A year since Financial Conduct Authority (FCA)’s announcement to phase out LIBOR by 2021, both the FCA and the Commodity Futures Trading Commission (CFTC) in July reemphasised the urgency for market participants to be able to demonstrate tangible progress on their transition away from LIBOR. The message, delivered in unison, was: “act now and be prepared to demonstrate that you have plans in place to mitigate the risks, and to reduce dependencies on LIBOR.”
On the 19th September 2018, the FCA and PRA also issued a joint letter to the leadership of banks and insurance firms requiring firms to identify an accountable Senior Manager and produce a transition plan along with a board-approved risk assessment by 14th December 2018. In the EU, the urgency to move away from EUR Libor, Euribor and EONIA is greater still, as the EU Benchmark Regulation (BMR) deadline for authorisation remains set for January 1, 2020.
The markets that reference Libor and Euribor exceed $440 trillion in size, making early cost estimates of the Interbank Offered Rates (IBORs) transition comparable to that of MiFID II. Adding to the mammoth scale of the challenge is the continuing uncertainty over Alternative Reference Rates (ARRs), the successor to LIBOR. The immaturity and differences in the construction of various ARRs also mean that they can perform differently during episodes of market stress, owing to their distinct methodologies and size of their credit components.
The International Organization of Securities Commissions (“IOSCO”) re-emphasised the importance of firms selecting appropriate benchmarks in a statement earlier this year. The statement cites examples of relevant considerations which include a benchmark’s representativeness of the market it seeks to measure – an increasingly complex consideration for LIBOR, inter-bank offered rates generally and ARRs.
The questions over the appropriateness of both IBORs and ARRs pose uncertainties over the future state of markets beyond 2021, challenges to the transition journey, as well as risks of mis-selling and litigation today. As Andrew Bailey made clear in his speech at Bloomberg this summer, “banks and investment firms … need to consider the design and risks of any new LIBOR-referencing instruments as part of their product governance obligations, considering and describing the impact of LIBOR discontinuation on those instruments.” In short, the cue is that banks should actively consider whether referencing LIBOR continues to be appropriate and disclose the risks associated with the benchmark, where they continue to reference it.
One immediate risk is around the suitability and appropriateness of products being sold. Compliance with the FCA principles demands that banks design products that meet identified needs, characteristics and objectives of the target market, over the life of the product. Firms are also required to pay due regard to the interests of the customers and communicate information in a way which is clear, fair and not misleading, taking into account the complexity of the product and the sophistication of the investor. As the representativeness of LIBOR wanes towards 2021, so too will its appropriateness for various clients and counterparties – heightening the risk of mis-selling and regulatory sanctions.
The ongoing uncertainty over LIBOR’s future also implies a heightened risk of litigation ahead. In fact, seventy-one percent of respondents to one poll believe the proposed transition will result in disputes. One such example is that, for bonds, floating rates may become fixed if LIBOR is discontinued. The ultimate fall back for bonds in standard documentation is to effectively resort to a fixed rate and, in many instances, this is likely to be either commercially unacceptable for or contrary to the original intention of the parties. This litigation risk lies in marketing and papering an instrument as a floating rate bond where ultimately it will not be – making a case for the investor having been mis-sold the product. In other cases, the uncertainty of the eventual transition to ARRs also presents litigation risk as there are likely to be winners and losers based on the transfer of economic value.
Regulatory expectations on the discontinuation of LIBOR beyond 2021 are clear. This is not a problem of the future; the ongoing transition poses significant conduct, reputational and legal risks in the here and now. Banks need to put their best foot forward and prioritise getting the “hygiene factors” right to prepare for safe and effective IBOR transition:
- Robust product governance processes which fully consider the ongoing appropriateness of LIBOR (as well as other inter-bank offered rates and the new ARRs)
- Relevant communications to clients are clear, fair and not misleading – particularly considering the disclosure duties under the Prospectus Directive
- Robust fallbacks which take into account the possibility of LIBORs discontinuation or material change – Andrew Bailey has been clear that too many firms are inadequately prepared in this respect (which is also a requirement of Benchmark Regulation and IOSCO)
- Dedicated Board oversight – Senior Managers will need to remain cognisant of their responsibilities to prevent regulatory breaches under the Senior Managers Regime.
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