FCA moots synthetic Libor as rates fallback

Once Libor is allowed to die, replacement could be risk-free rate plus fixed credit spread

Andrew Bailey
Andrew Bailey: FCA has discussed with industry what the fallback could be

Existing derivatives contracts could be amended to reference a synthetic Libor rate should the benchmark cease to be produced after 2021, according to Andrew Bailey, chief executive of the UK’s Financial Conduct Authority (FCA). The fallback rate would be created by adding a credit component onto a dynamic, risk-free rate – potentially helping to avoid a sharp transition if Libor is abandoned.

Banks have agreed to continue participating in Libor-setting panels until that point – and the FCA has new powers to prevent drop-outs – but in a speech this morning, Bailey said the regulator would not ask contributors to continue indefinitely. A four- or five-year period is thought necessary for the market to transition away from Libor, he said.

“Our intention is that, at the end of this period, it would no longer be necessary for the FCA to persuade, or compel, banks to submit to Libor. It would therefore no longer be necessary for us to sustain the benchmark through our influence or legal powers,” he said.

The FCA oversees the Libor submission process for all currencies. 

If Libor was abandoned after the FCA ends its support for the benchmark, Bailey said there would be two ways of dealing with legacy Libor-linked swaps. Option one is to amend the contract to reference an alternative risk-free rate (RFR), such as reformed Sonia in the UK, or the broad Treasuries repo rate in the USbut lawyers say this option may require banks to post initial margin against the amended trades, adding potentially huge additional costs.

Option two is to change the contract’s fallback clauses, which specify the rate to reference should the original benchmark cease to exist. The choice of fallback is important, because it could produce a step-change in the value of contracts, or prevent them acting as an effective hedge.

Bailey said the FCA has discussed with industry what the fallback could be, and that a potential rate could be composed of an RFR as a base, with a buffer on top composed of “a one-off set of term credit spreads”. This would resemble Libor, which reflects both market interest rates and bank credit risk. Bailey did not say which credit spreads would be used.

The fallback clauses in existing swap contracts could be changed by protocol, he said. The International Swaps and Derivatives Association has previously said it could create a protocol to amend fallback clauses in legacy contracts, and Scott O’Malia, the group’s chief executive, says they will continue working with members on the issue.

“The most obvious concerns are ensuring adequate liquidity in the new rates, development of acceptable term fixings, agreement on a strategy to address legacy contracts and ensuring that the entire marketplace understands the changes and is prepared to move in the expected timeframes,” says O’Malia.

“Isda and its members are also actively working to develop and implement fallbacks for contracts, including legacy contracts, that continue to reference Libor and other inter-bank offered rates,” he adds.

In one currency-tenor combination, for which a benchmark reference rate is produced every business day using submissions from around a dozen panel banks, these banks, between them, executed just 15 transactions of potentially qualifying size in that currency and tenor in the whole of 2016
Andrew Bailey, FCA

The Libor rate relies on a panel of banks submitting estimates of their unsecured funding rates in different currencies and maturities to an administrator, which has been Ice Benchmark Administration (IBA) since 2014. Bailey, however, said a lack of transactions in the unsecured markets was making panel banks feel uncomfortable about providing submissions.

“To take an extreme example, in one currency-tenor combination, for which a benchmark reference rate is produced every business day using submissions from around a dozen panel banks, these banks, between them, executed just 15 transactions of potentially qualifying size in that currency and tenor in the whole of 2016,” he said.

The European Benchmark Regulation gives the FCA the power to deem a rate “critical” and force banks to submit rates to the panel, but these powers only last for a maximum of two years. The European Commission deemed Euribor a critical benchmark in August 2016, and Eonia followed suit on June 28 this year after the departure of Commerzbank, Crédit Agricole, KBC and UBI Banca from the submission panel in recent months.

Bailey said two years is too short a timeframe to transition the swaps market away from Libor. Instead, he said the FCA has obtained commitments from banks to voluntarily remain on the panels until the end of 2021.

“This date is far enough away significantly to reduce the risks and costs of a more sudden change. By having a date by which transition will need to be complete, however, we give market participants a schedule to plan to, and make it easier for them to engage as many counterparties and Libor users as is practicably possible in that planning,” said Bailey.

He said the changeover of the overnight rate in Switzerland from the current unsecured tomorrow/overnight index (Tois) to the Swiss average rate overnight (Saron) index has shown having a target date to work towards helps the transition process. Tois will be discontinued on December 30, kick-starting a race against the clock to prepare the Swiss swap market for the move to Saron.

From the start of 2022, Bailey said it would be up to IBA and the panel banks to decide whether to continue producing Libor rates. A spokesperson for IBA welcomed Bailey’s comments, but said they believed an evolved Libor rate had a future.

“Users want an International Organization of Securities Commissions-compliant, trusted rate, that is available every day for the entire curve. Our evolution for Libor is based on banks’ broad wholesale funding and minimises the use of subjective judgement unless necessary, to ensure that the rate can continue to be calculated even in the most extreme market conditions where transactions might not be available. Having consulted with regulators and over 1,000 market participants, we believe that the evolved Libor has a long-term sustainable future,” said the spokesperson.

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