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Interest rates – moving into the new risk-free rate environment

As announced by the FCA on 5 March 2021, 24 of the 35 LIBOR settings ceased after 31 December 2021. Six of the remaining settings will continue to be published throughout 2022 (see ‘Synthetic LIBOR’ below) and the cessation, or non-representativeness, of the remaining five USD LIBOR settings (Overnight, 1-, 3-, 6- and 12-month USD LIBOR) will only occur after 30 June 2023. Despite this longer wind-down period for these USD LIBOR settings, regulators in the UK, EU, US and other jurisdictions have called for market participants to cease, or prohibited market participants from, entering into new contracts that reference USD LIBOR subject to certain limited exceptions. Please see our note here for further details.

Regulators continue to be focused on transition, including in respect of remaining tough legacy contracts. We therefore expect interest rate reform to remain an area of focus for market participants in 2022 and set out below some key developments we expect to see during the year.

Synthetic LIBOR

The FCA exercised its powers under the UK Benchmark Regulation to compel ICE Benchmark Administration (IBA) to publish 1-month, 3-month and 6-month GBP and JPY LIBOR settings under a changed “synthetic” methodology, based on term versions of the risk-free rates rather than panel bank submissions, for the duration of 2022. Supervised entities are permitted to use synthetic LIBOR in legacy uncleared contracts only, use in new contracts (including new contracts to hedge legacy products) is prohibited. In the cleared space, LCH, CME and Eurex have played an important role in supporting transition to risk-free rates through mandatory contractual conversion of those legacy contracts referencing rates that have now ceased, or become unrepresentative, to the respective risk-free rates, ahead of end-2021.

The FCA has confirmed that it will only exercise its powers to compel publication of synthetic JPY LIBOR for those settings listed above for 12 months such that synthetic JPY LIBOR will not continue beyond the end of 2022. In the case of GBP LIBOR, however, the FCA will review, and potentially renew, the requirement for continued publication of some, or all, of the GBP LIBOR settings for which synthetic LIBOR is published for a further 12 month period[1].

During the course of 2022, the FCA is also expected to consult on use of its powers to compel publication of synthetic LIBOR for 1-month, 3-month and 6-month USD LIBOR from 30 June 2023. However, the FCA has cautioned against making assumptions based on its approach to synthetic LIBOR to date.

More generally, the FCA has emphasised that synthetic LIBOR is not a permanent solution. We therefore expect to see continued adoption of ISDA fallbacks and transition to risk-free rates.

EU statutory replacement rates

In Q1 2022, the European Commission is expected to designate statutory replacements for contractual references to certain GBP LIBOR and JPY LIBOR rates. It is hoped that the Commission will consult on drafts of these implementing acts, given the concerns in the market in respect of consistency between statutory replacements designated in different jurisdictions.

The new risk-free rate landscape - documentation

ISDA published the 2021 ISDA Interest Rate Derivatives Definitions (2021 Definitions) in June 2021 as the successor to the 2006 ISDA Definitions as the standard set of definitions applicable to interest rate derivatives. ISDA has since confirmed it has stopped updating the 2006 ISDA Definitions. We expect the usage of the 2021 Definitions to increase in 2022, as firms implement the required operational changes.

ISDA also published Supplement 75 to the 2006 ISDA Definitions, which allow parties to apply various compounding or averaging methods to overnight risk-free rates. Similar compounding and averaging methods are included in the 2021 Definitions.

It is likely that in 2022 firms will increasingly enter into derivatives referencing floating rates calculated by reference to these compounding and averaging methods, given the prohibition on use of most LIBOR settings for new products and the need to hedge cash products using similar compounding and averaging methods.

New term and swap rates

Term versions of some risk-free rates have been published, prompting questions in the market as to the scope of permitted use. Regulators and the relevant risk-free rate working groups have issued relevant guidance and we expect further guidance where needed to address this uncertainty.

New swap rates are being published, based on risk-free rates and in some cases incorporating a spread adjustment. We expect to see an increase in new products referencing these swap rates in 2022. The IBA is also expected to consult in 2022 on the potential cessation of USD LIBOR ICE Swap Rate, following its similar consultation and announcements of cessation in respect of GBP LIBOR ICE Swap Rate in 2021.

For more information visit our Global Interest Rate Reform microsite.

This publication is intended merely to highlight issues and not to be comprehensive, nor to provide legal advice. Should you have any questions on issues reported here or on other areas of law, please contact one of your regular contacts, or contact the editors.

[1]    Under the UK Benchmark Regulation, the FCA can undertake this annual review for a maximum of period of 10 years from end-2021. The FCA has noted, however, that intends to use these powers for no longer than necessary to ensure an orderly wind-down of LIBOR.

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