Transition from LIBOR to Risk-Free Rates
Transition from LIBOR to Risk-Free Rates by Katie Kelly, Charlotte Bellamy and Mushtaq Kapasi
Tough legacy: FCA consultation on use of critical benchmarks On 16 June, ICMA responded to an important UK FCA consultation on the exercise of the FCA’s new powers related to use of critical benchmarks. These new powers were granted to the FCA pursuant to the UK Financial Services Act in spring 2021 and now form part of the UK Benchmarks Regulation. They are part of the UK’s efforts to support an orderly wind-down of LIBOR and pave the way for: (i) the introduction of synthetic Japanese yen and sterling LIBOR; and (ii) the restriction of new use of US dollar LIBOR by UK supervised entities, at the end of this year. The key points of ICMA’s response were as follows. 1. The challenges associated with transitioning legacy LIBOR bonds are well known. The introduction of synthetic LIBOR is therefore welcome because it will help to avoid the risk of market disruption that could otherwise occur when LIBOR ceases. Several legacy LIBOR bonds have been transitioned to alternative reference rates following successful consent solicitation exercises. However, as recognised in the Working Group on Sterling Risk Free Rate’s Paper on the Identification of Tough Legacy Issues, the use of consent solicitations to transition the whole of the legacy LIBOR bond market before the end of this year is unlikely to be feasible because some bonds cannot be transitioned and there are too many to transition in the time available. 2. It will be important that the FCA grants UK supervised entities a broad permission to use synthetic LIBOR for legacy LIBOR bonds. Without this, significant legal and practical uncertainty will arise, which could pose a threat to market integrity and consumer protection. 3. There could also be unintended, disruptive or unfair consequences, such as floating rate bonds becoming fixed rate bonds for the remainder of their term, events of default being triggered and/or mandatory redemption of legacy securitisations at par. All of these outcomes could also pose a threat to market integrity and consumer protection.
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4. Bonds are distributed and traded internationally and involve different types of entities located in different jurisdictions. International consistency is therefore a very significant factor and relevant to UK market integrity. Broad permission for UK supervised entities to use synthetic LIBOR for legacy LIBOR bonds would help to ensure international consistency for bond market participants, noting that non-UK supervised entities are unlikely to be subject to a prohibition on use. The interconnected nature of different product types within more complex structures such as securitisations and repackagings is another relevant consideration. 5. In terms of the “new use restriction power”, which will be relevant in the context of US dollar LIBOR, we believe the most important factors in deciding whether or not, and how, to exercise this power should be international consistency and market preparedness and confidence in alternative rates. As outlined in the latest roadmap of the Working Group on Sterling Risk-Free Reference Rates, the FCA is expected to publish a feedback statement and policy statement in Q3. A subsequent consultation is expected to be published in Q3 on the FCA’s decision on exercising its powers for use of Japanese yen and sterling synthetic LIBOR and restricting new use of US dollar LIBOR, with a final announcement in Q4. This will leave market participants with only a short window to prepare for implementation of the FCA’s decisions when they take effect at the end of the year. It will therefore be important that market participants follow this process and start to consider the possible outcomes, as well as continuing to transition actively as many bonds as possible to alternative rates. ICMA is currently considering the UK FCA consultation on its proposal to require the administrator of LIBOR, ICE Benchmark Administration (IBA), to change the way 1 month, 3 month and 6 month sterling and Japanese yen LIBOR settings are determined after 2021, which was published on 24 June. Contact: Charlotte Bellamy charlotte.bellamy@icmagroup.org
