FCA’s Bailey discusses risk free rates, considers synthetic LIBOR proxy

Excerpt from speech by Andrew Bailey, chief executive of the FCA, at the ACME, ICMA and ISDA breakfast briefing:

LIBOR reference rates are no longer supported by significant volumes on transactions. This puts panel or submitting banks in a difficult position. Work on the transition to alternate reference rates is underway around the world. In the UK this is being driven by the cross-market group (as referenced earlier) which is focused on sterling bond markets, under Paul’s able leadership. It brings together sell side, buy side and non-financial firms. Its work spans derivative and cash markets, with sub-groups already meeting on bond markets, loan markets, and pensions, amongst other issues.

In the United States, the Alternative Reference Rates Committee (ARRC) has also been reconstituted to facilitate a broader transition. In Switzerland there is focus now on specific retail and derivatives transition issues. In Japan the Risk Free Rates Working Group is encouraging financial institutions to use the Overnight Indexed Swap (OIS), which is critical to transition. The market led work is now starting in the euro area, and the European Central Bank (ECB) has decided it will publish an overnight rate, starting in 2019.

There seems to be a consensus that interest rate markets will, in future, be centerd on the risk free rates chosen by various industry groups – like (Sterling Over Night Index Average) SONIA in the UK and Secured Overnight Financing Rate (SOFR) in the US. The expectation is that this will lead to a stronger financial system. For the many LIBOR users for whom it was never an ideal reference rate, a shift of liquidity into the chosen risk free rates offers an opportunity for better hedges and lower risk exposures.

Those who want to hedge interest rate risks will be able to choose a reference rate that does not include an unwanted, but economically significant, credit risk component. Borrowers should have better access to variable rates that do not make them carry the risk that their interest payments will go up because confidence in their banks has fallen.

This leaves a very big question unanswered. It is all very well to talk about a future with new benchmarks, and one that importantly matches closely to interest rate risk, but what about the very large legacy of contracts? There will be cases where it is not practical or economic to change reference rates. The Intercontinental Exchange (ICE) Benchmark Administration has opened up the prospect of a voluntary arrangement to sustain LIBOR after the end of 2021. I don’t rule this out, but I would stress that I don’t see a prospect of a reversal in the decline of the market activity that LIBOR seeks to measure, and the FCA has not changed its position that it is not going to use powers of compulsion towards submitters beyond that point. My best guess is that some panel banks would already have departed were it not for the voluntary agreement to stay in until the end of 2021 that we were able to obtain.

Now, I would not rule out that it might be possible to produce a form of LIBOR proxy which could satisfy the legal definition of what LIBOR is taken to be and serve as a legacy benchmark. This is at root a question of legal interpretation. Would it, for instance, be possible to create a synthetic LIBOR which amounts to a risk-free rate plus an add-on? I’m not sure, but we are encouraging this issue to be assessed as soon as possible. I do not, to be clear, see this as an alternative to the risk free rates as the best measure of interest rate risk, but it is worth assessing whether this could be the way to assist with the legacy.

Read the full speech

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