financial institutions fined up to $10bn. As a result, LIBOR’s standing in the global economy came under intense scrutiny.

LIBOR controversies, coupled with a decline in interbank lending, prompted Andrew Bailey, the now former chief executive of the Financial Conduct Authority (FCA) and current governor of the Bank of England, to call for an end to the use of LIBOR and a transition to alternative reference rates that are based firmly on transactions.

Reform

Following the 2008 financial crisis, regulators in the US and UK began exploring a replacement benchmark rate system. In the UK, the FCA announced in 2017 that after 2021, banks would no longer be compelled to submit the data required to populate LIBOR. “The continued reliance of global financial markets on LIBOR poses a risk to financial stability that can only be reduced through a transition to alternative risk-free rates (RFRs) by end 2021,” said Mr Bailey.

In the US, financial regulators have been working closely with industry groups and other stakeholders to establish a new system to replace LIBOR. The Alternative Reference Rates Committee, convened by the US Federal Reserve to oversee the transition process for US dollars, named the Secured Overnight Financing Rate (SOFR) as its recommended alternative to USD LIBOR. SOFR represents the cost of borrowing cash overnight in the interbank market, collateralised by US treasury securities. Therefore, unlike LIBOR, it is based on actual market activity.

“Transitioning away from LIBOR was never likely to be a simple process, given its position in the global economy as the benchmark supporting hundreds of trillions of dollars in contracts.”

According to the FCA’s announcement – arguably the most important it has made regarding LIBOR to date – the LIBOR settings will either cease to be provided by any administrator or no longer be representative after the following dates: in the case of all sterling, euro, Swiss franc and Japanese yen settings, and in the case of the one-week and two-month US dollar settings, immediately after 31 December 2021, and in the case of the remaining US dollar settings, immediately after 30 June 2023. So from 2022 onward, the world will need to rely on new reference rates for pricing financial assets.

That said, the sterling working group had already set clear milestones for the loan market’s transition to RFRs. First, there would be no new GBP LIBOR-linked loans that expire after the end of 2021, after Q1 of this year. And second, there would be active conversion of all legacy GBP LIBOR contracts expiring after the end of 2021, by the end of Q3 of this year.

But the FCA’s March announcement not only provides certainty for the financial markets regarding LIBOR, it also fixes the spread adjustment contemplated under certain industry-standard documents as of 5 March 2021, providing greater clarity around the economic impact of the transition to an RFR, such as SOFR or the Sterling Overnight Index Average (SONIA).

“The FCA’s announcement on 5 March 2021 provided market participants with the certainty needed on the dates for the cessation of publication of, and/or non-representativeness of, the various settings of LIBOR,” says Jeremy Duffy, a partner at White & Case LLP. “This announcement, along with the sterling working group’s milestone dates, has spurred progress in the market, in particular around those using Loan Market Association (LMA)-based loan documentation. In addition, for those using the LMA’s rate switch agreements, the announcement sets the ‘Rate Switch Trigger Event Date’ for each currency on which LIBOR loans will automatically switch over to RFR terms, unless an earlier ‘backstop date’ has been used.

“Separately, for legacy loans, the announcement could – this will need to be checked on a document-by-document basis – also amount to a ‘Screen Rate Replacement Event’, on a per tenor basis, such that the consent threshold for implementing amendments to legacy loans could now be reduced to the levels agreed in the relevant underlying loan agreement – parent and majority lenders, in most cases. This announcement will therefore help the loan market meet the milestones set by the sterling working group,” he adds.

The FCA stated that all 35 LIBOR settings will either cease to be provided by any administrator or no longer be representative after the relevant dates. The FCA made its statement aware that it will engage certain contractual triggers for the calculation and future application of fallbacks that are activated by pre-cessation or cessation announcements made by the FCA in contracts.

In March, the ICE Benchmark Administration Limited (IBA), the authorised administrator of LIBOR, published a feedback statement regarding its intention to cease publication of LIBOR. The feedback statement explains that in the absence of sufficient bank panel support and without the intervention of the FCA to compel continued panel bank contributions to LIBOR, the IBA is required to cease publication of the various LIBORs.

Importantly, both the IBA feedback statement and the FCA’s announcement note that the UK government has published draft legislation – in proposed amendments to the UK Benchmarks Regulation (BMR) set out in the Financial Services Bill 2019-21 – proposing to grant the FCA the power to require the IBA to continue publishing certain LIBOR settings for certain limited and yet to be finalised purposes, using a changed methodology known as a ‘synthetic’ basis.

Specifically, the FCA has advised the IBA that “it has no intention of using its proposed new powers to require IBA to continue publication of any EUR or CHF LIBOR settings, or the Overnight/Spot Next, 1 Week, 2 Month and 12 Month LIBOR settings in any other currency beyond the intended cessation dates for such settings”.

However, for the nine remaining LIBOR benchmark settings, the FCA has advised the IBA that it will consult on using its proposed new powers to require the IBA to continue publishing, on a synthetic basis, one month, three month and six month GBP and JPY LIBOR, for certain limited periods of time, and will continue to consider the case for the ‘synthetic’ publication of one month, three month and six month USD LIBOR.

Contractual complexity

The transition from LIBOR is likely to affect over $400 trillion worth of financial arrangements globally – from loans and derivatives to insurance contracts, leases and mortgages, according to KPMG. It will require companies to make significant alterations to current business models and contracts.

“The transition away from LIBOR is an arduous process for all concerned,” suggests Mr Duffy. “The scale and complexity of the process cannot be underestimated, as it impacts both new and legacy documentation across all product areas. One of the main complicating factors is the different approaches, whether conventions, documentary approaches or otherwise, that are being taken across currencies, but also product areas, such as loans and derivatives, for the same currencies. Market participants therefore need to familiarise themselves with multiple models.

“Likewise, the timetable for conversion has also been set for different dates, with the sterling market requesting a transition across to RFRs ahead of US dollar, for example. This can complicate decisions as to transition, especially for multicurrency loans,” he adds.

As inter-bank offered rates (IBORs) are used so broadly, transitioning to new reference rates will be a fundamental and complex change for many current business and financing arrangements. Companies will be required to amend all financial instruments, including loans, that refer to an IBOR by replacing it with the appropriate non-IBOR rate by the beginning of 2022. This applies to agreements with both related and unrelated parties. The FCA indicated that it would consult, in the second quarter of 2021, on using proposed new powers under the BMR to address contracts that are difficult to amend prior to cessation of LIBOR publication.

Vast numbers of financial contracts still reference LIBOR and are not fit for purpose in the post-LIBOR world. Firms need to negotiate amendments to their contracts as soon as possible and update contractual fallback language to include references to benchmark rates other than LIBOR. They should approach those negotiations carefully to mitigate their litigation and regulatory risk.

According to Mr Duffy, another crucial point is operating systems. “Market participants will need to ensure that they have new operating systems in place to handle the new conventions going forward,” he says. “The fact that different timetables and conventions are being followed across currencies and product areas means that these operating systems need to be robust enough to allow for multiple iterations to co-exist. Technology will be the key in assisting in a smooth transition to RFRs.”

Pandemic

The LIBOR transition process, like so much of the global economy, has of course been impacted by COVID-19. But despite the disruption, commitment to LIBOR ceasing by the end of 2021 has not changed amid the pandemic. What has been affected, however, is the transition timetable for market participants.

“With COVID-19 causing financial distress for many companies, focus had moved to ensuring that companies had sufficient liquidity and flexibility under their loan documentation to continue to operate,” says Mr Duffy. “Accordingly, in many cases new loans and amendments to existing LIBOR loans were quickly put in place, with no time to discuss the potential use of RFRs.”

“As one would expect, COVID-19 shifted focus to immediate business needs and away from a transition that was still some time away,” he continues. “However, while the sterling working group had moved some interim milestones early in the pandemic, it had stressed that transition was still expected to occur by the end of this year and participants were expected to be ready.”

End of the road

Transitioning away from LIBOR was never likely to be a simple process, given its position in the global economy as the benchmark supporting hundreds of trillions of dollars in contracts. Indeed, unpicking the current system is one of the most significant challenges facing financial institutions today.

Many proposed replacement for LIBOR are country-specific and will not allow for easy comparison between investments across borders. Furthermore, LIBOR was available in multiple currencies, while its replacements are denominated in local currencies, which increases the exposure of investors to foreign exchange swings. Furthermore, LIBOR replacements tend to have a smaller range of term-rate offerings.

Despite these issues, the long road to LIBOR transition appears to be drawing near. After relying on LIBOR rates for so long, market participants may hope for a more stable foundation for the financial system.

Richard Summerfield