The FCA has been consistently clear about synthetic LIBOR: where at all possible it should not be relied upon. It is the rate of last resort. Market participants should press on with active transition and amend contracts to get the benefits of converting to a stronger and more liquid benchmark, the compounded RFR - what the FCA calls the "new centre of gravity of sterling interest rate markets". Active conversion allows market participants and their counterparties to keep control over the economics of their contracts; synthetic LIBOR brings with it uncertainty. Uncertainty as to what it will be, who can use it and how long it will last.
Tough legacy contracts
However, for some contracts maturing after end-2021 that contain no fallbacks or inappropriate fallbacks that cannot practicably be amended by the time the relevant LIBOR panels cease, active conversion may simply not be possible. For these tough legacy contracts synthetic LIBOR, with all its uncertainties, offers a temporary safety-net.
In the FCA's live Consultation Paper on its decision to require publication of synthetic LIBOR the regulator assesses that most tough legacy contracts are in cash markets (bonds and securitisations and loans, including retail mortgages and commercial lending) and reference six LIBOR tenor settings: the 1-, 3- and 6-month sterling and Japanese yen LIBOR tenors (6 LIBOR settings). For bonds and securitisations contract amendment within the timeframe is likely to be difficult particularly where high numbers of bondholders are required to consent or engagement with some parts of the bond or note holder community is tricky. For mortgages some mortgage lenders may not be able to amend contractual provisions without explicit borrower consent and getting consent within the timeframe available is likely to be difficult; many retail mortgage borrowers are unlikely to be familiar with LIBOR transition and may not engage with lenders’ efforts to amend their mortgage contracts. In the commercial lending space lenders are dealing with a very diverse range of borrowers, some of whom may be unable or unwilling to engage with lenders to amend their contracts.
The modified methodology for synthetic LIBOR
The FCA expects to use its powers under the Benchmarks Regulation to compel the continued publication of the 6 LIBOR settings and impose requirements on the benchmark administrator relating to the way in which the benchmark is determined, including by changing the benchmark’s methodology. The proposed changed (synthetic) methodology would take effect immediately after end-2021 when the LIBOR settings cease.
The aim of the synthetic LIBOR methodology is to achieve a reasonable and fair approximation of the LIBOR benchmark’s expected value. In economic terms LIBOR is made up of two elements: a risk-free reference rate (RFR) over a fixed period coupled with an adjustment or premium reflecting bank credit risk and liquidity conditions in funding markets over the corresponding fixed period.
The FCA's proposed modified methodology for synthetic LIBOR involves measuring each of these elements in a different way and then adding those different components together to produce an approximation of the relevant LIBOR setting. The two new components for the calculation of the 6 LIBOR settings are:
• the relevant forward looking RFR term rate
• a fixed spread adjustment to reduce any value transfer which might otherwise result if only the forward looking RFR term rate were used.
The proposed spread adjustment is a 5-year historical median of the spread between the corresponding LIBOR setting and the relevant RFR (ie it is the relevant ISDA spread adjustment that applies as part of the ISDA IBOR fallback and that is published for the purposes of the ISDA IBOR Fallbacks Supplement and Protocol).
So, for example, the 3-month sterling LIBOR is to be calculated as the sum of the 3-month Term SONIA Reference Rate provided by the benchmark administrator and the ISDA spread adjustment for 3-month sterling LIBOR.
The RFR: why a forward-looking term rate?
While the recommendation of the Working Group on Sterling Risk-free Reference Rates is a transition to SONIA in arrears, this requires not only a change to the reference rate but also changes to other contractual terms (such as break costs and prepayments provisions) necessary to reflect and accommodate the fact that SONIA is a backward-looking overnight rate. For tough legacy contracts, currently referencing LIBOR (a forward-looking term rate), amendment is not practicable. The FCA have concluded that a forward-looking RFR term rate captures more accurately the element of LIBOR which measures the market expectation of interest rates over a fixed term and is also more operationally suitable for tough legacy contracts currently based on LIBOR.
The spread adjustment: why a lookback approach?
A forward approach requires functioning markets and extensive market data. As there are so few transactions in these markets the FCA has been unable to find an appropriate and robust way of measuring in a dynamic way unsecured inter-bank credit risk and funding market liquidity conditions in relation to the 6 LIBOR settings beyond end-2021. Unlike a forward approach, a historical approach based on readily available information is robust against manipulation and captures the tendency of interest rates to fluctuate around a long term mean.
The spread adjustment: why a 5-year historical median?
The FCA considers this is the fairest and most robust method of calculating credit risk and market liquidity conditions. The 5-year lookback period reflects a range of economic and market conditions, and the median approach disregards outliers (in contrast to an approach based on the mean of all data) which the FCA views as a better method of calculating the spread adjustment.
The spreads were fixed at the point of the FCA's announcement on the end of LIBOR (5 March 2021) to ensure against underlying data used in the median calculation being affected as a result of the knowledge that LIBOR will cease or become unrepresentative on a particular date.
The consultation closes on 27 August. The FCA still needs to confirm which legacy contracts will be permitted to use synthetic LIBOR and that decision will not be confirmed until Q4. Qualifying for synthetic LIBOR is not the end of the process for legacy contracts. Market participants whose contracts qualify need to be able to ringfence, service and manage those contracts applying synthetic LIBOR after 31 December, and, as synthetic LIBOR will only be available for a limited time frame, transition work (away from synthetic LIBOR) will remain to be carried out post end-2021. Market participants should not be holding off for the FCA's announcement in Q4, they should press on with active conversion and amend contracts where they can to retain control not only of the economics but also of the practical operation of their contracts.
Our next Banking & Finance Academy virtual session will discuss this and other key LIBOR conversion issues facing market participants at this point on the transition timeline - to register click here.