The UK regulator, the Financial Conduct Authority (the FCA), has made it clear that will cease supporting LIBOR beyond the end of 2021. The process of transition to alternative rates is well underway and alternative ‘risk free’ rates (RFRs) have been identified for the five LIBOR currencies (GBP, USD, EUR, CHF and JPY), including the Sterling Overnight Index Average Rate (SONIA) and the Euro Short-term rate (€STR).
Two other euro rates are also undergoing change, alongside the discontinuance of LIBOR. The European Overnight Index Average Rate (EONIA) will be discontinued from January 2022 given that it does not comply with the EU Benchmarks Regulation (BMR) and replaced by €STR. In the interim period, from the first publication of €STR in October 2019 to EONIA’s discontinuance from January 2022, EONIA is being published as €STR pus a spread (known as ‘€STR+’), primarily to assist with the transition of relevant EONIA-referenced legacy contracts.
In addition, the Euro Interbank Offered rate (EURIBOR), which was originally expected to be discontinued in the same way as LIBOR, has, instead, been reformed using a hybrid methodology to meet the requirements of the BMR. The reformed rate received authorisation from the Belgian Financial Services and Markets Authority (FSMA) in December 2019 to continue being published and used by market participants after 1 January 2020. EURIBOR-referenced contracts may, nonetheless, need amendment given its longer-term existence is not certain and such contracts do, to some extent, incorporate EONIA as a reference rate or the basis for certain calculations.
Despite the likely impact of COVID-19 on firms’ transition programmes, in the UK the FCA, Bank of England and working group on sterling RFRs (the UK RFR WG, whose members include the FCA and the Bank) have indicated that the assumption that LIBOR will cease at the end of 2021 has not changed and that date remains the target for firms to meet. The Financial Stability Board has also indicated that LIBOR transition remains a priority to strengthen the global financial system and firms’ employees working on transition should be classified as ‘key financial workers’ for the purposes of COVID-19. While the ECB euro RFR working group (ECB RFR WG, whose members include the ECB, FSMA, ESMA, the European Commission and a number of European banks) and the FSMA have not, as yet, made similar announcements it is reasonable to assume that both bodies will take the same approach.
The UK regulators have, however, acknowledged that COVID-19 may impact firms’ progress and, in particular, firms’ achievement of the transition targets set by the UK RFR WG in January 2020 (one of which has already been revised by the WG - see further below). They have indicated that they will continue to monitor and assess the impact and update the market as soon as possible. In the interim, these targets remain in place and firms need to continue working towards them.
The transition process
The transition process continues to be significant and complex, both for firms transitioning large volumes of new and existing LIBOR, EONIA and EURIBOR-referencing contracts and for the working groups responsible for, and the industry bodies involved in, identifying alternative rates.
While alternative RFRs have been identified, work continues in relation to a number of aspects still to be settled. These include the development of forward-looking term rates based on RFRs, including SONIA and €STR, although the UK RFR WG is increasingly coming to the conclusion based on consultation and analysis that such rates may not be needed for the vast majority of the loan market which has been calling for them and instead on overnight SONIA rate compounded in arrears can provide the cashflow certainty desired by market participants. To assist in the development of this rate, following consultation, the Bank of England has confirmed that it will publish a SONIA-linked index from August 2020 to facilitate accurate rate calculations.
Work also continues in relation to legacy contracts and the development of fallback provisions and the potential triggers for these. This work includes such provisions for EURIBOR-referencing contracts, both existing and new, because, as mentioned above, although EURIBOR is continuing beyond 2021, its long-term future is not entirely certain and a number of EURIBOR products incorporate EONIA as a reference rate or as the basis for certain calculations.
Work is also ongoing in relation to ‘tough’ legacy contracts (those that cannot easily convert to RFRs or add fallback provisions). The UK’s ‘Tough legacy taskforce’ published a report in May 2020 indicating its preference for a legislative solution, similar to that proposed by the US’s Alternative Reference Rates Committee (ARRC), where legislation would prescribe a rate. Acknowledging that such a solution may not, ultimately, be possible, it proposes an alternative solution to be pursued in parallel, of a ‘synthetic methodology’ to facilitate the stable continuance of LIBOR for a wind down period following the expected panel bank departure after end 2021. It further acknowledges that ‘official sector’ intervention or a willing administrator would be required in order to modify LIBOR in this way.
In response to this, HM Treasury announced in June 2020 that it intends to bring forward legislation to amend the BMR (as onshored into UK law). This will provide the FCA with powers to direct the LIBOR administrator to alter the benchmark methodology so that certain LIBOR rates can be stabilised and used in limited legacy contracts during that wind down period. Nonetheless, it, and the FCA, have also reiterated the importance of market participants continuing to progress active transition as the only way to achieve contract certainty.
The stance of the regulators
The UK regulators have been increasing their pressure on UK firms to step up the pace of transition to RFRs and increasing their supervisory focus on firms’ transition implementation, emphasising that 2020 is the year to ‘turbo charge’ transition. The UK RFR WG announced in January 2020 a number of targets for 2020, including no new LIBOR-referenced cash products by Q3 2020 and a significant reduction of LIBOR-referenced legacy contracts by Q1 2021. The first target has since been revised in relation to the sterling loan market in light of COVID-19, now requiring lenders to be in a position to offer non-LIBOR referenced lending products by Q3 2020. The ECB RFR WG is also encouraging markets participants to transition relevant contracts ‘as soon as possible’, as well as updating standard documentation, IT systems and risk management procedures.
More specifically in the UK, following the announcement of the above targets, the UK regulators published letters to banks and insurers (January 2020) and asset managers (February 2020) setting out their 2020 transition expectations of firms. These letters followed the FCA’s conduct risk guidance in late 2019 intended to support firms in managing the conduct implications of transition and the PRA’s indication in December 2019 that is considering the prudential-related implications of transition.
While COVID-19 has begun to impact the progress of transition and the transition targets set in early 2020, it is clear that the UK and EU regulators continue to be committed to achieving LIBOR transition by the end of 2021 and expects firms to continue working towards that deadline. Firms which unreasonably delay or slow their pace of transition are likely to face close regulatory scrutiny and pressure to step up their commitment.
© Slaughter and May 2020
While COVID-19 has begun to impact the progress of transition and the transition targets set in early 2020, it is clear that the UK and EU regulators continue to be committed to achieving LIBOR transition by the end of 2021 and expects firms to continue working towards that deadline.