Tough legacy and synthetic LIBOR

Introduction

A recent spate of publications - namely the FCA's September "tough legacy" consultation, HMT's proposed Critical Benchmarks (References and Administrators' Liability) Bill and (most recently) the FCA's questions and answers addressing the impact of September's designation of certain sterling and yen LIBOR rates as Article 23A benchmarks under the UK Benchmarks Regulation (UK BMR) and the future use of synthetic LIBOR - collectively provide much-needed clarity on the scope and operation of the UK's tough legacy and synthetic LIBOR regimes.

Broadly, key points are:

• the vast majority of sterling LIBOR English law contracts, both in and out of scope of the UK BMR, will migrate to synthetic sterling LIBOR - in the short term at least. Affected counterparties will be statutorily precluded from asserting breach of contract, material adverse change, or frustration upon the switch;
• similarly, market standard cessation triggers will be statutorily precluded from being activated upon a switch from LIBOR to synthetic LIBOR, but market standard pre-cessation triggers will be unaffected;
• synthetic sterling LIBOR will be published and available for unrestricted use until the end of 2022. Thereafter, it will be subject to annual FCA review for potential renewal and/or the imposition of use restrictions; and
• the FCA expects market participants to continue their transition efforts and not rely on the availability of synthetic LIBOR over the longer term.

Questions and answers

In the Q&A below we consider the impact of these developments in greater detail. For more information on LIBOR transition generally, and to access our previous publications, please visit our LIBOR Transition Hub.

Q: How will synthetic LIBOR be calculated?

A: Synthetic LIBOR will be calculated as the sum of:

• the forward-looking term rate for the applicable tenor based on either (i) IBA's ICE Term SONIA Reference Rate or (ii) the Tokyo Term Risk Free Rate provided by QUICK Benchmarks Inc.; and
• the applicable spread adjustment published by Bloomberg Index Services Limited for use in fallback rates under Supplement 70 to the ISDA 2006 Definitions.

Q: Will synthetic LIBOR rates be published on the same screens as LIBOR rates?

A: This is a vital question for contractual continuity, and it appears from the FCA Q&A that this is the expectation.

Q: Which of the designated rates will continue in synthetic form?

A: One-month, three-month, and six-month sterling and yen LIBOR will continue in synthetic form after the end of 2021.

Q:What about US dollar LIBOR?

A: One-month, three-month and six-month US dollar LIBOR are expected to remain representative until 30 June 2023. Given this extended time frame, the FCA is prioritising the sterling and yen rates and will decide in due course whether any of the US dollar rates should continue in synthetic form after June 2023.

Q: For how long are the designated rates likely to continue in synthetic form?

A: Under the UK BMR, the FCA has the ability to compel continued publication of the designated rates for up to ten years, one year at a time and subject to annual review - although, according to the FCA consultation, unrestricted use of synthetic sterling LIBOR is only guaranteed for one year, until the end of 2022.

The FCA has indicated in previous consultations that it only intends to compel publication of the affected yen rates for a year, until the end of 2022. It is likely that the affected sterling rates will continue for longer than a year (possibly on a restricted basis, as discussed above), but in the Q&A the FCA notes that it intends to intervene for as short a time as possible to ensure an orderly wind-down.

Q: Will the Critical Benchmarks Bill affect my contractual fallback provisions?

A: Possibly. Many contracts contain "cessation" fallbacks, which are activated by an official announcement that a rate has been discontinued or will be discontinued on a particular date. There has been debate around whether a switch to synthetic LIBOR would activate these triggers, with some market participants arguing that a change in a rate's methodology would effectively give rise to an entirely new rate, causing the original rate to "cease" and triggering the fallback provisions. Based on the provisions set out in the Critical Benchmarks Bill, this argument will not be possible and any "cessation" trigger will only be activated on the cessation of the synthetic rate, which may be several years from now.

Q: What about pre-cessation triggers?

A: Pre-cessation, or "non-representative" triggers, are activated by an official announcement that a rate is either no longer representative of its underlying market, or will not be representative of its underlying market from a particular date.

These triggers are unaffected by the provisions of the Critical Benchmarks Bill. Most triggers of this nature were activated for the following rates by the FCA's announcement of 5 March 2021:

(a) 1m, 3m, and 6m GBP LIBOR;
(b) 1m, 3m, and 6m USD LIBOR; and
(c) 1m, 3m, and 6m JPY LIBOR.

Once a trigger has been activated, most fallbacks will take effect after the rate in question stops being representative. This will be on 1 January 2022 for the sterling and yen LIBOR tenors mentioned above, and on 1 July 2023 for the US dollar LIBOR tenors mentioned above. In ISDA terminology this date is referred to as the Index Cessation Effective Date.

However, where a contract's fallback provisions provide for it to fall back to the last published rate under the contract (as with, for example, older euro medium term notes) , the Critical Benchmarks Bill suggests that this may not take effect and that the synthetic rate may need to be used instead.

Q: Has there been an Index Cessation Event under my contract?

A: That depends on how the triggers are drafted.

Cessation and pre-cessation triggers: many up-to-date market standard contracts (including derivative contracts incorporating the standard form fallback provisions contained in Supplement 70 or the ISDA 2020 IBOR Fallbacks Protocol) contain both cessation triggers and pre-cessation triggers. If this is the case, subject to the specific provisions, an index cessation event will have occurred in respect of all LIBOR currency/tenor combinations under those contracts on 5 March 2021. Generally, this means that the fallbacks will take effect on the date on which the rate ceases to be published or ceases to be representative of its underlying market, or at some point thereafter.

Cessation triggers only: pre-cessation triggers were not widely incorporated into contracts until mid-2020, so contracts pre-dating this may only contain cessation triggers. In these contracts, assuming that they contain market standard drafting incorporating triggers that would be activated by a statement of future cessation by a rate's administrator or the applicable regulatory supervisor, an index cessation event will only have occurred in respect of those rates for which there is a known cessation date. These rates are:

(a) GBP LIBOR: Overnight, one-week, two-month, twelve-month;
(b) USD LIBOR: Overnight, one-week, two-month, twelve-month;
(c) JPY LIBOR: all rates¹;
(d) EUR LIBOR: all rates; and
(e) CHF LIBOR: all rates.

Q: Has an Administrator/Benchmark Event (as defined in the 2018 ISDA Benchmarks Supplement and the 2021 ISDA Interest Rate Derivatives Definitions) been triggered in respect of any of the designated rates?

A: No. In order to trigger an Administrator/Benchmark Event, use of the benchmark in question must be officially prohibited under a particular contract. The broad scope of the tough legacy regime is permissive, allowing the continued use of synthetic LIBOR under a very wide range of contracts. As such, other than in cleared derivatives, there is currently no prohibition on use of the designated rates, and therefore no activation of an Administrator/Benchmark Event trigger. However, if use restrictions are introduced after 2022, they may activate provisions of this nature.

Q: Is use of synthetic LIBOR permitted in derivative contracts that are hedging LIBOR loans?

A: Yes – for now. Restrictions may be introduced after the end of 2022.

While the majority of derivative contracts contain adequate fallbacks, either because they are cleared through clearing houses or because they have been amended by the ISDA IBOR Fallbacks Protocol, the FCA consultation notes that there are a significant number that do not. The FCA considers that there are few genuine obstacles to transitioning these contracts on fair terms. For example, the consultation notes that derivatives are bilateral agreements, often between sophisticated financial entities, and that there are market standard amendment methods available to facilitate transition.

Going further still, the FCA says that it does not agree with market participants' assertions that, where a derivative is being used to hedge a cash product that is permitted to use a synthetic rate, the derivative must also be permitted to do so. In such cases, the FCA suggests that basis swaps could be used to mitigate divergences, or that the loan itself could be transitioned as well. The FCA does, however, acknowledge that derivatives that are structurally linked to other uses of the designated rates, such as those used in securitisation structures, do need continued permitted use. The FCA intends to continue its analysis throughout 2022, as discussed above.

Q: Assuming synthetic LIBOR is continued after 2022, how likely is it that the FCA will restrict its use?

A: It's hard to say, but the FCA clearly plans to monitor transition progress very closely. The FCA consultation suggests that the decision to permit such broad tough legacy use initially was driven in part by the fact that more time is required to establish exactly which categories of contracts (particularly derivative contracts) genuinely need the ability to continue to reference the designated rates after the end of 2021. It therefore seems likely that the FCA's analysis will continue throughout 2022, with restrictions possibly being introduced at a later date.

The FCA also suggests in the consultation that it may consider introducing time limits and/or other restrictions at the end of 2022 if market participants' ability to rely on synthetic rates in the short term leads to a marked drop in transition efforts (as to which, see below).

Q: As "tough legacy" will be extremely broad, do I still need to transition away from the rates that are going to continue in synthetic form?

A: Yes. The scope of tough legacy is broader than originally anticipated, and will permit the vast majority of English law contracts² referencing the designated rates to migrate to synthetic LIBOR initially. However, the FCA has said that the ability to use synthetic LIBOR should be viewed as "bridging" tool only, providing market participants with additional time to transition to RFRs if they have not yet been able to do so. The FCA's message to market participants is clear: transition efforts are expected to continue in earnest; synthetic LIBOR is not a permanent solution; and if market participants postpone transition efforts as a result of these developments, use restrictions may be imposed.

In any event, publication of synthetic LIBOR is only guaranteed until the end of 2022. Thereafter, use of synthetic LIBOR in contracts that are in scope of the UK BMR may be restricted or time-limited, particularly if market participants postpone their transition efforts in light of the initial broad scope.

<sub>1. This is based on the following statement in the FCA's June 2021 consultation (CP21/19):
"For Japanese yen LIBOR settings, we advise market participants now that we intend to compel only for one 12-month period until end-2022, after which point publication of Japanese yen LIBOR will cease."
2. The exception being cleared derivatives, which already contain adequate fallbacks through clearing house rules.</sub>

Authors: Alex Biles, James Knight, Mike Logie and Kirsty McAllister-Jones