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In a statement on June 23, the UK chancellor crushed any hopes for a government-sponsored extension of LIBOR at the end of 2021. However, he also introduced legislation giving the FCA new powers to mandate the production of a synthetic LIBOR rate derived from other benchmarks and data instead of bank submissions for a limited period of time. On the one hand, this makes clear that active efforts by users of the LIBOR benchmarks to migrate to alternative rates remain vital. On the other, this step represents a significant government intervention to maintain market integrity.
Given the significant cost of compliance and potential for reputational damage, banks had become reluctant to remain contributors to LIBOR, particularly as the interbank overnight lending market underpinning the rate had largely ceased to trade. As a result, since 2012, UK authorities have been using their powers (or the threat thereof) to ensure no bank ceases its contributions. However, authorities have said this will cease by the end of 2021 and it is expected that this will rapidly lead to the demise of the benchmark. This is why financial regulators have been pressing the financial industry to migrate to alternatives before that date.
It has also become increasingly clear that there are several so-called tough legacy contracts referencing LIBOR, where transitioning to an alternative rate will be hard or impossible to achieve. These contracts may be floating rate notes (FRNs) where transition to a new rate would require the consent of the majority of investors who may be unwilling to engage. As a result, a task force of the UK Sterling RFR Working Group reviewed these issues and published its findings in May. Given the complexity of some of the issues identified, there had been expectations that authorities might eventually be forced to diverge from their stated goal of completing transition at the end of 2021.
In the event, the government remained firm that, while interim milestones could be flexible, the overall deadline would not change but instead chose another option designed to provide some certainty of continuity for market participants and buy more time for market participants to identify solutions for tough legacy contracts.
The option will see the FCA receive new powers allowing it to require the administrator of LIBOR to change its methodology, creating synthetic LIBOR rates and effectively putting the benchmark on life-support for a while. Tough legacy contracts will therefore be able to continue to reference LIBOR for some time without fear of it disappearing overnight.
The FCA will consult on the details over the next few months. However, a likely scenario in which it would use its powers is already clear. At the beginning of 2022, it is expected that certain banks will start to withdraw from LIBOR or at least from certain currency panels, meaning the calculation of the rate will be based on ever fewer submissions. For those currency panels where there are already low numbers of contributors, this will quickly result in the benchmark being found unrepresentative and therefore will trigger a cessation event, meaning that the publication of LIBOR will have to be stopped in the near future.
It is at this point that the FCA will be able to intervene and force a change to the way LIBOR is calculated for the affected currency panels. The authority will likely allow the administrator to provide a synthetic LIBOR rate for the struggling currency and maturity using established methods such as the compounding of overnight rates to arrive at a forward-looking interest rate. That will remove the requirement for banks to submit rates for these maturities, but that in turn means that the published rate for that maturity would have to be computed from other data rather than directly observed, potentially removed from real-world funding costs. Therefore, the FCA will only allow this to go on for what the regulator says will be a “reasonable time period.” Additionally, only contracts which qualify as tough legacy will be allowed to make use of the synthetic LIBOR, although how the rule will be enforced isn't clear.
Were the FCA to make use of its powers, the regulator will in effect have put LIBOR on life support. The hope will be that this additional time will help to address the issue of tough legacy contracts. It must also be clear that such government intervention by itself does not provide a complete solution to the issues identified. Rather, it may help to mitigate the problem in one of two ways. Firstly, tough legacy contracts may simply expire during the period over which a synthetic LIBOR is published. FRNs, for example, have a typical maturity of two to five years and therefore may mature during a six-month period after the end of 2021. Secondly, in some cases more time to negotiate and agree on an alternative may allow more of these processes to succeed.
Ultimately, those contracts where no alternative has been identified and transitioned to may still cease to perform. Shortly before that point is reached, the UK authorities will be faced with another difficult decision. They may have to choose the other option proposed by the taskforce on tough legacy contracts: legislation to mandate the transition to an alternative. This may produce winners and losers, in effect picked by the government; an outcome that is unlikely to appeal to the UK Treasury, Bank of England and the FCA. It would likely be chosen as a last resort where there are significant risks to market integrity and financial stability.
Therefore, the authorities will continue to push the industry to proactively migrate to alternatives and address as many tough legacy contracts as possible in the time remaining. For users of LIBOR, the message is clear: Engage in this process now to ensure the best possible outcome.
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