FSB and FSOC Reflect on Post-LIBOR Transition Landscape

Nihal Patel Commentary by Nihal Patel

The Financial Stability Oversight Council ("FSOC") and the Financial Stability Board ("FSB") considered the "post-LIBOR transition landscape" and steps forward to ensure market resilience.

In a statement titled, "Final Reflections on the LIBOR Transition," the FSB encouraged market participants to use robust reference rates that are "anchored in deep, credible and liquid markets" and to continue to use robust contractual rate fallbacks in order to avoid a future repeat of a similar exercise as LIBOR transition. The FSB urged firms using term risk free rates ("RFRs") to use fallbacks referencing "IOSCO compliant alternatives of a similar risk-free nature" as primary fallbacks, rather than refer to "cost of funds," "lender discretion," or rates selected by a central bank or other official body (unless consented to by such a body).

In addition, FSB echoed IOSCO's recent statement on term rates and "credit sensitive rates" ("CSRs") (see related coverage). FSB said that term rates derived from RFRs (e.g., Term SOFR) may have a role, but should be limited to outlined circumstances that "are compatible with financial stability." FSB also said that recreating rates "based on LIBOR's underlying wholesale unsecured markets" leads to the same inherent vulnerabilities and poses financial stability concerns. FSB expressed support for a recent review by IOSCO on CSRs and term rates, and, in particular, the message that market participants should proceed with caution and understanding of the (IOSCO-identified) risks of CSRs.

At a meeting convened by U.S. Secretary of the Treasury Janet L. Yellen, FSOC stated that the "successful transition to SOFR bolstered the resiliency of the financial system" and was the result of a "public-private partnership spanning nearly a decade." In a statement, SEC Chair Gary Gensler called the LIBOR transition a "cautionary tale not to just trust something because it’s popular and ubiquitous." He stressed the importance of ensuring that any rate used to replace LIBOR be "robust and not ill clad." Mr. Gensler warned that some of the LIBOR alternatives, such as the Bloomberg Short-Term Bank Yield Index rate ("BSBY"), present flaws similar to those of LIBOR. Among these flaws, Mr. Gensler pointed to "thin markets" with few underlying transactions, which create vulnerabilities of system collapse and manipulation. Specific to the BSBY rate and other "credit sensitive rates," Mr. Gensler questioned their ability to provide financial stability due to "infirmities that will not stand the test of time."

Commentary

It is not surprising given the IOSCO statement from last month, but the FSB statement and Mr. Gensler's statement are two additional regulatory stances urging against use of CSRs and emphasizing the uphill battle for market participants seeking to make use of those rates.

One can imagine the policy behind the footnote in the FSB statement indicating more specifically how term rate fallbacks should be drafted. Generally, FSB seems to be indicating a preference for defined rates and certainty, rather than discretion (even governmental third-party discretion). It's not obvious, however, if this is the best result for lenders and financial stability. What may be viewed as certain today may be less certain (or less than ideal, commercially) in the far off future or during times of turmoil when the agreed rate is unavailable.

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