Conduct risk during LIBOR transition

LIBOR is used as the interest rate benchmark to price or value a wide range of financial products, including but not limited to:

• mortgages
• commercial and personal loans
• bonds
• securitisations
• derivatives

LIBOR is being wound down and there are now clear end dates for all of the LIBOR panels. Firms therefore need to find suitable alternatives to LIBOR. The market-led Risk Free Rate Working Group (RFR Working Group[1]) recommends the Sterling Overnight Index Average rate (SONIA) as the preferred risk-free rate (RFR) to replace Sterling LIBOR[2]. We and the Bank of England (‘the Bank’) support transition to SONIA and alternative rates.

Many firms are affected, including:

• investment banks
• asset and wealth managers
• insurers
• retail banks
• building societies and mortgage lenders
• other intermediaries such as advisors and brokers

For many firms, LIBOR transition will involve:

• developing and offering new products linked to RFRs and other, appropriately robust alternative rates
• assessing and reducing their own and clients’ exposure to legacy LIBOR contracts by amending or replacing existing contracts to either:
  • include robust fall back provisions and or
  • replace LIBOR with RFRs or an alternative rate
• for firms investing on clients’ behalf, avoiding/managing risks relating to LIBOR discontinuation by either:
  • investing in RFR-linked instruments
  • engaging issuers of LIBOR-referencing securities, and derivative and loan counterparties, to convert LIBOR-linked instruments and products to alternative reference rates, eg through consent solicitation processes or buy-backs for bonds and or compression or other conversion exercises for derivatives

Even where a firm does not itself provide or distribute products linked to LIBOR, it may have links to LIBOR in its systems, or in its contractual relationships with other firms. While the following questions focus on conduct, firms also need to consider operational, financial resilience and business model risks posed by LIBOR transition. 

Firms’ senior managers and boards are expected to understand the risks associated with LIBOR transition and take appropriate action to move to alternative rates.

What to do

Firms should have robust governance arrangements[3] for managing risk in their business. Insufficient preparation for transition from LIBOR to alternative rates could:

• impact on the safety and soundness of firms
• cause harm to clients and the market

So, where appropriate, firms that are subject to the Senior Managers and Certification regime (SM&CR)[4] that are impacted by LIBOR transition should:

• identify the Senior Manager responsible for overseeing transition away from LIBOR
• detail those responsibilities in the relevant Senior Manager’s Statements of Responsibilities (SoRs)

FG 19/2 Senior Managers and Certification Regime: Guidance on statements and responsibilities and Responsibilities Maps for firms[5] contains more information on what firms should do in this regard.

Firms must also have effective processes and controls to identify, manage, monitor and report risks to their business, including risks associated with critical outsourced functions. Firms have existing obligations to this effect such as SYSC 4.1.3R[6], SYSC 7.1[7] and SYSC 8.1[8]. Firms must also identify and prevent or manage conflicts of interest (SYSC 10[9]).

Firms need to consider whether any LIBOR-related risks are best addressed within existing conduct risk frameworks or need a separate, dedicated program.

Firms also have obligations to:

• act with due skill, care and diligence
• make and retain adequate records

What to consider

Firms will need to consider how to meet these obligations in the context of LIBOR transition. This may include, for example, keeping appropriate records of management meetings or committees that demonstrate they have acted with due skill, care and diligence in their overall approach to LIBOR transition and when making decisions impacting customers.

It’s important firms recognise LIBOR transition is likely to impact multiple:

• business lines
• operational areas, and,
• geographical regions (for firms with international business)

For many, LIBOR transition will impact their overall business strategy and front-office client engagement, rather than being a narrow legal and compliance risk. Potential impact and risk therefore needs to be considered and addressed in an appropriately coordinated way across a firm.

Firms will, where possible, need to amend contracts for LIBOR-linked products with their customers to ensure the products continue to operate effectively once LIBOR is no longer available (whether it is no longer published or no longer available for use in the product). This may include:

• inserting robust fall back provisions in existing contracts (taking effect before or at the time of LIBOR cessation or unrepresentativeness) and/or
• converting the contract to reference an alternative rate

Contracts relying on LIBOR may not perform as customers expect them to, both when LIBOR is no longer available and potentially before that because liquidity in LIBOR-referencing instruments is likely to decline.

Treating customers fairly when replacing LIBOR

An overarching concern for us will be whether firms have taken reasonable steps to treat customers fairly.

In choosing replacement reference rates, considering the contract as a whole, firms need to ensure the replacement rate is fair and should consider the following:

• LIBOR discontinuation should not be used to move customers with continuing contracts to replacement rates that are expected to be higher than what LIBOR would have been, or otherwise introduce inferior terms. We will pay close attention to any case where a contract amendment is made in this way as firms may be failing to meet their obligation to treat customers fairly.
• When transitioning their existing contracts, firms receiving LIBOR-linked interest are not expected to give up the difference between LIBOR and SONIA, which results from the term credit risk premium that is built into the LIBOR rate, but not into SONIA.

Firms that insert fall back provisions in existing contracts to replace LIBOR with a new reference rate, should ensure they communicate effectively how these fall back provisions are expected to operate (eg whether clauses operate at, or before cessation, and on what basis).

Firms will also need to consider whether any contract term they may rely on to amend a LIBOR-related product is fair under the Consumer Rights Act 2015 (the CRA) in respect of consumer contracts. FG18/7: Fairness of variation terms in financial services consumer contracts under the Consumer Rights Act 2015[10] contains factors that firms should consider when thinking about fairness issues under the CRA when they draft and review unilateral variation terms in their consumer contracts.

We continue to support industry initiatives to reach agreement on fair replacement rates, including work done by the International Swaps and Derivatives Association (ISDA)[11] and the RFR Working Group.[1]

Firms are more likely to be able to demonstrate they have fulfilled their duty to treat customers fairly where they adopt a replacement rate that aligns with the established market consensus, reached through appropriate consultation, and is recognised by relevant national working groups as an appropriate solution.

ISDA’s work on fall back rates has identified a broad consensus for calculating a fair replacement rate in LIBOR derivatives, receiving substantial support across the market, including both payers and receivers of floating rates. ISDA has now finalised its documentation which sets out the parameters of adjustments that will apply to derivatives fallbacks for certain interbank offered rates (IBORs). The RFR Working Group has also undertaken further work to consider how to calculate a fair replacement rate for use in fall backs for legacy cash products (such as bonds and loans).

As part of our involvement in these industry initiatives, we have emphasised the importance of ensuring these are progressed in compliance with competition law.

However, firms must ultimately exercise their own judgement on when and how to remove LIBOR dependencies in legacy contracts.

The most effective way to avoid LIBOR-related exposure is not to write new LIBOR-referencing business, and to transition to alternative rates, taking into account the considerations on selecting a fair replacement rate outlined above.

Substantial consensus has been established across multiple jurisdictions that a fair way to approximate the expected future difference between LIBOR and risk-free rates (RFRs) such as SONIA, from the point that LIBOR can no longer be published on a representative basis or ceases, is to take a historical median of that difference. The median will sometimes be below or above the actual market prices on any given day prior to LIBOR ceasing. In spring 2020, for example, as financial markets reacted to the impact of coronavirus (Covid-19), the spread between LIBOR and SONIA moved substantially above the then 5-year historical median. The spread then moved below the 5-year historical median due to various market factors, which likely included the significant expansion of liquidity provided by central banks. 

As set out previously, LIBOR transition should not be used to move customers with continuing contracts to replacement rates that are expected to be higher than LIBOR would have been. Firms receiving LIBOR-linked interest are also not expected to give up the difference between LIBOR and SONIA (or other alternative rates), which results from the term credit risk premium built into the LIBOR rate but not built into other rates such as SONIA.

It is up to firms and their customers to determine when and how to transition. They should factor the costs, risks and benefits of any options, and the information available to them at the time. 

There are many examples of mutually-agreed conversion of LIBOR obligations to SONIA across bond and loan markets. These demonstrate that counterparties with a close understanding of interest rate markets can agree fair conversion arrangements that take account of the expected future path of interest rates. Reaching such agreements ensures all parties have control over the economic terms of their contract. It also removes risk that the contract will fail to work, or fail to work as expected, when LIBOR ceases or becomes unrepresentative. 

Where firms are dealing with counterparties who may not be fully able to assess fair terms, they may wish to consider other conversion mechanisms. For example, they may consider whether it is appropriate to use contractual arrangements which see the last reset (before cessation or loss of representativeness) being based on LIBOR, before moving to an alternative rate thereafter. 

There’s international consensus on how to calculate a fair replacement rate for LIBOR from the point that it ceases or can no longer be published on a representative basis: adding a fixed credit spread, based on a historical median, to the relevant compounded risk-free rate (RFR). In the UK, the market has chosen SONIA as the relevant RFR, and the RFR Working Group has recommended[12] compounded SONIA (or any other relevant SONIA rate) plus the fixed credit spread as a fair replacement for sterling LIBOR in cash product fallbacks.

Counterparties less familiar with interest rate markets may have a better understanding of Bank Rate, the Bank of England’s monetary policy rate, than of SONIA. Some counterparties have therefore suggested that customers would be more comfortable with a conversion to Bank Rate plus spread, rather than SONIA plus spread. They have asked us if this can also be achieved in a fair way. 

Counterparties may agree to convert sterling LIBOR contracts to Bank Rate plus a spread rather than SONIA plus a spread. Our key expectations also apply where conversion to Bank Rate plus a spread takes place. In particular, LIBOR unavailability should not be used to move customers with continuing contracts to replacement rates that are expected to be higher than LIBOR would have been. 

We note that the relationship between Bank rate and SONIA has been fairly stable over recent years, with movements in SONIA being highly correlated with Bank Rate (which has tended to be a few basis points higher than SONIA). We expect firms to take this into account, for example by a corresponding reduction in the spread added to Bank Rate, compared with the spread that would be added to SONIA.
 
Firms will need to be able to demonstrate how their approach to choosing that spread is fair to the customer. For example, while the difference between SONIA and Bank Rate will vary day by day and over time, firms should – at the point conversion is agreed – be able to show that the arrangements would not reasonably be expected to result in the customer paying more.

Yes. Firms should aim to provide products that meet customers’ needs and perform as they are led to expect.

LIBOR-linked products that mature after LIBOR has become unavailable may not perform as customers are led to expect. Depending on the terms of the contract, the uncertainty over LIBOR means that the interest rate borrowers pay and lenders receive may or will change after LIBOR is no longer available. In some cases, it may not be clear how this rate will be determined.

LIBOR-linked contracts that include robust fall back provisions help reduce, but not always eliminate, these risks.

What firms should do:

• take care in describing to the customer the risks associated with LIBOR ending and how it will affect them
• be aware that there is a risk that some customers may not fully understand the implications

The best way to avoid the complications of calculating and explaining fall backs from LIBOR to replacement rates is to avoid new LIBOR contracts. The RFR Working Group roadmap[13] identified end-March 2021 as the final date for issuing any new sterling LIBOR lending products that mature after end-2021. Authorities internationally, including in the UK, have also supported US guidance that there should be no new use of US dollar LIBOR after the end of 2021.  

Where firms were offering LIBOR-linked products in advance of these deadlines, we expected them to carefully consider whether these products could:

• meet the needs of customers
• continue to perform as customers are led to expect both leading up to and following LIBOR becoming unavailable

In derivatives and securities markets, SONIA compounded in arrears is established as the preferred alternative reference rate. The view of the RFR Working Group[14] is that SONIA, compounded in arrears, will and should become the industry standard in most parts of the bilateral and syndicated loan markets.

Some customers, for example some retail mortgage borrowers and some small to medium-sized enterprises (SMEs), may prefer having precise cash flow certainty (ie to know at the start or well before the end of the interest period the precise amount of interest they will owe) rather than rely on a calculation based on SONIA rates compounded in arrears at or near the end of the interest period.

The RFR Working Group supports production of a forward-looking term rate compiled from transactions in SONIA derivatives markets. This sets the interest rate at the start of the interest period. This can form the basis of a fair replacement rate for legacy cash products that rely on the LIBOR term rate. It may also be an option for new products in some circumstances but may not be the optimal choice. It is not necessary to use a forward-looking term rate to provide cash flow certainty. Other products (eg products based on SONIA compounded over an earlier period, fixed rates, or on ‘Bank Rate’ as in some existing mortgages) may be more appropriate for meeting the needs of customers who prefer cash flow certainty, are likely to be more stable than forward-looking rates compiled based on market transactions on a single day, and or easier to explain and understand.

The RFR Working Group has identified certain areas, such as trade finance, working capital finance and Islamic finance, that may benefit from a forward-looking term rate. These use cases have been written for the sterling market. As outlined in our March 2021 LIBOR Dear CEO letter[15], firms should take into account relevant industry guidelines and recommendations when selecting benchmarks for use in their products. Such guidelines should be followed for each LIBOR currency respectively.

The RFR Working Group identified end-first quarter 2021 as the date to stop new sterling LIBOR cash contracts that mature beyond 2021. We supported this date as a key milestone for firms to meet to reduce their dependencies on LIBOR and potential harm to their customers.

Firms must communicate information to customers in a way that is clear, fair and not misleading.

Information should be presented in good time to allow customers to make informed decisions about relevant products and the risks to which the customer may be exposed. We encourage firms to keep their customers appropriately informed about the impact of LIBOR cessation on existing and new financial products and services they offer or distribute.

What to do

Where firms continued to market, distribute and or sell LIBOR products that mature after the point at which LIBOR may be unavailable, it is essential they explained fully what would happen in that event and its effect on the customer.

To avoid the risk that customers do not understand how the change will affect them, we were clear that firms should consider offering alternative products that do not reference LIBOR.

When dealing with existing customers with legacy contracts that need to be amended, firms should communicate in good time to ensure customers can consider all the options available and respond in advance of LIBOR becoming unavailable.

To ensure customers are appropriately informed, firms should:

• engage with customers early to raise awareness and educate them on general implications and timing of LIBOR transition for both existing and new contracts
• plan for, and subsequently roll out, increased engagement and client-specific conversations in the run up to the unavailability of LIBOR. This could include:
  • considering an appropriate time to discuss new products or solutions that meet customers’ needs when those products become available
  • solutions for existing LIBOR-referencing products
• ensure all client communications linked to LIBOR transition are clear, fair and not misleading. This means:
  • firms should describe the risks and impacts from LIBOR use for existing LIBOR-linked products
  • where alternative options are presented for new products or to change existing LIBOR-referencing contracts, any range of options should be reasonable and fairly presented, including the benefits, costs and risks
  • those communications should not disguise, reduce or hide relevant information (see for example our financial promotions guidance[16] and MCOB communications guidance[17])
  • consider the knowledge and experience of the intended audience (eg firms should assume that retail mortgage borrowers have a lower level of knowledge and understanding of LIBOR compared with large corporates)
• ensure relevant client-facing staff have adequate knowledge and competence[18] to understand the implications of LIBOR use and can respond to client queries appropriately, which may require additional training. This should include ensuring staff understand relevant regulatory obligations, including the boundary between providing information and advice.
• ensure they have identified any product-specific obligations which may require them to take action in the context of LIBOR transition. For example, authorised fund managers should consider whether and how they need to engage with investors when replacing LIBOR references, including whether this amounts to a fundamental, significant or notifiable change (COLL4.3[19]).

What to avoid

We will challenge whether firms are treating their customers fairly where:

• contracts have ‘small print’ resulting in higher costs for the customer (for example by replacing LIBOR with a higher rate)
• conversations with customers affected by LIBOR are delayed to the point the client is left with insufficient time to understand their options and make informed decisions
• firms do not present or discuss alternative products due to unfounded fears of straying into a personal recommendation. Firms can provide an objective overview of the benefits, costs and risks of a range of alternatives to a client’s existing LIBOR-linked exposure, without inferring a recommendation

Consistent with our expectations for banks and insurers, “buy-side” firms, such as asset managers, should be preparing for LIBOR transition. This will include assessing and working to manage their customers’ exposure to LIBOR in a way that protects their customers’ best interests (either within a fund or through a firm’s portfolio management activities).

We sent a Dear CEO Letter[20] to all UK regulated asset managers in February 2020 setting out our expectations for LIBOR transition, and firms should ensure they reflected on the points raised in this letter and are acting as appropriate.

Asset managers may have exposure to LIBOR in a number of areas, including the use of LIBOR-referencing interest rate derivatives to hedge interest rate risk, and investments in bonds or other securities in which interest payments reference LIBOR.

Asset managers will need to take steps to:

• identify the extent of their and their clients’ exposures to LIBOR as a result of LIBOR-referencing instruments in asset portfolios
• consider how to manage the impact of transition, including:
  • ensuring they assess and manage risks associated with LIBOR use, including the impact on contract continuity, expected interest payments, risks of declining liquidity in LIBOR-referencing products,
  • engaging with issuers of LIBOR-referencing securities, derivatives and loans counterparties, to convert these instruments and products to alternative reference rates, for example through consent solicitation processes or bond buy-backs, in good time before LIBOR’s cessation

Firms concerned about incurring costs, particularly those on behalf of customers should consider the likely increase in costs of dealing for LIBOR-linked products as the transition to SONIA-linked or alternative rate products progresses and liquidity in LIBOR products begins to diminish compared with alternatives. Firms should have a plan in place for their investment strategy and best execution that considers the costs and implications of transition to deliver in the best interests of customers.