The FCA’s Dear CEO LIBOR letter: a call to action for asset managers

The FCA’s letter is a call to action for firms with the FCA declaring that it “expects firms to take all reasonable steps to ensure the end of LIBOR does not lead to markets being disrupted; or harm to consumers and to support industry initiatives to ensure a smooth transition.”

The FCA warns that firms should not expect or base their transition plans on future regulatory relief or guidance, or on legislative solutions. For the FCA, LIBOR ending is a market event and the transition to alternatives is market-led; the FCA expects firms to take proactive steps immediately where appropriate and not to wait for instructions from clients.

The letter throws up questions for firms which their management, in particular, need to consider immediately.

What must firms do?

Although it comes at the end of the letter, the FCA’s expectations on “next steps” are an important starting point for what must be done.

• Determine if the firm has LIBOR exposures or dependencies.
• If it does, the FCA expects transition activities are now underway.
• If LIBOR transition is not yet underway, take immediate action to develop and begin to execute an appropriate plan.
• If the board decides that no LIBOR transition plan is needed, the FCA may seek to understand and, where appropriate, challenge the reasons for this decision.
• If, following careful review, the board decides that a barrier to transition is insurmountable, or transition preparations will not be completed in time, the FCA will expect to be notified immediately and kept up-to-date on developments.

What priorities and milestones does the letter identify?

The FCA points to the Bank of England (BoE) and the Working Group on Sterling Risk-Free Reference Rates documents containing targets for 2020 on LIBOR transition (the BoE documents). These state that “firms need to accelerate efforts to ensure they are prepared for LIBOR cessation by end-2021”.

The FCA identifies further targets in the BoE documents which are intended to support the smooth transition of the industry to alternative rates ahead of end 2021; it directs firms to consider how they might usefully adopt them in their LIBOR transition plans, citing the following examples:

• Today (2 March 2020) as an appropriate date for the change in the market convention for sterling interest rate swaps from LIBOR to SONIA which, the letter states “implies that [firms] should now consider switching from LIBOR swaps to SONIA swaps for new positions where possible.”
• End of Q3 2020 as the appropriate date to “cease issuance of GBP LIBOR-based cash products maturing beyond 2021 by” which, the letter states, suggests that firms “should consider not making any new investments in GBP LIBOR based cash products maturing beyond 2021 by end Q3 2020.”
• End of Q3 2020 as the date on which the letter states it would be a sensible for firms to “cease launching new products with benchmarks or performance fees linked to LIBOR.”
• Q1 2021 as the date by which the transition of legacy LIBOR products, to reduce significantly the stock of GBP LIBOR referencing contracts, should have occurred, with the letter stating that “if your firm has LIBOR exposures or dependencies, but does not have a plan in place, you must act now.”

Given that the first date identified falls less than a week after the date of the letter, the need for firms to have started their LIBOR planning cannot be over-emphasised.

Which products and services are caught?

If the firm offers products or services that are exposed to, or dependent on, LIBOR, it should consider very carefully whether its products and services will meet the needs of clients and perform in the manner expected after 2021.

Where the firm issues new products with LIBOR exposure beyond 2021, it will need to pay attention to whether such products comply with product governance rules asking, for example, whether the use of LIBOR affects whether the charging structure is appropriately transparent or too complex to understand.

What governance and planning is expected?

The letter identifies the following considerations:

Operational processes

Firms should ensure all operational processes are prepared for the transition to alternative rates. The letter indicates that firms will need to consider which systems and infrastructure LIBOR is embedded in and identify the following:

• systems and infrastructure used for valuation, measurement and management; and
• contractual relationships with clients and other firms.

More broadly, the FCA expects firms to understand how operations might be vulnerable to LIBOR cessation, and to take appropriate steps to protect clients, markets and the firm itself.

Firms should consider whether they need to complete a contractual review exercise in a short time frame to identify LIBOR dependencies. Where the volumes of agreements are very large it may be possible to use artificial intelligence solutions to assist with, and potentially expedite this review exercise. Please do not hesitate to contact us if you would like to discuss whether our AI solutions could be of assistance to you.  

Outsourcing

The letter indicates that as firms retain full responsibility and accountability for discharging all regulatory obligations upon any outsourcing, the LIBOR transition plan should include an examination of outsourcing arrangements that may be in place, whether intra-group or to third parties.

Board approved transition plan

The FCA expects firms to have established a proportionate transition plan agreed by the board. If the firm retains material exposures to or dependencies on LIBOR and, if you believe you do not, the FCA would expect this view to be tested periodically, with oversight from the board.

Effective board oversight

The FCA will expect the board to have oversight of the transition process, and seek support and challenge from compliance (second line of defence) and internal audit (third line of defence).

Senior managers need to be aware of the risks of LIBOR transition and will need to be clear about who is accountable for managing each aspect of transition where this is appropriate. Statements of Responsibility should include any responsibilities arising from LIBOR transition plans.

Characteristics of an effective transition plan

Generally, a transition plan should include appropriate milestones and be:

• resourced adequately;
• devised holistically, across all relevant business functions; and
• prepared and executed with active engagement with the wider transition efforts in the market, recognising any priorities and milestones outlined by the FCA and industry initiatives such as ISDA’s work on benchmark fall-back adjustments, where appropriate.

More particularly, the plan should:

• carefully quantify all investments, operations and activities with LIBOR exposures and dependencies for the firm and its clients;
• consider both how the firm will remove or ameliorate existing exposures and dependencies in a timely manner and avoid creating new ones;
• include a strategy for keeping clients appropriately informed of such changes as they are developed and implemented; and
• consider the risks arising from LIBOR transition, and identify appropriate mitigation, noting the FCA’s Q&A for firms about conduct risk during LIBOR transition.

Execution of the transition plan

When executing the plan, firms should monitor progress to ensure exposures and dependencies diminish at an appropriate rate over time.

The letter indicates that the FCA would expect firms to:

• exercise skill, care and diligence;
• manage conflicts of interest appropriately;
• ensure clients are not misled and are treated fairly; and
• act in the best interests of clients.

Are we expected to replace LIBOR with alternative rates in existing and new products?

If firms operate funds, collective investment schemes and/or segregated mandates, with objectives and other features that reference LIBOR, such as benchmarks or performance fees, the FCA suggests that you:

• develop and offer new products that reference alternative rates;
• amend the constitutional documents of existing products either to include fall-back provisions or to replace LIBOR with alternative rates; and
• consider what obligations may be triggered when making changes to product documents, such client notifications, before making the changes.

What are our obligations when investing on clients’ behalf?

If firms invest on behalf of clients in instruments, such as bonds, loans, swaps and structured products which reference LIBOR, the FCA suggests that you:

• invest in instruments that reference alternative rates or have fall-back provisions; and
• engage with issuers and counterparties to convert outstanding instruments to alternative rates or to add fall-back provisions.

If firms invest on behalf of clients in third-party funds or segregated mandates that have benchmarks or performance fees, or which hold instruments, that reference LIBOR, the FCA suggests that you:

• engage with third-party managers to switch benchmarks or performance fees to alternative rates or to add fall-back provision; and
• undertake ongoing due diligence of third-party managers to ensure holdings in funds and mandates are being transitioned from LIBOR appropriately.

What are the FCA’s expectations on managing conflicts of interest?

The letter mentions specifically conflicts of interest arising from LIBOR transition and the need to mitigate or, where that is not possible, manage such conflicts appropriately. The FCA states specifically that it would expect firms to:

• prioritise LIBOR transition appropriately and not expose clients to unpredictable or unreasonable costs, losses or risks;
• when managing the transition of investments held on behalf of clients, ensure that all clients are treated fairly and that their interests are upheld throughout;
• when changing benchmarks, not misrepresent performance, even if inadvertently; and
• when adjusting performance fees, ensure that clients are not disadvantaged.