Financial Services Bill: an overview

The Financial Services Bill 2019-21 (the Bill) was introduced to Parliament on 21 October 2020.  Amongst other things, the Bill will amend the EU Benchmarks Regulation 2016/1011 (the UK BMR) to provide the FCA with new powers to manage the orderly wind-down of a critical benchmark such as LIBOR.

In conjunction with its second reading in the House of Commons on 9 November 2020 we take a look at the new/enhanced powers introduced by the Bill, in particular those intended to deal with ‘tough legacy’ contracts and some of the key issues arising.

Overview of the new powers

Assessment of representativeness

The Bill sets out certain circumstances[1] in which the FCA must undertake an assessment of the capability of a critical benchmark to measure the underlying market or economic reality that it is intended to measure (i.e. its “representativeness”).

Following such an assessment, the FCA must then give written notification to the relevant administrator stating that it considers either that:

• the benchmark is either not representative (or at risk of becoming so); or
• its representativeness is not at risk.

Designation of certain critical benchmarks

Where the FCA has given notice to an administrator[2] that a benchmark is unrepresentative or its representativeness is at risk, the FCA must then decide and notify the administrator whether it intends to designate the benchmark under a new Article 23A (an Article 23A Benchmark).

The FCA cannot designate a benchmark if it considers that its representativeness can reasonably be restored and maintained, and that there are good reasons to do so.

Use of an Article 23A Benchmark by UK supervised entities will be prohibited (on at least 4 months’ notice by the FCA).

Orderly cessation

However where the FCA considers it is desirable to ensure the orderly cessation of a benchmark it can impose certain requirements on the administrator of an Article 23A Benchmark to ensure the continuing publication of that benchmark.

These requirements may relate to the way in which the benchmark is determined, its rules, and any applicable code of conduct for contributors.  The FCA may also (amongst other things) confer a discretion on the administrator.

In exercising these powers the FCA is not tied to the underlying market or economic reality that the benchmark was previously intended to measure (although it may have regard to this); i.e. in those circumstances, the question of representativeness becomes less relevant and a ‘synthetic’ version of the benchmark is created.

Exception for legacy use

The ability to compel the administrator to produce a synthetic rate is in recognition of the likelihood that there will be a significant number of legacy LIBOR contracts that cannot, for a variety of reasons, be transitioned to an RFR before the end of 2021.  The FCA will therefore be able to permit “some or all legacy use” of an Article 23A Benchmark where it considers it desirable to advance its consumer protection and/or integrity objectives[3].

Comment

The Bill provides some, limited, clarity on the powers that will be given to the FCA to deal with the issue of tough legacy contracts as part of the wind-down of LIBOR.  However it only provides a framework and leaves a lot of questions unanswered, potentially creating more uncertainty at a time when the expectation is that firms are beginning the process of transitioning their legacy contracts away from LIBOR.

Some of the immediate questions which arise are:

What “legacy use” is likely to be permitted under the exemption?

Unhelpfully, the Bill itself provides little if any guidance.  Perhaps the best indication currently can be found in HM Treasury’s accompanying policy statement[4] (the Policy Statement).  This defines “tough legacy” contracts as those which “face insurmountable barriers in transitioning away from LIBOR” and states that HM Treasury and the FCA agree the exemption is intended for contracts “that genuinely have no realistic ability to be renegotiated or amended”.

That would appear to set a very high bar, and it is unclear what test the FCA would apply to determine which contracts fall within that definition where the consequences for contracts that fall outside the definition will be severe.  The current absence of any FCA policy statement in this respect leaves a lot of room for uncertainty, which works against the high level message to firms to transition proactively.

What impact does the Bill have outside of the UK?

It applies to all UK supervised entities and is not limited to UK law contracts, so certainly asserts international scope.  On the other hand, the Bill does not (for example) prohibit non-UK supervised firms from using an Article 23A Benchmark.  There is clear potential for mixed messaging and implementation within international firms with an FCA regulated UK presence.

More broadly, the Policy Statement acknowledges the UK’s distinct role as the home jurisdiction of LIBOR’s administrator.  A recurrent theme throughout the Bill is that in exercising certain powers the FCA “may” (notably not “must”) have regard to its likely effect outside the UK. Will governments or regulators in other jurisdictions similarly prohibit the use of an Article 23A Benchmark in circumstances where the continued publication of a synthetic rate offers an easy way out to avoid the challenges of the transition process?

Some market participants may elect to wait until other relevant regulators have confirmed their proposals for the transition before beginning their own process; which would undermine efforts to achieve a timely and orderly cessation.

Does the Bill’s approach invite challenge by borrowers?

In the event that LIBOR is designated as an Article 23A Benchmark, will it lead to challenge by borrowers who, potentially grappling with the challenges that arise as a result of a switch to SONIA (with its complex rate calculations meaning borrowers will not know the interest payable in any interest period until days before the payment is due), can readily see what they would be paying if they had remained on LIBOR?

Unlike the draft legislation proposed by the Alternative Reference Rates Committee (ARRC) in the US, the Bill does not include a ‘safe harbour’ against any claims for lenders who transition customers to recommended risk-free rates (RFRs).  Arguably the US approach is more effective in pushing market participants onto a new rate, almost regardless of the consequences, whereas in the UK the approach of continuing to publish synthetic LIBOR to ensure contractual continuity for tough legacy contracts which cannot be transitioned invites the consequences of counter parties being able to quantify the effect of the switch on them.

This differing approach by regulators will require them to carefully co-ordinate to mitigate the risk of potential conflict and overlap.

In short, the Bill is a step forward in managing the wind-down of LIBOR but (as ever) the devil will be in the detail, which has yet to be worked through.  Firms should certainly familiarise themselves with the provisions of the Bill and then be ready to consider and respond to FCA policy statements in respect of the intended exercise of its new powers once they are published.