The FCA announced in a speech last week that it will consult on two of the proposed powers conferred on it by the Financial Services Bill, which (subject to parliamentary approval) will introduce new provisions to the EU retained law version of the Benchmarks Regulations (UK BMR).
The powers in question are the FCA's ability to:
- restrict use of a critical benchmark when it becomes clear that the administrator can no longer produce a representative LIBOR rate based on submissions from panel banks (Article 21A UK BMR); and
- define which legacy contracts will be allowed to use 'synthetic LIBOR' to help an orderly wind down (Article 23C UK BMR).
The Article 21A power can be exercised only to advance the FCA's consumer protection and/or integrity objectives under the Financial Services and Markets Act 2000. Article 23C applies to legacy use (ie not to new cases) of an 'Article 23A Benchmark', which includes so-called 'synthetic LIBOR'.
What is 'synthetic LIBOR'?
When it becomes clear that the administrator can no longer produce a representative LIBOR rate based on submissions from panel banks, and its representativeness cannot be maintained or restored, as well as restricting the use of that LIBOR rate under proposed Article 21A, the FCA can, under other proposed powers, direct the administrator to change the methodology by which LIBOR is produced. This creates a synthetic form of LIBOR, published in the same way LIBOR is but based on a different methodology.
Like the ability to restrict the use of LIBOR, the use of a synthetic LIBOR is aimed at protecting consumers and ensuring market integrity, and it is intended for 'tough legacy' contracts.
What are 'tough legacy' contracts?
These are contracts which, upon cessation of LIBOR (scheduled for the end of this year), have no or inappropriate alternatives (or fallbacks) to LIBOR and no realistic ability to be renegotiated or amended. One example is a syndicated loan where the large number, or diverse characteristics, of the borrowers, the resources available, or other practical difficulties make amending the agreement prior to the end 2021 nigh on impossible.
Which legacy contracts will be allowed to use synthetic LIBOR?
As mentioned above, the FCA has indicated that it will consult on this, but it has delivered consistently clear messages on its proposed approach:
- when considering different legacy contracts the FCA consciously needs to 'strike a careful balance' between necessity and desirability, and it must have at the forefront of its mind its statutory objectives of consumer protection and/or market integrity.
- For contracts which fall 'unambiguously into the 'tough legacy' bucket', consumer interests under a mortgage, for example, are likely to be best protected by using synthetic LIBOR offering a fair approximation to what panel bank LIBOR might have rather than those contracts becoming inoperable. Similarly, market integrity may best be protected by using synthetic LIBOR for financial instruments, such as bonds, where attempts to transition away from LIBOR have proved unsuccessful and those securities would otherwise not function in the way intended.
- synthetic LIBOR will be preserved for 'tough legacy' contracts. Relying on synthetic LIBOR is not an alternative to LIBOR transition. Where agreement to convert to market standard fair terms across derivatives, securities and loan markets is practicable that is the course parties should take, not least because that way they can keep control of the economics of their agreements. Mutual agreement, where practicable, is by far the preferable option. It is in parties' best interests to act on the FCA's clear warning delivered in a speech last summer: "if you rely on regulatory action you will have neither certainty nor control, and you may not get what you want."
What next?
We can expect FCA consultation proposals in the Spring on a framework for the FCA using both proposed powers outlined above. The FCA's exercise of those powers, drawing on input from market participants, will be essential to the successful management of the LIBOR wind down.
If you have queries about what the transition away from LIBOR means for you please get in touch.
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