Much of the clamour for reviving LIBOR was driven by sectors such as trade finance (and to a lesser degree the loan markets) with their structural problems with alternative backward-looking compounded risk-free rates. The need was thought to be two-fold – a continuation of a term rate that would work for new contracts and instruments as well as a rate that would allow existing ("legacy") LIBOR contracts to avoid a cliff-edge when mandatory panel rate submissions ended.
Under newly-forged regulatory powers and proposed legislation, the UK Financial Conduct Authority finally announced in late summer that it would create a form of synthetic LIBOR in an effort to reduce disruption to markets in relation to any critical benchmark that ceases to be published or that is designated as no longer representative of the reality it seeks to measure. Under the proposal, the FCA would direct LIBOR's administrator to continue to publish 1, 3 and 6-month GBP and JPY LIBOR under a changed calculation methodology so that the relevant settings may continue to be used for certain financial contracts and instruments. USD LIBOR's partial reprieve takes it outside the scope of this article, however US legislators have proposed their own intervention for the continuing use of USD LIBOR in contracts.
What has come to be known as "synthetic" LIBOR is something of a derived rate: where, in the absence of panel submissions, a rate is calculated taking as its baseline a forward-looking term risk-free-rate (RFR) to which is added a fixed spread adjustment for the relevant tenor, taking into account the historic difference between the underlying RFR and LIBOR. The spread will be the same one which ISDA has determined should apply to OTC derivative contracts which move from LIBOR to a compounded risk-free rate. The FCA believes that it is a reasonable and fair approximation of what the relevant LIBOR setting might have been had it not been discontinued.
There is then an argument that the fear of an unrepresentative benchmark, continuing beyond 2021 has passed, because the FCA's synthetic rate does not seek to resuscitate LIBOR. Nor is it a spectral form, based on historic numbers. But can market participants re-emerge, safe in the knowledge that danger has passed?
Not quite.
Crucially synthetic LIBOR will no longer be representative for the purposes of the UK benchmark regulations. It is therefore not for use in new contracts, like derivatives, bonds and mortgages, to which those regulations apply. Although those regulations td not apply to commercial loans, banks would be expected not to use it and it cannot be used for any hedging of new loans. It is therefore only a legacy solution and, despite the wider-than anticipated permitted use cases, the FCA continues to discourage the use of the non-representative synthetic LIBOR settings where appropriate alternatives are available.
Other risks include:
- The FCA has not, in fact, made any final decisions about the use of synthetic LIBOR in legacy contracts, pending the outcome of consultations. It may yet adopt a different calculation methodology, decide not to permit the use of synthetic LIBOR for certain products or sectors or simply decide not to create synthetic LIBOR at all.
- Synthetic LIBOR for a relevant tenor is also only intended to be an approximation of the equivalent LIBOR setting, and is not representative of the underlying markets. The behaviour of that rate and the economic consequences on both sides of the debt equation, may not echo that which we came to expect from LIBOR and will differ from the new compounded risk-free rate benchmarks.
- Synthetic LIBOR will not be published indefinitely. The FCA can only require synthetic LIBOR to be published for a maximum of 10 years. However, the FCA's decision to publish it must be renewed every year and so it may not be published after the end of 2022. (Synthetic Yen LIBOR will not be renewed after 2022.) Accordingly the prospect of synthetic LIBOR and any legislative transition effected will be limited for long-dated contracts and arrangements that may well out-live the expected lifespan of synthetic LIBOR.
- The FCA has the power to specify certain financial products that can be linked to synthetic LIBOR. However the underlying regulation restricts the use of LIBOR by supervised entities only in the context of certain financial contracts and instruments. Significantly this does not include commercial loans. Because the FCA's remit on the use of synthetic LIBOR is limited to the scope of the regulatory regime, that means the use of synthetic LIBOR in certain contracts or arrangements (such as commercial loans) that fall outside the scope of the regulations, will be unrestricted (similarly uncleared derivatives that are used to hedge loans are currently within the permitted use of the synthetic rates).
- The FCA may subsequently decide to prohibit certain stakeholders from referencing synthetic LIBOR in their contracts and financial instruments.
So how does synthetic LIBOR help the loan markets? The FCA's intervention is focused on minimising disruption and dispute by enabling legacy references to LIBOR to be interpreted as references to synthetic LIBOR (for so long as such rate is available), including provisions that seek to avoid any argument that the change is nevertheless fundamental enough to have altered the parties' initial contractual bargain.
Importantly as far as cessation triggers, contractual fall-backs and rate replacement waterfalls are concerned the draft legislation supporting the proposals enables parties to contract out of the interpretation 'override' effect and existing fallbacks should be preserved and apply in preference. It is not entirely clear how this might operate, and there is a risk that the override may yet cut across negotiated fallbacks and cessation triggers. If parties do not want synthetic LIBOR to apply, they may need to check the fallback provisions in their loan documents to avoid the legislation overriding their contractual intentions and applying a synthetic LIBOR rather than another alternative.
Special consideration must be given to finance-linked derivative transactions to ensure that the benchmark rate of interest and other conventions continue to follow the loan being hedged. Despite the existence of Supplement 70 to the 2006 ISDA Definitions and the ISDA 2020 IBOR Fallbacks Protocol, uncleared derivatives are considered by the FCA to form part of the universe of "tough legacy" contracts. However, whether synthetic LIBOR will apply to a particular uncleared derivative transaction will depend on a number of factors, including whether Supplement 70 and the pre-cessation triggers are applicable.
Where Supplement 70 and the pre-cessation triggers are applicable, the ISDA fallbacks should apply to the derivative once the relevant LIBOR has become non-representative at the end of 2021. These fallbacks should apply to the exclusion of synthetic LIBOR. This will then lead to an economic mismatch between the loan and the hedge as the loan would move to synthetic LIBOR and the derivative would move to a compounded risk-free rate. UK-based hedge providers are prohibited by the UK Benchmarks Regulation from writing new derivatives that directly reference synthetic LIBOR so they cannot amend the derivative to exactly match the loan. They could, however, reduce the mismatch by amending the derivative so that it is linked to the ICE Term SONIA Reference Rate – the key component of synthetic GBP LIBOR – as an alternative.
If Supplement 70 is not applicable, or it is but the parties have opted to disapply the pre-cessation triggers, then the derivative should automatically flip over to synthetic LIBOR once LIBOR ceases to be published in its current form. The derivative should therefore continue to match the loan.
The position described above should also hold true where the derivative incorporates the new 2021 ISDA Definitions.
Early suggestions that synthetic LIBOR would only be permitted for limited categories of "tough legacy" contracts, (where the transition to risk-free rates would be difficult) have not materialised and in that context the proposals are certainly a welcome addition to the toolkit for dealing with LIBOR transition, particularly for a broader range of contracts referencing GBP (and JPY). However the FCA, other global regulators and working groups continue to stress the need for active transition and structural change in the loan markets and there is a practical imperative for bond investors to want notes that pay and trade on a standardised basis and not be stuck with potentially illiquid holdings.
Whilst synthetic LIBOR may be the saviour from a potential cliff-edge, inaction without diligence is potentially dangerous and a switch to synthetic LIBOR may have unwanted economic implications.