In a Q&A with Steven Burrows, director, Financial Markets and Products at European law firm, FieldFisher, we explore what synthetic LIBOR is, its status in the UK market and intended use. Read on for insight into how synthetic LIBOR will progress in the coming year and what market participants, including derivatives professionals, should know now.
Q. What is synthetic LIBOR?
A. Firstly, synthetic LIBOR is not a term used in any of the relevant legislation. It is a colloquial term that refers to LIBOR, but specifically the derived rate that emerged after the Financial Conduct Authority (FCA) used its powers under article 23D of the UK’s Benchmarks Regulation to direct ICE Benchmark Administration (IBA) – the administrator of LIBOR – to change the underlying methodology on which LIBOR has been calculated.
Today, synthetic LIBOR has been created for one, three and six-month Sterling and Yen LIBOR only, and I will refer to those as the “synthetic tenors”, to distinguish them from the other tenors.
To be clear, synthetic LIBOR has not been created for all LIBORs but for only for certain currencies and tenors. All other currencies and tenors of LIBOR have now been discontinued as of 2022, apart from the overnight, one, three, six and 12-month tenors, which will be discontinued separately on 30 June 2023. In theory, the FCA may direct IBA to create a synthetic U.S. LIBOR later, depending on how things develop in the USD LIBOR market.
Q. How does the methodology underpinning synthetic LIBOR work?
A. The original LIBOR methodology, as we all know, is based on a panel bank methodology. This methodology relies on panel banks making submissions to the administrator, in response to the hypothetical question of at what rate could funds be borrowed in various currencies and for various tenors in a reasonable market size. Those answers are then trimmed and averaged to arrive at the final fixing rate.
Synthetic LIBOR, however, is quite different. It is calculated based on a reference rate that is derived from overnight index swap (OIS) prices published on multiple electronic order books operated by various trading venues that are linked to a particular risk-free rate (RFR), depending on the reference currency. Then the relevant International Swaps and Derivatives Association (ISDA) calculated spread adjustment is added on top. And for Yen LIBOR, there is a day count adjustment that takes place as well.
Sterling and Yen Synthetic LIBOR
Synthetic Sterling LIBOR is based on the relevant tenor of the Term SONIA Reference Rate, which is linked to Sterling OverNight Index Average (SONIA) and calculated by Intercontinental Exchange (ICE), with the addition of the relevant ISDA spread.
Synthetic Yen LIBOR is calculated similarly. It is based on the relevant tenor of the QBS TORF, which is linked to the Tokyo Term Risk Free Rate (TORF) and calculated by QUICKs Benchmarks Inc (QBS), the Japanese benchmark administrator, with the addition of the relevant ISDA calculated spread adjustments. And those spread adjustments are the ones that have been calculated by ISDA by taking a five-year historic median of the difference between the particular LIBOR tenor and the relevant RFR that has been compounded in arrears over that same tenor.
So now, synthetic LIBOR is linked to the relevant RFRs for that currency on a forward-looking basis over the particular tenor. The full details of the methodology are set out in a notice that has been published by the FCA.
Synthetic is not intended to be a perfect substitute for LIBOR
Synthetic LIBOR is a tidy solution because it basically solves the problem at source by redefining the methodology into something else. It is intended to behave the same as LIBOR in that it is a forward-looking term rate rather than one of the overnight, backward-looking risk-free rates.
One point to note is that synthetic LIBOR is not intended to be a perfect substitute for LIBOR. The FCA does believe that it is a reasonable approximation to what LIBOR would have been had it not been discontinued, but there would invariably be some sort of economic difference between the two.
More importantly, there is no sort of compensation element if a counterparty to a transaction does feel that it has lost out because it is party to a deal that has automatically switched from LIBOR to synthetic LIBOR.
Q. Can you briefly explain how we got to synthetic LIBOR as it is now?
A. Synthetic LIBOR now exists with the first publication of it taking place on 4 January 2022, which was the first business day of 2022 in the UK.
How synthetic LIBOR was born
Before looking at the current status, I think it is worth looking at the history of how the industry got to this point through the FCA’s actions.
Before the FCA could create synthetic LIBOR, it had to designate the synthetic tenors of LIBOR under article 23A of the Benchmarks Regulation as “article 23A benchmarks” to identify them as critical benchmarks, which are benchmarks that back a very large volume of transactions, that are unrepresentative (or are at risk of becoming unrepresentative) and their representativeness will not be restored.
Many of the FCA’s powers in the Benchmarks Regulation are triggered by this concept and requires this initial designation as an article 23A benchmark. The FCA made this designation for the synthetic tenors when it published its notice in September 2021. This notice designated one, three- and six-months Sterling and Yen LIBOR as article 23A benchmarks.
So, it is only in the few weeks of January that these benchmarks have now been officially recognised as being unrepresentative and thus article 23A benchmarks. Therefore, it is only at this point when the FCA’s powers to modify the methodology or to prohibit legacy use have commenced. The effect of that designation is it is now not possible to use synthetic LIBOR unless it is a specific type of use that the FCA permits under article 23C of the Benchmarks Regulation or it is a type of “use” that is outside the scope of the Benchmarks Regulation.
Critical Benchmarks Act
It is also important to highlight that currently there is a supplemental piece of legislation that has come into effect – the Critical Benchmarks (References and the Administrators’ Liability) Act 2021 (Critical Benchmarks Act). Critical Benchmarks (References and Administrators’ Liability) Act 2021 (legislation.gov.uk) ) This legislation is designed to do a number of things, but importantly in relation to synthetic LIBOR, it is designed to preempt arguments about contractual frustration or contractual interpretation that might be raised by counterparties that feel aggrieved for one reason or another because of the shift to synthetic LIBOR.
Specifically, the Critical Benchmarks Act sets out, on a statutory basis, some rules of contractual interpretation for article 23A benchmarks, such as synthetic LIBOR. And in broad terms, it also states that where an existing contract or arrangement has a reference to LIBOR, for instance, that reference is interpreted as meaning that it always included a reference to synthetic LIBOR. The legislation also tries preserve any pre-existing fallbacks to different rates that are regarded as being robust, to avoid a situation where synthetic LIBOR is applied despite the parties embedding fallbacks to alternative benchmarks in their contracts. The purpose of the legislation is to avoid a situation where the creation of synthetic LIBOR effectively would stop that fallback from applying where the parties did not really intend synthetic LIBOR to apply. This is quite an important development in the industry and relevant to synthetic LIBOR.
Q. How can synthetic LIBOR be applied to products and by whom? Who can use it, and what are the limitations?
A. As mentioned previously, when we talk about the “use” of synthetic LIBOR, we are referring to how “use” is defined in the Benchmarks Regulation. The Benchmarks Regulation regulates use of benchmarks by supervised entities. The term supervised entities covers, very broadly speaking, regulated institutions in the UK which includes: credit institutions, investment firms, asset managers, insurers, clearinghouses, mortgage, and consumer credit lenders, and a range of other regulated firms. The restrictions on the use of synthetic LIBOR only apply to those types of institution.
Additionally, “use” is defined by both reference to certain types of products and specific types of use that are within the remit of the Benchmarks Regulation.
For instance, certain types of lending arrangements (including consumer credit and residential mortgage lending) would be covered by the Benchmarks Regulation, however, general corporate lending would not be covered as this is outside the scope of the regulation.
Article 23B of the Benchmarks Regulation effectively bans use of article 23A benchmarks (including synthetic LIBOR) except where that use has been expressly permitted by the FCA in accordance with article 23C of the Benchmarks Regulation.
Tough legacy means broader use
Tough legacy, which is another colloquial term not used in the relevant legislation, essentially refers to certain types of legacy use that is permitted specifically by the FCA through use of its powers under article 23C of the Benchmarks Regulation. The FCA published a notice under article 23C that took effect on the 1st of January this year that sets out when synthetic LIBOR can be used and when it would otherwise be prohibited by the Benchmarks Regulation.
The scope of that notice is very broad and effectively states that synthetic LIBOR can be used by supervised entities in all legacy business, apart from in cleared derivatives. The reason for excluding cleared derivatives is that the clearinghouses have extensive powers in their rule books to transition transactions that they have cleared away from LIBOR and therefore, it is unnecessary for those kinds of products to be included in the bucket of tough legacy products.
This means the universe of products that that can be used with synthetic LIBOR is very broad. And in fact, it is probably much broader than people may have expected.
The concept of “tough legacy” was really only meant to refer to contracts where it is basically impossible to amend the contract to provide for an alternative benchmark to apply, but the FCA has now extended this concept much further to include many other types of contracts. Derivatives, for instance, is the quintessential example of something which is not really tough legacy because there are market tools, such as ISDA protocols, which can be rapidly and easily used to amend huge portfolios of transactions in one fell swoop. Uncleared derivatives, however, are now technically regarded as a type of tough legacy contract in this context.
Tough legacy is not static
It is important to note that the scope of what is considered to be a tough legacy contract is not static. Yes, the universe of tough legacy contracts currently may be very broad, but where the FCA has used its powers to keep an article 23A benchmark going on a synthetic basis, the use of those powers is subject to an annual review and a 10-year maximum. So, the most that synthetic LIBOR could ever exist for is 10 years from now and the scope of the contracts that are regarded as tough legacy may get narrower over time.
For market participants relying on synthetic LIBOR, they need to be aware that it may only exist for this year. And, in fact, that will be the case with synthetic Yen LIBOR because the FCA already signaled it will not continue it after the end of this year.
What may happen with Sterling LIBOR is that in subsequent years, the universe of tough legacy products is reduced further until there are fewer and fewer products that fall within the scope of tough legacy.
Q. What is the next step with synthetic LIBOR?
A. The key point is that synthetic LIBOR will not, and in fact cannot, last forever. Again, the powers the FCA has under article 23D are only exercisable for up to 10 years and again, are subject to annual reviews.
The FCA has already stated in its various policy statements that it intends to continue to monitor the situation. It will need to keep updating every year its decision to compel the publication of synthetic LIBOR. And again, the FCA already stated in its original policy statements that it does not believe there is a big enough universe of people who will be using synthetic Yen LIBOR to warrant the extra administrative burden on IBA to keep it going after a year.
I expect the FCA will keep synthetic Sterling LIBOR going after the end of 2022 because of the quantity of business that is still going to be linked to it. I think, however, there will be a tapering of the permitted use cases over time, until the point it is ultimately discontinued. The FCA has also made it very clear that there will come a point where the amount of business that is left on synthetic Sterling LIBOR becomes simply disproportionate to require IBA to carry on publishing it for only a small universe of contracts that have not yet migrated away from LIBOR. The FCA will not therefore carry on compelling the publication of synthetic Sterling LIBOR until every single contract has transitioned away from using it.
Q. What do market participants need to know before moving ahead? What advice would you give them?
A. The most important point I would stress is that it is critical to keep in mind that synthetic LIBOR is not a substitute for active transition. The FCA has been banging this drum for a very long time and it continues to do so. Synthetic LIBOR is just a stop-gap measure to make sure that contractual arrangements do not simply fall over because of the absence of LIBOR and in the absence of more robust fallbacks. And the FCA will certainly not take kindly to firms that are within its jurisdiction who sit on their hands and use this as an excuse not to do anything.
Additionally, firms need to keep the conduct risks in mind, including their obligations to their customers to treat them fairly, and to be open and transparent with them about what is going on with LIBOR.
And even though there might not be any need to make any contractual amendments to account for synthetic LIBOR – it is essentially an automatic switch over – it is still a very good idea to keep customers updated as to what is going on, what synthetic LIBOR is, and to discuss the options for a more permanent active transition where appropriate.
The need to transition away to something else has largely been obviated now by the existence of synthetic LIBOR but active transition needs to remain at the forefront of this project.
ISDA Definitions and Fallbacks
It is also important to understand when synthetic LIBOR will apply to contracts and transactions, and particularly with derivatives that incorporate the new 2021 ISDA definitions or the latest supplements to the 2006 ISDA definitions, which already contain robust fallbacks to address the discontinuance of LIBOR.
The effect of the new Critical Benchmarks Act should be to preserve the new ISDA fallbacks. For instance, if there are derivative transactions that reference one of the synthetic tenors, that transaction will not go onto a synthetic LIBOR but the ISDA fallbacks will apply instead. It is important to understand your contractual terms and what fallbacks you might have in place, and whether those will be preserved by the new Critical Benchmarks Act. This may come into play in the derivatives markets with finance-linked derivatives, which means firms will want to understand how the derivative and the underlying debt being hedged will react to synthetic LIBOR.
Many loan agreements are clearly going to be moved over to synthetic LIBOR because legacy loans will generally not have robust fallbacks. So synthetic LIBOR will apply to those agreements. The derivatives portion, however, may well have robust fallbacks in it. For example, if the counterparties have adhered to the ISDA IBOR Fallbacks Protocol, it will end up in a situation where the loan goes to synthetic LIBOR, but the derivative goes to a form of compounded in arrears SONIA. This situation could end up with an economic mismatch.
Another key point to understand is how synthetic LIBOR is constructed and how it might behave relative to how LIBOR behaved previously. Specifically, where synthetic LIBOR is underpinned by a RFR – such as synthetic Yen and Sterling LIBOR – it will generally be less volatile and will track the central bank policy rates more closely. It is important to understand how this is different.
Market participants also need to consider how they might go about hedging their synthetic LIBOR exposures because one cannot directly reference synthetic LIBOR in a derivative contract now because it would require creating a new contract linked to synthetic LIBOR, which is now banned by the Benchmarks Regulation. Instead, however, a firm may be permitted to trade derivatives that are linked to the key components of synthetic LIBOR, such as the Term SONIA Reference Rate. It is important to understand that interaction as well.
Firms need to also be aware of how the FCAs powers might interact with the legislative solutions in other jurisdictions. The powers in the UK’s Benchmarks Regulation are UK specific and they were created post Brexit to manage with the wind down of LIBOR, with LIBOR having such strong links to the UK.
The European Union has taken slightly different approach. The EU has now added new powers to the European Benchmarks Regulation (BMR), which empowers the European Commission to designate statutory replacement rates, in circumstances where the contract is governed by the laws of an EU member state or in certain circumstances, the law of a third country, such as English law. The Commission intends to deploy these powers for Sterling and Yen LIBOR to designate synthetic LIBOR as a statutory replacement rate for them. So, that is a work in progress within the EU.
And again, a different approach is underway in the United States where they are looking to put federal legislation in place to manage the wind down of contracts that are governed by the laws of a U.S. state, as well. There is potential for the conflict of laws issues to arise on this as well and market participants should be aware of upcoming market developments in addition to understanding the proper use and limitations of synthetic LIBOR in the UK market.