Marking the end of Libor

Need to Know

legal issues column

Deborah Sabalot discusses progress on the transition from Libor to other risk-free benchmarks and looks at how the FCA will use its new supervisory powers

One of the key features of the Financial Services Bill now before parliament is a series of measures on the transition from Libor (London Inter-bank Offered Rate) to other risk-free benchmarks.

In 2014, the Financial Stability Board (FSB) recommended moving away from Libor, which is the benchmark interest rate at which major global banks lend to one another, to alternative ‘risk free’ rates. The rationale was that Libor is inherently based more on “expert judgment” than on market reality. The Working Group on Sterling Risk-Free Reference Rates was established in 2015 to implement the FSB’s recommendations on alternative risk-free rates and it has developed Sonia (Sterling Overnight Index Average) as its preferred benchmark across the sterling market.

The banking industry has not found the transition from Libor easy and the deadline has softened little by little

The FSB and the Basel Committee on Banking Supervision have published a further report on the supervisory issues associated with benchmark transition, setting out recommendations for authorities to support financial institutions and their clients’ progress in transitioning away from Libor. The FSB has also recently published a Global Transition Roadmap to help remove the dependence on Libor.

But progress on killing off Libor has been slow. In July 2020, the FSB reiterated that financial and non-financial sector firms across all jurisdictions should continue their efforts to reduce reliance on IBORs (Interbank Offered Rates) and stop using that as a ubiquitous reference rate by the end of this year.

This transition is difficult because Libor is so integral to a wide range of existing private law contracts. The UK Libor panel banks agreed with the Financial Conduct Authority (FCA) to continue issuing the rate on a voluntary basis until the end of 2021. It became clear to regulators globally, however, that such goodwill would not be enough. The UK bill gives the FCA extraordinarily wide powers to deal with the rump of legacy contracts that reference Libor and other IBOR-related benchmarks. The bill also makes certain amendments to the UK Benchmark Regulations as amended by the Financial Services (Electronic Money, Payment Services and Miscellaneous Amendments) (EU Exit) Regulations 2019, and the Financial Services Regulations 2020 that onshores the EU benchmarks regulation into UK law. Those amendments came into effect from 31 December, 2020, when the UK’s Brexit transition ended.

The banking industry is not finding the shift easy and the December 2021 deadline for the demise of Libor has softened little by little. Some US dollar Libor tenors will continue to be published until 30 June, 2023, to prevent disruptions, but the Bank of England stressed in December 2020 that “new use of these rates must stop at the end of 2021”.

When it gets critical

Libor is classified and regulated as a ‘critical benchmark’ under the UK Benchmarks Regulations (BMR). That gives the FCA the power to dictate terms to its administrators to ensure Libor’s orderly wind-down and to prevent threats to market integrity, financial stability, consumers and the real economy.

The existing UK regulations provide that a benchmark needs to be ‘representative’ of the underlying market that it is intended to measure. But the banks themselves have traditionally decided whether to be on the panel and their withdrawing could undermine the benchmark’s credibility. The new bill would give the FCA powers to compel supervised banks to contribute in order to keep the benchmark representative.

The bill also proposes various amendments to the regulation to give the FCA the powers to manage the orderly ‘winddown’ of a critical benchmark.

When it gets tough

Firms are supposed to be preparing for Libor to end at the end of this year, but some contracts that have Libor integrated in their payment terms cannot be renegotiated or have the terms modified in order to move away from Libor. If there is no alternative or fallback rate, these socalled ‘tough legacy’ contracts would be at risk of claims of frustration if the payment obligations were found to have been fundamentally altered. This could result in legal disputes between parties to these contracts.

In May 2020, the Working Group on Sterling Risk-Free Rates recommended that a legislative solution would be needed to assist these contracts and the parliamentary bill now includes some of those recommendations. It gives the FCA the power to review critical benchmarks to determine whether they remain representative. If they do not, or if the representativeness of the benchmark cannot be restored, then the benchmark can be ‘designated’ by the FCA.

Designation gives the FCA powers to require the administrator to change the way in which the benchmark is determined; to change the rules of the benchmark; and to change its input data and the code of conduct for contributors. The FCA could also compel the benchmark administrator to continue publishing the benchmark for a period of up to 10 years.

The FCA has the power to review critical benchmarks to determine whether they remain representative

Where an administrator proposes to cease publication of a benchmark, the FCA would be able to prohibit some or all of the use of a designated benchmark by banks and other authorised firms. It will also have the ability to postpone the prohibition on use by a period of up to four months, and will have the power to exempt ‘legacy use’ of the benchmark from the prohibition.

The bill also extends existing requirements for administrators of all benchmarks to publish a robust procedure outlining the actions that they will take in the event of changes to, or the cessation of, a benchmark.

New provisions would also allow different ‘versions’ of ‘umbrella’ benchmarks to be considered separately. For example, Libor would be considered an umbrella benchmark, and it would comprise many different versions according to the particular currency and tenor in question. So, three-month sterling Libor would be one version, three-month US dollar Libor would be another one, and so on.

The FCA would be allowed to make designations, or take other action, in respect of each of the different Libor rates as a standalone rate. The UK Benchmarks Regulations also provide a transitional period for UK firms to continue using benchmarks administered in third countries. That gives third-country benchmark administrators breathing space to demonstrate compliance with UK benchmark rules and to apply for continued market access. Through the Financial Services Regulations 2020, the transitional period for third-country benchmarks has been extended to the end of 2022. The new bill extends this period further until the end of 2025.

After the end of 2025, UK firms will not be able to use benchmarks provided by an administrator located outside the UK without the Treasury’s blessing. The Treasury will want to see that the relevant third-country has equivalent rules to UK regulation. Otherwise, the third-country benchmark administrator would have to appoint a UK representative that can be recognised by the FCA, or a UK benchmark administrator has to have endorsed the thirdcountry benchmark. That UK benchmark administrator would also have to agree to be held responsible for the benchmark’s compliance.

In exercising these powers, the FCA would have to be transparent. It would be required to issue policy statements and explain how it is exercising them in line with its statutory objectives on consumer protection and protecting and enhancing the integrity of the UK financial system. It may also consider the international impact of its actions before exercising these powers.

In its recent consultation on its use of these powers under the bill, the FCA warned market participants that they should continue working to renegotiate or amend Liborbased contracts before the end-2021 deadline. But for those tough legacy contracts that genuinely have no or inappropriate alternatives and no realistic ability to be renegotiated or amended, the FCA proposes to use its new powers to avoid economic disruption and legal uncertainty and to ensure that appropriate benchmarks are available – dead or alive.

Deborah Sabalot

Deborah Sabalot is a consulting lawyer who advises financial sector clients on UK and international regulatory and compliance issues