HM Treasury announces intention to bring forward legislation to address LIBOR “tough legacy” contracts
In response to the recommendations of the Working Group on Sterling Risk-Free Reference Rates’ Tough Legacy Taskforce (the “Taskforce”), in its paper at the end of May, HM Treasury announced that it intends to utilise the framework of the UK onshored version of the existing EU Benchmarks Regulation (the “UK BMR”) to enhance the powers available to the FCA to address the “tough legacy” issues raised by the Taskforce.
In accompanying statements, the FCA reiterates the importance of market participants continuing to actively transition outstanding contracts prior to the anticipated demise of LIBOR as we know it. An active transition of legacy contracts will be the only way for market participants to ensure certainty and contractual continuity ahead of the discontinuation of LIBOR.
What is “tough legacy”?
“Tough legacy" in the context of transition away from LIBOR refers to existing LIBOR referencing contracts that are unable, before the end of 2021, to either convert to a non-LIBOR rate or be amended to add fallbacks to cater for a situation where the relevant LIBOR rate is no longer available. The FCA, in its statements accompanying the Treasury’s announcement, reiterated that “tough legacy” should be considered as a narrow pool of contracts that “genuinely have no or inappropriate alternatives and no realistic ability to be renegotiated or amended”.
For further background see ‘Libor transition - tough legacy contracts’ (3 June 2020).
What will be the nature of the new powers?
The proposed new powers, which will apply to ‘critical’ benchmarks under the BMR (including LIBOR), will allow the FCA to direct ICE Benchmark Administration (as administrator of LIBOR) to change its methodology for the compilation of LIBOR to “protect consumers and market integrity”.
Such powers would permit the publication of what some have previously termed “synthetic LIBOR” to be used to manage the wind-down of legacy LIBOR contracts during a “pre-cessation” period, where LIBOR is deemed by the FCA to no longer meet the regulatory standard of being representative of the underlying market it seeks to measure and will not be restored to representativeness.
Further detail as to how these powers may be exercised is expected to be available following extensive stakeholder engagement, which will include seeking views on methodology changes based upon the risk-free reference rates (“RFRs”) selected in each LIBOR currency jurisdiction. The FCA has noted it will seek market input on methodology changes that will reduce the risk of any such “synthetic LIBOR” diverging from the value resulting from the operation of fallbacks during a pre-cessation period.
The introduction of the new legislation does not mean that LIBOR’s methodology will be changed, but it will make it possible to require such a change in certain circumstances.
How will this legislation be implemented?
The Government intends to utilise the forthcoming Financial Services Bill to implement the new powers by way of amendment to the UK BMR, as applicable in the UK following the end of the Brexit transition period.
What will the implications be globally?
LIBOR is currently published in five currencies and a number of different tenors which are all under the regulatory remit of the FCA in the UK, with USD LIBOR being the most prevalent globally.
The FCA has indicated it will consider each LIBOR currency tenor pair individually, so the powers are unlikely to be used in respect of all currencies and tenors at the same time or, potentially, at all (in the case of some currencies where appropriate inputs for an alternative methodology may not be available).
The UK authorities are proposing a different path to that which is under consideration the United States in respect of New York Law governed contracts referencing USD LIBOR. The ARRC (the body tasked with catalysing the transition away from USD LIBOR to the alternative RFR, SOFR in the US) have put forward a legislative solution under New York law which would, among others, see a statutorily endorsed benchmark replacement apply to contracts which either lack fallback provisions or which would fall back to a LIBOR based rate.
Given LIBOR’s global usage it will be important to follow legislative developments across different jurisdictions closely, and UK authorities have indicated that the FCA may consider the international impact (including the interaction with other legislative solutions should they become available) before exercising its new powers.
This latest development provides further insight into how the UK authorities intend to support a smooth transition away from reliance on LIBOR and reduce the “cliff edge” risk for “tough legacy” contracts. However, the emphasis remains on market participants to actively reduce their LIBOR exposure.
As the FCA has indicated, there will be further stakeholder engagement and future policy statements on the anticipated use of these powers and most importantly the methodology changes applicable to each LIBOR currency tenor pair.
It is worth also noting that there is no guarantee that the use of these powers will be possible in respect of all LIBOR currencies. Finally, large parts of the derivative, bond and other cash markets are transitioning, or preparing for the transition to, RFRs compounded in arrears at the end of a relevant interest period. Methodology changes to LIBOR that replicate the forward-looking term element of LIBOR may not be consistent with market conventions expected to prevail in new markets based on the RFRs.
The only way for market participants to ensure that the transition away from LIBOR is managed in a way that delivers their preferred economic outcome is to transition actively by mutual agreement or adopt sufficiently robust and workable fallbacks including via ISDA’s protocol mechanism, without relying on legislative intervention.