The transition to a world without LIBOR has been high on the agenda of UK regulators lately. In June, the Financial Policy Committee (FPC) of the Bank of England underlined the financial stability risks around Libor and warned that market participants continue to accumulate Libor-linked sterling derivatives for periods well after 2021.
Today, Andrew Bailey, Chief Executive of the Financial Conduct Authority (FCA) stressed the need for market participants to be prepared for transitioning away from LIBOR. He made it clear that firms that the FCA supervises will need to be able to demonstrate to FCA supervisors and their PRA counterparts that they have plans in place to mitigate the risks, and to reduce dependencies on LIBOR.
In particular, some firms will also have obligations to disclose and consider risks to investors when they sell LIBOR-related instruments, he explained. Issuers of LIBOR-related listed securities, for instance, owe duties of disclosure under prospectus requirements, and must ensure these have been fulfilled. Banks and investment firms also need to consider the design and risks of any new LIBOR-referencing instruments as part of their product governance obligations, considering and describing the impact of LIBOR discontinuation on those instruments. And they will need to provide all appropriate information to all distributors of those financial instruments.
Furthermore, those acting on behalf of investors will have to ensure they have considered and understand what will happen to LIBOR-referencing instruments in the event of LIBOR discontinuation. Investment advisors and portfolio managers may need to be able to demonstrate that they have considered whether such investments remain suitable for a particular client or portfolio if there is no clear and appropriate plan on what will happen in the event of discontinuation.
“Brokers or platforms offering non-advised services need to disclose to clients in an understandable way information on the key features and risks of financial instruments they make available. For an instrument relying on LIBOR beyond end-2021, the risk of discontinuation will need to be covered”, Andrew Bailey said.
Surveys and feedback indicate too many firms are not yet adequately aware. They are not yet making or planning the necessary investments in preparing systems, processes and business practices for transition.
Regarding what remains to be done, the FCA head noted that cash markets are still at a very early stage in transition. While the EIB’s SONIA-referencing bond issue has shown the feasibility of issuing a floating rate note referencing SONIA, the FCA understands that some firms require system changes to manage bonds and loans where interest payments are calculated at the end of the reference period.
Furthermore, some parts of bond, loan and securitisation markets have economic or operational preferences for ‘forward-looking’ term rates. Because current processes in these markets assume such forward-looking term rates, some participants are uncertain about how overnight risk-free rates (RFRs) would fit in their business models.
This, Andrew Bailey said, highlights an important next step for transition, the exploration of the potential to create forward-looking term rates based on the RFRs. The sterling Risk Free Rate Working Group will next week launch a landmark consultation on this.
Mr Bailey noted that the largest part of the market currently relying on LIBOR – that is the bulk of interest rate derivatives – does not need term rates. This part of the market is focused on hedging the general level of interest rates rather than term bank credit risk. However, there is demand in cash markets for forward-looking term rates, perhaps especially in respect of smaller and medium-sized issuers, and in syndicated loan markets. That is why the FCA supports the development of forward-looking term rates derived from the RFRs.
Once available, these term rates are set to play an important role in facilitating LIBOR transition, particularly in loan and debt capital markets.
Mr Bailey forecasts that there will be two centres of gravity in interest rate reference rates – the largest one, used in the bulk of interest rate derivatives, will likely be around overnight RFRs. But a segment of cash markets, and perhaps a small part of the derivatives market which directly hedges cash market instruments, may prefer term rates.
The biggest risk to transitioning away from LIBOR is inertia, Mr Bailey warned. That is, a hope that LIBOR will continue, or that work on transition can be delayed or ignored.
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