A triumvirate of the Working Group on Risk-Free Reference Rates (RFRWG), the FCA and the Bank of England published joint statements in March and April (see my previous blog LIBOR Wars) reiterating that firms must move away from referencing LIBOR and reduce the stock of legacy LIBOR contracts. While pragmatically accepting that COVID-19 may have slowed the progress, the timetable for the implementation of such changes remains unaltered. Existing arrangements between the FCA and submitting banks will expire at the end of 2021 and, as a result, firms will be unable to rely on the publication of LIBOR beyond that date. Indeed, the FCA could declare the benchmark unrepresentative of the market, which would be the final nail in LIBOR’s coffin. The authorities are firmly in control of the throttle as we hurtle towards the end station.
This state of affairs has been bolstered by the UK government’s announcement on the 23rd of June that it will introduce new legislation to increase the powers of the FCA if the FCA decides LIBOR has ceased to be representative and, in the event of such a determination, its representativeness will not be restored. This is intended to clear a significant blockage further down the tracks. The RFRWG published a paper (Tough Legacy Issues) addressing the particular issue with “tough legacy contracts”, and this spurred the government to move to enact further powers in the forthcoming Financial Services Bill. The proposed legislation would:
- Grant the FCA powers to require an administrator of LIBOR to alter its methodology in calculating the benchmark if LIBOR ceases to be representative of the market and its representativeness is not to be restored (which is expected to occur when panel banks are no longer required to make submissions after the 1st of January 2022). This would not restore LIBOR’s representativeness, but could sustain publication of a robust rate until its cessation; and
- Allow the FCA to permit the continued use of LIBOR for a narrow category of “tough” legacy contracts where it considers this appropriate.
This has obvious ramifications for the transition from Sterling LIBOR to SONIA. The aforementioned RFRWG report we should note the following – “but the group has also considered the exposure of UK and non-UK market participants to LIBOR settings in other currencies under contracts governed by the laws of England and Wales (English law). The Taskforce has concluded that, in their view, there is a case for action to consider what can be done to address tough legacy LIBOR exposures in the UK.” Indeed, the aforementioned new powers would be capable of being applied to all currencies in which a LIBOR benchmark is set. With so many derivatives and bonds using LIBOR and English law, this will have a far-reaching impact on financial markets.
Another problem the markets face is in the question – “What is a tough legacy contract?”. The consultation paper refers to “those contracts that cannot be dealt with in any other way” apart from continuing to reference LIBOR. If, for example, you are negotiating with a party to the contract and agreement cannot be reached on a replacement rate and adjustment, would this be a “tough legacy contract”? We will need further guidance on this critical point and an indication of the FCA having provided a fair default fallback during any pre-cessation period. Where LIBOR has been deemed unrepresentative, it cannot be used for new business, but legacy contracts still exist. Also, the legislation gives the FCA the power to create a new methodology for LIBOR. Still, the FCA is unlikely to provide any guidance on any new methodology for some considerable time.
So, the implications for firms of LIBOR reaching the end of the line are very significant. First off is to identify all the contracts that reference LIBOR and have no embedded fallback provisions in them, thus requiring them to be re-negotiated. These legacy contracts will take some working through, and with legal principles such as the doctrine of frustration (see here for an explanation) being mentioned, this is in itself a massive undertaking. A further complication to moving toward backwards-looking RFRs from the forward-looking LIBOR rate setting is you are not replacing like for like so economic differences have to be taken into account potentially resulting in the legacy contracts issue that has required legislation.
So, as firms move to the new benchmarks and seek to fix legacy contracts, a thorough inventory needs to be taken of all front and back-office systems that use LIBOR. This will be extensive as LIBOR is used everywhere and covers many instruments, from derivatives to bonds to savings products and many more in any lending department, as well as underpinning many front-office, risk and analysis systems. Many different departments of a bank are impacted, and even after identifying the use of a LIBOR rate, you have to track its transformation into multiple iterations through complex bank processes. Just getting a coordinated approach from all the internal business owners is no small feat!
Hopefully, everyone is well and truly aboard the LIBOR Reform train and has well-advanced plans as we await the intermediate stops on the journey as further guidance is given, market consensus on fallbacks is reached, and the outlier contracts are documented ready for classification of “to be fixed” or “tough legacy”. One thing is sure, the end of the line is fast approaching and will be quickly reached in 2022!