Six key takeaways from FCA and IBA’s announcement on LIBOR cessation

Don’t let the complexity of the FCA’s statements on permanent cessation and non-representativeness fool you: After the end of 2021, no setting of the five currency LIBORs will be widely available for use in new contracts. That includes those USD LIBOR settings that will continue to be published on a representative basis until June 2023. 

Yes, the continued publication of some USD LIBOR settings into 2023 on a representative basis will allow for additional time to remediate existing exposures. It also reduces the number of legacy contracts requiring remediation ahead of their contractual expiry, as contracts that expire before June 2023 would be able to mature on their own terms. However, the availability of USD LIBOR is expected to be limited to existing exposures. Interagency guidance issued by the US banking regulators has set a clear expectation that there will be no new USD LIBOR contracts after 2021. A narrow set of exceptions are permitted (e.g., market-making activities, novation and risk management or supporting central counterparty auction processes following a member default), provided they relate only to LIBOR transactions entered into prior to January 1, 2022. The explicit reference to safety and soundness concerns provides an indication for how the regulator could compel US-based institutions to comply with these limitations on the use of LIBOR. The FCA has indicated that it intends to curtail the use of USD LIBOR as well, in alignment with the approach taken by US regulators. Regulators in other jurisdictions might look to establish similar expectations for institutions under their supervision, although it isn’t yet clear that any and all financial institutions around the globe will be subject to formal limitations on the use of USD LIBOR in new products after 2021.

The additional time may lower the urgency to amend legacy USD LIBOR contracts by the end of 2021, but retaining LIBOR exposures beyond 2021 will likely pose risk management, pricing, valuation and liquidity challenges. Liquidity in hedging instruments past 2021 will likely be adversely affected, possibly reduced to a fraction of today’s level, making hedging and risk management of USD LIBOR exposures a rather costly affair. 

The use of USD LIBOR in new contracts will end after the end of 2021.

In a nutshell:

• Overnight and 1-month, 3-month, 6-month and 12-month USD LIBOR will continue to be published until June 30, 2023 — but regulatory guidance is clear: Do not use USD LIBOR in new contracts after December 31, 2021.

• Don’t be confused by the different announcements on cessation dates and representativeness. After the end of 2021, no LIBOR will be available for use in new contracts. Period.

The UK Financial Services Bill, which is currently making its way through the UK legislature, is expected to bestow the FCA with the powers to a) mandate a change in the calculation methodology of a critical benchmark and b) compel its administrator to continue publishing that benchmark on an unrepresentative basis. Pending future consultations by the FCA, today’s declaration of future non-representativeness, rather than permanent cessation, of 1-month, 3-month and 6-month tenors of GBP LIBOR and JPY LIBOR paves the way for their publication in synthetic form after December 31, 2021. However, given their loss of representativeness, the rates would be unavailable for use in new contracts under both the EU and UK Benchmarks Regulation (BMR) from that point on. Even with respect to existing exposures, their use is expected to be restricted to a very narrow set of contracts, primarily those that cannot be remediated prior to LIBOR’s cessation. The FCA has indicated that it would consult on both the use of its new powers and on precisely which legacy contracts would be permitted to reference a synthetic LIBOR in Q2 of 2021. 

As a result, firms should not only continue their efforts to proactively transition legacy LIBOR exposures, but even accelerate their efforts wherever possible. Most importantly, there aren’t many potential benefits associated with relying on synthetic LIBOR as a solution for contracts that could reasonably be remediated prior to the end of 2021. Economically speaking, synthetic LIBOR is an IBOR in name only. Synthetic LIBORs are expected to be based on a specific LIBOR’s RFR replacement, plus any recommended spread adjustment. In other words, there won’t be a material economic difference between synthetic LIBOR and the recommended hardwired fallback. On the other hand, the inclusion of a hardwired fallback, or repapering a contract to directly reference an alternative reference rate, would allow banks to stay clear of the various uncertainties and eventualities associated with relying on synthetic LIBOR. 

The same holds true for any synthetic USD LIBOR rates that may or may not be published at some point in the future. While the FCA will consider the case for publication of synthetic USD LIBOR after June 2023, it noted the need for views and evidence (emphasis added) from US authorities and other stakeholders. We might never see a consultation on synthetic LIBOR, whereas plans for a consultation on GBP and JPY synthetic LIBOR are firmly in place. The mere prospect of USD LIBOR continuing on might tempt some market participants to delay efforts to actively transition legacy exposures. Giving in to that temptation would almost certainly come at a cost — and create additional transition risk. 

There are other factors that make reliance on a possible synthetic USD LIBOR a risky proposition. Only recently, during testimony to the House Committee on Financial Services, Fed chair Jerome Powell repeated his doubts about synthetic USD LIBOR as a viable solution for the US markets. He previously cited litigation concerns as a possible obstacle. In fact the UK’s HM Treasury itself is currently consulting on the possible need for legal safe harbors to limit the risk of litigation associated with a synthetic LIBOR. It is also likely that US regulators would seek to severely curtail or limit the type of contracts that would be permitted to reference such a synthetic rate, similar to what the FCA has suggested.

In a nutshell:

The use of GBP and JPY LIBOR in new contracts will end after the end of 2021, even if they are published in synthetic form.

• The FCA has announced 1-month, 3-month and 6-month GBP and JPY LIBOR could be published in synthetic form after December 31, 2021. But the use of synthetic LIBOR would be restricted to a narrow set of tough legacy contracts.

• The FCA suggested it would continue to consider publication of synthetic 1-month, 3-month and 6-month USD LIBOR after June 30, 2023. But: firms who plan to reference such a synthetic USD LIBOR will likely encounter many obstacles and challenges.

Today’s announcement triggered the fixing of ISDA’s spread adjustment for all LIBOR settings, including those USD LIBOR settings expected to be published into June 2023. The spread adjustment is a component of ISDA’s IBOR Fallbacks, which were incorporated into derivatives master contracts for new transactions in January of this year. Market participants have been able to amend their existing trade documentation with these fallbacks by signing up to the ISDA IBOR Fallbacks Protocol, provided that each counterparty to a trade has adhered to the protocol. 

Upon LIBOR’s cessation, references to LIBOR in derivatives contracts subject to ISDA’s IBOR Fallbacks would be replaced by risk-free rates, including a spread adjustment to address the tenor and credit basis between the various LIBOR settings and their replacement rates. The spread adjustment is based on the five-year median difference between the various LIBOR settings and their respective RFR replacements. Under ISDA’s IBOR Fallbacks protocol and Bloomberg’s IBOR Fallbacks Adjustment Rule Book, the vendor appointed to publish the replacement rates, the spread adjustment is fixed at the time of an announcement on LIBOR’s cessation, rather than the date on which contracts are actually transitioned from LIBOR to their replacement rate. As a result, we now know the value of the spread adjustments.

With respect to legacy cleared derivatives transactions, major central counterparties (CCPs) have indicated they will use the powers in their rulebooks to broadly align to ISDA’s IBOR Fallbacks in all of their legacy cleared derivatives transactions. 

The fixing of the spread adjustment has implications beyond the derivatives markets. In the US, the Alternative Reference Rate Committee (ARRC) has committed to recommending ISDA’s spread adjustment values for use in ARRC recommended fallback language for cash products. Similarly, the Working Group on Sterling Risk-Free Reference Rates has recommended ISDA’s methodology for the calculation of a spread adjustment in GBP LIBOR contracts that contain fallbacks to a spread-adjusted SONIA. Now that the spread adjustment values have been fixed, market participants have clarity around the economics of following a contractual fallback at the time of LIBOR’s cessation. With a known anchor for a conversion price, or economic baseline, we expect that parties will look to accelerate the proactive transition of legacy cash products in the coming weeks and months. 

Similarly, we expect hardwired fallback language to become much more prevalent in new LIBOR-based cash issuances, now that the replacement spread can be numerically defined, rather than describing a framework, providing greater economic certainty on the economic impact of these fallbacks at the time of transition. 

But while known fallback spreads provide a baseline for the renegotiation of existing LIBOR-based contracts, they do not mandate or dictate, nor should they be relied upon for the pricing of originations of new RFR-based cash products. Banks will need to perform their own analysis to price RFR-based transactions to consider margins and hurdle rates that contemplate a lack of credit sensitivity in RFRs and take into account current market conditions. ISDA’s spread adjustments are fixed, calculated over the last five years, and will increasingly become more distant and demonstrably less representative of expectations for future economic conditions. As a result, the pricing of new issuances and bilateral negotiations to address legacy exposures will likely have slightly different outcomes. 

In a nutshell:

The announcement triggered the calculation and fixing of spread adjustments that are intended to account for the economic differences between LIBORs and their risk-free rate (RFR) replacements. 

• Spread adjustments are now fixed for all LIBOR settings, including any USD LIBOR tenors that will continue to be published into 2023.

• Known spread adjustments provide an anchor for the renegotiation of existing LIBOR-based contracts but DO NOT dictate pricing of new RFR issuances.

Under the ARRC’s recommended fallback language for bilateral and syndicated loans, as well as other variations of language contained in variable loan or debt contracts, the IBA and FCA’s announcement likely triggered a requirement for lenders or administrative agents to notify other parties to the transaction that an announcement on LIBOR cessation has occurred. In the case of contracts that rely on the amendment approach, the announcement also allows lenders and borrowers to begin the process of negotiating an alternative benchmark that will take LIBOR’s place upon its cessation. 

There are many permutations of bespoke, non-standard contract language in the loan markets. Given the variety, and at times vagueness, of contractual language, determining the specific obligations of an administrative agent or lender might not always be straightforward — firms that have completed a detailed analysis of provisions embedded in their contracts likely find themselves at an advantage today. 

We expect that many firms might find it operationally easier to provide a notice to all of its counterparties, irrespective of whether they are contractually obligated to do so or not. From a business or client relationship point of view, there might be associated benefits of proactively communicating to all clients at the same time, rather than treating customers differently based on contractual language. Others may conclude that such notifications should only be executed to address contractual obligations. But no matter what approach an agent or lender might choose, one thing is certain: the announcements on LIBOR’s cessation are bound to trigger a flurry of notifications, announcements and mainstream press coverage.  

Once borrowers receive notifications from one or more of their lenders, combined with an increase in the general awareness of LIBOR transition, the phones will begin ringing. Organizations should ensure that client-facing staff can respond appropriately to any inquiries to articulate a clear response, process, strategy and timing for the remediation of existing deals.

In a nutshell:

The announcement doesn’t typically replace LIBOR in existing contracts, but action may still be required.

• In contracts containing provisions addressing LIBOR’s cessation (i.e., “fallbacks”), LIBOR references won’t actually be replaced until the actual cessation date.

• But many contracts, commonly those requiring parties to bilaterally agree upon a replacement rate, contain notification requirements. Some lenders and administrative agents might be required to issue certain notices — right now.

• Irrespective of contractual language, the announcements will raise general awareness of LIBOR’s cessation. Customer inquiries are almost certain to increase in volume.

The resolution of uncertainty about LIBOR’s cessation, including the fixing of the spread adjustments, removes most any remaining barrier for inaction. Regulators already have been unequivocal in their expectation that firms move away from issuing new LIBOR-based products. Now that a definitive end date for LIBOR is on the horizon, it appears difficult to make an argument for continuing in a wait-and-see position. The pressure to move away from LIBOR will likely be the strongest in the lending markets, where progress to date has lagged behind that in other products. 

Following the announcements on LIBOR’s cessation, lenders should find it easier to finally make the move to alternative benchmarks. First, with the spread adjustment known, there is less economic uncertainty associated with issuing a loan based on an RFR vs. issuing a LIBOR-based loan containing a hardwired fallback with known conversion terms. Second, the increase in general awareness might help to re-engage corporate clients, who up to now have taken a rather passive role in transition efforts. 

The anticipated acceleration in the move away from LIBOR also means that banks will need to come to terms with employing RFRs as lending rates. Market participants that continue to hold out for the availability and broad adoption of term rates or credit-sensitive benchmarks can no longer afford to do so. Which isn’t to say that term rates or credit-sensitive alternatives won’t be part of the future lending landscape, but time isn’t on the lenders’ side. It seems unlikely that the ARRC will meet its target date of Q2 2021 for the publication of a SOFR term rate, given the continued slow adoption of SOFR in the derivatives markets. And while credit-sensitive benchmarks are beginning to be published, it will take time for these rates to go through the process of regulatory scrutiny, IOSCO compliance and other review processes before they can be broadly adopted and accepted as alternatives. 

On the other hand, there are clear regulatory expectations for banks to move away from LIBOR as soon as practicable, if not immediately. With today’s announcements, those pressures are bound to increase even further. Many organizations have long adopted a wait-and-see approach to the transition away from LIBOR, waiting on others to make the first move. Some have proposed they’d intend to be fast followers. With today’s announcements, the gun has finally gone off — how far are you down the track?

In a nutshell:

Firms need to accelerate efforts to use alternative reference rates in new products. 

• Regulators have been urging market participants to move away from LIBOR for quite some time. With cessation dates set, the pressure will only increase.

• Term rates and credit-sensitive alternatives continue to evolve but aren’t ready for primetime. Market participants need to come to terms with employing RFRs as lending rates at this point.