Focus remains on the transition away from the London Interbank Offered Rate (LIBOR), a key interest rate benchmark that is referenced across many of the agreements that you, funds you manage or advise or entities that you have invested in, have entered into. The end of 2021 remains a critical date for LIBOR cessation – being the date after which the FCA will no longer compel panel banks to contribute submissions to the administrator of LIBOR, ICE Benchmark Administration (IBA), for determining the majority of LIBOR tenors.

Whilst the UK is the home of LIBOR, this is a multi-currency, international issue as LIBOR is published in five currencies: USD, GBP, Euro, CHF and JPY. Alternative largely risk-free interest rates (the RFRs) have been identified as replacements for each of the LIBOR family of currencies: SONIA (GBP), SOFR (USD), SARON (CHF), €STR (EURO) and TONA (JPY).

Many regulators see the transition from LIBOR as a financial stability risk given the prevalence of LIBOR’s use across a multitude of agreements. Exposures to LIBOR can arise at every level of a business – investments, loans, hedges, fees, systems and infrastructure. Achieving a smooth transition away from LIBOR benchmarks by 31 December 2021 remains a priority for the FCA and other regulators. For the remainder of the year as 31 December 2021 draws closer, we expect to see an increased focus on LIBOR related issues.

The FCA continues to prioritise the transition away from LIBOR and market participants are actively being encouraged, and indeed incentivised, to move to alternative risk-free rates. In the UK these efforts are being led by the Working Group on Sterling Risk-Free Reference Rates (WGRFR), the FCA and the Bank of England (BoE), in the EU by the working group on euro risk-free rates (EURFRWG) and in the U.S. by the Alternative Reference Rates Committee (ARRC). There has also been significant input from industry associations, in particular ISDA (as the vast majority of LIBOR exposure lies in derivatives products) and also the Loan Market Association.

Changes to the regulation of benchmarks

On 23 June 2020, the UK government declared its intention to change the UK Benchmarks Regulation to permit changes to the methodology for determining LIBOR rates with a view to enabling LIBOR to continue to be used as a benchmark in certain limited circumstances.¹ There was also a Summer 2020 proposal from the EU Commission to amend the EU rules on benchmarks set out in the EU Benchmarks Regulation to empower the EU Commission to designate a replacement benchmark that covers all references to widely used reference rates such as LIBOR when this is necessary to avoid a disruption of the financial markets. Both the UK and EU legislative proposals are progressing, and we explore some of the detail immediately below.

The regulation amending the EU Benchmarks Regulation was published in the EU Official Journal (OJ) on 10 February 2021.²

The amending regulation provides that a replacement rate mandated by the EU Commission will replace a benchmark rate only in contracts and financial instruments that either (i) do not contain any fallback provisions, or (ii) do not contain "suitable" fallback provisions (so-called "tough legacy" contracts). It applies to EU law-governed contracts and MiFID II financial instruments (which includes transferable securities, UCITS and derivative contracts) that reference an affected benchmark and to non-EU law-governed contracts that reference an affected benchmark, where the contracting parties are EU entities and the applicable jurisdiction does not provide for the orderly wind-down of the benchmark in question. One final notable amendment is that the amending regulation extends the third-country transitional period until the end of 2023, with an option for a further two-year extension if necessary.

In the UK, the Financial Services Act 2021 (the FS Act, see Section 'Financial Services Act 19' below) makes significant amendments to the UK Benchmarks Regulation, providing an overarching legal framework that gives the FCA new and enhanced powers to manage the wind-down of a critical benchmark. The changes that the FS Act makes to the UK Benchmarks Regulation took effect on 1 July 2021 and will expand the circumstances in which the FCA can conduct a formal assessment of a benchmark’s representativeness and also grant the FCA powers to prohibit some or all use of a specific benchmark by supervised entities. See, the FCA webpage explaining its new powers, policy and decision-making under the UK Benchmarks Regulation.

Although the changes to the UK Benchmarks Regulation are now law, this only provides a framework for the changes. On 20 May 2021, the FCA launched a consultation³ on the exercise of two of its new powers pursuant to the UK Benchmarks Regulation relating to the use of critical benchmarks that are being wound down. The first power relates to “legacy use” and would enable the FCA to designate a critical benchmark as an ‘Article 23A benchmark’ where it has become permanently unrepresentative of the market it is intended to measure. Designation as an Article 23A benchmark would result in an automatic prohibition on use of the benchmark by UK supervised entities. The second power would give the FCA the ability to prohibit some or all new use of a critical benchmark where the FCA has been notified by the benchmark administrator that it will cease to be provided. Restricting new use of a ceasing critical benchmark could help reduce the risk of misuse, or unnecessary risk to market integrity from the creation of new exposures, during a wind-down period. The consultation closed on 17 June 2021 and the FCA has stated that it will publish a Statement of Policy and feedback statement in Q3 2021.

On 26 June 2021, the FCA launched a further consultation in relation to its use of the new Article 23D(2) powers to secure an orderly wind-down of the six Sterling LIBOR and Japanese yen settings. The proposal is to require IBA to change the way 1-month, 3-month and 6-month sterling and Japanese yen LIBOR settings are determined after 2021 to secure an orderly wind-down – it is this rate i.e. LIBOR in name but calculated on a changed methodology approved by the FCA that is referred to as “synthetic” LIBOR. This consultation on the FCA’s proposed decision to use its ‘methodology change’ power closed on 28 August 2021.

The FCA plans to consult in Q3 2021 on a proposed decision on precisely what legacy use to allow for any synthetic sterling and yen LIBOR and to confirm all final decisions in Q4. It is these legacy use contracts that will be the so called “tough legacy” contracts. The regulators have been clear that synthetic LIBOR for any such tough legacy contracts will be time limited and is intended as a safety-net only for contracts that cannot transition. Market participants are encouraged to continue active transition away from LIBOR wherever practicable and in line with relevant industry milestones, and not to delay their plans by waiting for a potential ‘synthetic’ solution.

What else to note?

LIBOR transition remains a regulatory priority. By way of reminder, Spring 2021 saw the official confirmation of the end of LIBOR across all currencies and tenors with a sequence of significant statements made on 5 March 2021:

• The IBA published the feedback statement on the results of its December 2020 consultation, including an announcement that, in the absence of sufficient panel bank support and without the intervention of the FCA to compel continued panel bank contributions to LIBOR, it would not be possible for the IBA to publish the relevant LIBOR settings on a representative basis beyond 31 December 2021 or 30 June 2023.
• The FCA published a statement announcing the dates after which panel bank submissions for all LIBOR settings will cease and confirming the future cessation and loss of representativeness of all LIBOR settings. The FCA announcement covered a range of LIBOR-related items including links to Statements of Policy with respect to its exercise of future powers, so called “Article 23A” and “Article 23D” powers, included in the FS Act.
• ISDA⁴ confirmed that the FCA's announcement constitutes "an index cessation event under the IBOR Fallbacks Supplement and the ISDA 2020 IBOR Fallbacks Protocol for all 35 LIBOR settings.” This means that the fallback spread adjustment published by Bloomberg is fixed as of 5 March 2021 for all euro, sterling, Swiss franc, U.S. dollar and Japanese yen LIBOR settings (including for the USD LIBOR settings that will be published until June 2023). For more information on the events of March 2021, please see our OnPoint, “Dechert on LIBOR – Officially the Beginning of the End”.

Although publication of USD LIBOR will continue on a representative panel bank basis until the end of June 2023, it is not to be used in new contracts. The remaining USD LIBOR tenors are only for use in legacy contracts, and for managing legacy LIBOR risk. There is a clear expectation that use of USD LIBOR in new contracts should stop by the end of this year, in the U.S. and in other key jurisdictions.⁵ The Federal Reserve’s Vice Chair for Supervision was emphatic when delivering a speech on 22 March 2021 – “there should be complete certainty about this guidance from U.S. regulators: after 2021, we believe that continued use of LIBOR in new contracts would create safety and soundness risks, and we will examine bank practices accordingly.” He also stated that “there is no scenario in which a panel-based USD LIBOR will continue past June 2023, and nobody should expect it to.”⁶ The Vice Chair also confirmed that Federal Reserve Board examiners have been instructed to assess supervised institutions' plans to transition away from the use of LIBOR and if they are not making adequate progress, examiners should consider issuing supervisory findings or taking other supervisory actions.

The PRA and FCA have confirmed that they are intensifying supervisory focus on firms’ management and oversight of the risks associated with transition and continue with their focus on the transition away from LIBOR.

On 26 March 2021, the PRA and the FCA published a joint “Dear CEO letter” on the transition from LIBOR to RFRs.⁷ The letter sets out a list of priority areas where further action by firms is necessary to prepare for the cessation of LIBOR. Key points in the letter include:

• Cessation of new sterling LIBOR business milestones – from 1 April 2021, the regulators do not expect to see incremental sterling LIBOR loan, bond, securitisation or linear derivatives business being written by PRA and FCA regulated firms and groups, unless specifically permitted within the RFRWG milestones. The regulators warn that any incident of sterling LIBOR referencing loan, bond or securitisation issuance after that date that expires beyond the end of 2021 would potentially be viewed as indicative of poor risk management and poor governance of transition.
• Active transition of legacy LIBOR exposures – the regulators expect firms to intensify efforts to execute plans to transition the stock of legacy LIBOR-linked contracts before the confirmed cessation dates of LIBOR, wherever it is feasible to do so. All legacy sterling LIBOR contracts should, wherever possible, have been amended by the end of Q3, 2021 to include at least a contractually robust fallback that takes effect upon an appropriate event, or, preferably, an agreed conversion to a robust alternative reference rate.

On 5 July 2021, the FCA’s Director of Markets and Wholesale Policy delivered a speech⁸ highlighting that while a great deal has been achieved, challenges remain. Emphasis was placed on making sure that all legacy contracts that can be converted are converted. Specifically, “[W]hether it is some form of active conversion, or use of fallbacks, you need to make an informed decision on when and how to transition your contracts.” The next WGRFR milestone is end-Q3 2021 where the expectation is that by this date market participants should complete active conversion of all legacy GBP LIBOR contracts expiring after end 2021 where viable and, if not viable, ensure robust fallbacks are adopted where possible.

Most recently, on 21 July 2021 the FCA and BoE published a statement⁹ encouraging liquidity providers in the LIBOR cross-currency swaps market to adopt new quoting conventions for interdealer trading based on RFRs instead of LIBOR from 21 September 2021.

U.S. Developments and Term SOFR

In addition to the statements regarding no new use of USD LIBOR referenced above, Guidance from U.S. regulators is that banks in the U.S. should cease entering into new contracts that use USD LIBOR as a reference rate as soon as practicable and no later than the end of 2021 – notwithstanding the fact that certain USD tenors will be published until 30 June 2023.

In support of this guidance, the CFTC’s Market Risk Advisory Committee’s Interest Rate Benchmark Reform Subcommittee voted to recommend on 26 July 2021 for switching interdealer trading conventions for USD linear interest rate swaps from USD LIBOR to SOFR. This switch has now taken effect and as a result SOFR swaps are the primary pricing point.

From 26 July 2021, USD LIBOR is expected to be accessible only as a basis swap to SOFR in the interdealer broker market. However, screens for outright LIBOR swaps and LIBOR-based swap spreads are expected to remain available for informational purposes, but not trading activity, until 22 October 2021. After this date, these screens are expected to be turned off altogether.

The availability of term rates has been a hot topic of discussion in LIBOR transition particularly for the U.S. dollar market. A significant recent U.S. development took place on 29 July 2021 when the ARRC formally recommended the forward-looking term rates based on SOFR published by CME Group, clearing the way for use of CME Term SOFR Rates in many cash products and some related derivatives, as well as for the purpose of measuring the performance of an investment fund. See, our OnPoint “Term SOFR is Here – The ARRC Recommends CME Group’s Term SOFR Rates for Use” that discusses this development in detail. The ARRC have also since published an FAQ on the scope of use of the SOFR term rate.

EU Developments

On 18 June 2021, the EU Commission, ESMA, the ECB Banking Supervision and the European Banking Authority (EBA) issued a joint statement¹⁰ on the forthcoming cessation of all LIBOR settings. The joint statement encourages market participants to actively reduce their exposure to LIBOR and not wait for the exercise by the EU Commission of its new powers to designate a replacement for LIBOR pursuant to the amended EU Benchmarks Regulation. They also strongly encourage markets participants to (i) stop using the 35 LIBOR settings, including USD LIBOR, as a reference rate in new contracts as soon as practicable and in any event by 31 December 2021, and (ii) limit the use of any ‘synthetic LIBOR” to tough legacy contracts and include robust fallback clauses nominating alternative RFRs in all contracts referencing LIBOR. The EU Commission, ESMA, the ECB Banking Supervision and the EBA also state that they will continue to closely monitor the situation and LIBOR exposures.

On 26 July 2021, ESMA published a document setting out recommendations from the EURFRWG on the switch to risk-free rates in the interdealer market. The recommendations, which were made at the Working Group's meeting on 1 July 2021, relate to two initiatives:

• The €STR First Initiative – the EURFRWG recommends as market best practice that interdealer brokers change RFR swap trading conventions from EONIA to €STR from 18 October 2021. This recommendation relates to the trading of RFR-based swaps and does not apply to EURIBOR-based swap trading.
• Cross-Currency Swaps Initiative – the EURFRWG support the recommendation of a common start date of 21 September 2021 for a switch of quoting conventions in the interdealer market for USD, GBP, CHF and JPY legs of cross-currency swaps. The EURFRWG encourages eurozone market participants to adopt this market practice, subject to supportive market conditions at the time. The EURFRWG has stated that it will continue to monitor the development of market liquidity and the demand from end users for cross-currency swaps with a EUR-denominated leg.

In other EU developments, on 3 August 2021 the EU Commission published consultations on:

• a draft Implementing Regulation on the designation of a statutory replacement for certain settings of CHF LIBOR. This consultation follows an earlier consultation on designating a statutory replacement rate for certain settings of CHF LIBOR in March 2021; and
• a draft Implementing Regulation on the designation of a replacement for EONIA, which will be discontinued from 3 January 2022. The designated rate will replace contractual references to EONIA in the EU on 3 January 2022. As mentioned above, the transition of EONIA to €STR is supported by EURFRWG.

The consultations closed to comments on 31 August 2021.

Globally, the message remains the same – the time to act is now.

Footnotes

1. The FCA webpage explaining the extent of the proposals.
2. EU Regulation 2021/168 amending Regulation (EU) 2016/1011 as regards the exemption of certain third-country spot foreign exchange benchmarks and the designation of replacements for certain benchmarks in cessation, and amending Regulation (EU) No 648/2012.
3. CP 21/15 “Benchmarks Regulation: how we propose to use our powers over use of critical benchmarks”.
4. For more details on the ISDA Supplement and Protocol, please see our OnPoint “LIBOR Transition – The Moment the Market has Been Waiting For”.
5. Stated in a speech given by Edwin Schooling Latter, the FCA’s director of markets and wholesale policy, on 13 April 2021 at the ISDA Benchmark Strategies Forum.
6. Stated by Randal K. Quarles in his Keynote Speech on 22 March 2021 at "The SOFR Symposium: The Final Year," hosted by the ARRC.
7. The joint FCA and PRA Dear CEO letter.
8. The speech “LIBOR - 6 months to go”.
9. The joint statement from the BoE and FCA to encourage market participants in a switch to RFRs in the LIBOR cross-currency swaps market from 21 September 2021.
10. The ESA’s Joint Statement.