LIBOR transition Q3 2021 update – Safe Harbours and Synthetic LIBOR
- 6 LIBOR settings in GBP and JPY will be published on a changed "synthetic" methodology for 12 months following 1 January 2022
- Supervised users of all financial contracts other than cleared derivatives will be permitted to use these settings, which will apply as though the contract always provided for the change
- Where contractual fallbacks are triggered only on cessation or unavailability of the setting, the synthetic methodology will override the contractual fallback
- Where contractual fallbacks are triggered by non-representativeness or material change in the setting, the contractual fallback will prevail
- Where synthetic LIBOR settings apply, the effect is to switch to a forward-looking term RFR rate plus a spread
- New use of USD LIBOR settings that continue until June 2023 will be prohibited for supervised entities from 1 January 2022 subject to limited exceptions
We have now passed the end of the third quarter of 2021, the date set by the Sterling RFR Working Group for the completion of the active transition of financial contracts away from LIBOR. Our briefing in June outlined the roadmap to transition and the progress being made in the cash and derivatives markets. Some transition activity inevitably continues into the fourth quarter ahead of the final publication date for the majority of LIBOR settings at the end of the year. The question remains however - what happens to contracts which have not transitioned by 31 December 2021? Two recent publications provide some answers.
On 29 September 2021, the FCA published a Consultation Paper (CP21/29) on its proposals for use of its new powers under BMR in respect of 6 LIBOR settings in sterling and Japanese Yen, including the power to require the administrator of LIBOR to continue publication of those settings on a synthetic basis.
On 8 September 2021, the Critical BenchmarksBill (the Bill) was introduced to the House of Lords. The Bill introduces a "safe harbour" preventing contracts referencing LIBOR from being frustrated or breached by reason of the transition to a synthetic LIBOR rate.
This note explains how these two publications operate to determine the circumstances in which these synthetic fallbacks will apply.
Article 23A of the BMR gives the FCA the ability, in certain circumstances, to designate a critical benchmark such as LIBOR as an "Article 23A" benchmark, thereby prohibiting its further use by regulated entities, except where the supervisor permits legacy use of the benchmark. Permitting any legacy use naturally requires that there will be ongoing publication of the designated Article 23A benchmarks for parties to legacy contracts to use. For this purpose, Article 23D of the BMR enables the FCA to require the administrator of the Article 23A benchmark to continue publication on a changed or "synthetic" methodology.
As this change to the agreed LIBOR setting potentially raises questions of breach of contract, frustration and other issues, earlier this year HMT proposed introducing a "safe harbour" to deal with these issues, as well as questions of whether the agreed fallbacks or the statutory synthetic rate will prevail.
The Bill will, if enacted as drafted, insert a new Article 23FA into the BMR. The main provisions include:
- Article 23FA(1) of BMR which provides that references to a benchmark that has been designated as an “Article 23A benchmark" should continue to be interpreted as references to that benchmark after publication continues on a synthetic basis. Article 23FA(2) extends the operation of Article 23FA(1) to any benchmark that is not named but is described, and a benchmark which is an Article 23A benchmark falls within the description. Article 23FA(1) and (2) may be expressly excluded by contractual agreement;
- Where parties have referenced a benchmark in a contract before the Bill comes into force or before the benchmark is designated as an Article 23A benchmark, once the benchmark is designated an Article 23A benchmark the contract will be treated as if it has always provided for the reference to include the synthetic benchmark; and
- Unless the contract provides otherwise, the combined effect of this is to create a "safe harbour" preventing parties from arguing that the switch to a synthetic benchmark is a breach of contract, that there has been a material change to the contract, or that the contract has been frustrated.
The Bill also confirms in law the priority as between contractual fallbacks and Article 23A benchmarks that continue to be published. For this purpose the Bill defines a "fallback provision" to include a provision for the contract (a) to operate by reference to something other than the benchmark in question (temporarily or permanently), or (b) to terminate.
The Bill states that the new Article 23FA will not prevent the operation of fallbacks which are triggered by events other than the cessation or unavailability of the benchmark in question. However, if a fallback operates only on cessation or unavailability of the benchmark, the Bill operates to prevent the fallback taking effect, and references to the benchmark will instead be treated as references to the designated Article 23A benchmark which continues to be published on a changed methodology.
The Bill also provides that HMT can make further regulations as to i) instances in which Article 23FA(1) does not apply, ii) specific descriptions that may constitute a fallback and iii) specifying further cases, in addition to those which operate only on cessation or unavailability of the benchmark, in which contractual fallback provisions are not triggered.
Designation of 6 LIBOR settings as Article 23A Benchmarks
The FCA has now designated:
- 1 month, 3 month and 6 month GBP LIBOR; and
- 1 month, 3 month and 6 month JPY LIBOR,
as Article 23A benchmarks with effect from 1 January 2022, meaning these 6 LIBOR settings will become permanently unrepresentative of their underlying markets from 1 January 2022. From that date, supervised entities will be prohibited from using these LIBOR settings not only in new contracts, but also in legacy contracts entered into prior to 1 January 2022 except where the FCA permits such legacy use.
The FCA has confirmed that it will require ICE Benchmark Administrator (IBA), the administrator of LIBOR, to continue to publish the designated LIBOR settings on such a changed or "synthetic" methodology. It is the permitted legacy use of these synthetic LIBOR settings that is the primary focus of the consultation.
CP21/29 – permitted legacy use of synthetic LIBOR
The FCA now proposes to use its power to require publication of synthetic settings for an initial period of 12 months until the end of 2022. Under the BMR the FCA must review the use of its power to require publication of a ceasing benchmark at least annually (up to a maximum period of 10 years). The FCA has indicated there will be no extensions beyond the end of 2022 in respect of the JPY settings, and that the sterling settings will be published "at least" until the end of 2022.
The FCA proposes that it will permit legacy use of the 6 LIBOR settings above in all contracts except (directly or indirectly) cleared derivatives. This is a broader category of use cases than had been expected, with some earlier comments from the FCA suggesting that use of an Article 23A benchmark would only be permitted for certain categories of "tough legacy" contracts for which making the transition to risk-free rates would be difficult, such as consumer loans and mortgages.
CP21/29 – synthetic LIBOR v contractual fallbacks – which takes priority?
With respect to contracts that contain fallback language, the FCA makes the following comments:
- Fallbacks that operate only when the relevant LIBOR setting ceases permanently may not be triggered when the setting is designated as an Article 23A benchmark and continues to be published (this is confirmed in the Bill – see above), although whether or not it is triggered will depend on the wording of the contract in each case.
- Where the fallback operates on the permanent unrepresentativeness of the benchmark, the fallback rate will begin to operate at the time the setting becomes unrepresentative. LIBOR becomes unrepresentative on its designation as an Article 23A benchmark taking effect, so the contract will reference the fallback rate and not synthetic LIBOR from the 1 January 2022.
This raises some questions around the operation of fallback triggers in standard market documentation.
With respect to the ISDA IBOR Fallbacks Supplement, in the case of sterling LIBOR and JPY LIBOR, the fallback trigger includes the situation in which the FCA makes such an announcement that the benchmark will as of 1 January 2022 become unrepresentative of the underlying market and economic reality that the benchmark is intended to measure and that representativeness will not be restored. That has already happened, as the FCA made such a statement in March, as covered in our earlier briefing.
As a result, where parties have incorporated the ISDA IBOR Fallbacks Supplement into their derivatives contracts, the publication of the 6 synthetic LIBOR settings will not disrupt the operation of the fallbacks. All LIBOR settings became the subject of the earlier Index Cessation Event in March, and there is no need to use linear interpolation between the synthetic settings to arrive at a rate for the discontinued sterling and JPY LIBOR tenors.
As discussed in our briefing in March, the fallback triggers used in the loan market are more variable than in the OTC derivatives market. Parties will have adopted different versions of the fallback trigger event, depending on when the documentation was agreed (or subsequently amended) and whether the triggers were subject to further negotiation (including backstop dates). In many case key milestones (such as non-representativeness) simply trigger modified voting rules for the parties to agree pricing adjustments.
Most loan documents drafted based on earlier LMA forms will include a waterfall of pricing fallbacks (designed before LIBOR discontinuation was in contemplation) which purport to be triggered "if no Screen Rate is available for LIBOR". If the contract provides that the fallback is triggered only on the cessation or unavailability of the benchmark, the effect of the Bill will be to override the operation of the agreed fallback (or waterfall of fallbacks) and from 1 January 2022 the contract will be treated as referring to the LIBOR tenor as published under a synthetic methodology. This will need to be considered on a case-by-case basis according to the wording of the trigger. If the parties do not wish synthetic LIBOR to apply, they may need to renegotiate the fallback rate or amend the fallback language in the loan document.
CP21/29 – FCA encourages use of appropriate alternatives
Notwithstanding the broad application of permitted use, the FCA discourages the use of the non-representative synthetic LIBOR settings where appropriate alternatives are available. The mixed messaging is perhaps understandable following 4 years of encouraging market participants to transition in order to increase trading volumes in RFR-linked instruments, but it is not entirely clear what approach the FCA will take towards firms that choose to rely on the synthetic LIBOR settings where an appropriate alternative is viable.
The FCA has set out the reasons behind its decision to allow broad legacy use for the initial 12 month period. These include the following:
- The FCA is aware that there are significant numbers of contracts that do not contain pre-cessation fallback triggers (such as non-representativeness) and there is a risk of market disruption as of 31 December 2021 without permitted use.
- Ease of transition differs by class of financial instrument. The FCA takes the view that derivatives are straightforward to amend as they are bilateral and there are standard industry protocols developed for that purpose, however some uncleared derivatives contracts may still include unworkable fallbacks. Meanwhile, amending bonds requires consent solicitation and amending LIBOR-linked fee provisions in fund documentation can take several months.
- Some contracts are explicitly or structurally linked to other instruments that use the benchmark – e.g. where a derivative is embedded within a structured transaction, such as a securitisation or collateralised loan obligation, this may be an obstacle to transition away from a benchmark.
- Where only one (or some) of the parties are subject to the prohibition on use, there may be misaligned incentives to amend the contract on fair terms, thus a fallback to a statutory rate facilitates a fair transition.
- Distinguishing and setting out clear criteria for determining whether reliance on the synthetic rates is appropriate or not in any class of instruments is not possible in the time allowed. The only class of instruments for which permitted use is not necessary is cleared derivatives, as these will all transition from the LIBOR settings prior to the prohibition coming into force.
Nevertheless, the FCA makes very clear that synthetic LIBOR should not be relied upon indefinitely. If it appears that market participants are relying on synthetic LIBOR and continuously postponing transition, it may need to reconsider whether restrictions on permitted use are necessary for certain asset classes.
CP21/29 – Loan hedging
With respect to loan facility hedging, the FCA did not agree with feedback from market participants who argued that where a derivative is being used to hedge a cash product that is permitted to use synthetic LIBOR, the derivative must necessarily be permitted to use synthetic LIBOR as well. Where conversion of the derivative contract to a compounded RFR is unsatisfactory because an exact hedge is needed, the FCA believes that there may be other routes to achieving this, e.g. via an additional basis swap or conversion of the cash contract to the RFR rate.
However, the FCA has taken the view that given the small number of derivatives contracts that will remain referencing the relevant LIBOR settings once the prohibition on use takes effect, it is not beneficial at this point to attempt to delineate those that are structurally or explicitly linked to other permitted uses from those that are not, as the prohibition is due to come into force in a matter of weeks.
For the time being then, uncleared derivatives used to hedge a cash product are within the permitted use of the synthetic rates. It seems likely that the FCA will revisit these points in its annual review of its powers under the BMR.
CP21/29 – methodology for publication of synthetic LIBOR
At the same time as it published CP21/29 the FCA gave notice to IBA that it will require IBA to continue to publish the 6 sterling and JPY LIBOR settings after 1 January 2022 using two components:
- the relevant forward-looking term RFR; plus
- the ISDA credit adjustment spread for the relevant LIBOR setting.
For sterling LIBOR, the FCA has selected the ICE Term SONIA Reference Rate (TSRR) provided by IBA as a component for the purpose of producing 1-, 3- and 6- month sterling LIBOR settings under the changed methodology. The TSRR measures the expectation of SONIA interest rates over the relevant forward-looking time period.
For JPY LIBOR, the FCA has selected TORF as a component for the purpose of producing 1-, 3- and 6-month Japanese yen LIBOR settings under the changed methodology. TORF measures the expectation of TONA interest rates over the relevant forward-looking time period.
The ISDA credit adjustment spread is calculated based on a 5-year historical median spread between LIBOR and the corresponding RFR in-arrears and was fixed in March 2021 when the FCA announced the impending cessation of LIBOR. Fixing the credit adjustment spread at the point of the announcement ensured that the data used to calculate the historical median were not affected, or perceived to have been affected, by knowledge of the impending cessation.
Where contractual fallbacks are based on the RFR compounded in arrears plus either the ISDA credit adjustment spread or another negotiated spread, this synthetic setting is likely to give a different outcome from the replacement rate calculated using contractual fallbacks, in the event that the latter are overridden by the statutory provisions.
The consequence of the statutory fallback prevailing over a contractual fallback means that the forward-looking term SONIA rates, which to date the market has been discouraged from using except where the FCA has set out limited use cases, may be used indirectly through the use of synthetic LIBOR, at least for the year from 1 January 2022.
CP21/29 – New use of USD LIBOR settings
CP21/29 also sets out the FCA's proposals to use its powers under Article 21A of the BMR to prohibit new use of the overnight, 1 month, 3 month, 6 month and 12 month USD LIBOR settings, which IBA will cease to publish at the end of June 2023 (the 2023 discontinued USD settings). The prohibition on new use of the 2023 discontinued USD settings would take effect from 1 January 2022. The FCA proposes some exceptions to this, chiefly for market-making and risk management activity, novations and CCP auctions related to USD LIBOR transactions entered into prior to the end of 2021.
As we explained in our briefing in March, under the ISDA Fallbacks Supplement, when the other USD LIBOR tenors – i.e. the 1 week and 2 month tenors - are switched off at the end of 2021 (the 2021 discontinued USD settings), the tenors that continue to be published until June 2023 can be used to interpolate a replacement rate for the tenors discontinued at the end of 2021.
The FCA has therefore proposed a specific exemption from the prohibition on new use of the 2023 discontinued USD settings where they are being used for the purpose of such linear interpolation.
Note that the FCA expressly states that the 2023 discontinued USD settings are not expected to become unrepresentative until June 2023