I am Paul Richards. I am a managing director at ICMA, which is the international bond market association. I am here to give evidence on the transition from LIBOR. I am involved in the transition from LIBOR to SONIA—the sterling overnight index average—because I chair the bond market sub-group, which consists of issuers, banks, investors and four major law firms. We work closely with the FCA and the Bank of England. If you will permit me, I shall make a short introductory statement.
I hope to be able to give you a bond market perspective on the Bill but, for the market as a whole, we are all trying to move away from LIBOR to risk-free rates while minimising the risk of market disruption and litigation. The Bill is welcome and very important for the bond market because it will give the FCA extra powers to deal with tough legacy LIBOR contracts and wind them down in an orderly manner.
There are three main points on which it would be very helpful if the Committee was willing to strengthen the Bill. First, the Bill needs to provide continuity of contract between the current definition of LIBOR and the new definition of LIBOR for legacy transactions once LIBOR is prohibited for new transactions. Legacy contracts referencing LIBOR under the current method of defining LIBOR need to be read as references to LIBOR under the new definition as determined by the FCA, so that there will be continuity there—this is sometimes called a deeming provision. This will reinforce the message that LIBOR will continue to appear on the same screen page, and it should also help to remove uncertainty and minimise the risk of a legal challenge on the basis that the current definition of LIBOR and the new definition are not the same and one party or another is worse off.
This is particularly a risk in the bond market in cases where LIBOR is specifically defined in legacy bond contracts in terms of its current definition. Continuity of contract or deeming provision like this was used when the euro was launched in 1999, and it worked well. Clearly, it would need to be drafted with the help of the Treasury and it would probably need to be drafted in terms of an article 23A benchmark in the way that the Bill is looked at. That is the first point.
The second and related point on which I hope the Committee will help is that the provision of the continuity of contract under the Bill needs to be accompanied by a safe harbour against the risk of litigation. This would provide that the parties to contracts would not be able to sue each other as a result of the change in the definition of LIBOR, and it would allow them to make conforming changes to bond market documentation.
The third point on which I hope the Committee will help is that the safe harbour and contract continuity provisions in the Bill need to be drawn as widely as possible, to protect any entity that uses the new definition of LIBOR for legacy transactions in place of the current definition of LIBOR. This would need to cover not just supervised entities in the Bill, but non-supervised entities, as the range of institutions involved in the international bond market is very wide.
Finally, I would like to draw your attention to two other points where there are significant legal risks under the Bill. One is that there needs to be equal treatment between legacy LIBOR bonds when the new definition of LIBOR takes over from the current definition, so that some legacy bonds are not preferred to others and there is no discrimination between them; otherwise, legal problems may arise. This would be a matter for the FCA under the Bill.
The other point is that there needs to be alignment internationally between the Bill and the similar legislation that is being introduced in the US and the EU, so that the rate used for legacy dollar bonds under English law and legacy dollar bonds under New York law is the same. Thank you, Mr Davies. I would be very happy to do my best to answer your questions.
Q Thank you, Paul. The Committee will be very aware of the breadth and depth of your experience in this domain. You have gone into three quite specific issues. Could you set out, at a higher level, the LIBOR challenges that you think this Bill does not deal with, and where you think it is going to be defective? Obviously, a lot of work has been done with regulators to get to this point and we have had evidence previously about the nature of this change and the more general desire for it. Perhaps you could contextualise the specific issues you talked about with respect to continuity and the other matters you raised.
Thank you, Minister. First, as I mentioned, we welcome the Bill. The only question is: can it be improved to minimise disruption and litigation? The essential point is that, in the bond market, we have moved to SONIA as the risk-free rate, and new issues have been in SONIA for over two years now. That is the first step in the process.
The second step in the process is that we actively convert as many bonds as we can from legacy LIBOR to SONIA. We are making some progress there, but the third point is that we will still have tough legacy contracts that cannot be converted, either because they are too difficult to convert or because there are too many to convert by the end of 2021. In those circumstances, the provisions in the Bill are extremely helpful, because they provide for an orderly wind-down of tough legacy contracts. From that perspective, the Bill is very helpful. My questions relate to when the current definition of LIBOR is replaced by a new definition. Will there be contract continuity and a safe harbour to minimise the risk of disruption in the market and litigation?
LIBOR was set by a panel of banks. As the market no longer uses the underlying information that it used to use for banks, it has now changed, or will change, with the admission of SONIA, to a different definition. SONIA is essentially an overnight rate. It is a robust rate, because it is used widely in the market, whereas LIBOR is no longer used in the market as it was 30 or 40 years ago. That is one difference. A second difference is that LIBOR is a term rate—it is expressed over one month, three months or six months—whereas the liquidity in the SONIA rate is focused on the overnight market, which is therefore a much more representative selection and does not require expert judgment, unlike LIBOR.
A third point, perhaps, is that it is not just a UK proposal to replace LIBOR with risk-free rates in SONIA. A similar change is taking place globally. In the US, USD LIBOR is being replaced by the secured overnight financing rate, which has a similar sort of construction, and the situation is similar around the world. Those are the main reasons for the change.
Q Can I just focus on the point about expert judgments? That is quite a polite term for some of things that happened with LIBOR. They were not really expert judgments in some cases, were they? They were effectively deals between different traders to put in submissions at particular prices, to the individual advantage of the traders, based on the trades that they were doing. To what degree is SONIA insulated against that kind of manipulation?
As you say, LIBOR depended on expert judgment in many cases, because the market was no longer using LIBOR in the way it had been constructed. With SONIA, it is a much more liquid market and there is no need for expert judgment at all. That is one of the reasons why it is being preferred as the replacement for sterling LIBOR, and similarly around the world in other currencies.
Q Can I take you back to the second point you made about the danger of litigation? We might all agree that moving away from LIBOR is a good thing, partly because we do not want to see a benchmark manipulated in the way that LIBOR was. However, as a consumer, I might have agreed trades or contracts based on a particular price set by LIBOR. What is the situation with potential litigation from a consumer who says, “You’re telling me that SONIA is a more honest benchmark because it’s based on actual trades and actual prices in market transactions, but now I’m being told that instead of paying x%, I will be paying x% plus y%”? What does the Bill say about that kind of situation at the moment, and what would you like it to say?
A significant difference between LIBOR and SONIA is what is called the credit adjustment spread, which takes account of the difference between LIBOR and SONIA. In the consumer market, the proposals are, at a general level, to treat customers fairly. In the wholesale market, the aim is to have continuity of contracts between the old definition of LIBOR and the new definition that will be used for legacy transactions. This will be determined under the Bill by the FCA. It is not specified how it will determine it. There are market assumptions about that, but it is not decided yet how they will determine it. It is thought that it will consult the market before making a decision, but the end result will be that the rate that arises under the new definition of LIBOR will take over from the old definition of LIBOR, and there will be continuity of contracts between them. If that is emphasised in the Bill, that will give legal protection for all those involved, which is one of the main reasons for providing it. It needs to be accompanied by a safe harbour provision, which would protect all the different market participants involved. I would like to be able to tell you that this will eliminate the risk of litigation, but I cannot tell you that. What I can tell you is that it will minimise the risk of disruption and litigation that might otherwise occur because of the huge volume and value of transactions.
They are both needed, I think. The FCA’s judgment about treating customers fairly relates primarily to consumers. The protection that a safe harbour would provide, so that parties would not sue each other as a result of the change from the old definition to the new definition, is essentially designed for the international markets. So they are both needed. The FCA is already making statements about treating customers fairly, but the Bill should include both the continuity of contracts provision and a safe harbour protection to accompany that. The broader the safe harbour protection is drafted in the Bill—the Treasury, I am sure, could help on this—the better and more effective it will be in minimising disruption and the risk of litigation.
Q Have you already made these arguments to the Treasury only to be rebuffed, or is this the first chance you have had to make them because the Bill was published only a few weeks ago?
These are points that law firms that work in the City are acutely aware of from their previous experience. The law firms have been looking at what needs to be done to ensure that there is continuity of contract and a safe harbour protection. Of course, I hope that the Treasury will take account of that, as your Committee will take account of it before reaching a final conclusion. We should do everything we can to minimise the risk of market disruption and litigation, within the context of the overriding point, which is that we do need to move away from LIBOR to risk-free rates. That is, of course, what we have done, with new issues in the bond markets and with the conversion of legacy contracts from LIBOR to SONIA. We have a tough legacy problem for the future, which needs to be dealt with. The Bill helps to deal with that.
I think it would be helpful for the Bill, specifically, to make provision for continuity of contracts—the deeming provision—and also for protection against litigation through a safe harbour, to be drafted as broadly as possible. That is not because the move away from LIBOR is not something that we should do—on the contrary, it is something we must do and we have made great progress in doing it already—but because, to deal with the tough legacy contracts in the Bill, we have to make sure that the new definition and the old definition are treated in the market as the same.
Okay, that is useful. IQ have been looking through some of the lawyers’ statements and I would be grateful if you could clarify something for me, as this is not an area of expertise for me but it is for you. You mentioned article 23A benchmarks, and something else I read mentioned the types of contracts that would fall within the article 23C exceptions. Can you tell me a wee bit more about what that would mean?
I think that we are talking about 23A benchmarks in general in the Bill. What I have been talking about is specifically relevant to LIBOR. When the Treasury looks, as I hope it will, at whether anything is needed to advise you to strengthen the Bill, it might need to draft that in terms of benchmarks in general and not just LIBOR in particular.
Thank you. You talked about the costs of litigation and the impact that that would have. What is the extent of these legacy LIBOR contracts—their value, their number and the cost that that litigation might entail?Q
In the bond markets, we have to convert legacy contracts bond by bond, so it is the number of the bonds that is important, not just their value. In the sterling bond market, we think we have about 520 different legacy bond contracts, or 780 if you include the different tranches of securitisations. We have converted just over 20 of those so far in the market, but we know that we will not be able to convert all of them because some are too difficult to convert and there are too many to convert.
The FCA has an international role and English law applies in dollars as well as in sterling, so we need to take account of dollar legacy bond contracts under English law. In terms of number, we understand that there are more than 3,000 of those. In terms of value in bonds, we think we have around 110 billion in sterling outstanding.
The critical point for us in the bond market is that we need to convert them bond by bond. You will notice that that is different from the derivatives market, where there is a multilateral protocol that enables the market to do everything at once, which is currently in course. We cannot do that in the bond market.
In the US, the alternative reference rates committee, which is the group equivalent to the sterling risk-free reference rates working group, has proposed legislation that is not identical to the UK’s but has the same effect, and so the concepts of continuity of contract and protection through safe harbours in the UK context will be recognised, we think, internationally as well.
Of course, we are not dealing here just with the proposals under New York law. We are having to look more generally. The EU has a proposal for legislation as well. It is important to recognise that the FCA has an international role, because the FCA is the regulator of the administrator of LIBOR, so what the FCA, through this Committee, decides in the UK will have an international impact.
Q Okay. You did not answer the question from my right hon. Friend the Member for Wolverhampton South East earlier about whether you had asked the Government for this and they had said, “No, the FCA can do it; we’re not putting it on the face of the Bill,” and so you have come here to make the argument again, or whether it is work that you are in the process of doing and you have got to the stage where you want to make these proposals, as the Bill has arrived. Have the Government considered this and said no, or is it something that you have just proposed?
No, I hope that the Government will consider this and say yes. I hope that that will happen, but it needs to be looked at in the context of the Bill as a great help to the market. It needs to be looked at in this context: can anything be done to strengthen the wholesale market?
The FCA has great powers under the Bill and I am sure that it will exercise them wisely, but we are dealing here with law internationally, and anything that can be done to strengthen that—and the Bill has the capacity to do that—will be helpful. I hope that it will also be helpful to the FCA.