Critical Benchmarks (References and Administrators’ Liability) Bill [HL]

Lord Agnew of Oulton Excerpts

2nd reading
Wednesday 13th October 2021 Lords Chamber

Moved by

[Lord Agnew of Oulton]

That the Bill be now read a second time.

[The Minister of State, Cabinet Office and the Treasury (Lord Agnew of Oulton) (Con)]

My Lords, through this Bill, the Government are supporting the transition away from Libor by providing further legal certainty for contracts that rely on Libor past the end of this year.

This Bill builds on the Financial Services Act 2021, which provided the Financial Conduct Authority with powers to effectively oversee the cessation of a critical benchmark in a manner that protects consumers and minimises disruption to financial markets. In particular, it draws on the work and engagement of my noble friends Lady Noakes and Lord Blackwell, who proposed amendments to that Act which are similar to the provisions in this Bill. I thank them for their constructive engagement on this issue.

I will first take a few minutes to put the Bill in context and to explain the connection to the Act passed by Parliament earlier this year. A benchmark is an index in a wide range of markets to help set prices, measure performance or establish what is payable in financial contracts. Libor is one such benchmark. It seeks to measure the cost that banks pay to borrow from each other in different currencies and over various time periods. It is calculated using data submitted by a panel of large banks to Libor’s administrator, the IBA.

Libor is used in a huge volume and variety of contracts, including in derivatives markets, mortgages, consumer loans, structured products, money market instruments and fixed income products. For example, a simple loan contract may say that the interest payable is Libor plus 2%. In this example, Libor represents the cost to the lender of getting access to the money to lend it out, and the 2% represents the additional risk to the lender associated with making the loan.

Libor was designated as a critical benchmark. This reflects the fact that it is systemically important. Libor is referenced in approximately $300 trillion of financial contracts globally but, from the end of this year, the FCA has said it is clear that Libor will no longer represent the interbank lending market it seeks to.

There is significant history to this. As many will remember, in 2012 it emerged that the Libor benchmark was being manipulated for financial gain. Following the subsequent Wheatley review, Libor came under the jurisdiction of the FCA in 2013. Significant improvements to the regulation and governance of Libor have been made since the Libor scandal. However, in 2014 the G20’s Financial Stability Board declared that the continued use of these kind of rates, including Libor, represented a potentially serious source of systemic risk. The FSB said that financial markets should voluntarily transition towards the use of more robust and sustainable alternatives.

This is because Libor has become increasingly reliant on expert judgments rather than real transaction data, due to the structural decline in the frequency of banks borrowing from each other through the unsecured wholesale lending market. The market that the benchmark seeks to measure increasingly no longer exists. This underscores the fundamental need to transition away from Libor.

Since the FSB’s recommendation, the Government, the FCA and the Bank of England have worked together to support a market-led transition away from use of the Libor benchmark. Primarily, they have pushed contract holders to voluntarily move to robust alternatives before the end of this year, in accordance with guidance from the FCA and the Bank of England. The vast majority of contracts are expected to make this transition away from Libor without any government intervention. We expect 97% of all sterling Libor-referencing derivatives to have transitioned by the end of the year.

However, despite this extensive work and progress, there remains a category of contracts that face significant contractual barriers to moving away from Libor by the end of this year. The measures in the Financial Services Act 2021 sought to provide a safety net for these “tough legacy” contracts. Through the Act, the Government granted the FCA powers to “designate” a critical benchmark if it determines that the benchmark no longer accurately represents what it seeks to measure. The Act also provided the FCA with powers to require the administrator of such a designated benchmark to continue to publish it and to change how the benchmark is calculated.

In the case of Libor, the FCA has announced that it will use these powers to compel the continued publication of Libor using a revised methodology, referred to as “synthetic Libor”. The FCA has done this so that these tough legacy contracts can continue to function. They will have a Libor rate to refer to in its synthetic form, providing for the benchmark to cease in an orderly manner. It is important to emphasise that this synthetic rate is a temporary safety net for those legacy contracts that have not been able to move away from Libor in time for year end. It is not intended to replace Libor in the long term.

The Bill is vital to support the use of the synthetic rate. Clause 1 provides explicitly that Libor-referencing contracts can rely on synthetic Libor. This is covered in the new Articles 23FA and 23FB. Specifically, where the FCA imposes a change in how the benchmark is determined, such as a synthetic methodology, the Bill is clear that references to the benchmark in contracts also include the benchmark in its synthetic form. In the case of Libor wind-down, this means that where a contract says “Libor”, that should be read as referring to synthetic Libor. The effect of that is to provide legal certainty for those contracts that now reference synthetic Libor.

The Bill also provides a narrow and targeted immunity for the administrator of the critical benchmark for action it is required to take by the FCA. This includes where it is required to change how a critical benchmark is determined, such as a change in the benchmark’s methodology. This will protect the administrator from unmerited and vexatious legal claims. The Government have done this in the narrowest way possible. This does not protect the administrator in any area where they act with discretion. It protects the administrator only to the extent that it is acting purely on a direction from the FCA. It also does not in any way change the ability to challenge the FCA; its decisions on setting a synthetic methodology are subject to challenge on the usual public law grounds.

The Bill reaffirms the Government’s commitment to protecting and promoting the UK’s financial services sector. As the global home of Libor, having a clear legal framework and process in place for the Libor wind-down will further underpin our position as a global financial hub. However, I understand that some are concerned that the synthetic methodology may result in a rate higher than the current Libor rate. That is not an issue for the Bill, which does not seek to instruct the FCA on how this synthetic rate should be constructed. That role has already been delegated to the FCA under the Financial Services Act 2021.

It is appropriate that the FCA takes these technical decisions. Indeed, our regulatory system often sees independent bodies empowered to produce calculations which reflect and influence economic reality, such as the Bank of England setting interest rates. It is vital that the FCA is able to create the methodology free of political interference.

I understand concerns about the possible retail impacts of Libor transition and would like to try to address these. First, I remind noble Lords that Libor is primarily the preserve of sophisticated financial operators, not retail investors. The vast majority of Libor contracts are derivatives. These are sophisticated financial products and 95% of these will transition away from Libor voluntarily.

Secondly, synthetic Libor is a last resort. The regulators have been working with the market to encourage operators to move to alternative rates for several years. The vast majority of contracts will not need to use this synthetic rate at all. Thirdly, the FCA’s approach is entirely in line with the global consensus among industry and regulators internationally.

However, I am sympathetic to concerns raised by some noble Lords about the impact this could have on some mortgage holders. I remind noble Lords that the Financial Services Act 2021 allows the FCA to impose a synthetic methodology only if it considers it desirable to do so to protect consumers or to protect and enhance the integrity of the UK’s financial system. The FCA’s proposals have been approved by its statutory consumer panel.

The FCA’s synthetic rate seeks to provide a reasonable and fair approximation of what Libor would have been had it continued to be based on panel bank contributions, while removing a major factor in the volatility of the rate. This is to the benefit of mortgage holders and other retail borrowers, who will no longer be exposed to perceived changes in bank creditworthiness or liquidity conditions in wholesale funding markets.

Today’s Libor rate is at historic lows, but it can fluctuate significantly. Three-month sterling Libor has varied from 0.28% in September 2017 to 0.92% at the end of December 2019 and is now 0.09%. The FCA’s synthetic methodology will protect contract holders from these large swings. We do not know precisely what the difference between synthetic Libor on 4 January 2022 and panel bank Libor on 31 December 2021 will be. We can reasonably expect that it will remain at a historic low when the synthetic methodology is imposed and that contracts referring to this rate will be protected from large swings in the Libor rate.

Finally, only a relatively small number of mortgages use Libor in the UK—around 200,000 out of some 11 million. It is much more usual for a mortgage to reference the Bank of England base rate. The FCA estimates that only around half of these 200,000 mortgages are residential; the rest are buy-to-let mortgages. The FCA expects that the majority of these mortgages will transition away from Libor before the end of the year and so never use the synthetic rate.

Customers holding Libor-referencing mortgages should speak to their lender to switch to an alternative rate. The FCA does not expect firms’ transition efforts to result in worse customer outcomes than would be achieved through synthetic Libor, given the clear market consensus on fair replacement rates that has been established in the market for some time. The FCA would pay close attention to any evidence or feedback suggesting the contrary and take the necessary action to intervene.

The approach the FCA has taken produces a fair approximation of the Libor rate and is the best thing for any consumers or businesses which will need to rely on this rate. The alternative is having no rate at all or being put on an unsuitable fallback rate, which may well be designed for a different situation, such as a short-term problem with publishing Libor.

The Bill supports the wind-down process. It ensures that contracts remain unaffected by the Libor transition if they are not able to move to alternative rates in time. The Government have carefully considered responses to their consultation and the complex range of contracts which reference critical benchmarks. The FCA has confirmed the process to wind down Libor by the end of this year. The Government will continue to engage with Parliament with a view to securing passage ahead of the end of the year.

I hope that, having provided the House with the background to the Bill, an explanation of its provisions and an update on the broader work being undertaken by regulators on the Libor transition, we can debate the provisions in the Bill in a constructive manner and push forward this vital legislation. I beg to move.

--- Later in debate ---

[Lord Agnew of Oulton (Con)]

My Lords, I thank noble Lords for their detailed and collaborative contributions on this very technical Bill. I would particularly like to welcome and thank my noble friend Lord Altrincham for his excellent and personal maiden speech. I know that his experience in financial matters will be of great benefit to us all.

The Bill reinforces the provisions in the Financial Services Act 2021 that provide the FCA with powers to oversee the wind-down of a critical benchmark in a manner which protects consumers and minimises disruption in financial markets. In doing so, it provides key support to the Libor transition and market confidence.

I will try to address a number of the questions raised by noble Lords this evening, but I will write on the more technical ones on which I may not be able to come up with the answers immediately.

I start with the noble Lord, Lord Sharkey, and his concern about the late running of this, so to speak. I accept his point that work could possibly have been done before the Financial Services Act 2021 received Royal Assent. The FCA feels strongly that it needs to follow an orderly and sequenced process to consult first on the framework for decisions and then on the decisions themselves, but I accept that the timing will be tight.

The noble Lord, Lord Sharkey, also asked why this year is taken as the cut-off. This date was selected back in 2017 after engagement with panel banks, so it has been in the works for quite a long time and there has been time for the industry to plan for it. We have had very close engagement with the US and the timings are aligned. It has now said that the new use of US dollar Libor rate will stop at the end of this year, following supervisory guidance from the US and UK and other international authorities.

The noble Lord, Lord Sharkey, also asked about the mechanisms for the synthetic rate to be smoothed. The FCA has confirmed that that is the approach. The synthetic methodology is based on a broad global consensus and it would cause significant market disruption to change course at this point. It is not clear that that would deliver better outcomes for markets or consumers. As discussed at the briefing yesterday, the smoothing has been put in place taking the five-year median rate, but I can write with more detail if the noble Lord would like, as I accept that this is an important issue.

The noble Lord, Lord Sharkey, said he was worried about congestion at the end of the year. We have been clear that the active transition is the main mechanism; we have seen a large transition away from Libor over the last few months. I take my noble friend Lord Blackwell’s point that the latest data shows that some 55,000 contracts are still outstanding, but they are moving quickly. The FCA has taken on board market feedback on distinguishing between contracts that can be amended before the year end and those that cannot. Every step it is taking is to minimise disruption, in line with the objectives.

My noble friend Lady Noakes asked about the cost of funds fallbacks. This legislation provides certainty on how references to the Article 23A benchmark should be interpreted in contracts and other arrangements in which the FCA has exercised powers under the benchmarks regulation to require a change in the benchmark methodology. Where a contract or arrangement has a fallback that is triggered by the temporary or permanent unavailability of Libor, Article 23FA provides that the benchmark continues to be available and consequently that it does not cease to exist, be published or otherwise be made available. This means that the cost of funds fallbacks, which are generally triggered by the unavailability of the benchmark, will not be triggered.

My noble friends Lord Blackwell and Lady Noakes asked what happens after the proposed 10-year period. The legislative framework put in place in the Financial Services Act 2021 allows the FCA to support the orderly wind-down of the benchmark. Specifically, it allows the FCA to impose a synthetic methodology to provide for the continuity of a Libor setting for the benefit of tough legacy contracts for up to 10 years. The Government will continue to work closely with the FCA and the Bank of England to support an orderly wind-down of Libor and will continue to monitor the risks in this area, given its systemically important role in the UK economy.

My noble friend Lord Blackwell asked about the shorter term, after a year. The benchmark regulation provides that the FCA can review the decision to compel continued publication of a synthetic benchmark after a year. The FCA has been clear about the expected direction of travel with regard to the sterling synthetic Libor rate and does not intend that it will cease automatically after a year.

The noble Lord, Lord Sharkey, and the noble Baroness, Lady Kramer, are concerned about FCA accountability and, linking to that, parliamentary oversight. The FCA must operate within the framework of statutory duties and powers agreed by Parliament. The FCA is also fully accountable to Parliament for how it discharges its statutory functions. This direct accountability to Parliament reflects the FCA’s statutory independence and the fact that it is solely responsible for everyday operational decisions, without government approval or direction, and so is primarily accountable for them. The legal framework ensures direct accountability of the FCA to Parliament, including through a requirement for it to produce annual reports and accounts which are laid before Parliament by the Treasury.

The FCA is subject to full audit by the NAO, which has the associated ability to launch value-for-money studies on the FCA. The FCA is subject to scrutiny from Select Committees. The Treasury is the FCA’s sponsor in government; it is responsible for the statutory framework of financial services regulation and for the continued effective operation of the FCA as part of that framework. The mechanisms for the FCA can be directly accountable to the Treasury. This includes direct controls over appointments to the FCA board and powers under the Financial Services Act 2012 to commission reviews.

The noble Lord, Lord Sharkey, and my noble friend Lady Noakes asked about safe harbour. The responses to the Treasury consultation earlier this year identified the risks that parties may look to contest the continued publication of synthetic Libor by its administrator, or to seek damages against the administrator. This risk might be heightened if other avenues of litigation are closed off to parties by the Bill.

Where the administrator of an Article 23A benchmark is subject to legal challenge for complying with statutory requirements imposed by the FCA under the benchmarks regulation, it could impose a significant unreasonable and unmerited burden on the administrator of an Article 23A benchmark. If faced with too much legal risk, the administrator may seek to resign from administering the benchmark, which in turn risks causing disruption. Such action could serve to erode parties’ confidence in using the benchmark, undermining the operation of the FCA’s powers to oversee an orderly wind-down of it.

My noble friend Lady Noakes also asked about alternative benchmarks. The focus of this legislation is on providing legal certainty regarding the operation of the FCA’s powers to wind down this critical benchmark. Where contractual parties have acted in line with regulatory guidance to transition the contract to an alternative rate, the Government do not see that there is a need for further legislative clarity. The Government continue to encourage parties to contracts that reference Libor to transition those contracts to alternative benchmarks wherever possible, in accordance with regulatory guidance.

Several noble Lords, including my noble friend Lord Blackwell, asked about legal certainty. It is the Government’s view that it is appropriate to provide legal certainty as to how references to Libor should be interpreted in contracts or other arrangements, once the switch to the synthetic rate occurs. This legislation comprehensively addresses the risk of contractual claims relating to the exercise of the FCA’s powers to wind down a benchmark, as identified in response to the Treasury’s consultation on this matter.

It is important to stress how narrow the contractual continuity provision is. It does not protect the parties to the contract from all legal challenge. This would result in parties to those contracts not being able to challenge any element of that contract, and would be too broad. It simply specifies that where a contract references Libor, that should be read as referring to synthetic Libor. The effect of that is that legal claims cannot be brought on the basis that synthetic Libor is not included in the contract.

As the home jurisdiction of Libor’s administrator, the UK has a unique role to play in minimising financial stability risks and disruption to financial systems arising from the wind-down, both in the UK and globally. This plays to the comments made by several noble Lords in relation to London’s reputation as a financial centre and the unfortunate events that surrounded the problems with Libor 12 or more years ago.

In the UK framework, the FCA will be able to provide for the continuation of Libor settings under a synthetic methodology. Subject to the legislative framework in other jurisdictions, any change of methodology imposed by the FCA would flow through to global users of Libor contracts continuing to reference the rate. By taking this approach, the UK has provided a global solution rather than an approach that would have been effective only in the UK.

My noble friend Lord Blackwell asked about the methodology. Noble Lords will appreciate that setting this methodology is a responsibility that Parliament has granted to the operationally independent FCA, within the parameters established by the recent Financial Services Act. However, the FCA has an overriding responsibility to act in the best interests of consumers in this country. It is also important to note that the FCA’s approach is in line with the global consensus.

As we all acknowledge, and as I said in my opening remarks, Libor is mostly used by sophisticated financial operators, not retail investors. We estimate that there are only around 200,000 mortgages left on Libor, with that number estimated to fall to somewhere between 50,000 and 100,000 in the next few months. The synthetic Libor rate is a last resort and regulators have been encouraging markets to move to alternative rates for some time.

I remind noble Lords that the Financial Services Act 2021 allows the FCA to impose a synthetic methodology only if it considers it desirable to do so to protect consumers or protect and enhance the integrity of the UK’s financial system. Furthermore, the synthetic rate seeks to provide a reasonable and fair approximation of Libor while removing a major factor in its volatility: the variable credit spread, which has often spiked in times of economic stress. Reducing volatility will benefit consumers who pay interest with reference to Libor.

I will write to the noble Lord, Lord Eatwell, on his specific points; I am afraid that I do not have that information to hand at the moment.

This Bill is vital to the protection of consumers and the integrity of UK markets. I would be happy to arrange another detailed technical session in a similar form to the two we have had so far, because I am aware of how technical this Bill is. I hope that we have noble Lords’ support.

[Lord Tunnicliffe (Lab)]

My Lords, may I raise a bureaucratic point before the Minister sits down? He intends to put letters in the public domain through the medium of the Library. It would be convenient if he could simultaneously copy them to everybody who has participated in the debate and registered interested parties like me.

[Lord Agnew of Oulton (Con)]

I would be happy to do that. I am pleased to see the noble Lord, Lord Tunnicliffe, back here without Covid; we were worried that he might have had it. I will certainly do that.

Bill read a second time and committed to a Grand Committee.