ASIC issues information sheet on managing conduct risk during LIBOR transition

ASIC has published INFO 252, a long-awaited information sheet which addresses conduct risk issues for both sell-side and buy-side firms arising out of the discontinuation of LIBOR. As the transition from LIBOR rates to alternative reference rates (ARRs) enters its final stage (with the end of 2021 assumed to be the deadline by which transition must be achieved), Australian institutions will no doubt find ASIC’s articulation of the ways in which they can seek to mitigate the clear risk of conduct issues arising from their engagement with customers useful. However, fundamental concerns will remain and those institutions will need to continue to undertake their own analysis, and monitor the LIBOR transition landscape carefully to reflect what remains a highly dynamic situation, in the way that they prepare for the end of 2021.

Background

The end of LIBOR, and the replacement of those rates by ARRs, raises profound issues for the financial services industry. LIBOR rates appear in huge volumes of contracts (both in number and value) and the fall-backs which have typically been incorporated within those contracts are uncommercial or impractical. Moreover, the switch to any of the available ARRs have economic consequences (i.e. they will change the rate payable under the contract, benefiting one party and causing detriment to the other) which are not possible to predict (and therefore fully mitigate) in advance.

We have often heard financial services regulators, over the last few years, seek to place the onus on the sell-side institutions to engage with their customers and encourage them to agree to amendments to their contracts so that a smooth transition can be achieved. On one level, that is perfectly understandable. Banks are sophisticated counterparties to high volumes of impacted contracts, and are subject to a range of regulatory duties which are of relevance in the transition process. However, there is a clear danger that the pressure which is being placed on banks to transition their customers from LIBOR may cause those customers to believe that the banks are accepting greater responsibility than they in fact are for the decision to agree to proactive amendments to legacy LIBOR contracts, and the outcomes which follow. In particular, a real concern will be that customers are left with the impression that, as a result of the educational role which banks can no doubt play, they are being advised by the banks that a particular ARR is the most suitable one for their individual circumstances.

It is against that background that the ASIC information sheet will be welcomed. However, it is fair to say that significant concerns remain.

Sell-side guidance

The information sheet provides some helpful reminders about the steps that banks can use as they seek to satisfy the requirement to treat clients fairly, and (for entities that are AFS licensees) to do all things necessary to ensure that the financial services they provide are provided efficiently, honestly and fairly. It is broken into four sections: Treating clients fairly; performance of products and services; client communication; and risk management framework.

A critical part of getting this aspect right is for buy-side firms to ensure that their staff, particularly those with customer-facing roles, are appropriately trained to undertake the important task of reducing any asymmetries of information. Unpacking this, it is vital that those staff-members understand both the substance of the issues which LIBOR transition raises, as well as the nature of the duties which the institution owes to its customers in the process. The former is particularly challenging in the context of LIBOR transition – not only are the adjustment methodologies which are used in many of the ARRs complex, but many remain (even at this late stage in the process) under development. For example, forward-looking term rates (in broad terms, the closest equivalent replacement rates for LIBOR terms rates) are still very much in the process of being developed, with no certainty that they will be available for all (or any) LIBOR currencies. Accordingly, whilst banks are expected by ASIC to explain the benefit of transition to ARRs, it will be important also to explain the risks inherent in the process. However, importantly, ASIC have put down a marker that attempts to rely on warnings and disclosures will have limited effectiveness. It will therefore be necessary for banks to carefully articulate, in clear and objective terms, what the potential range of outcomes might be, and what factors may impact on those outcomes, instead of warnings which amount to no more than a generic exposure to risk. This will be a significant undertaking.

An area in which the information sheet does not provide much guidance is in relation to the performance of the products and services which it makes available to customers, and the customer communications which will ensure that the customer understands the way in which it will perform. This is a difficult area in which to generalise because the point is that what an appropriate decision looks like for a given customer will be highly dependent on individual circumstances; there is no one size fits all approach. Slightly unhelpfully, ASIC uses the straightforward example of a long-dated LIBOR contract with an expiry after 2021 without adequate fall-backs being sold to a customer who is led to believe that it will continue to perform in the same way before and after 2021, as its example of misconduct. The overwhelming majority of situations will look very different to this example and will require far more detailed analysis. As such, the ASIC guidance does not in this respect take banks very much further forward; they will have to form their own views on what products to propose to particular customers. Moreover, whilst unsurprising, banks will need to treat the blanket statement that they should adhere to the ISDA Protocol for “all relevant derivative contracts” with appropriate caution. Whilst that may well be the right outcome in respect of many derivative contracts, there will be some for which that may expose clients to basis risk or where the amendments introduced by the Protocol need more careful consideration.

There is clearly an important governance aspect to banks’ approach to LIBOR transition. In order, ultimately, to be able to explain and address questions regarding the process which they have followed, banks will rely on the frameworks which they have in place as well as their record-keeping practices which record those frameworks. In the risk management framework section of the information sheet, ASIC has provided a reminder about the importance of these governance arrangements to address the complexity and the “constantly evolving dependencies and processes” which are involved. Whilst much work has been done across the industry to form consensus on appropriate adjustment methodologies to apply to ARRs and contractual fall-back language to use to bring them in effect, there are many twists and turns which can be expected between now and the end of 2021. Just to take one particularly topical category of such developments, the contractual and extra-territorial scope, as well as the ultimate economic effect, of the legislative proposals for LIBOR currently being considered by various legislatures around the world may well affect outcomes for contractual counterparties in ways that will remain uncertain well into 2021. Planning a transition programme, including oversight of the design of communications to clients to explain the issues involved, is an even more challenging task given the evolving landscape. Given that ASIC’s clear statement that overall responsibility and accountability for that programme rests with the board and senior management, it is obviously critical that they are closely engaged in its direction and the impact on it of developments (including those in other jurisdictions).

Buy-side guidance

The information sheet also helpfully provides some useful pointers for buy-side institutions. As ASIC notes, the impact on buy-side institutions is broad, and focus is needed on the relevance of LIBOR to performance fees, borrowing arrangements, portfolio management, client reporting, market trends and product liquidity. Buy-side institutions will need to be particularly careful in managing their indirect exposures to LIBOR transition through the investments which they have with third parties portfolio managers, by conducting adequate due diligence, risk management and contingency planning for each of those providers.

 

Michael Vrisakis

Michael Vrisakis
Partner
+61 2 9322 4411

Fiona Smedley

Fiona Smedley
Partner
+61 2 9225 5828

Charlotte Henry

Charlotte Henry
Partner
+61 2 9322 4444

Harry Edwards

Harry Edwards
Partner
+61 3 9288 1821

LIBOR Transition Status Update: October 2020

The cessation of the London Inter-bank Offered Rate (LIBOR) at the end of 2021 has long been an issue vexing the global financial services industry given the scale and geographic spread of exposures to the affected benchmarks across the currencies and terms in which it is published.

The LIBOR Transition Status Update: October 2020 provides a comprehensive update on what is happening, including the current status in key markets, the impact of Covid-19, proposed legislative interventions on legacy contracts, litigation and regulatory risks, as well as potential next steps for financial services companies.

 

Charlotte Henry

Charlotte Henry
Partner
+61 2 9322 4444

Harry Edwards

Harry Edwards
Partner
+61 3 9288 1821

Patrick Lowden

Patrick Lowden
Partner
+61 2 9225 5647

Michael Vrisakis

Michael Vrisakis
Partner
+61 2 9322 4411

Fiona Smedley

Fiona Smedley
Partner
+61 2 9225 5828

FSB Report: Supervisory issues associated with benchmark transition: major LIBOR transition risks

This article was originally posted on Banking Litigation Notes.

The Financial Stability Board (FSB) has published its long-awaited report to the G20 on supervisory issues related to LIBOR transition. It follows a survey of the state of preparedness of regulators around the globe and presents its recommendations. The purpose of this engagement is to facilitate greater coordination on a global level, to mitigate the impact on financial stability generally and both financial institutions and non-financial institutions specifically: FSB Report: Supervisory issues associated with benchmark transition.

 

Results of survey on preparedness of global regulators

The results of the questionnaire on supervisory issues strikingly, but unsurprisingly, reveal a wide range across different jurisdictions’ levels of preparedness for LIBOR transition in advance of the expected transition date of end-2021. While some differences in approach and timeline between jurisdictions are to be expected, the report is critical of the differing timelines and supervisory expectations for transition across jurisdictions:

“Jurisdiction by jurisdiction differences in approach and timeline are unavoidable. However, to avoid the greater risk of being unprepared by the end of 2021, there should be no excuses for a ‘race to the bottom’ to move at the pace of the slowest.”

For example, very few jurisdictions have dedicated roll-off timelines or targets to industry, and, where timelines are in place, monitoring is complicated by the varying timelines for different products. The report recommends that authorities in each impacted jurisdiction establish a formal LIBOR transition strategy, which may include interacting with national working groups with a view to set out milestones and a transition roadmap with clearly specified actions that market participants should take. The report also suggests increased international cooperation as a means of mitigating the inconsistency in transition timing and approaches by sharing information on best practices and challenges.

In light of the survey’s conclusion that a considerable portion of financial institutions across jurisdictions are yet to start or are still in the planning stages of their transition, the FSB has highlighted a need to step up the coordination and monitoring effort at an international level. It has accordingly identified a number of areas for strengthened supervisory actions in order to facilitate efforts by individual institutions to progress their transition programmes.

 

Major LIBOR transition risks identified by the FSB

The FSB has also provided a useful summary of some of the major LIBOR transition risks for financial institutions, which will be very familiar to those who have been following the developments on this topic over the last few years, and which we explained in more detail in our previous article on the risks (LIBOR is being overtaken: Will it be a car crash? (2019) 34 J.I.B.L.R.):

  • Operational/systems risks – Systems and processes must be updated for all products currently referencing LIBOR so that they can instead rely on alternative reference rates and calculate and manage any fallback adjustments in order to prevent any operational disruptions.
  • Legal risks – Contract frustration and counterparty litigation are key areas of concern if institutions do not adequately identify and address affected legacy contracts, especially with regard to cash market products and long-dated contracts. The risks could be compounded by the volume and complexity of potential contract amendments and potential consent required for covenant modifications.
  • Prudential risks – Institutions may find difficulties in managing market risks and calculating embedded gains or losses for margin requirements, and experience a range of capital impact issues in case pricing and valuation inaccuracies arise. Where interest rate models need to be developed and approved, institutions may face capacity constraints or a lack of historical data.
  • Conduct, litigation and reputational risks – The report notes risks around conduct risk identification and management, especially with regard to the fair treatment of clients, potential conflicts of interests, mis-selling and misconduct, which could lead to potential class-action litigation.
  • Hedging risks – Different parts of hedged positions may transition at different times or to different fallback rates, leaving institutions exposed to new basis risks. Market participants may also face increased hedging costs if liquidity remains low in the alternative RFRs.
  • Accounting risks – If work to reform national and international accounting standards is not adequate or completed on time, there may be unintended impacts on accounting (e.g. with respect to hedging or profitability) or taxation.
  • Others – Financial institutions face difficulties in communicating transition-related issues with clients (finding the right informational level, etc.) and in pricing instruments (particularly in the early stages of transition when liquidity in new instruments is low). Further, financial institutions and non-financial institutions face potential resource constraints.

 

Michael Vrisakis

Michael Vrisakis
Partner
+61 2 9322 4411

Fiona Smedley

Fiona Smedley
Partner
+61 2 9225 5828

Charlotte Henry

Charlotte Henry
Partner
+61 2 9322 4444

Harry Edwards

Harry Edwards
Partner
+61 3 9288 1821

UK Government announces LIBOR legislative fix: summary of proposals and our initial observations

This article was originally posted on Banking Litigation Notes.

In a written statement on 23 June 2020 made by Rishi Sunak, The Chancellor of the Exchequer, the UK Government has announced its intention to introduce a legislative solution for the transition of so-called “tough legacy” LIBOR-linked products. It intends to include measures in the forthcoming Financial Services Bill to ensure that, by end-2021, the FCA has the appropriate regulatory powers to automatically transition tough legacy contracts away from LIBOR (as we know it) without the need for bilateral or multilateral contractual amendment. The FCA has issued two supporting statements: FCA statement on planned amendments to the Benchmarks Regulation and Benchmarks Regulation – proposed new powers.

In this blog post, we consider the key elements of the proposals and make a number of initial observations as to the potential market and legal impact.

 

Summary of proposals

Reasons underlying the proposals

The Government recognises that progress towards interim milestones for LIBOR transition has been slowed by the COVID-19 pandemic, citing the various recent statements published by the Working Group on Sterling Risk-Free Rates (RFRWG) and the FCA (see our blog post: LIBOR transition: The risks of interim milestone delay for the cash market due to COVID-19).

Without wishing to dilute the message that active transition away from LIBOR remains the best route for contractual and economic certainty, the Government acknowledges that there will be a narrow pool of “tough legacy” contracts that have no appropriate fallback mechanism and cannot be renegotiated or amended by the end of 2021. For these tough legacy contracts, the Government has concluded that legislative steps are necessary to assist transition, agreeing with the Tough Legacy Taskforce report published by the RFRWG (see our blog post: UK Tough Legacy Taskforce recommends LIBOR legislative fix: key risks and next steps).

Mechanism for legislative fix

The proposed primary legislation will not directly impose legal changes to LIBOR-referencing contracts governed by UK law, but instead will grant the FCA certain “appropriate” regulatory powers, via the following mechanism:

  • The Financial Services Bill will introduce amendments to the Benchmarks Regulation 2016/1011 (as amended by the Benchmarks (Amendment) (EU Exit) Regulations 2018) (UK BMR).
  • The amendments to the UK BMR will extend the circumstances in which the FCA may require an administrator to change the methodology of a critical benchmark (e.g. LIBOR) and clarify the purpose for which the FCA may exercise this power.
  • The new powers will be available where the FCA (as the supervisor of the benchmark administrator) makes an announcement that LIBOR is no longer representative (for example, where some submitting banks no longer make submission for given LIBOR currencies or tenors) and will not be restored to representativeness.
  • The new powers will enable the FCA to direct the administrator of LIBOR to change the methodology used to compile the benchmark if doing so will protect consumers and market integrity.
  • The methodology that will be used instead has not yet been determined and it will be left to the FCA to do so. The FCA intends to seek stakeholder views on possible methodology changes in subsequent consultations. However, all indications are that “legislative LIBOR” will be produced using some iteration of the risk-free rates chosen by each LIBOR currency area (i.e. SONIA for the sterling market) with a fixed spread adjustment added to provide a proxy for the credit risk element of LIBOR.

The Government intends to take these measures forward in the forthcoming Financial Services Bill, but the more important developments and detail will be communicated through a series of statements of policy by the FCA, in which it will confirm its approach to the new powers provided by the legislation.

 

Initial observations

  1. Change of approach from the Government and the regulators

For a number of years, the UK Government and the regulators have carefully and deliberately avoided giving any clear signal that a legislative fix for the transition of LIBOR-linked contracts would be forthcoming. This is likely to have been primarily driven by the concern that to do so may result in portions of the market slowing their LIBOR transition efforts. The latest announcements therefore represent a dramatic change of tack.

According to the statements made by the Government and FCA in the context of this announcement, this change of approach has been triggered, in part at least, by the delay to transition efforts as a result of the COVID-19 pandemic. However it seems clear that, in addition, the authorities have recognised the difficulty/impossibility of transitioning certain tough legacy contracts away from LIBOR, notwithstanding the efforts from many sections of the market to achieve this.

  1. Lack of detail provided as to the proposed legislative solution

These announcements are significant but are very light on detail and a number of key questions remain, for example:

  • Which contracts will be caught by the legislation? The announcement suggests that it will cover only “tough legacy” contracts, but how will this be defined?
  • What will be the new methodology for calculating legislative LIBOR? Presumably sterling LIBOR will transition to SONIA plus a spread, but what version of SONIA will be used (spot, compounded in arrears, forward looking term), how will the spread adjustment be calculated, and will there be any variation in the methodologies applied to different asset classes?
  • Which LIBOR currencies and tenors will continue (in the form of legislative LIBOR) and which will not? The FCA has suggested that methodological change may not be appropriate or feasible in all LIBOR currency tenor pairs and so certain pairs may cease entirely.

It seems that the market will need to wait for the draft Financial Services Bill and, in particular, the policy statements to be published by the FCA, in order to understand fully the scope of the proposed legislative solution and its implications for those sections of the market that are most difficult to transition. Given that the FCA envisages “extensive engagement” with market participants and other stakeholders over the coming months to inform this policy work, there may be a significant delay before the market has real clarity on these issues.

Accordingly, while the market has been offered some comfort that a cliff-edge scenario ultimately will be avoided, there is still enough uncertainty surrounding the proposals to make sure that most market participants will not take their foot off the pedal of LIBOR transition – which is presumably exactly the position that the Government and regulators intended to achieve as they continue to attempt to strike a delicate balance.

  1. What will the UK legislative solution mean in practice?

The UK solution means that LIBOR-linked contracts will continue to reference LIBOR – and as such there will be no direct amendment to those contracts. Rather, the way in which the reference to LIBOR in those contracts will play out, will be entirely different. Instead of the current LIBOR methodology, “legislative LIBOR” will apply. The new methodology will bear no resemblance to the previous process of panel bank submissions based on the (theoretical) rate at which banks lend to one another in the interbank unsecured funding market. It will be LIBOR in name only.

This is in many ways an elegant solution, because it means any legacy fallback mechanisms that would be engaged by the permanent cessation of LIBOR will not be engaged unless and until legislative LIBOR ends (thereby avoiding problematic fallbacks in legacy contracts; for example, those that revert to the last available published LIBOR rate, thereby converting a floating rate contract to a fixed rate).

However, there is a potential downside of this approach. Care will be needed in the mechanism that brings about this result, to ensure that contracts that have already been amended to include more robust fallbacks are not caught out. Those that were designed to take effect on the permanent cessation of LIBOR (i.e. contained no pre-cessation trigger) may not engage those negotiated fallbacks as intended or possibly at all (assuming legislative LIBOR will continue for the duration of the longest tough legacy contract). Such contracts could switch to legislative LIBOR, rather than the fallback the parties chose, if they fall within the scope of the proposed legislation.

  1. Contrast in approach in the UK vs the US

The UK’s proposed legislative solution is fundamentally different to the approach being taken in the US, set out in draft legislation prepared by the Alternative Reference Rates Committee (the US equivalent of the RFRWG) (see our blog post: LIBOR transition: What does the US regulator’s proposed legislative fix mean for UK financial markets?).

The US approach involves direct changes to contracts governed by US law. It is a central pillar of the draft US legislation that – following a public statement from one of a number of specified persons (including the US Federal Reserve or one of the regulators) – certain changes will take place automatically in all US law contracts that reference LIBOR as a benchmark interest rate. For example, contracts without fallback language (or which fall back to a LIBOR-linked rate) will automatically transition from LIBOR to a “recommended benchmark replacement” (likely SOFR) plus a spread adjustment. To deal with contracts containing other problematic fallbacks, such as polling for LIBOR or other interbank funding rates, the draft legislation states that such fallbacks will effectively be ignored.

The proposed legislative solution in the UK arguably offers a neater solution, removing the need for complex drafting of this kind. Although the price of that is a longer period of uncertainty while the FCA considers the methodology which it decides to adopt.

  1. Interaction with pre-cessation triggers

It seems likely that the FCA will make an announcement that LIBOR is no longer representative after end-2021, when panel banks are no longer compelled to submit data and confirm they intend to stop submitting. The FCA has said that it will make an assessment of representativeness each time a panel bank departs (see this speech by Edwin Schooling Latter, Director of Markets and Wholesale Policy at the FCA, 28 January 2019).

This announcement will be the trigger for both the FCA’s powers to change the methodology of LIBOR (i.e. it will trigger the replacement of LIBOR with legislative LIBOR) and will also be the trigger for contracts that have been amended to include pre-cessation fallbacks (e.g. derivative contracts where both parties have adhered to ISDA’s proposed single Protocol).

Any statement of non-representativeness will be within the control of the FCA, and will trigger at the same time, the switch of both unamended legacy LIBOR contracts and amended contracts with a pre-cessation trigger. This is good news, particularly for market participants seeking continuity across a portfolio. However, there is a real risk of divergence in the applicable replacement rate, as discussed further below.

  1. Potential impact on litigation risk

The proposed legislative solution itself may give rise to a number of litigation risks. In particular:

Automatic change in interest rate payable resulting in “winners” and “losers”

  • The most obvious impact of the proposed legislative solution is that it will automatically change the interest rate payable under the contract when the methodology for calculation of LIBOR changes. A party paying an interest rate referenced to LIBOR on the date (t) that a statement of non-representativeness is made, will be paying a different rate on day t+1 when the rate switches to legislative LIBOR. However, the spread adjustment will not make the transition present value neutral on t+1 because it will almost certainly be calculated as the difference between the two benchmarks over a set period of time (e.g. the past 5 years). In this sense, it is a blunt tool and unlikely to represent the bargain which the parties would have struck had they been able to/chosen to.
  • The fact that the interest rate payable under LIBOR contracts will change overnight gives rise to the inevitable possibility of “winners” and “losers”, i.e. with parties receiving less or paying more interest under legislative LIBOR from t+1 than they would have received/paid had LIBOR continued without the methodological change. One of the notable benefits of the proposed legislative solution is that the differential will not be as transparent, i.e. it will not be possible to compare the two rates. Even if there are panel banks willing to submit data when no longer compelled to do so – the administrator of the benchmark will no longer publish LIBOR calculated in that way. The legislative solution thereby likely prevents the continuation of a so-called “zombie” LIBOR.
  • However, the change in interest payable will be immediate and obvious on t+1 and this will provide fertile ground for disputes. In particular, there will be mis-selling risks in relation to both the original product referencing LIBOR (e.g. that the customer was mis-sold a LIBOR-linked product when it should instead have been sold a SONIA-linked product, particularly for products post-dating the FCA’s first announcement in July 2017 that LIBOR would be discontinued); but also for contracts actively amended to switch from LIBOR (e.g. that the customer would have been better off not amending and relying instead on the legislative solution).

Portfolio mismatches

  • There will be a particular risk of creating mismatches between different parts of a portfolio, where some products move to legislative LIBOR, but others are amended via bilateral agreement or (for example, in the case of hedging products) the ISDA Protocol. A stated criterion of the FCA is to find a methodology that reduces the risk of divergence between the values of legislative LIBOR and the fallbacks that would come into effect following a non-representativeness determination. However, it seems likely that there will be some differences, as explained by ISDA’s CEO, Scott O’Malia in a statement made on 26 June 2020:

“For one thing, derivatives markets have opted to use overnight RFRs compounded in arrears, which require amendments to contractual terms in addition to referencing a different rate. Given tough legacy contracts currently reference a forward-looking term IBOR and cannot be amended, it indicates a ‘synthetic LIBOR’ will be a forward-looking term rate based on the RFRs plus a spread adjustment. Indeed, the FCA says that use of overnight RFRs compounded in arrears ‘may not be possible to replicate within the restrictions of the existing LIBOR framework’.”

Potential breach of BMR

  • There is a further risk of public or private law claims on the basis that continued publication of legislative LIBOR breaches the requirements of the BMR. The BMR provides that if a benchmark’s representativeness cannot or will not be restored, then its publication must cease within a “reasonable period of time”. The FCA has confirmed that the representativeness of LIBOR will not be restored by the proposed methodology change. As such, it may be argued that the continued publication of legislative LIBOR is in breach of the BMR.

Slowing transition efforts

  • Finally, there is a risk that (contrary to the directions and intentions of the regulator) there will be a slowing in transition efforts, which will result in a larger pool of unamended LIBOR-linked contracts when LIBOR ends. If such contracts are not caught by the proposed legislative solution (e.g. because “tough legacy” contracts are defined narrowly), then there will be serious questions about what fallbacks apply and even the validity of the contracts. Accordingly, in our view, parties would be well advised to press on with their transition efforts, particularly once the ISDA Protocol and Supplement to its 2006 Definitions are published (expected by the end of July).

 

Michael Vrisakis

Michael Vrisakis
Partner
+61 2 9322 4411

Fiona Smedley

Fiona Smedley
Partner
+61 2 9225 5828

Charlotte Henry

Charlotte Henry
Partner
+61 2 9322 4444

Harry Edwards

Harry Edwards
Partner
+61 3 9288 1821

The Bank of England’s attempts to “turbo-charge” LIBOR transition in the cash markets: will these increase or decrease the litigation risks?

This article was originally published on Banking Litigation Notes.

The past week has been important for developments in LIBOR transition, particularly for the cash markets where progress has hitherto been less advanced than other markets.

On 26 February 2020, the International Swaps and Derivatives Association (ISDA) and Securities Industry and Financial Markets Association (SIFMA) hosted a joint conference on benchmark reform in London. One of the most important speeches at this event was given on behalf of the Bank of England (BoE) by Andrew Hauser: Turbo-charging sterling LIBOR transition: why 2020 is the year for action – and what the Bank of England is doing to help.

So what is the BoE doing to accelerate the transition? It seems the answer is to offer both “carrots” and “sticks” to encourage the transition of financial products from LIBOR to SONIA. In a nutshell, the BoE has announced measures:

  1. Supporting the adoption of SONIA in cash products by simplifying the calculation of compounded interest rates by agents through the publication of a SONIA-linked index from July 2020;
  2. Acknowledging the market’s desire to go a step further by agreeing to consult the potential publication of daily “screen rates” for specific period averages of compounded SONIA which would avoid agents having to perform any calculation at all; and
  3. Penalising firms which continue to hold LIBOR assets by October 2020, by increasing haircuts on LIBOR linked collateral when using the BoE’s funding window, if that collateral remains LIBOR-linked.

These measures are explained further below, together with a discussion as to how these developments are likely to be received by the market, and how they might alter the profile of the litigation risk faced by financial institutions and other corporates given the impact on ease, certainty and necessity of transition.

 

  1. BoE to publish compounded SONIA-linked index from July 2020

The BoE intends to publish a compounded SONIA-linked index from July 2020. It has said that this will complement its existing publication of the overnight SONIA rate and the index will provide a flexible tool to help market participants construct compounded SONIA rates in an easy, consistent and flexible way. The stated intention of the BoE is to support market participants to cease issuing GBP LIBOR-based cash products (maturing beyond 2021) by Q3 of 2020. This is the deadline set by the UK Risk Free Rate (RFR) Working Group in its roadmap for 2020 – see our banking litigation blog post for further discussion of the 2020 roadmap and the accompanying suite of documents published by the regulators and working groups at the beginning of this year.

The BoE has celebrated the speed with which SONIA has become the default reference rate of choice for floating-rate notes and securitisations (which are predominantly wholesale transactions), but recognises that replicating this success in the bilateral and syndicated loan market is a different challenge. It is understood that one of the challenges to widespread adoption is the practical difficulty of calculating compounded SONIA rates in a simple and consistent way that can easily reconcile with the overnight SONIA rate published by the BoE. For example, to calculate the compounded interest rate for a three month period requires approximately 60 data inputs (the overnight SONIA rates for each working day of the interest period) and there are a number of different ways in which the precise calculation can be performed that might create difficulties without universal acceptance of established conventions.

It is to overcome this (primarily operational) challenge, that the BoE plans to publish a “golden source” SONIA-linked index from which bespoke rates can more readily be calculated.

 

  1. BoE consultation on publication of daily “screen rates” for specific period averages of compounded SONIA rates

The BoE recognises that some market participants are calling for it to go a step further and publish daily “screen rates” for one or more specific period averages – for example 6-month, 3-month or 1-month compounded SONIA rates – so that the agent need perform no calculation at all; it can simply use the relevant screen rate. It is therefore consulting on whether there is sufficient market consensus on which set of period averages it should publish as screen rates, or whether the number of different screen rates which would need to be published to meet the market’s needs would create the risk of confusion and undermine the very certainty which the BoE is seeking to achieve.

In our view, while the index is helpful, it is the BoE’s second initiative to consult on publishing a daily “screen rates” for specific period averages which is what the market really wants and needs. The need for a term replacement remains as strong in the market as ever, and the comments from the BoE underline the regulatory commitment to force the transition, irrespective of the state of market readiness, and so the development of a term replacement will continue to rest with the market.

Even if ultimately the BoE decides only to publish a SONIA-linked index, this represents a step forward in terms of helping the bilateral and syndicated loans market move to using RFRs. A number of the barriers to the Loan Market Association (LMA) producing a RFR facility agreement, or even a hard-wired fallback to RFR document, stem from the fact that the market has not yet agreed on the method of calculation of the compounded average RFR. This proposal from the BoE largely dispenses with these concerns, aids standardisation and provides a screen rate for agents to use, assuming the market is willing to accept a single standardised source calculated on this basis.

In terms of litigation risk, the simple point is that if publication of the SONIA-linked index (or daily screen rates for specific period averages) reduce the volume of new cash products written in LIBOR, then that will mean a reduction in the volume of risky LIBOR-linked products in existence on cessation of LIBOR.

However, a number of questions still remain. In particular, even if the operational challenges are removed by publication of a SONIA-linked index (or daily screen rate) in order for parties to transition legacy LIBOR-linked contracts to SONIA, they will have to agree the quantum of the spread adjustment which mitigates or eliminates the value transfer between them. As discussed in our article in the Journal of International Banking Law and Regulation on the types of litigation which may arise on LIBOR discontinuation, there is no procedure to amend legacy loan facilities on an industry-wide basis and there are clear obstacles for achieving effective adoption of revised fallbacks on a bilateral basis. As such there still remains a risk of significant volumes of legacy loan facilities which are not amended before LIBOR cessation takes place, notwithstanding this development.

 

  1. BoE to increase haircuts on LIBOR-linked collateral it lends against from October 2020

And so to the stick. The BoE currently makes funding available to firms as part of its normal market operations against a wide set of eligible collateral, but applies a “haircut” to that collateral to protect against possible falls in its value in the period between a counterparty default and collateral sale.

The current average haircut is just under 25%, but from Q3 2020 the BoE will progressively increase the haircuts on LIBOR-linked collateral – increasing to 35% in October 2020, to 65% in June 2021 and, at the end of 2021, to 100% (i.e. effectively rendering such collateral ineligible). In addition, LIBOR-linked collateral issued after October 2020 will be ineligible for use.

The BoE says this graduated approach will give firms the time they need to replace that collateral with RFR alternatives, ensuring their borrowing capacity is maintained while also protecting public funds. The intended effect is clear, the higher the haircuts the less attractive the collateral, and so this step is likely to further wean firms from holding stocks of LIBOR linked assets and continue the evolution towards RFRs.

This development presents an interesting and novel litigation risk in relation to LIBOR discontinuation for market participants. If firms are unable to transition a sufficient amount of their book of LIBOR-linked products to SONIA in time, then it will affect their borrowing capacity at the BoE. Given that the BoE’s lending operations are designed to provide liquidity support to market participants experiencing either a predictable liquidity need or responding to an idiosyncratic or market wide liquidity shock, impairing the availability of effective liquidity at a possibly critical moment for firms could be significant.

 

Michael Vrisakis

Michael Vrisakis
Partner
+61 2 9322 4411

Fiona Smedley

Fiona Smedley
Partner
+61 2 9225 5828

Charlotte Henry

Charlotte Henry
Partner
+61 2 9322 4444

Harry Edwards

Harry Edwards
Partner
+61 3 9288 1821