Synthetic Libor powers give FCA ‘massive discretion’

Consultation on use of new benchmark clout may not limit safety-net rates to economic realities

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The UK financial regulator’s new powers for averting chaos in Libor’s stickiest contracts may be more potent than some envisaged, as two amendments set to be inserted into the UK’s iteration of the European Union Benchmarks Regulation would allow the Financial Conduct Authority to alter the methodology underpinning flimsy rates without limitation. 

In a consultation launched on November 18 about how it would exercise clout afforded under the Financial Services Bill currently passing through the legislative process of the UK parliament, the FCA left the door open to revamp waning benchmarks in ways that may not reflect the economic reality of markets they intend to measure.

“This gives the FCA massive discretion as the amendments can allow them to deviate and make the methodology whatever they think is OK in this context,” says Diego Ballon Ossio, senior associate at Clifford Chance. “It’s an interesting and wide-ranging power, and the way they’re proposing to exercise it, I don’t think is in line with what participants were expecting.”

The proposals set out a two-pronged approach for saving “tough legacy” contracts, which cannot be re-hitched to alternatives ahead of Libor’s demise after the end of 2021. Under Article 23A, the FCA could designate a benchmark as non-representative, preventing its use in new contracts. Article 23D allows the regulator to compel publication of a benchmark for up to 10 years and impose new methodology requirements on the benchmark administrator to keep a synthetic version on screen.

In exercising this power, the FCA states its “intention generally” to take into account the underlying economic reality of the market measured by a benchmark prior to it acquiring Article 23A status. The regulator also states its intention to use powers in a way that ensures “least disturbance or disadvantage” to affected parties.

While there’s no official limitation on how far a synthetic rate could deviate from its original guise – a disappointment to some participants – Guy Usher, co-head of financial markets and products at law firm Fieldfisher, says concerns may have been overplayed. 

“It’s important to remember the FCA has to exercise these powers for certain purposes – to preserve market integrity and protect consumers. With such a generic piece of legislation it’s very hard to be specific, and in theory there’s no limit on what it could be. But they’re not going to do that without consulting with everyone,” says Usher.

Some say the roadmap towards a synthetic Libor may already be pushing the boundaries of what may constitute a deviation from the economic reality of the original benchmark.  

This gives the FCA massive discretion as the amendments can allow them to deviate and make the methodology whatever they think is OK in this context

Diego Ballon Ossio, Clifford Chance

The FCA plans a separate consultation in 2021 on the exercise of these powers with respect to Libor’s demise, but this week’s one lays out a blueprint for synthetic Libor as part of the wider discussion around Article 23D.

This would ditch panel bank submissions in favour of formula-based methodology based on a term version of the relevant successor risk-free rate (RFR) plus a fixed spread adjustment, representing term bank credit risk that is included in Libor but absent from the overnight rates.

The spread adjustment would be calculated as a five-year historic median spread between Libor and its successor RFR – the same methodology that has been established for swaps fallback language following an industry consultation by the International Swaps and Derivatives Association.

“Our provisional view is that this is a fair and robust way of approximating the outcome delivered by Libor,” says the FCA in its consultation.

Yet the absence of a dynamic credit element that changes as that risk shifts – and use of a secured RFR in the case of US dollar markets – may fundamentally alter the nature of the index for holders and issuers of cash market instruments, including loans and bonds, for participants who may not have been party to derivatives-related consultations. 

“Going with the Isda definition for these tough legacy cash markets is going to cause trouble,” says Sharon Freeman, consultant for Anetevorta Consultants. “The FCA is saying the industry has accepted this method to calculate the credit component, but there’s a huge disconnect between derivatives dealers and the real economy. We need to think about what’s happening on the cash side and not just have this as a Wall Street initiative.”

The FCA’s power to require the use of a synthetic Libor in new contracts may also be limited – particularly outside the UK, where it has no jurisdiction to impose Article 23A.

Overseas firms, including their UK-based branches, could continue to use the synthetic Libor index in contracts. What’s more, the legislation only applies to the benchmark’s use in “financial contracts” within the context of the Benchmarks Regulation. This excludes loans and many other financial instruments.

According to Clifford Chance’s Ballon Ossio, this could put UK firms at a disadvantage compared to overseas competitors in a range of activities.

“UK-supervised entities are at a disadvantage if they need to make some limited use of Libor for hedging rolling-off transactions or if they need to use post-trade risk reduction techniques which would generate new offsetting contracts referencing Libor. That is because non-UK firms accessing the UK market – including those with UK branches – do not immediately qualify as supervised entities,” he says.

He adds these issues largely reflect the policy as expressed in the legislation “but it seems odd that the FCA is not acknowledging the resulting issues.”

Overseas meddling

The breadth of the UK regulator’s new-found super-power regarding the fate of legacy Libor contracts globally has been a cause of concern across the Atlantic, where transition to SOFR is slower. As regulator of Ice Benchmark Administration – administrator of 35 Libor currency/tenor pairs – the FCA could force fundamental changes in sterling, dollar, euro, Swiss franc and yen-denominated interest rate benchmarks. 

Market participants widely expect dollar Libor’s life to be extended after its administrator, Ice Benchmark Administration, confirmed on November 18 that the world’s most-tracked benchmark would be excluded from its consultation on plans to axe all settings in the four remaining currencies after the end of 2021.

The FCA states it would only exercise synthetic Libor powers under Article 23D in the event it is necessary to prevent a disorderly wind-down, for example due to a mass of tough legacy contracts, and if appropriate inputs – namely term versions of the relevant RFR – are available. Sonia is the only RFR with available term rates, but these are still in beta-testing mode and are unavailable for use in contracts.

Swiss franc and euro Libor are unlikely to meet these conditions, the regulator says, given limited contract volume and the lack of term RFRs. It adds sterling Libor does meet those conditions and the policy framework would also be “relevant” to dollar Libor.

“I suspect if the UK legislative solution is used, it will be used mostly on dollar Libor, just because it’s so prevalent and used for so many different purposes,” says Fieldfisher’s Usher.

Others say the UK regulator would rather avoid meddling in US contracts, not least because of proposed federal legislation that would offer a litigation safe harbour when US contracts are re-hitched to alternatives. These proposals are still being debated, however, and may only cover US contracts and entities.

“In respect of sterling, I think the roadmap is relatively clear and they’re going to do the two-pronged approach under the Financial Services Bill. In respect of other currencies, the question is whether, despite the global efforts, the FCA perceives a risk of a disorderly wind-down or not,” says Ballon Ossio.