Over the past couple of weeks, the FCA has released two important communications in the context of the discontinuation of LIBOR, which is expected to cease after end-2021.

On 19 November 2019, the FCA published a paper setting out a series of questions and answers for firms about conduct risk during LIBOR transition. Then on 21 November 2019, a speech was made by Edwin Schooling Latter, Director of Markets and Wholesale Policy at the FCA, setting out the next steps in transition from LIBOR from the FCA’s perspective. We consider below what these communications tell the market about the current approach being adopted by the FCA to LIBOR transition, together with the key takeaways in relation to regulatory risks and next steps.

Conduct risks Q&A publication

For context, the background to the conduct risks Q&A communication from the FCA is:

  • The Dear CEO letters published by the FCA in September 2018, which asked for details of the preparations and actions being taken by major banks and insurers in the UK to manage transition from LIBOR to alternative interest rate benchmarks (SONIA in the UK).
  • A joint statement published by the FCA and 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”.

We considered the thematic feedback and guidance provided by the joint statement in a previous banking litigation blog post. One of the key themes of the joint statement was the real divergence across the market in terms of preparedness for LIBOR discontinuation.

While the joint statement previously identified and emphasised good practice for LIBOR transition, the FCA appears to have changed tactics and approach to engage market participants in its latest missive. The conduct risks Q&A communication is framed as the publication of initial answers to some of the most commonly raised conduct questions, but it is clearly 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).

The conduct risk Q&As offer only general guidance to firms, but we highlight below some of the key takeaways emphasised by the FCA.

Governance and accountability

  1. DO identify the Senior Manager responsible for overseeing transition away from LIBOR (for firms subject to the Senior Managers and Certification regime) and detail those responsibilities in the relevant Senior Manager’s Statements of Responsibilities.
  2. DO consider whether any LIBOR-related risks are best addressed within existing conduct risk frameworks or need a separate, dedicated program.
  3. DO keep appropriate records of management meetings or committees that demonstrate the firm has acted with due skill, care and diligence in their overall approach to LIBOR transition and when making decisions impacting customers.
  4. DO consider and address potential impact and risk in an appropriately coordinated way across a firm: how it will impact overall business strategy and front-office client engagement, rather than being a narrow legal and compliance risk.

Replacing LIBOR with alternative rates in existing contracts/products

  1. DON’T use LIBOR discontinuation to move customers with continuing contracts to replacement rates that are expected to be higher than what LIBOR would have been, or otherwise introduce inferior terms.
  2. DO communicate effectively with customers as to how fall-back provisions are expected to operate (e.g. whether clauses operate at, or before cessation, and on what basis) where fall-back provisions are inserted in existing contracts to replace LIBOR with a new reference rate.
  3. DO consider whether any contract term relied on by the firm to amend a LIBOR-related product is fair under the Consumer Rights Act 2015 in respect of consumer contracts.

Offering new products with risk free rates (“RFRs”) or alternative rates

  1. DO offer new products that reference RFRs and other alternative rates that meet customers’ needs, rather than LIBOR-linked products.
  2. If offering LIBOR-linked products which mature after end-2021, DO take care in describing to the customer the risks associated with LIBOR ending and how it will affect them; and be aware that there is a risk that some customers may not fully understand the implications.

Communicating with customers about LIBOR and alternative rates/products

  1. DO ensure that existing customers with legacy contracts are appropriately informed about what will happen in the event of LIBOR ending and its effect on the customer (the Q&A publication includes a number of points of more detailed guidance to ensure customers are appropriately informed, e.g. ensuring relevant client-facing staff have adequate knowledge and competence to understand the implications of LIBOR ending and can respond to client queries appropriate, which may require additional training).
  2. DON’T delay conversations with customers to the point the client is left with insufficient time to understand their options and make informed decisions.

Next steps in LIBOR discontinuation

The speech delivered by Edwin Schooling Latter on 21 November 2019 is the latest in a line of speeches on LIBOR discontinuation from senior directors at the FCA. We highlight below the most important points of interest in this speech, from the perspective of banks and other financial institutions.

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-2021, there has been some degree of variance between the various speeches on what assistance (if any) the market can expect in particular in relation to some form of legislative fix.

In a speech by Andrew Bailey, Chief Executive of the FCA, on 15 July 2019, the FCA hinted at the possibility – for “tough” legacy contracts – of legislators redefining LIBOR as RFRs plus fixed spreads. Mr Bailey was 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 the second half of 2019. 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 Mr Schooling Latter. 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.

Pre-cessation trigger in the derivatives market

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 fall-backs in the global derivatives market (because of the systemic importance of LIBOR in the swaps market). By way of brief background, the International Swaps and Derivatives Association (“ISDA”) has consulted derivatives market participants on a number of aspects of the proposed fall-back provisions in ISDA documentation, including whether or not to include a pre-cessation trigger (see the consultation and the results).

The ISDA pre-cessation trigger consultation was engaged because of concerns from the FCA and the Financial Stability Board Official Sector Steering Group (“OSSG”) that the “end-game” for LIBOR may include a period in which it is still published (post end-2021, when panel banks are no longer compelled to submit rates), but no longer passes the key regulatory test in the European Benchmarks Regulation of being capable of measuring the underlying market or economic reality, i.e. it is not “representative”. In such circumstances, the FCA could make a public statement that LIBOR is no longer representative (likewise, other regulators could make a statement that the relevant covered IBOR is no longer representative). The purpose of the ISDA consultation was to determine whether and how to include a pre-cessation trigger regarding “representativeness”, so that the relevant fall-backs would be triggered following such an announcement. The majority of respondents supported the inclusion of a pre-cessation trigger, but there was some variation of views on how best to implement that trigger, with support for an optional approach (i.e. where market participants could choose whether or not to include the pre-cessation trigger, with the result that some amended legacy derivatives contracts would include such a trigger and some would not).

It is very clear from the recent speech that the FCA is in favour of the pre-cessation trigger in ISDA documentation being integral and not optional, saying that reservations expressed by respondents to the consultation about making the trigger optional were “compelling”. Considering the other side of this debate, the FCA addressed (in some detail) the principal concerns from respondents who expressed reservations about including both triggers as standard (i.e. removing optionality and making the pre-cessation trigger integral). The FCA’s view is in line with that of the OSSG, which wrote to ISDA to encourage them to consult on making the pre-cessation trigger an integral, and not optional, part of the standard language.

Given the view of the regulators, it seems likely that the next word from ISDA on contractual fall-backs will be to consult market participants to make a final decision on whether the pre-cessation trigger should be integral or optional.

Loan market

The FCA remains concerned by the volumes of new LIBOR-linked loans being written which mature after end-2021. While the FCA accepts the challenges inherent in transition for the loan market, it emphasised the following key messages for market participants:

  • The target to stop new lending using LIBOR is Q3 2020 (as set by the sterling RFR Working Group).
  • The loan market should not delay transition of new business away from LIBOR until the production of forward-looking term rates based on SONIA; the market is capable of shifting to overnight rates compounded in arrears (in the same way as the bond and securitisation markets).
  • The FCA accepted that there may be some parts of the loan market where forward-looking term rates are needed (e.g. to calculate fair replacement rates for legacy LIBOR contracts that cannot be amended to work on overnight rates compounded in arrears). Forward-looking SONIA term rates will therefore be the central issue in a forthcoming sterling RFR Working Group publication on term rate use cases.

Rupert Lewis
Rupert Lewis
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Harry Edwards
Harry Edwards
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Nick May
Nick May
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Ceri Morgan
Ceri Morgan
Professional Support Lawyer
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Jon Ford
Jon Ford
Senior Associate
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