Financial Markets

Switching from the London interbank offered rate (Libor) to an alternative interest rate benchmark is a journey not only fraught with very real operational challenges, but also poses some tricky conduct issues as well. By Henning von Sachsen-Altenburg, a partner at McCarthy Denning.

The reference rate (sterling) Libor is expected to cease at the end of 2021, when the voluntary agreement of banks to submit their rates to the Libor reference rate ends and it is replaced by a number of risk-free rates (RFR) which have been developed recently to avoid the risk of market manipulation and distortion. The RFR recommended by the market-led Risk-Free Rate Working Group is the Sterling Overnight Index Average Rate (Sonia), but other RFRs are available and firms will have to decide which alternative rate they want to adopt. Firms using Libor will have to take swift action to implement the transition to the chosen RFR because liquidity in products referencing Libor is expected to reduce significantly earlier than its cessation date. 

The transition to an RFR will be a thorny one as it will force firms currently using Libor as a reference rate to find internal consensus on a suitable alternative reference rate, integrate a new RFR methodology into their current operational set-up, business model and systems, and engage with clients and customers to agree the new RFR before they begin the Herculean task of implementing the agreed replacement rate into their existing documentation. While internal changes to the governance system, the business model and the responsibility framework remain subject to the existing legal or regulatory requirements (such as existing  consumer legislation, the Senior Managers and Certification Scheme and the Senior Management Arrangements, Systems and Controls), it is the front-office client engagement and the implementation of the transition where most of the conduct risk arises. 

To help market participants, the Financial Conduct Authority (FCA) issued a Q&A document about conduct risk during the Libor transition. The document was first published on the FCA website on November 19, 2019, and will be occasionally updated. The paper was welcomed by the market-led RFR Working Group, a group of market participants, market associations and the FCA co-ordinated by the Bank of England.

Market participants will have to demonstrate that they have taken reasonable steps to treat customers fairly in deciding which RFR they use to replace Libor. The transition cannot be used to impose an overall higher interest rate or more inferior terms on customers. This may sound easy, but the economic terms of the replacement RFRs currently on offer do not necessarily mirror Libor terms. This also applies to the term ‘credit risk’, which is reflected in Libor but not currently in other RFRs. Further, regulators are still analysing whether these RFRs and their providers are stable and reliable enough to receive regulatory approval. 

New fallbacks 

In addition to the implementation of a replacement RFR, firms will also want to include robust fallback provisions into their product documentation to allow a further replacement of the reference rate in case their chosen RFR ceases to exist at some point. 

‘Robust’ in this context not only means that these fallbacks enable a quick and simple way to replace the reference rate but also that the replacement mechanism takes account of the interest of customers and treats them fairly. 

The FCA, like other regulators, is pressuring market participants to switch rates while recognising that the market is far from finding a consensus in many areas and that firms must judge the timing of the replacement and which rate to use. 

However, the FCA also states that firms can feel safest when ‘moving with the pack’, following market consensus established through appropriate consultation and recognised by relevant national and international working groups and associations (such as the International Swaps and Derivatives Association) as an appropriate solution. 

Whether replacing references in their existing products or issuing new ones with different RFRs, firms will have to explain clearly to their customers what they are trying to do and the risks for the customer. 

The way firms should do this will be influenced by the terms of their existing products which can be a problem given the vast variety of products and terms in circulation. Communication will have to be clear, concise, fair and unambiguous. It is impossible for firms to prepare for all potential responses from their customers but firms will have to react to each response in a fair and adequate way to reduce conduct risk effectively. This is something that will stand in the way of any wholesale approach firms may be tempted to take. In particular large market players have started gearing up with huge sums spent on technology, legal expertise and manpower for their global implementation exercises. 

Even the timeline is somewhat governed by the need to mitigate conduct risk. Delaying outreach to customers to the point where the customer has insufficient time to react is considered unfair and increases conduct risk. Therefore, outreach preparations should be thorough and systematic to avoid chaos. This should consider that customers have different degrees of sophistication and as such deserve a differentiated approach.

Speaker’s Corner: A Speakers' Corner is an area where open-air public speaking, debate and discussion are allowed. The original and most noted is in the north-east of Hyde Park in London

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