On 12 July, UK and US regulators sent the clearest warning signal yet to market participants on the need to abandon the London Interbank Offered Rate (LIBOR) and transition to alternative Risk Free Rates (RFRs). We circulated a briefing note to clients on 13 July regarding these developments. Andrew Bailey, Chief Executive of the Financial Conduct Authority (FCA), J. Christopher Giancarlo, Chairman of the U.S. Commodity Futures Trading Commission (CFTC), and Commissioners Brian Quintenz and Rostin Behnam, as well as the Financial Stability Board (FSB) released statements on benchmark reform.
The communications were co-ordinated, clear and broadly consistent. The overall message for those who might have been expecting LIBOR to continue in some shape or form post-transition was “abandon hope”. This message was clearest and loudest from Andrew Bailey, but was also echoed by the other authorities. The authorities set out a future in which overnight RFRs would underpin the majority of transactions, with RFR-derived term rates being used for a minority of transactions. Importantly, they took the view that for some products, firms should not wait for term rates and could transition to RFRs for new contracts now. Fall back rates would also be predominantly based on overnight RFRs, but there was a very clear preference from Andrew Bailey for moving new contracts on to RFRs as soon as possible rather than continue to use a rate that firms know is going to be discontinued.
The FCA and CFTC set out clear expectations, including that firms demonstrate to supervisors that they have a good understanding of their financial exposures and risks and are making efforts to address them. Andrew Bailey detailed key obligations that firms owe their clients, including that they must disclose risks “in an understandable way” and consider whether certain investments remain suitable for particular clients.
The fact that these developments occurred on the same day – and almost one year exactly since Andrew Bailey’s 2017 speech – demonstrates that the authorities are broadly aligned in their thinking and share a desire to accelerate the pace of transition to RFRs. Below, we set out exactly what happened on 12 July as well as further analysis of the most significant messages that came out.
What happened on 12 July?
- Andrew Bailey gave a speech entitled “Interest rate benchmark reform: transition to a world without LIBOR”. He also announced that the sterling RFRs working group would launch a consultation in July on developing a term forward-looking benchmark.
- The CFTC hosted a Market Risk Advisory Committee Meeting at which J. Christopher Giancarlo provided opening remarks; Commissioner Brian Quintenz issued a statement and Commission Rostin Behnam also provided a statement.
- The FSB published a statement on interest rate benchmark reform.
- The International Swaps and Derivatives Association (ISDA) published a market consultation on fall back terms.
Why LIBOR needs to go
Both Andrew Bailey and Chairman Giancarlo make clear that market participants should not consider the discontinuation of LIBOR as a remote possibility but as “a certainty”. Commissioner Quintenz is slightly less definitive: he notes whilst “LIBOR may continue to exist in the future, if participation continues to decline, questions may arise as to whether the rate continues to accurately reflect market conditions”.
The FCA, CFTC and FSB explain that there is a scarcity of underlying transactions in the international interbank and wholesale unsecured funding markets. This raises the question of what LIBOR is actually representative of, which has implications for the requirements of the EU Benchmarks Regulation (for further detail, see below). Without sufficient transaction data, LIBOR submissions must rely on expert judgement, which can make the benchmark more susceptible to misconduct; ensuring that LIBOR and other benchmarks are not vulnerable to manipulation and that the rate is representative is central to the EU Benchmarks Regulation and is also a “key part of the statutory mission of the CFTC”. For these reasons, the authorities take the view that transition must happen.
Avoiding a LIBOR “car crash”
Despite this, progress is not happening fast enough. In particular, Andrew Bailey raises the concern that the amount of contracts referencing LIBOR continues to grow: approximately $170 trillion of the interest rate swap contracts cleared by LCH reference LIBOR, and a little under one-third of these, by notional, mature after end-2021.
Whilst fall back clauses are useful, Andrew Bailey likens them to a “seat belt” in case of a “crash when LIBOR reaches the end of the road”. However, the “smoothest and best means for this transition is to start moving away from LIBOR in new contracts”.
He notes that one way in which future LIBOR could unfold is that either the administrator of LIBOR or the FCA judges that the benchmark is no longer sufficiently representative and no longer satisfies the requirements of the EU Benchmarks Regulation. Whilst it is possible that LIBOR production would cease at this point, the provisions allow for continued publication to prevent frustration or breach of legacy contacts. That would mean that the market could rely on LIBOR for legacy contracts, but not for new business. Andrew Bailey states that this “restriction on new trades would have a major impact on the ability to manage and hedge legacy portfolios, with impacts on liquidity or even availability of pricing”. He notes that those writing fall back provisions should consider this scenario carefully.
On the treatment of legacy contracts, Commissioner Quintenz confirms that the CFTC can provide “regulatory certainty” regarding legacy contracts that are amended to refer to alternative RFRs – “including how margin, trading and clearing requirements would apply to such amended contracts”.
Andrew Bailey states that, at this stage, he would not advise firms to rely on the possibility of “synthetic LIBOR” to assist with the legacy issue. The FCA has not seen a “compelling answer to how one-month, three-month, six-month and twelve-month term bank credit spreads can be reliably measured on a dynamic and daily basis”. LIBOR users must therefore “not rest any hopes on this”. On the question of whether a synthetic LIBOR, assembled from a RFR and a reasonable credit spread would be better than nothing for “stranded legacy contracts”, he notes that this is a similar idea to the fall back ideas that ISDA set out in its consultation (referred to above) and that he does not rule this out in principle.
The FSB’s view – which is supported by Andrew Bailey – is that in some markets, notably the largest part of the interest rate derivatives markets, it will be important that transition away from interbank offered rates is to the overnight RFRs rather than to RFR-derived term rates. The FSB highlights key weaknesses which could undermine the robustness of term rates and the fact that term rates are still at an early stage. Commissioner Quintenz, however, presents a slightly different view. He accepts that the “introduction of RFRs poses significant challenges for derivatives markets” and explains: “For starters, the markets must develop a forward-looking term structure for overnight rates”. At the same time, he agrees that firms must develop their transition plans.
Overall, the authorities consider that the majority of new contracts could move to RFRs now, without term rates being available. They acknowledge that for some parts of the market, term rates will be important but that “they should only be used where necessary”.
What supervisors expect from firms
The FCA, CFTC and FSB set out clear expectations of what firms need to do in relation to transition. Andrew Bailey asserts that firms must ensure that they can demonstrate to their supervisors “that they have plans in place to mitigate the risks, and to reduce dependencies on LIBOR”.
This is echoed by Commissioner Quintenz, who states that each firm must develop an “individual implementation plan, including assessing its exposures tied to LIBOR-based products and determining how to amend legacy contracts to reflect an alternative RFR”. The FSB highlights that the International Organization of Securities Commissions has set out the importance of contingency plans for the cessation of a benchmark, including sufficiently robust fall back provisions, and that the EU Benchmarks Regulation requires firms to include robust plans in the event of the discontinuance of a benchmark.
Furthermore, Commissioner Quintenz points out that “risk management models must be updated to incorporate RFRs and take into account the basis risk that will exist between LIBOR and the various RFRs across jurisdictions during any transition period”.
Importantly, Andrew Bailey outlines key obligations that firms owe to their clients, including that:
- issuers of LIBOR-related listed securities owe duties of disclosure under prospectus requirements;
- banks and investment firms need to consider the design and risks of any new LIBOR-referencing products as part of their product governance obligations;
- those acting on behalf of investors will need to guarantee they have considered and understand what will happen to LIBOR-referencing instruments in the event of LIBOR discontinuation;
- investment advisors and portfolio managers may need to show that they have considered whether investments remain suitable if there is no clear plan on what will happen in the event of discontinuation;
- brokers or platforms offering non-advised services need to disclose to clients “in an understandable way” information on the key features and risks of financial instruments they make available; and
- for an instrument relying on LIBOR beyond end-2021, the risk of discontinuation will need to be covered.
It is clear that regulators expect firms to act now and be able to document and demonstrate to their supervisors the steps they have taken to deal with transition and mitigate any associated risks.