With great power comes great responsibility, FCA & LIBOR tough legacy

25 June 2020

Phil LloydHead of Market Structure & Regulatory Customer Engagement

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On 23 June the UK Treasury announced they will bring forward legislation to provide the FCA1 with additional powers to manage the run down of 'tough legacy' contracts referencing LIBOR2. This is a big deal. 

In practical terms this means the FCA will be able to direct a benchmark administrator to continue to publish a 'synthetic LIBOR rate' once LIBOR itself has been deemed non-representative, but, and this is important, only for use in very limited legacy contexts.

Both the FCA in their announcement and the Treasury were quick to point out that this absolutely does not mean anyone should take their foot off the gas in terms of LIBOR transition ahead of the end of 2021. Everything that can go should go, and the use of the synthetic rate will be tightly limited to legacy contracts for which there is no genuine alternative. New business will all be on the new rates.

You heard it here first...

Back in October last year in LIBOR on the ropes we called for the creation of a term rate to help with tough legacy, though cautioning it should not be used as an excuse by the wider market to avoid adopting the new rates wherever possible.

Treasury announcement  

  • Government will ensure that by the end 2021 the FCA has powers to “manage and direct any wind-down period prior to eventual LIBOR cessation in a way that protects consumers and/or ensures market integrity”
  • FCA may require benchmark administrator to change the methodology for a critical benchmark where the benchmark becomes non-representative
  • FCA will have the ability to specify limited continued use of the synthetic rate in legacy contracts only
  • Active transition of legacy contracts remains key and the best route to providing certainty to all parties
  • The regulatory bodies caution that any counterparties relying on legislative action for legacy contracts will not have control of the economic terms and solutions may not be practicable in all circumstances 

FCA has followed up on the Treasury announcement with their own statement and some more detailed commentary in the form of a Q&A.

Our observations

  • The synthetic rate is likely to be built upon a term rate – i.e. a forward looking RFR3 over a given term
  • The risk free rate will have a fixed credit spread applied – reflecting the expected difference between LIBOR and risk free interest rate; the benefit here is that it is likely it will closely align to derivatives fallback credit spread
  • The use of a Term RFR to underpin the synthetic LIBOR rate will likely result in one of the current competing term rate providers becoming market standard going forward
  • It seems unlikely that a Term Rate derivatives market will develop (libor2.0 issues) so re-hedging tough legacy instruments will be difficult in the future; as such transitioning/re-papering still the optimal solution
  • Not all LIBOR currencies will change at the same time, some may simply cease to be published, others may follow when they are no longer representative
  • The read across to the US legislative initiative should be considered... the UK authorities acknowledge that depending upon how that progresses it may affect how the measures will apply there
  • This is a step in the right direction to get people with both tough legacy and ISDA4/Cleared derivatives in their portfolio to be more confident in signing up to the fallback protocol, given there is expected to be some alignment between derivatives and the tough legacy 'fallback', albeit with some basis between realised RFR and term RFR

Conclusion?

We welcome this development. It will bring greater comfort around legacy and encourage adoption of the protocol for those that might have been concerned about how hedges would align to tough legacy.

  1. FCA Financial Conduct Authority
  2. LIBOR - London Inter-Bank Offered Rate
  3. RFR - Risk Free Rate
  4. ISDA - International Swaps and Derivatives Association
Market infrastructure & regulation
LIBOR
SONIA


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