Synthetic LIBOR - More devils in the detail?

Counterintuitively, the suite of LIBOR regulatory reform measures has often served to actually stoke market confusion. Judging from client reactions, the FCA’s latest consultation adds to the list of measures in the ‘confusing’ category. In this blog we explore the CP21/29 consultation, place it in its proper context, explain what may be causing the confusing, and work on demystifying it. All is not as it seems!

FCA CP21/29

On 29th September the UK’s FCA issued a number of important market notices, which included a seemingly innocuous consultation paper CP21/29, Proposed decisions on the use of LIBOR (Articles 23C and 21A BMR).

CP21/29 follows on from previous, related consultations:

§  CP 21/15 of May 2021, on the FCA use of critical benchmark powers, and

§  CP 21/19 of June 2021, on GBP and YEN LIBOR settings.

The key to understanding CP21/29 is that it pertains to two quite specific areas of benchmark reform, to use the FCA’s own language:

1.       The decision on whether and how the FCA might permit legacy use of GBP and YEN Synthetic LIBOR settings after January 1st, 2022.

2.       The question of whether and how the FCA might prohibit new use of overnight, 1m, 3m, 6m and 12m US dollar LIBOR settings after January 1st, 2022.

While we will explore the prohibition of use of US dollar LIBOR settings in a later post, we focus here on the linked questions around whether and how the FCA might permit legacy use of GBP and YEN Synthetic LIBOR settings?

Grounds for confusion?

Since the sweep of LIBOR reforms commenced major global regulators have uniformly urged market participants to deal with legacy LIBOR contracts in two broad ways:

1.       amending contractual fallbacks; or

2.       conducting active LIBOR-ARR transitions.

 For those contracts that might “prove unable to convert or be amended” regulators in major jurisdictions have focussed extensive past-year efforts trying to determine how best to a) define, and b) accommodate post-cessation treatment of “Tough Legacy” contracts.

Exemplifying this, the Bank of England established a Tough Legacy Taskforce within the Bank’s Working Group on Sterling Risk-Free Reference Rates while the UK Parliament passed laws in early 2021 giving the FCA wide powers to deal with this issue. Similar US legislation passed the New York State Assembly in April 2021.

The combination of these various efforts and widespread common use of the descriptor “tough legacy” has not unreasonably led market participants to develop LIBOR-cessation plans on the assumption that the sub-set of products deemed “tough-legacy” would likely be narrowly defined in any jurisdiction. Further, that reliance on a regulatory response for contracts other than those deemed “tough” would be unwise.

Consider the FCA’s language under section 3, The Article 23C legacy use power:

Our proposed decision

3.1 We propose to permit legacy use of these 6 synthetic LIBOR settings in all contracts except cleared derivatives (whether directly or indirectly cleared).

3.2 We do not propose to apply any limitations or conditionality to the above permissions, at least before the end of 2022.

While the CP21/29 is not a foregone conclusion (consult responses are requested by 20th October), LIBOR exposed parties could infer that it hints at a 180-degree turn on the part of the regulator, and we wouldn’t blame them: 

§  Far from being narrowly defined, the availability of a Synthetic LIBOR for legacy GBP and YEN contracts will be exceptionally broad.

§  Parties to non-ISDA LIBOR-referencing contracts that have not yet transitioned (in any way) can now consider a third option: doing nothing.

§  Parties that elected to repaper contracts, particularly via common switch provisions, or who have actively transitioned deals already, may feel they were somewhat misled in the lead-in to their decision-making.

These reactions are not unreasonable, but that is not to concede that they’re warranted.

Martialis View

The “proposed decision” outlined in Point 3. CP21/29, should not be read in isolation.

Significant practical constraints to reliance on Synthetic LIBOR remain and market participants should carefully evaluate whether to utilise it, particularly where more robust alternative paths are clearly available.

Synthetic LIBOR could be thought of as a makeshift substitute to robust fallback or active transition, but important considerations, not limited to the following, should be carefully taken into account:

1.       The FCA’s preparedness for an all-contract use case is not open ended

While they have the power to compel IBA publication of a Synthetic LIBOR for up to 10 years, the extent of a commitment outlined in CP21/29 is to end-2022, to wit: they do not propose to apply any limitations or conditionality to the above permissions, at least before the end of 2022.

To be specific, under ARTICLE 21(3) BENCHMARKS REGULATION – NOTICE OF FIRST DECISION, of September 29th, the FCA state that: the compulsion period shall be for 12 months starting immediately after the final publication of the 6 LIBOR Versions (GBP and YEN) on 31 December 2021 and before the 6 LIBOR Versions would otherwise cease.

The FCA will regularly assess Synthetic LIBOR (annually is likely) and may discontinue its publication prior to the 10-year maximum allowed.

This should give significant pause for consideration to those who might otherwise accept what presents as an easier path past the end-2021 cessation event.

1.       Term-RFR use case limits across derivative markets remain unsettled

While a jurisdictional divide on this question appears to have opened up between the UK and US (and Japan), it’s clear that UK regulators have misgivings over unlimited Term-SONIA use.

For those who may subsequently seek term-rate hedges to replace Synthetic LIBOR in legacy deals, a downstream lack of use-case availability or liquidity should be a consideration.

However, we do note the use of Term SOFR in large syndicated deals in the US is becoming more common.

2.       Parties with fixed-rate products

In examples such as the hedged-facilities common across asset and infrastructure-finance, active reliance on Synthetic LIBOR for both facility and hedge (provided it is uncleared) should be carefully considered.

Subject to points 1 and 2 (above) this approach may hold advantages where parties attempt to preserve existing fixed rates, a topic we are particularly familiar with.

3.       New products and reference rates

With what appears like a ‘stay on execution’ of GBP and YEN LIBOR the markets will have additional time to develop new products and alternatives which may include term rates. These may be more suitable for some participants.

Firms will need to remain alert to these developments as many end-users have shown a preference for term rates such as Term SOFR and BSBY.

Conclusion

For those who feel they could have avoided transition or repapering costs/disruption, a degree of frustration at the FCA’s poorly telegraphed announcement could be expected. We believe it will be important for participants to better understand this topic, and how it actually adds to choices that need to, like so much in the post-LIBOR finance, be carefully evaluated.