The Government’s has announced that it intends to bring forward legislation to amend the Benchmarks Regulation (BMR[1]) to give us enhanced powers. Find out more on this proposed legislation and what the changes intend to achieve.
What will this legislation apply to? Will the new powers apply to LIBOR?
The proposed legislative changes are anticipated to apply to ‘critical’ benchmarks as defined under the Benchmark Regulation. LIBOR has been designated a critical benchmark, so these changes would apply to LIBOR.
The powers apply in a scenario where a critical benchmark is no longer representative and will not be restored to representativeness. As the FCA has said before[2], this is a scenario which could occur in respect of LIBOR, in particular as a result of panel bank departures.
What are the changes intended to achieve?
The proposed changes will create a possible way of reducing disruption to holders of ‘tough legacy’ LIBOR contracts (ie contracts that genuinely have no or inappropriate alternatives and no realistic ability to be renegotiated or amended) by enabling continued publication of a LIBOR number using a different and more robust methodology and inputs.
The representativeness of LIBOR would not be restored by such a methodology change. However, as the Risk Free Rate Working Group has recommended to authorities, tough legacy contract holders would face considerable disruption from an abrupt cessation of LIBOR. This could be significantly reduced if LIBOR could be produced using a different methodology and inputs which provide a reasonable approximation of its expected future value from the date that the methodology changes.
The changes create additional options to manage the wind-down of LIBOR (or other critical benchmarks) during a 'pre-cessation' period where the benchmark no longer meets the regulatory standard of being representative of the underlying market it seeks to measure. During this pre-cessation period, the critical benchmark will remain unrepresentative and its representativeness will not be restored.
The FCA will seek market input on feasible and robust methodology changes that would, if these powers are used, reduce the risk of published LIBOR values diverging from the value of fallbacks that come into effect in line with market consensus on how to calculate fair fallback values for LIBOR during a pre-cessation period.
Do these changes mean transition from LIBOR is no longer necessary?
No. Continued focus on transition remains both necessary and desirable for those who can remove their current reliance on LIBOR.
First, these powers are intended to provide a potential way of resolving recognised issues around legacy LIBOR contracts. Because of a legal prohibition on the use of a benchmark which will no longer be representative in new business, and restrictions of such use for many supervised users, businesses will need to be able to conduct future business without LIBOR.
Second, the use of these powers might not be possible in all circumstances or for all LIBOR currencies, for example where the inputs necessary for an alternative methodology are not available in the relevant currency.
Third, even if feasible, parties who rely on regulatory action enabled by the legislation, will not have control over the economic terms of that action. The LIBOR transition process has already shown that some markets such as derivative, bond and large parts of cash markets prefer transition to realised overnight interest rates compounded in arrears at the end of a relevant interest period. International authorities have supported that preference.
In contrast, tough legacy contracts using term LIBOR benchmarks use a forward-looking measure of interest rate expectations. Methodology changes that replicated the forward-looking term interest rate expectations in these contracts would not, for example, deliver the preferred outcome for some LIBOR users, including the majority of derivative and bond contracts. Industry-agreed fallback arrangements or conversions would be preferable for a range of contracts.
Will LIBOR's methodology change and when?
The legislation does not mean that LIBOR’s methodology will be changed, but will make it possible to require such a change in some specific circumstances.
If LIBOR is no longer representative and its representativeness will not be restored, the FCA will have the power to require modification of the methodology if we consider this is necessary to protect consumers or the integrity of the market, and if it is feasible for the administrator to change the methodology in the way required. This may not always be the case.
Market participants may prefer that publication of some LIBOR currency tenor pairs ceases, rather than there being a change to the methodology. In other cases, methodological change may be desired by some market participants, but may not be feasible (for instance the administrator may not have access to robust input data in the relevant currency), and instead publication may cease.
The FCA will publish a statement of policy in respect of how it could exercise its change in methodology power, and will seek to engage with the market on this policy over coming months.
Will all of LIBOR’s currencies change at the same time?
This is unlikely. The power would only be used where a relevant LIBOR currency tenor pair is no longer representative and its representativeness will not be restored, intervention is necessary to protect consumers and market integrity, and the administrator is able to change the methodology in the way required. This may not always be the case. Market participants may prefer to cease publication of some LIBOR benchmarks.
In other cases, methodological change may not be appropriate or feasible (for instance the administrator may not have access to robust input data in the relevant currency) and instead publication may cease.
What would a new LIBOR methodology be if it were used?
We cannot say now whether there will be an appropriate and feasible change of methodology for all LIBOR currencies, but will set out in future statements of policy our thinking on where methodology change could be feasible and appropriate.
The FCA notes, however, the market consensus that has emerged internationally and in the UK on how to calculate fair alternatives to LIBOR in some important markets, notably derivatives, bonds and some parts of the loan market, using the risk-free rates (RFRs) chosen by each LIBOR currency area, adjusted for the relevant term of the contract, and with a fixed credit spread adjustment added.
Consistent with the transition to the risk-free rates (RFRs) that have been chosen in each of the LIBOR currency jurisdictions, and supported by authorities in those jurisdictions, the FCA will seek stakeholder views on possible methodology changes that are based on those RFRs, and on the consensus already established in international and UK markets on a way of calculating an additional fixed credit spread that reflects the expected difference between LIBOR and risk free rates.
Where contracts can feasibly be converted by bilateral or multilateral agreement (for example through ISDA’s protocol mechanism for derivative contracts, or through consent solicitations for bonds) they can be adjusted to work on the basis of the overnight RFR compounded in arrears. These contracts do not form part of the ‘tough legacy’.
Where contracts do form part of the tough legacy, this is because there is no realistic ability for them to be renegotiated or amended. These contracts, cannot therefore be amended to work on an overnight rate compounded in arrears. Typically, these tough legacy contracts use a term LIBOR setting (for example 3-month or 6-month LIBOR) that is ‘forward-looking’. Forward-looking term rates based on the RFRs, where these are developed before end-2021, and based on current plans on how to produce them, would in essence be economically equivalent to the expected value of the overnight RFR compounded in arrears over the relevant period or term.
We will engage further with the market on this and will develop our statement of policy on how the FCA could exercise this methodology change power in due course.
The Government’s statement says use will be prohibited where representativeness won’t be restored: does that mean prohibition of use only in new contracts, or also in legacy contracts?
The changes will make clear that, in principle, where a benchmark loses representativeness and its representativeness will not be restored, use of the benchmark must cease. However, the intention is to protect consumers and market integrity where there are legacy contracts that cannot be amended. Accordingly, when using its powers to operationalise this principle the FCA will seek to do so in a manner that prevents market disruption.
In addition, the FCA will have the power to permit continued use in legacy contracts, where it considers this appropriate. The FCA will publish a statement of policy on our approach to the use of this power in due course and in advance of any exercise of the power. The FCA envisages extensive engagement with market participants and other stakeholders over the coming months before the agreement with LIBOR panel banks comes to an end, to inform this policy work. However, the FCA reiterates that where it is feasible for parties to contracts to transition away from LIBOR by mutual agreement, they should do so and should not look to these legislative changes to provide them with an alternative to transition.
Should users now include a pre-cessation trigger in their contracts?
The FCA recommends that firms actively transition away from LIBOR by mutual agreement where this is feasible. Fallbacks which come into effect at the point a benchmark becomes non-representative (and enters a pre-cessation period) provide another route to ensure that contracts move away from LIBOR before it becomes non-representative, and before any prohibition on use comes into effect.
Where a benchmark’s representativeness will not be restored then the Benchmarks Regulation (BMR) says it should cease to be published – so how is a methodology change relevant?
The BMR requires that, if a benchmark’s representativeness cannot or will not be restored, then its publication must cease within a reasonable time period. A methodology change might be appropriate to sustain the rate if reliance on its current methodology became inappropriate or not feasible before the end of the reasonable time period (as determined to be appropriate for the orderly wind-down of the benchmark).
The methodology change would not restore the benchmark’s representativeness, but it could sustain publication of the rate in a robust manner until its cessation. The FCA will seek market input on feasible and robust methodology changes that would, if these powers are used, reduce the risk of published LIBOR values diverging from the value of fallbacks that come into effect in line with market consensus on how to calculate fair fallback values for LIBOR during a pre-cessation period.
How will a new methodology help ’tough legacy contracts that cannot be renegotiated or amended?
Once LIBOR is no longer representative and its representativeness will not be restored, there could be circumstances in which changing the methodology would be appropriate. Relying on a very small number of panel banks such that LIBOR was no longer representative of the underlying market or economic reality that LIBOR sought to measure, means that its value could deviate significantly from that economic reality, as well as becoming more volatile.
In such circumstances, the FCA could consider whether it would be more appropriate and feasible to move to an alternative more robust methodology that is not based on panel bank submissions – and if so, whether doing so would better protect consumers and the integrity of the market than cessation of the rate. By acting via the administrator, the LIBOR rate (including the screen rates) would be preserved and remain in place for tough legacy contracts.
What should market participants do now?
As the Government has noted, market participants that want certainty of contract continuity and control over the economic terms of contractual rights and obligations during the wind down of LIBOR should continue work to renegotiate or amend LIBOR contracts. The FCA accepts that there will be some contracts that cannot transition: these legislative changes are aimed at helping this narrow pool of ‘tough legacy’ contracts that genuinely have no or inappropriate alternatives and no realistic ability to be renegotiated or amended
Where contracts do not fall within this narrow pool of 'tough legacy' contracts, market participants should continue to progress their transition efforts and plans and to meet their regulatory obligations, particularly through active conversion or the insertion of robust and workable fallbacks. Through the FSB’s OSSG and the Sterling RFRWG, the FCA continues to support the work of trade associations, notably ISDA, to include appropriate pre-cessation fallbacks in contracts.