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The Financial Conduct Authority (FCA) is to be given new powers to make changes to the methodology of LIBOR for certain “tough legacy” contracts.
The UK Government has announced that it intends to bring forward legislation amending the Benchmarks Regulation 2016/1011 as amended by the Benchmarks (Amendment) (EU Exit) Regulations 2018, which would provide the FCA greater powers in relation to benchmarks (such as LIBOR) recognised as “critical”, in situations where these benchmarks are no longer representative and will not be restored to representativeness.
“Tough legacy” contracts have been identified as those having no alternative or fallback rate, or an inappropriate alternative rate, together with no realistic ability to be renegotiated or amended to work with the new overnight risk free rates. Tough legacy classification is also given to contracts which, when looked at in isolation, do not raise these specific issues, however in their wider context hedge or are otherwise linked with another contract that does. It is also important to note that a relevant contract must not only display characteristics which make it tough to resolve, they must also already be in existence; the FCA has stressed that its new powers cannot be used in respect of new LIBOR exposures.
Previously it had been considered that HM Treasury might step in to delay the transition away from LIBOR as a consequence of the COVID-19 pandemic. For all the tough talk by the regulators at the start of the year about the immutability of the 2021 deadline, in reality the pandemic has caused many firms to divert attention away from transition efforts. Furthermore, their workload has actually been increased by the influx of many new loans referencing LIBOR, recently entered into in both the UK and the US, as a consequence of the respective governments’ emergency stimuli programmes.
However, the Bank of England takes the view that the COVID-19 pandemic underlines the need for transition to occur, and to do so by its original deadline. The Bank points out that against the backdrop of market volatility in March and April, whilst central bank policy rates fell, LIBOR actually rose. This means that homeowners and businesses with loans linked to the near risk free rates which will replace LIBOR have seen a greater benefit from the action taken by central banks. Furthermore, LIBOR’s rise was on the basis of a very low level of transaction-based submissions and significant use of expert judgement, thereby striking at LIBOR’s robustness and sustainability.
The UK Government’s proposed changes will provide the FCA with enhanced powers to require the modification of a benchmark rate calculation methodology if it considers this necessary to protect consumers or the integrity of the market. The changes have been proposed to facilitate both a reduction in disruption to holders of “tough legacy” LIBOR contracts following the cessation of LIBOR, and to assist with the orderly wind down of the LIBOR benchmark.
The FCA’s proposed new powers would allow it to direct the administrator of LIBOR to transfer the benchmark methodology to a more sustainable basis, using robust inputs, as opposed to panel bank submissions.
These powers have the capacity to provide protection against significant disruption for the affected “tough legacy” contracts by allowing a re-compiled LIBOR rate to remain in place, following the cessation of the current LIBOR. This limited use and continued reliance on LIBOR within “tough legacy” contracts would not restore the representativeness of the rate but would allow these contracts to continue to operate. It is important to note however, that parties who avail themselves of this protection will not have control over the economic terms of the revised methodology. They might find that the re-compiled LIBOR rate is a fixed proxy based on historical averages, or the new risk free rate plus a defined credit spread; the key point being that it will not be within their control.
The FCA proposes to consult the market on the feasibility and parameters of the proposed methodology amendments. This is in order to guard against the risk of the published LIBOR values diverging to any significant extent from the value of fallback rates that will come into effect during the pre-cessation period. This engagement will be conducted over the coming months, with the intention it is complete before 31 December 2021, when the FCA’s agreement with the LIBOR panel banks comes to an end.
The reaffirmation of the original timetable is important to both market participants and regulators worldwide. Many have been devoting extensive efforts and resources to the LIBOR transition, and will be grateful that their plans will not be disrupted by the UK Government and FCA taking this unilateral action. Indeed, the wording of the HM Treasury’s announcement suggests the FCA intends to reach out to its international counterparts – a positive sign of global collaboration.
Whilst the interim timetable for transition away from LIBOR has been slowed by COVID-19, the announcements emphasise that market participants should continue to engage in renegotiating or amending their contacts prior to the 2021 deadline.
However, against this backdrop, will the UK Government’s action actually help? Some market participants may interpret regulatory preparedness to resolve “tough legacy” as an indication that ultimately regulators will take action to resolve the difficult issues arising from LIBOR transition, and that, as a result, they need not. In speeches last week, the Bank of England’s Governor, Andrew Bailey, and the FCA’s Director of Markets and Wholesale Policy, Edwin Schooling Latter, both made efforts to discourage this, pointing out that the FCA will only use the new powers to protect consumers and market integrity. Additionally, they stressed that even where it is desirable to use such powers, it might not actually be possible to do so because of appropriate inputs for the re-compiled LIBOR not being available. Furthermore, the FCA said that it might not be comfortable using its powers unless the market has itself made widespread use of the ISDA protocol to achieve transition.
It is also possible that the UK Government’s action will experience scope creep: whilst it is clear the UK Government and FCA’s aim is to resolve “tough legacy” contracts, they do acknowledge that these include contracts which hedge, or are otherwise linked to, such “tough legacy” contracts, but are themselves relatively easy to amend. How easy they will find it to establish consistent and clear parameters, and to draw the fine line between contract classification, is yet to be seen.
Furthermore, whilst the legislation the UK Government has announced it will amend addresses the methodology of indices themselves, “tough legacy” issues are those that arise from the contractual terms of the products which reference those indices. It will be interesting to see how the FCA uses its powers in relation to indices to generate consequences in relation to the contracts that refer to those indices.
Whilst the British Government’s acknowledgement that “tough legacy” is a problem that needs to be solved is welcome, what that solution is requires further work. Market participants that wish to control the way their exposures will respond to LIBOR transition should continue to press forward with their existing programmes.