FCA’s Edwin Schooling Latter elaborates on transitioning away from LIBOR

Despite the progress made in transitioning away from LIBOR, uncertainty remains on how this transition will happen exactly. These issues were addressed by Edwin Schooling Latter, Director of Markets and Wholesale Policy at the FCA in a speech delivered today.

The share of cleared sterling swaps referencing the Sterling Overnight Index Average (SONIA) grew to 19% in the second half of 2018, from 11% in the first half of 2016, Mr Latter noted. On a monthly basis, cleared notional in SONIA swaps is now higher than that for sterling LIBOR. London Clearing House (LCH) data also show growth has begun in use of swaps referencing the near risk-free-rates (RFRs) identified to replace yen, Swiss franc and US dollar LIBOR rates.

With regard to futures, daily trading volume in SONIA futures, and SOFR futures, both averaged 15,000 contracts per day in December.

Progress has been in made in bond markets too. The FCA saw a total of £6.9 billion in SONIA referencing sterling floating rate notes (FRNs) issued between June and December 2018. Already in 2019, by Wednesday last week, the FCA had seen a further £7.2 billion. If past weeks are a guide, new sterling FRN issuance is only SONIA-based now.

Regarding the transition from LIBOR, the FCA considers that the best and smoothest transition from LIBOR will be one in which contracts that reference LIBOR are replaced or amended before fallback provisions are triggered. It will likely be in market participants’ best interests to have moved away from LIBOR contracts to ones based on the RFRs before liquidity in LIBOR-referencing contracts has significantly declined.

In terms of how LIBOR will end, Mr Latter suggested one scenario to be that Intercontinental Exchange (ICE) Benchmark Administration, or IBA, ’the administrator‘ of LIBOR, announces in advance that it will cease the publication of particular currency-tenor combinations.

But cessation is easier for currency-tenor pairs that are little used. For the most commonly-used LIBOR rates, there may be loud demands to continue publication from those who were slow, and in some cases, unable, to transition away from LIBOR in their outstanding contracts. As more banks leave the LIBOR panels, the problem of capturing enough transactions to underpin robust calculation of the rate becomes more serious.

At this point, the requirements of the European Benchmark Regulation become relevant. Amongst these requirements, is for the administrator and for the supervisor of the benchmark administrator to assess the capability of a critical benchmark to be representative of an underlying market and economic reality. In the case of LIBOR, the supervisor is the FCA. The FCA is required to make this assessment of representativeness each time a supervised contributor – ie a panel bank – announces that it intends to stop submitting data.

So, it is entirely plausible that “the end” for LIBOR will include an assessment by the FCA that one or more panels have shrunk so significantly in terms of number of banks or the market share of the banks remaining, that it no longer considers the relevant rate capable of being representative.

The potential solution to prevent some disruption in cash markets is allowing continued publication of LIBOR for use in legacy instruments that do not have mechanisms to remove their dependence on LIBOR. Possibly, even some derivative contracts that are designed and entered to hedge such cash market contracts would also benefit from such a solution.

For the major derivative markets, not being able to enter, or clear, new contracts that reference LIBOR would make managing and hedging a back book of legacy LIBOR contracts risky and complex. It would, the FCA thinks, be extremely problematic for large back books of derivatives to remain on a non-representative LIBOR in this circumstance.

Mr Latter stressed that there is no certainty that a route to use LIBOR only for legacy contracts will be available. But the possibility should be considered in design of contractual fallbacks.

Mr Latter concluded by stating that he cannot provide certainty about what the end-game for LIBOR will look like. He urged market participants that still creating new contracts that reference LIBOR, and have a contract life beyond end-2021, to move rapidly to the new RFRs whose continued publication beyond that date can be relied upon.

UK regulators have been carefully examining the situation around LIBOR and the switch to alternative rates. In June, the Financial Policy Committee (FPC) of the Bank of England underlined the financial stability risks around Libor and warned that market participants continue to accumulate Libor-linked sterling derivatives for periods well after 2021.

In July 2018, Andrew Bailey, Chief Executive of the Financial Conduct Authority (FCA) stressed the need for market participants to be prepared for transitioning away from LIBOR. He made it clear that firms that the FCA supervises will need to be able to demonstrate to FCA supervisors and their PRA counterparts that they have plans in place to mitigate the risks, and to reduce dependencies on LIBOR. In particular, some firms will also have obligations to disclose and consider risks to investors when they sell LIBOR-related instruments, he explained back then.