In July 2017, the Financial Conduct Authority (FCA) announced that banks and other market participants needed to prepare for the London Interbank Offered Rate (LIBOR) to be discontinued after 2021.
In recent years, LIBOR has been tarnished by scandal and been the subject of a FCA regulatory investigation. The FCA found that a significant problem with LIBOR is that it is calculated on the basis of bank submissions which are based on good faith estimates of borrowing costs - not actual transactions. In a landscape where the volume of wholesale bank borrowing is reduced, it is difficult for banks to submit a daily estimate when there are relatively few actual transactions to support that estimate.
The FCA has been supporting LIBOR by persuading banks to provide quotes and this has been a key factor in ensuring the continued publication of LIBOR. However, the FCA said that after 2021 it will no longer encourage or compel banks to provide LIBOR quotes. Ice Benchmark Administration Limited, which administers LIBOR, is free to continue to produce LIBOR (and has said it will do so) however the reality is that the usage of LIBOR as the primary interest rate benchmark is likely to be phased out following the withdrawal of FCA backing.
Impact on defined benefit schemes
The FCA has been supporting LIBOR by persuading banks to provide quotes. They note that this has been a key factor in ensuring the continued publication of LIBOR. However, the FCA said that after 2021 it will no longer encourage or compel banks to provide LIBOR quotes. The Intercontinental Exchange (ICE), which administers LIBOR, is free to continue to produce LIBOR (and has said it will do so) however the reality is that LIBOR is likely to discontinue due to the cut of FCA backing.
For defined benefit pension schemes the disappearance of LIBOR will have a key impact on the use of total return and interest rate swaps entered into as part of liability driven investment (LDI) strategies. KPMG's report on the UK LDI Market entitled No end to growth in sight, published in June 2017, noted that 1,808 pension schemes are using LDI with £980bn of liabilities hedged. A significant proportion of those liabilities will be hedged using a product which references LIBOR.
There was initially concern that the announcement of the pending withdrawal of FCA support for LIBOR would lead to banks stopping providing quotes prior to 2021 thereby threatening the controlled transition originally anticipated. This risk receded when the FCA announced on 24 November 2017 that it has reached agreement with all 20 panel banks that they will remain on the panels they currently submit to until the end of 2021. The FCA statement concludes that as a result of this support it expects the focus to turn to developing alternatives rates and working towards a transition that can be executed smoothly.
An orderly transition
On 29 November 2017, the Bank of England announced the next phase of its work with market participants in relation to the transition and handed the Working Group on Sterling Risk-Free Rates a mandate to catalyse a broad-based transition to SONIA over the next four years across sterling bond, loan and derivatives markets. SONIA is the Sterling Overnight Index Average and has been administered by the Bank of England since 2013. The rate is currently determined on the basis of a market of brokered deposits with limited transaction volumes but reforms to be implemented in April 2018 will capture a broader range of deposits. SONIA differs to LIBOR in that it tracks actual transactions rather than being based on submitted rates.
A key priority of the Working Group will be the further development of interest rate derivative products (and maturities) referencing SONIA and supporting the specific sub-group which has been established for the development of SONIA futures. A public consultation in relation to the expansion of SONIA-related products is expected in early 2018.
The membership of the Working Group is to be broadened to include investment managers, non-financial corporates and other sterling issuers, infrastructure firms and trade associations alongside banks and dealers. Membership is by invitation of the Bank of England and the FCA although expressions of interest in participating in LIBOR transition work are invited via the Bank of England website.
The FCA has commented that the Working Group is responsible for raising awareness of transition issues and seeking input from the broadest possible set of stakeholders, for example by establishing open discussion forums focused on particular sectors. It is critically important that the pensions industry ensures that its voice is heard in this process. Simon Wilkinson (Head of LDI Funds, Legal & General Investment Management) has agreed to act as Vice Chair of the Working Group.
Our comment
Whilst the exact market impact which may occur as a result of the change from LIBOR to SONIA is hard to predict, it is clear that the transitional process is critical for UK pension schemes and that there may be significant timing issues. Pension trustees should certainly start including the LIBOR transition on their list of horizon issues and to begin to discuss the implications with their investment advisers in order to ensure that they are fully engaged in the latest developments from the FCA and the Bank of England.
