The FCA welcomes the Government’s announcement today[1] that it intends to bring forward legislation to amend the Benchmarks Regulation (BMR) to give the FCA enhanced powers. These could help manage and direct an orderly wind-down of critical benchmarks such as LIBOR, and, in particular, help deal with the problem identified by the Sterling Risk Free Rate Working Group[2] of ‘tough legacy’ contracts that cannot transition from LIBOR.
The new powers proposed will be available where the FCA has found that a critical benchmark is not representative of the market it seeks to measure and representativeness will not be restored. The FCA and other authorities have been clear that those who can amend their contracts so that they move away from LIBOR at or before this point, should do so. For example, in this letter from the Financial Stability Board[3].
The legislation would empower the FCA to protect those who cannot amend their contracts in this way by directing the administrator of LIBOR to change the methodology used to compile the benchmark if doing so would protect consumers and market integrity. This is consistent with the recommendations put forward by the Sterling Risk Free Rate Working Group (RFRWG) in its Tough Legacy report in May. Although this would not make the benchmark representative again, it would allow the FCA to stabilise certain LIBOR rates during a wind-down period so that limited use in legacy contracts could continue, if suitable robust inputs to support such a methodology change are available.
The FCA will publish statements of policy on its approach to potential use of these powers following further engagement with stakeholders in the UK and internationally. Consistent with the transition to the risk-free rates (RFRs) that have been chosen in each of the LIBOR currency jurisdictions and supported by authorities in those jurisdictions, the FCA will seek stakeholder views on possible methodology changes that are based on those RFRs. It will also seek views on the consensus already established in international and UK markets on a way of calculating an additional fixed credit spread that reflects the expected difference between LIBOR and risk-free interest rates.
As the Government has noted in today’s statement, regulatory action to change the LIBOR methodology may not be feasible in all circumstances, for example where the inputs necessary for an alternative methodology are not available in the relevant currency.
Even if regulatory action to change the methodology enabled by the legislation is feasible, parties who rely on such action will not have control over the economic terms of that action. Any such methodology change may also be unable exactly to replicate the preferred structures expected to prevail in the new markets based on the RFRs.
The LIBOR transition process has already shown that a range of different approaches and rates will be appropriate for different product classes and users. The differing preferences of different markets cannot be achieved through a single methodology change. In particular, derivative markets and large parts of cash markets are expected to be predominantly based on realised overnight interest rates compounded in arrears at the end of a relevant interest period. For example, see this RFRWG paper[4]. International authorities have supported that preference, but this may not be possible to replicate within the restrictions of the existing LIBOR framework.
As the Government noted today, and as the RFRWG made clear in its May Tough Legacy report, market participants should continue to focus on active transition, as this is the only way for parties to have certainty about contractual continuity and control over their contractual terms when LIBOR ceases or is no longer representative. Work to substitute existing LIBOR references, or adopt sufficiently robust fallbacks, including through market standard documents, for example the documents produced by the International Swaps and Derivatives Association (ISDA), should continue.
Reducing the stock of outstanding LIBOR contracts referencing LIBOR, combined with wide adoption of ISDA’s protocol for outstanding derivative contracts, will increase the prospects that the FCA could use these proposed powers to address tough legacy needs in a way that maximises market integrity.
The FCA will continue to work closely with other UK authorities, the RFRWG and other market participants, and international counterparts, including through the Financial Stability Board’s (FSB’s) Official Sector Steering Group (OSSG), to help manage an orderly end to the LIBOR benchmark. This work will inform the FCA’s thinking on the factors affecting where and whether a change to LIBOR’s methodology could be appropriate and feasible, and what form any such change might take.
See further information for market participants following this announcement.