UK Benchmarks Regulation and tough legacy FCA consultation on use of new powers

Key points

• The FCA is consulting on the factors that it should consider when (i) determining the scope of permissible legacy usage of benchmarks which have become permanently unrepresentative (legacy use power), and (ii) deciding whether to restrict new use of an outgoing benchmark such as USD LIBOR (new use restriction power).
• The consultation will inform related policy statements, that will be published in due course.
• A more focused consultation on specific tough legacy requirements is expected in Q3 2021.
• The tough legacy rules will not be finalised until Q4 2021.
• A consultation on synthetic LIBOR is also expected soon.
• HM Treasury intends to implement safe harbours for tough legacy contracts that continue to reference synthetic LIBOR.

Overview

On 20 May 2021, the Financial Conduct Authority (FCA) published a consultation (Consultation) on how it intends to use certain of its new powers under the UK Benchmarks Regulation (UK BMR).

The Financial Services Act 2021 (the 2021 Act), which received Royal Assent last month, amends the UK BMR to give the FCA broad new powers (UK BMR powers) with regard to critical benchmarks such as LIBOR. The powers include the ability to restrict new use of any benchmark that is due to be discontinued and the ability to designate a benchmark an "Article 23A benchmark" if it has become or is at risk of becoming unrepresentative.

Following any such designation, UK supervised entities would be prohibited from using the benchmark under the UK BMR, except in certain "tough legacy" contracts. The FCA can also compel the continued publication of an Article 23A benchmark on the basis of an altered methodology, so any continued use in a tough legacy contract would be use of the altered rate. In the case of LIBOR, this would give rise to so-called synthetic LIBOR, which the FCA has suggested is likely to be based on an appropriate forward-looking term rate plus the applicable spread adjustment. A further FCA consultation on the specifics of synthetic LIBOR is expected soon.

Although the 2021 Act establishes the framework for the UK's tough legacy regime, it does not specify what constitutes tough legacy or when exemptions from the general prohibition would apply.

Unfortunately, the Consultation also stops short of providing this critical piece of the tough legacy puzzle. Instead, it sets out the factors that the FCA proposes to consider when determining the tough legacy criteria and deciding whether and how to exercise the UK BMR powers.

The Consultation closes on 17 June 2021 and the responses will inform related policy statements to be published in due course. A further consultation on specific proposed tough legacy criteria is expected in Q3 2021 and the FCA plans to confirm the scope of the regime as early as practicable in Q4 2021. This means that firms will not know until October at the earliest which of their legacy products fulfil the tough legacy criteria and will be granted a reprieve from transition.

You can read more about the UK BMR powers, synthetic LIBOR and related matters in our briefings on our LIBOR Hub.

Tough legacy carve-outs

In the Consultation, the FCA explains how it intends to decide whether and how to exercise its power to permit the continued use of an Article 23A benchmark in tough legacy contracts (the legacy use power). The overriding objectives of the legacy use power would be to avoid market disruption, protect consumers and maintain financial stability.

The FCA sets out the following two broad considerations in this regard, which drive the content of the rest of this section of the Consultation: 

1. the scale and nature of legacy contracts that do not contain adequate provisions to deal with a prohibition on use of a referenced benchmark; and
2. the degree to which it is feasible for parties to amend such contracts in a way that delivers fair outcomes.

Scale and nature of legacy contracts without adequate fallback provisions

The Consultation:

• asks respondents for their views on what types of fallback provisions might lead to unintended, unfair or disruptive outcomes, or prove inoperable in practice, if a critical benchmark could no longer be used;
• suggests that the FCA would be more likely to exercise the legacy use power in respect of retail contracts, particularly where retail consumers could be adversely affected; and
• proposes that the legacy use power would only be used if there were enough contracts of a particular type without adequate fallback provisions to cause market disruption or threaten financial stability.

Feasibility of amendment

The Consultation asks for respondents' views on a number of additional factors that it considers relevant, including:

• whether appropriate alternative rates are available and how widely they are used;
• how feasible it would be to amend the contract, including consideration of the level of consent required, the ease (or otherwise) of identifying relevant parties, and the nature of the amendment process. For example, the FCA notes that if a contract is held by a very large number of parties and all of them must consent to the amendment via a defined consent solicitation process, this may not be feasible;
• whether standard documents or protocols are available to assist in the amendment process (such as the ISDA 2020 IBOR Fallbacks Protocol);
• the nature of the contracting parties, including whether less sophisticated retail customers are involved;
• whether certain of the contracting parties are not within scope of the prohibition, putting supervised entities at a disadvantage;
• whether contracts of a similar type have been amended; and
• how much notice the parties have had of the prohibition and its likely effect.

Further considerations

The Consultation asks for feedback on the following additional proposed considerations:

• the effect that exercise of the legacy use power would have on the sustainability and robustness of related benchmarks: if continued use of a LIBOR rate were permitted, this would stop contracting parties under relevant contracts from moving to the applicable risk-free rate (RFR). This would reduce the volume of derivative transactions referencing that RFR, and in turn would jeopardise the representativeness of any related RFR-based term rate. It appears at present that synthetic LIBOR is likely to be based on term rates, so any such loss of representativeness would compromise the integrity of synthetic LIBOR;
• international consistency: where a contract is not governed by English law but one or more parties is subject to the UK BMR, this could cause confusion as to which regime applies. There is particular industry concern that the UK's tough legacy regime could conflict with new legislative regimes in the EU and the US that contemplate an automatic replacement of discontinued rates with adjusted RFRs;
• legal requirements to include suitable fallback provisions: since 1 January 2018, UK supervised entities have been required to have in place robust written plans specifying alternative benchmarks to apply on the discontinuation of a referenced benchmark. Where fallbacks are required but not present, the FCA says that it may exercise the legacy use power to protect consumers but may also take action to address the regulatory non-compliance, such as imposing conditions on continued benchmark use; and
• the degree to which it is possible to prescribe clear, practicable criteria applicable to any continued use.

The Consultation also suggests that the FCA may permit continued use on a limited basis and/or for specific purposes, such as for a limited time period or in order to calculate a final termination payment, and asks for respondents' views on this.

Restriction on use of outgoing benchmarks

Where the administrator of a critical benchmark has officially notified the FCA that it intends to discontinue a benchmark, the FCA is empowered to prohibit some or all new use of that benchmark (an outgoing benchmark), even if it remains representative until discontinuation (the new use restriction power). By way of example, the FCA cites the USD LIBOR maturities that are expected to cease or become unrepresentative on 30 June 2023, suggesting that it is considering using the new use restriction power in respect of those rates. This would also align with guidance provided by US authorities as to the continued use of such rates by US entities. 

The new use restriction power can only be used by the FCA where doing so would advance its consumer protection and/or integrity objectives. Again, the FCA suggests that it would be more likely to intervene in retail contracts, and says that the new use restriction power would only be used where the anticipated new use of a relevant benchmarks was significant. Given the widespread use of LIBOR, the Consultation notes that this is likely to be the case.

When assessing consumer protection and integrity risks, the FCA suggests a number of factors that it considers relevant and asks for respondents' views. These include:

• a staged transition away from a benchmark would prevent a potentially disruptive "big bang" approach, with new and legacy use transitioning at the same time, which could lead to market disruption;
• unexpected volatility and/or impacted liquidity caused by poor input data and a reduction in the benchmark's use over time could cause market disruption or consumer harm; and
• continued new use of an outgoing benchmark could stop market participants from transitioning to new alternative rates, impacting liquidity.

As with the considerations applicable to the legacy use power, the FCA says that it will take into account any actions taken - or not taken - by non-UK authorities. It will consider in particular whether divergent approaches could impact UK entities' ability to access liquidity and effectively hedge their positions. The FCA also says that it will need to consider the extent to which it is possible to provide clear, practicable and understandable restriction criteria.

Further considerations

The FCA is also considering when it would not be appropriate to exercise the new use restriction power, including where the new use is aimed at risk management of legacy exposures, or where suitable replacement benchmarks are not yet available for use.

Finally, as with the legacy use power, the FCA says that it might consider using the new use restriction power in a limited way, for example so that it is restricted to certain maturities, to certain product types and/or users, or so that it only applies for a defined time period.

What next?

While the Consultation provides helpful insight into the FCA's planned considerations around the exercise of the UK BMR powers, we still do not have the answer to the crucial question "What is tough legacy?". This will be disappointing for market participants who were expecting this Consultation to provide robust guidance around which of their legacy contracts might be expected to fulfil the tough legacy criteria and be granted a reprieve from transition. As it is, we remain in a "wait and see" situation, with affected market participants unable to finalise their transition analysis until the rules are agreed in Q4 this year.

Separately, HM Treasury has confirmed that it plans to bring forward new legislation to implement certain safe harbours for tough legacy contracts that reference synthetic LIBOR. Among other things, the safe harbours would give contracting parties protection from liability where a non-representative rate, such as synthetic LIBOR, continued to be used under the tough legacy regime. 

Authors: Mike Logie and Kirsty McAllister-Jones