London Interbank Offered Rate (“LIBOR”) is an interest-rate average calculated from estimates submitted by the leading banks in London, used in lending between banks on the London interbank market. Over time, LIBOR has been used as a reference for setting the interest rate on other loans and a myriad of other financial products. Following the uncovering of huge manipulation of this rate, the role of LIBOR in setting interest rates in the financial market has been called into question.
In July 2017, the UK Financial Conduct Authority (“FCA”) announced that from the end of 2021 it would no longer require banks to submit quotes in order to obtain interest rates to form LIBOR.
Therefore, market participants should not rely on LIBOR being available after this date. As a consequence, the FCA expects firms to be taking appropriate steps to ensure they can transition to alternative risk-free reference rates (“RFRs”) before the announced deadline of the end of 2021.
On 11 November 2019, the FCA published some questions and answers on conduct risk (“Q&A”), setting out its core expectations from firms during the transition away from LIBOR.
The FCA’s supervision of firms transitioning away from LIBOR is focused on such firms effectively managing the risks arising from such transition, including prudential, operational and conduct risks.
The background to the Q&A from the FCA is:
- The “Dear CEO” letters published by the FCA in September 2018, which asked the CEOs of major banks and insurers in the UK to provide details on the preparations and actions being taken by these institutions, in order to manage the transition from LIBOR to alternative interest rate benchmarks, and specifically the Sterling Over Night Index Average (“SONIA”) in the UK; and
- A joint statement published on 19 September by the FCA and the Prudential Regulation Authority (“PRA”) setting out their key observations from the responses of those firms to the “Dear CEO” letters, in particular identifying a number of critical elements which were present in “stronger responses”.
While the joint statement previously identified and emphasized good practice for LIBOR transition, in its latest Q&A of November 2019, the FCA appears to have changed tactics and approach, in order to further engage market participants.
The Q&A is framed as the publication of initial answers to some of the most commonly raised conduct questions the FCA has received; however, it is also designed to highlight the regulatory risks of failing to prepare properly for LIBOR transition, and is likely aimed primarily at those at the weaker end of the spectrum in terms of the responses to the “Dear CEO” letters (although of course applicable to all).
Governance and accountability
Unsurprisingly, the FCA reiterates its previous messages that firms’ senior managers and boards are expected to understand the risks associated with LIBOR transition, and take appropriate action to move to alternative rates ahead of the end of 2021.
While firms are under general regulatory obligations to have effective processes and controls to identify, manage, monitor and report risks to their business, they need to consider whether any LIBOR-related risks are best addressed within their existing conduct risk frameworks or, instead, need a separate, dedicated program. In many firms, LIBOR transition will impact the overall business and front-office client engagement; therefore, the potential impact and risks need to be considered and addressed appropriately and coordinated across the firm.
Additionally, firms that are subject to the Senior Managers and Certification Regime (“SMCR”) should allocate responsibility for overseeing the transition away from LIBOR to an identified senior manager. Those responsibilities must be detailed in the relevant senior manager’s statement of responsibilities.
Unlike in last year’s “Dear CEO” letters, where the PRA and the FCA have called for a senior manager in banks and insurers to be allocated this responsibility, rolling out the SMCR to FCA solo-regulated firms in December means that its requirements will apply to all firms affected by LIBOR transition, and not only to senior managers in bank and insurers.
Should a firm not manage its move from LIBOR effectively, in its Q&A of November 2019 the FCA has clearly signaled that it may look to hold not only the firm, but also the relevant senior manager accountable.
Senior managers should, therefore, act with due skill, care and diligence, and, among other things, keep detailed records of management meetings or committees as evidence of the steps they took to so act.
Senior managers should also make sure that the governance arrangements, frameworks and processes put in place to ensure a smooth transition away from LIBOR are clearly documented and are embedded in the firm’s overall transition program.
Replacing LIBOR with alternative rates and treating customers fairly
The FCA is particularly concerned that firms take reasonable steps to treat customers fairly when replacing LIBOR with alternative rates in existing contracts and products. The key element is considering the contract as a whole to ensure that the replacement rate is fair.
As a consequence, firms must:
- not replace LIBOR in existing contracts with a rate or terms that would be less favorable to the customer. For consumer contracts, firms are expected to consider the Consumer Rights Act 2015 and the FCA’s finalised guidance on the Act;
- ensure that, among other things:
- a) LIBOR transition is not used to move customers with existing contracts to replacement rates that are expected to be higher than LIBOR would have been, or otherwise introduce inferior terms. The FCA expectation is that fulfilling the duty to treat customers fairly is easier to demonstrate if firms adopt a replacement rate that aligns with the established market consensus, reached through appropriate consultation, which is recognised by relevant national working groups as an appropriate solution, referring in particular to the work both of the International Swaps and Derivatives Association, Inc. (ISDA) and the Working Group on Sterling Risk-Free Reference Rates (the “£RFR Working Group”).
- b) if new fall back provisions are incorporated into existing contracts to replace LIBOR with a new reference rate, customers have to receive effective communication on how these fallback provisions are expected to operate (such as whether the clauses operate at, or before cessation, and on what basis).
Although the FCA acknowledges that industry initiatives are still ongoing, nonetheless firms will need to ultimately exercise their own judgement on when and how to remove LIBOR dependencies in legacy contracts by the end of 2021. The authority also reiterates the statement previously made that the most effective way to avoid LIBOR related exposure is not to write new LIBOR-referencing business, but to transition to alternative rates, taking into account the considerations on selecting a fair replacement rate.
Offering new products with RFRs or alternative rates
If a firm continues to offer LIBOR-linked products that mature after 2021, it must carefully consider whether these products can meet the needs of customers and continue to perform in line with their expectations both before and after the discontinuation of LIBOR.
It is essential any such firm explains fully to its customers what will happen in the event of LIBOR ending and the impact on them. LIBOR-linked contracts that include robust fall back provisions help reduce, but do not always eliminate, these risks.
SONIA and other RFRs
SONIA compounded in arrears is the preferred RFR for sterling LIBOR – the FCA notes that in the derivatives and securities markets, SONIA compounded in arrears is established as the preferred alternative reference rate to sterling LIBOR and that the £RFR Working Group has the view that SONIA, compounded in arrears, will and should become the industry standard in most parts of the bilateral and syndicated loan markets.
The FCA acknowledges that a forward-looking SONIA term rate compiled from transactions in SONIA derivatives markets could form the basis of a fair replacement rate for legacy cash products and it may also be an option for new products in some circumstances but may not be the optimal choice. There may be other products (such as products based on SONIA compounded over an earlier period, fixed rates, or on “Bank Rate” as in some existing mortgages) that may be more appropriate for meeting the needs of customers who prefer cash flow certainty, which are likely to be more stable than forward-looking rates based on market transactions on a single day, and easier to explain and understand.
The FCA supports the target date of no more new sterling LIBOR cash contracts from end of the third quarter of 2020, set by the £RFR Working Group and will monitor firms’ progress on this during 2020. However, the FCA acknowledges that this will involve significant infrastructure and documentation preparation, customer communication and staff exercises for some banks.
A LEGISLATIVE FIX, AND PRE-CESSATION TRIGGERS
On 21 November 2019 the FCA, through its senior directors, delivered the latest of a line of speeches on LIBOR discontinuation. From the perspective of banks and other financial institutions, the most important point of interest is the possibility of a legislative fix. While it is fair to say that there has been no softening in the FCA’s message that LIBOR will cease at end of 2021, there has been some degree of variance between the several speeches on what assistance (if any) the market can expect in particular in relation to some form of legislative fix.
In a speech by the FCA’s Chief Executive on 15 July 2019, the FCA hinted at the possibility – for “tough” legacy contracts – of legislators redefining LIBOR as RFRs plus fixed spreads.
However, it has been made clear that this option should not be relied upon to be deliverable, but suggested that there would be a consultation on the possibility of legislation. In what will no doubt be a disappointment to many market participants, there was no update or further elaboration of this suggestion in the latest speech by the FCA. While such an option in the UK was not explored, the FCA noted that a legislative fix is being considered in the United States in relation to bond conversations – building in a so-called pre-cessation trigger.
ISDA TO ROLL OUT PRE-CESSATION TRIGGERS
The FCA’s wider discussion of the inclusion of a pre-cessation trigger is noteworthy, in particular its comments and concerns in relation to contractual fallbacks in the global derivatives market (because of the systemic importance of LIBOR in the swaps market). The co-Chairs of the Financial Stability Board’s Official Sector Steering Group (the “FSB”), Andrew Bailey, CEO of the FCA and John Williams, CEO of the Federal Reserve Bank of New York, whose work focuses on interest rate benchmarks that are deemed to play a critical role in the global financial system, have written to the International Swaps and Derivatives Association (“ISDA”) requesting that it includes a “pre-cessation trigger” alongside the cessation trigger in its standard language in derivatives contracts, via either definitions for new contracts or in a single protocol (without embedded optionality) for outstanding contracts. The FSB also advises against “opt-in” or “opt-out” alternatives as this would present additional complexity and risk management challenges, but notes that parties could still agree to bilaterally amend the pre-cessation and cessation triggers.
Further, the FSB’s letter further notes that, while the two largest central counter-parties intend to move cleared derivatives contracts away from LIBOR in the event of a “non-representative” determination by the FCA, no similar trigger exists for uncleared contracts. This could cause a discrepancy in rates between cleared and uncleared contracts, with potential market fragmentation ramifications. The pre-cessation trigger would cause a LIBOR-based contract to fall back to an alternative reference rate in the event that the FCA, as the regulator of LIBOR, deemed that LIBOR was no longer representative.
ISDA has therefore consulted derivatives market participants on a number of aspects of the proposed fallback provisions in ISDA documentation, including whether or not to include a pre-cessation trigger, and reported that the majority of respondents supported the move, but that there were differing views on how it should be implemented.
ISDA has not published any pre-cessation trigger language so far, and the FSB has urged it to take further steps, if necessary, to do so.
By publishing these Q&As and relying on the SMCR to allocate a senior manager responsible for LIBOR transitioning, the FCA is clearly putting firms on notice that it will challenge them if they fail to meet these standards. The FCA will also hold individuals accountable where appropriate.
Firms that have not already done so should draw up their LIBOR transition plans now. As the FCA has highlighted, given that LIBOR transition will impact a firm’s overall business, any transition plans should be considered and addressed in an appropriately coordinated way across the firm.
Transitioning legacy LIBOR contracts to new RFRs is an immensely complex task, particularly in light of the many uncertainties still outstanding, as it is evident in the derivatives market. A successful repapering exercise requires a precise understanding of the legal issues and the practical realities of the transition to the new RFRs across different currencies and financial products.
For more information, and any guidance or advice on LIBOR discontinuation, Cleveland & Co External in-house counselTM, your specialist outsourced legal team, are here to help.