Libor transition: Preparing for the twilight zone

UK authorities are preparing for the final phase of the Libor transition, where most ‘mainstream’ contracts have been amended or replaced to deal with the discontinuation of the benchmark but where a limited number of products, the ‘tough legacy contracts’, have not been modified. The statement also nods at the Working Group on Sterling Risk-Free Rates’ decision to maintain the end-2021 deadline for the Libor transition even if intermediate milestones have been slightly pushed back due to Covid-19.

According to the statement, the FCA will have sufficient powers to ‘manage an orderly transition from Libor’. In practice, this means the regulator will be able to direct administrators to change the methodology should a benchmark lose its representativeness without hope of recovering it. Note also that the UK government’s approach is to modify the existing regulatory framework rather than impose direct changes to contracts. The stated aim here is to protect consumers and to ensure market integrity.

This should go some way to allay concerns that if more panel banks stop contributing to Libor, its diminished reliability and unwarranted volatility would negatively impact parties exposed to tough legacy contracts. This will prove particularly important at the end of 2021 when the publication of Libor will no longer be guaranteed and as some contracts cannot be modified to stop referencing Libor.

In addition, the FCA should also gain power to limit the use of a benchmark should it lose its representativeness, and to ensure administrators have appropriate plans in place to wind Libor down. Here too, the legislation appears intent on making sure regulators have the appropriate tools in case private parties are unable to carry out the appropriate steps.

Note however that these steps should not be taken as an alternative to private parties negotiating alternatives to Libor on their own, as this is the only way for them to retain control over the economic impact of the transition. To that end, relevant industry bodies, such as ISDA, the LSTA or the LMA, are undergoing work to provide alternatives to Libor.

In mandating alternative benchmark methodologies, the FCA said in a separate communication that it intends to pay due regard to efforts by the private sector and other relevant authorities in providing fallback terms to Libor. It warns, however, that this may not always be possible. The FCA said it will publish statements on how it intends to use its new powers following consultations. Watch that space.