January 28, 2019

While speaking at the ISDA Annual Legal Forum in London, Edwin Schooling Latter of FCA discussed "what the final steps in transition away from the London Inter-bank Offered Rate (LIBOR) might look like." He expressed his views in the backdrop of the UK's planned adoption of the Sterling Overnight Index Average (SONIA) as its risk-free rate to replace sterling LIBOR. He also discussed that a fallback LIBOR rate is being worked upon for use in legacy contracts after 2021. He emphasized that the best and smoothest transition from LIBOR will be one in which contracts that reference LIBOR are replaced or amended before fallback provisions are triggered.

Mr Latter highlighted that, last year, the market took a very significant step forward on the fundamentally important task of calculating a fallback rate that could replace LIBOR in outstanding contracts. ISDA took the lead on this, at the request of FSB’s Official Sector Steering Group (OSSG), which is the international forum where authorities from across the globe have coordinated their work on interest rate reform. Through its consultation, ISDA has successfully established a wide consensus across different types of market participants and across jurisdictions, on an appropriate, and appropriately fair, way of calculating a fallback rate that could substitute for sterling, yen, and Swiss franc LIBOR in contracts. This fallback rate relies on the risk-free rates identified for these three currencies (that is, SONIA, TONA and SARON). The ISDA consultation proposals attracted a wide consensus that the term element of LIBOR should be replicated by compounding of the observed overnight rates at the end of the relevant term. There are consultations yet to come on the U.S. dollar LIBOR and with regards to euro LIBOR and Euribor. 

At this point, the requirements of the European Benchmark Regulation become relevant. Among these requirements is a clear and unambiguous requirement for not only the administrator, but also for the supervisor of the benchmark administrator to assess the capability of a critical benchmark to be representative of an underlying market and economic reality. In case of LIBOR, FCA is the supervisor and it is required to make this assessment of "representativeness" each time a supervised contributor—that is, a panel bank—announces that it intends to stop submitting data. Thus, it is entirely plausible that the end-game for LIBOR will include an assessment by FCA that one or more panels have shrunk so significantly in terms of number of banks or the market share of the banks remaining, that it no longer considers the relevant rate capable of being representative. FCA would announce such a view if and when it is reached. Market participants would then need to consider the many potential negative ramifications of using a rate when its regulator had found it not to be reliably representative of the underlying market.

Mr. Latter mentioned that the share of cleared sterling swaps referencing SONIA grew to 19% in the second half of 2018, from 11% in the first half of 2016. Furthermore, with regard to futures, daily trading volume in SONIA futures and SOFR futures, both averaged 15,000 contracts per day in December. He also added that there is now a wide recognition that LIBOR is coming to an end. Thanks to an agreement reached with 20 panel banks to continue submitting until the end of 2021, LIBOR is not expected to cease before that point. However, there is uncertainty on how LIBOR will end. Therefore, FCA urges those still creating new contracts that reference LIBOR, and have a contract life beyond end-2021, to move rapidly to the new risk-free rates whose continued publication beyond that date can be relied on. FCA believes that the smoothest transition to LIBOR will be one in which contracts that reference LIBOR are replaced or amended before fallback provisions are triggered. Market participants should not rely on the availability of an option to use LIBOR for legacy contracts.

 

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Keywords: Europe, UK, Banking, LIBOR, SONIA, Reference Rates, Interest Rate Benchmarks, FCA

 

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