Three significant speeches were made by members of the Financial Conduct Authority during July and August.
The Role of Investment Managers in the post COVID-19 Recovery
Christopher Woolard, Interim Chief Executive at the FCA, delivered a speech at a webinar hosted by The Investment Association (IA). Mr Woolard reflected on the COVID-19 crisis so far and discussed the role that the investment management industry could play to help aid recovery. The speech is summarized below. To read the full version click here.
Key points outlined in the speech were the following:
- The Treasury, the Bank of England and the FCA have been trying to build a bridge across the economic aspects of the COVID-19 crisis to help consumers and firms get to the other side in the best possible shape.
- The FCA is proud of its collaborative work with financial firms, trade associations, debt charities, consumer organizations and the Investment Management Association.
- The FCA deferred regulatory change where it could to help financial services firms concentrate on serving their customers.
- The FCA promoted the smooth running of the financial markets so businesses could continue to raise money and support jobs. The FCA provided clarity on its expectations of listed companies that rely on capital markets. The FCA and its colleagues in Europe, the US and Hong Kong have advocated that these capital markets remain open.
- The FCA has adapted as an organization to embrace quicker decision making and flexibility in resourcing.
- The FCA has drawn on its experience to manage the crisis and make itself a more operationally resilient organization.
The Resilience of Investment Management During the Crisis
The fund management industry showed great resilience against volatile market conditions. When uncertainty over commercial real estate values made it necessary to suspend daily dealing in open-ended property funds, fund managers worked with the FCA to action this quickly and safely.
As with Brexit, the COVID-19 crisis demonstrates the difficulty for funds to provide daily liquidity to investors when their assets are inherently illiquid.
The FCA has considered how to ensure redemption arrangements offer a fair deal to those remaining in the fund as well as those who exit. The FCA will consult on whether funds could safely transition to a structure in which liquidity promises to investors are better aligned with the liquidity of fund assets.
The Challenge Ahead
The government, central bank and regulators have tended to focus on credit during the crisis. The government is providing loans to struggling firms; the Bank of England has reduced the Bank Rate to near zero; and the FCA is providing forbearance to those consumer borrowers financially affected by the economic impact of the pandemic.
These interventions have helped companies and consumers to weather an unprecedented storm. but increased debt does not provide a sustainable foundation for rebuilding.
Listed UK companies have utilized their access to the UK public capital markets during the crisis. UK companies listed on the LSE’s main market and AIM raised £14.7 billion in equity between April and June this year, which is almost double (194%) the amount in the same period last year.
To continue to support the vital work of recapitalization, The FCA is seeking to understand whether there are some types of issuers that are unlikely to be served by public or private markets over the period of crisis into recovery. If so, whether there is a framework that accommodates a wide range of issuers and those investors able to understand and bear the inherent risks involved.
The FCA wants rules that balances the needs of both issuers and investors. High standards which are properly monitored and enforced, give investors the confidence to invest and therefore issuers whose securities are traded every day must meet continuous disclosure requirements. These are fundamental to preventing market abuse and supporting investor confidence in traded prices.
However, some smaller companies do not have sufficient equity to support daily trading. The FCA welcomes a discussion on how such companies could access capital markets, such as periodic disclosures. The FCA considers there is a link between less liquid securities and the IA’s own work on the Long-Term Asset Fund.
For larger corporates that meet the UK’s super-equivalent premium listing standard, the process for follow-on equity issuance could be simplified while maintaining valuable pre-emption rights and essential disclosures. Premium listed issuers could issue debt in lower denominations, making them more accessible to retail investors.
The FCA will engage with market participants on the issues discussed over the coming weeks.
LIBOR Transition – The Critical Tasks Ahead
On July 14, 2020 the Director Markets and Wholesale Policy at the FCA, Edwin Schooling Latter, delivered a speech at a webinar hosted by the International Swaps and Derivatives Association (ISDA) on ’The Latest in LIBOR Transition, The Path Forward'. Below is a summary, to read the speech in full click here.
LIBOR is the critical benchmark referenced in swaps and other derivatives contracts and is being replaced by risk-free-rates (RFRs).
LIBOR will continue to be published until end-2021, and the next 4 to 6 months are arguably the most critical period in the transition away from LIBOR. The need to act on LIBOR transition has not been pushed back by the impact of coronavirus (Covid-19). The time to act is now.
In July 2017, the FCA announced that markets had four and half years to transition from LIBOR. Since then ISDA has prepared the tools that derivatives market participants will need. ISDA plans later this month to finalize the protocol and other documentation through which outstanding derivatives contracts which reference LIBOR can work using the new RFRs.
ISDA’s work has established global consensus across currencies, across sell side and buy side, across private and public sector, on a preferred and on a fair way to calculate fallback replacement rates for LIBOR, and other IBORs. This fallback is the combination of the relevant overnight RFR, compounded in arrears, and a fixed spread to reflect the premium associated with unsecured lending at term.
The overnight risk-free rates provide the most robust benchmark interest rate available, derived from active and reliable markets.
Compounding in arrears rather than taking forward-looking expectations derived from a short trading window provides the most robust way of adjusting for term, and the power of averaging helps protect users from day-to-day spikes driven by varying liquidity. The consensus on fallbacks established through ISDA’s work in derivatives markets has also been embraced by cash markets in the UK and the US.
ISDA’s work has also enabled consensus to form on ensuring that these fallbacks make derivative markets robust not only to the final cessation of LIBOR, but also to the possibility of a messy pre-cessation period, preceding LIBOR’s final end, in which LIBOR can no longer be published on a representative basis.
The FCA and other authorities have consistently and repeatedly urged market participants from all sectors – sell side, buy side and non-financial, to ensure they are ready for the end of LIBOR by adhering to the ISDA protocol. Firms must now ensure they have signed the protocol within the four-month adherence period that ISDA will offer after the protocol is published this summer.
Current arrangements in older uncleared derivatives contracts for the end of LIBOR are no longer fit for purpose. These arrangements were designed when the world was different from now, requiring counterparts to ring round major banks for quotes. That is a similar sort of quote to those that underpin LIBOR itself through panel bank submissions. But if LIBOR is disappearing because the market it measures has been fading away and panel banks don’t feel able to support the LIBOR benchmark, those arrangements will not work for thousands of market participants trying to do this alone. The plausibility of relying on ringing round dealers to offer substitute rates is questionable. You could be left with a contract that no longer works. Not signing the protocol therefore seems a huge risk to take.
Regulators do not think financial firms can afford to take that risk. That is why, under UK and EU law there is more than just regulatory exhortation to be ready for the end of LIBOR. Under the Benchmark Regulation (Article 28(2)), it is a regulatory requirement for supervised firms to have a plan for cessation or material change in a benchmark like LIBOR. The FCA considers that signing the protocol meets that requirement. Conversely, any UK regulated firm with major uncleared derivative exposures that chooses not to sign will need to be ready for some serious questions from FCA supervisors on how they will mitigate these risks.
Decisions on the various LIBOR settings and cessation of settings at the end of 2021 could be announced in the final weeks of 2020. There could also be announcements that it will no longer be possible to produce LIBOR settings on a representative basis from the end of 2021.
New Powers and 'Synthetic' LIBOR
On 23 June, HM Treasury announced additional powers FCA to enhance the FCA’s ability to manage the LIBOR endgame. These powers would kick in when the administrator could no longer produce a representative LIBOR rate based on panel bank submissions. Providing certain other circumstances prevail, the FCA could require the administrator to change the methodology by which LIBOR is produced, known as creating a 'synthetic' LIBOR. This would not make LIBOR representative again, but it could provide a way of reducing disruption and dislocation in the LIBOR endgame.
These powers are intended to provide a way of resolving issues around existing or so-called 'tough legacy' LIBOR contracts – those that cannot practicably be converted. They do not support continued use of LIBOR in new business. For many, there will be a legal prohibition on the use in new business of a benchmark which will no longer be representative.
The FCA will only use these powers in respect of legacy transactions where it is necessary to protect consumers or market integrity. There may be consensus that these interests are better served by simply stopping some LIBOR settings.
It might not be possible for the FCA to use these powers for all LIBOR currencies if the inputs necessary for an alternative methodology are not available for the relevant currency, or not available on appropriate terms to the LIBOR administrator.
Even if the inputs are available and the consumer and market tests are met, parties who rely on regulatory action enabled by this legislation, will be relinquishing their control over the economics of their contracts. The LIBOR transition process has already shown that derivatives markets, bond and large parts of cash markets, prefer transition to overnight interest rates compounded in arrears at the end of a relevant interest period. LIBOR is a forward-looking benchmark. Tough legacy contracts using term LIBOR benchmarks use a forward-looking measure of expected interest rates.
Methodology changes that replicate the forward-looking nature of these contracts would not therefore deliver the first-best outcome for many LIBOR users, including the majority of derivative and bond contracts. Industry-agreed fallback arrangements – for example through the ISDA protocol – or bilaterally or multilaterally agreed conversions before end-2021 will be preferable for a wide range of contracts.
The only way for contractual counterparties to have that certainty and control over the future of their obligations is to convert them by mutual agreement.
The FCA may not use these powers unless there has been wide take up of the protocol, because it does not view a synthetic LIBOR as a suitable foundation for derivatives markets. A wide adoption of ISDA’s protocol will increase the prospects that the FCA will be able to use these proposed powers to address tough legacy needs in cash markets.
These powers could reduce concerns regarding the important pre-cessation triggers in derivatives contracts which have noted the discomfort that could arise for some if a non-representative panel bank LIBOR continued to be published. This is because panel bank LIBOR’s value could diverge from that of an RFR-based fallback with a fixed spread. The new powers would allow the FCA to require methodology changes that aligned the retiring and now non-representative LIBOR rate with market consensus on how to calculate fair fallback values for LIBOR during a pre-cessation period – by using a term-adjusted RFR plus the same fixed credit spread around which market consensus has formed. There would be no mandated LIBOR methodology change before the point of non-representativeness. If all the conditions were met, it would be possible to mandate a change to coincide with the conversion of contracts that have pre-cessation fallbacks based on non-representativeness.
Conversion Ahead of the Protocol
Many are already well advanced in the transition from LIBOR. Trading in swaps and futures based on the new RFRs is established and is a growing share of both new flow and outstanding stock.
Liquidity is most developed in sterling, where we had a head start with active SONIA swap markets at shorter maturities. There is now plentiful liquidity at the long end too. Liquidity needs to build in US dollar too, as we approach the important landmark of switching discount rates to SOFR at the major CCPs.
ISDA’s protocol is necessary but not sufficient. The FCA will be expecting firms to be able to show that they have robust fallback documentation in place before LIBOR ceases or becomes unrepresentative, and that have completed transition for all new business, and have plans that make use of opportunities to reduce legacy LIBOR books before the end comes.
Capital Market Regulation and COVID-19
Mark Steward, the FCA’s Executive Director of Enforcement and Market Oversight, delivered a speech at the ShareSoc Webinar: building market and investor confidence.
Key points covered in the speech included the following:
- How the FCA’s secondary market surveillance capability gives it visibility over trading in the market so that it can more readily identify and probe potential suspicious activity and distortions in the market.
- How compensation being provided to shareholders affected by market abuse can play an important part in addressing market abuse consequences.
- The temporary measures introduced by the FCA to address the difficulties faced by capital markets during the COVID-19 pandemic.
Mr Steward referred to the FCA’s decision not to fine a listed IT service provider for misstating its accounting balances, because of the steps taken by the company to remediate its governance, both in terms of systems process and personnel. Furthermore, the company remediated, as far as it could, losses to those shareholders who bought shares during the period in which the company’s share price was affected by the false or misleading information net of any shares sold in the period. The FCA also considered the negative impact a fine would have on the company, which provides vitally needed services in the fight against Coronavirus. The FCA issued a public censure against the company in June 2020.
Mr Steward emphasized that the FCA is working to bridge the pre-coronavirus and post-coronavirus worlds by ensuring markets continue to work well.
The full speech can be found here.