FCA confirms broad tough legacy approach and restricts use of USD LIBOR

Key points

•  The FCA's final tough legacy regime is in line with the approach proposed in its recent consultation.
• Unrestricted use by UK BMR supervised entities of synthetic one-month, three-month, and six-month GBP and JPY LIBOR can continue in all non-transitioned legacy contracts except for cleared derivatives until the FCA notifies otherwise.
• Synthetic JPY LIBOR is expected to be discontinued after 31 December 2022, while synthetic GBP LIBOR may continue for up to ten years.
• The FCA may impose restrictions or conditions on the use of synthetic LIBOR if it considers this necessary, including if publication of synthetic GBP LIBOR continues beyond 31 December 2022.
• Notwithstanding the broad tough legacy parameters, the FCA expects market participants to transition away from LIBOR wherever possible.
• The FCA has officially prohibited new use by UK BMR supervised entities of overnight, one-month, three-month, six-month, and twelve-month USD LIBOR after 31 December 2021, subject to certain exceptions.

Tough legacy regime

Unrestricted use of synthetic LIBOR

On 16 November 2021, the UK's Financial Conduct Authority (FCA) published a Notice of Permitted Use by Supervised Entities (Notice) confirming its approach to the use of synthetic LIBOR in so-called tough legacy¹ contracts under the UK Benchmarks Regulation (UK BMR).

The approach is in line with proposals set out in the FCA's recent consultation (Consultation) (discussed in this briefing) and will permit the use²  by supervised entities of one-month, three-month, and six-month synthetic GBP and JPY LIBOR (Permitted Rates) in all in-scope legacy contracts other than cleared derivatives that have not transitioned to an alternative rate by 31 December 2021. Unrestricted use of the Permitted Rates may continue until the FCA changes or withdraws the permission.

The Notice confirms the view expressed in the Consultation that time limits and/or conditions on Permitted Rates' use may be introduced if necessary, including if publication of synthetic GBP LIBOR extends beyond the end of 2022 (also see Calculation and duration of synthetic LIBOR below).

The Notice is currently only published in draft form but the final form, which is expected to be published when the Permitted Rates' designation as "Article 23A benchmarks" takes effect on 1 January 2022, is not expected to deviate from the draft.

Calculation and duration of synthetic LIBOR

The FCA confirmed in September 2021 that the Permitted Rates will be calculated as the sum of the forward-looking term rate for the relevant currency/tenor combination and the applicable ISDA fixed spread adjustment published for use in fallbacks documented under the ISDA IBOR Fallbacks Supplement³ .

Publication of the Permitted Rates is expected to continue at least until the end of 2022. Thereafter, synthetic JPY LIBOR is expected to be discontinued, so any JPY LIBOR contracts or instruments that are due to mature after 31 December 2022 will need to be remediated in the meantime.

GBP LIBOR may continue for up to ten years (subject to annual review), although the FCA only intends to compel GBP LIBOR publication for as short a time as is necessary to ensure an orderly wind-down.

Modifications to UK BMR

The FCA has the power to modify the UK BMR as it applies to synthetic LIBOR, to ensure that it is appropriate for the amended LIBOR rates. On 16 November 2021, the FCA notified ICE Benchmarks Administration (IBA) of proposed amendments to the UK BMR and associated delegated acts as they apply to synthetic LIBOR, to remove or modify certain provisions, including those that require the exercise of discretion by IBA where IBA is acting on instructions from the FCA.

Regulator expectations

In a related press release, the FCA reminds lenders to treat customers fairly, communicate with borrowers promptly, and ensure that they consider all options in good time, echoing the themes addressed in its LIBOR conduct Q&A. In the same press release, the FCA reiterates its message to market participants that synthetic LIBOR is not a permanent solution and contracts and instruments need to be transitioned wherever possible.

Furthermore, in the Notice, the FCA emphasises that market participants are expected to address "promptly and appropriately" any non-compliance with Article 28(2) of the UK BMR, which requires supervised entities to maintain robust written plans setting out the actions they would take if a particular benchmark were to change materially or be discontinued.

Restriction on use of USD LIBOR

On 16 November 2021, the FCA officially restricted the use by UK BMR supervised entities of overnight, one-month, three-month, six-month, and twelve-month USD LIBOR after 31 December 2021.

Although these rates are expected to continue and remain representative until 30 June 2023, they will not be available for new use⁴  by UK BMR supervised entities after 31 December 2021, except in the case of:

1. market making undertaken at the request of a client seeking to reduce or hedge USD LIBOR exposure on contracts entered into before 1 January 2022;
2. transactions that reduce or hedge the supervised entity’s or any client of the supervised entity’s USD LIBOR exposure on contracts entered into before 1 January 2022;
3. novations of USD LIBOR transactions executed before 1 January 2022;
4. transactions executed for the purposes of participation in a CCP auction procedure in the case of a member default, including transactions to hedge the resulting USD LIBOR exposure;
5. interpolation or other use provided for in contractual fallback arrangements in connection with one-week or two-month USD LIBOR (which are due to be discontinued from 31 December 2021); or
6.  new single currency USD LIBOR basis swaps entered into in the interdealer broker market.

These are all broadly in line with the FCA's original proposals, except that additional clarifications have been made in respect of 1 above to confirm that:

• market makers executing such trades for their clients may accumulate USD LIBOR risk as a result of this activity; and
• market makers do not need to check the client's intention on every trade, but are expected to make "all reasonable efforts" to ensure that the client is aware of the USD LIBOR prohibition and to engage with them on the extent to which the prohibition has been taken into account.

Related Developments

On 15 November 2021, the Euro risk-free rate working group wrote to the European Commission, suggesting that the EU and UK approaches to tough legacy contracts be aligned through the designation of synthetic GBP and JPY LIBOR as statutory replacement rates for GBP LIBOR and JPY LIBOR, respectively. The letter acknowledges that divergences between the UK BMR and the EU Benchmarks Regulation (EU BMR) may give rise to challenges in this regard, but highlights the fact that a consistent approach would help achieve legal certainty for market participants.

Under the EU BMR, a public consultation is required before a statutory replacement rate can be designated, so if the EU adopts this approach the necessary consultations would need to be launched soon.

Finally, the Critical Benchmarks Bill (discussed in this briefing), which is designed to address residual risk to contractual certainty in respect of legacy English law LIBOR contracts, has passed through the House of Lords and is undergoing review by the House of Commons. It is expected to be enacted by the end of 2021.

Authors: Amelia Howison, Kirsty McAllister-Jones, and Mike Logie

_{1   LIBOR-referencing contracts that cannot reasonably be converted to an alternative rate before 31 December 2021.
2   Within the meaning of the UK BMR definition of "use".
3   Supplement 70 to the 2006 ISDA Definitions.
4   Within the meaning of the UK BMR definition of "use".}