Libor transition

The decision is part of a long series of delays and exemptions to help the industry transition to alternative interest rate benchmarks [from Global Risk Regulator].

Fears of potential market disruption have prompted the UK’s Financial Conduct Authority (FCA) to temporarily allow the use of ‘synthetic’ sterling and yen London interbank offered rates (Libor) for legacy contracts referencing the benchmark that are not changed before December 31. But this will not apply to cleared derivatives.

The decision is part of a long series of delays and exemptions to help the industry with the mammoth task of transitioning away from the scandal-tarnished Libor to alternative interest rate benchmarks. 

Risk of disruption

The FCA noted in a statement on November 16 that there is a risk of disruption to markets and consumers if interest rate payments on some mortgages, bonds and other Libor-based contracts have not switched to new interest rate benchmarks before year end. “As a result, the FCA is requiring the publication of 1-, 3-, and 6-month Libor rates for sterling and Japanese yen on a synthetic basis until the end of 2022, to allow more time to complete transition,” the regulator said. 

Currently, Libor is calculated from rate submissions by banks. ‘Synthetic’ Libor will be calculated using risk-free forward term rates adjusted with a fixed credit spread. The UK authorities paved the way for the FCA to change Libor’s methodology back in June 2020. 

Edwin Schooling Latter, the FCA’s director of markets and wholesale policy, warned that while ‘synthetic’ Libor reduces transition risks and provides a bridge to risk-free rates like Sonia (sterling overnight index average), it will not last indefinitely and contracts need to be moved away from Libor wherever possible.  

The industry breathed a sigh of relief over the FCA’s decision because if the move had not been made some contracts could have been left in limbo or forced onto fixed rates triggering widespread legal actions. 

This fix has been on the cards for some time but there has been some uncertainty as to permitted use cases

Davide Barzilai, Norton Rose Fulbright

Norton Rose Fulbright’s global head of Ibor transition, Davide Barzilai, said the FCA’s decision brings market certainty to existing loan and bond contracts. “This fix has been on the cards for some time but there has been some uncertainty as to permitted use cases,” he said. “In any event, this is recognised to be a short term fix – one year, in the case of Japanese yen – and regulated firms have to continue with their efforts to amend contracts away from Libor so the work will continue into 2022.”

Welcome relief

Robin Penfold, partner at law firm TLT, added: “The FCA’s decision to permit broad use of ‘synthetic’ Libor until at least end-2022 will be a welcome relief to many across the financial services industry still engaging with the challenges of what to do with ‘tough legacy’ contracts as December 31, 2021, when Libor ceases in its current form, looms near.” He explained that there is every indication that in the longer-term the FCA may need to revisit whether limitations or restrictions on use are necessary – so any permanent long-term solution for the toughest of ‘tough legacy’ contracts remains far from clear.

“I think it’s important to remember, even when many think they’ve seen the back of sterling Libor, even at the end of 2021, this will not be all done. The legislation [Critical Benchmarks Bill] in reality is only a short-term solution. Every contract needs to move away from Libor,” said Sarah Boyce, policy expert at the Association of Corporate Treasurers.

Meanwhile, the FCA reiterated that although five US dollar Libor settings will continue to be calculated by panel bank submission until end-June 2023, it added that the use of US dollar Libor will not be allowed in most new contracts written after December 31, 2021. 

“The US dollar market is working to longer timescales than sterling but, even there, and despite the market being significantly larger and more fragmented, transition has started to pick up speed making it possible for less developed markets to start their transition journey too,” says Ms Boyce. However, she believes the end of Libor will leave financial markets more fragmented, which will have consequences for market liquidity. 

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