On 13 July Andrew Bailey, Governor of the Bank of England (“BoE“), made a speech on the continued importance of the transition away from LIBOR.
The continued importance of the transition
In Mr Bailey’s view, the shock seen in financial markets in May in response to Covid has reinforced the importance of removing the financial system’s dependence on LIBOR, and not further delaying the transition. Fundamentally, this is due, he said, to the fact that LIBOR is trying to measure a market – the market for unsecured wholesale term lending to banks – that is no longer sufficiently active.
He also discussed the necessity for change and argued that the market volatility seen in March and April underscores the long-standing weaknesses of the LIBOR benchmark. Mr Bailey pointed out that during this period LIBOR rates – and hence costs for borrowers – rose as central bank policy rates fell to support the economy and, given this, he questioned how well LIBOR actually reflects the cost of bank funding. There have already been significant changes to the way banks fund themselves since the global financial crisis that first highlighted LIBOR’s failings.
Mr Bailey outlined that there is no one size first all approach. While there is a common view across jurisdictions that liquidity should move to overnight near risk-free rates where appropriate, this is not to exclude the use of other robust benchmarks.
Adapting to the impact of Covid
He recognised that, despite Covid, work on transition in sterling markets has continued and there has been considerable progress since last year – both in the UK and the US.
The early focus has, he said, rightly been on raising awareness across those in the financial industry that generate LIBOR linked exposure that will need to support their clients through transition. That said, Mr Bailey recognised that regulators’ and markets’ efforts will increasingly need to turn to much broader communication to ensure the end users of LIBOR understand the weaknesses with the rates, why they need to move to alternatives and what the timeline is for the action they will need to take.
The BoE is working to make this process as accessible and straight forward as possible and from next month it will begin begin publication of a compounded SONIA index to support use of the rate across a wide range of sterling products. There has already been promising signs of growth in SONIA futures and of development of a SONIA options market to go with the already established swaps trading.
Mr Bailey reinforced that from October UK banks should all be offering alternatives to LIBOR. The BoE will not expect to see any further sterling LIBOR linked lending after the end of March 2021. UK regulated firms should expect their supervisors to monitor and discuss their progress with these milestones.
Mr Bailey outlined ISDA’s extensive consultation, which means there will be a robust and trusted fallback for trillions of dollars of derivative contracts, and called for early sign up to the protocol while moving business onto near risk-free rates. Firms have started to convert LIBOR linked instruments to alternative rates.
The BoE is clear that this transition should be market driven, but it also acknowledges that the authorities have an important role to play. This is, he said, why the UK government intends to legislate to provide the FCA with increased powers to deliver an orderly wind-down of critical benchmarks, such as LIBOR. The FCA will consult on what that action may look like and what the limitations of any solution may be for the ‘tough legacy’.
Mr Bailey said the message remains clear: those who can transition away from LIBOR should do so on terms that they themselves agree with their counterparties.