In this post, the third of a series of posts addressing the end of Libor and her relatives, we discuss the consequences of such a vast monetary reform.
Will LIBOR reform look like “Y2k for the legal profession?”
Recall back in the late 1990s, industry woke up to the reality that computer code had been written with a convenience that would no longer work after Dec 31st1999 – the famous “Y2k problem”, making many technology and programmer millionaires in the years up to 2000.
With LIBOR impacting millions of contracts globally, offering a boon for the legal profession, this brings us to the fifth problem – the legal costs of replacing LIBOR with something else(e.g. SOFR/BTFR) are likely enormous, and no one will want to do this twice, let alone switch to a failure. Some suggest a two-stage switch, from LIBOR to the (fed-funds or SONIA based) OIS, and then subsequently, should the rate become established, on to the SOFR. The latter stage may or may not initially be on a fully cleared basis, perhaps seeing bilateral trading grow first. But with millions of documents to be changed, it seems likely cost issues will prevent such a two-stage transition from evolving. However, as we noted in the exhibits in Appendix 3, in most currency regimes, 60-70% of these contracts will mature, and as such either expire or be rolled into new contracts employing new language. The Trade associations like ISDA and LSTA will surely create new standard language to be incorporated in fresh contracts, providing further economies of scale. Lawyers will be involved, but likely not to the broad extremes of the Y2k problem. There will be areas where things are unlikely to proceed so smoothly, to which we turn now.
What happens if nothing happens?
Most, if not all LIBOR-related transactions have some governing guidance to cover the lack of LIBOR fixings. They may not be clear, or legally binding, but they likely exist. These documents, together with the relevant administrator and trade association’s guiding rules, will determine how arduous this process becomes.
For example, Libor is administered by ICE (Intercontinental Exchange), and they have a policy to cope with the circumstances where panel banks pull out. However, their fall back of “re-publish the previous day’s published rate for all tenors in that particular currency” is unlikely to be sufficient, and it’s almost certain ICE will adjust their fallback processes in the meantime.
As the transition evolves, the financial system will have to cope with the sixth and final problem – reaching agreement on the language for converting the old existing trades or loans into the new benchmark formats. ISDA (International Swaps and Derivatives Association) is the trade association governing most over-the-counter (OTC) derivative markets. Contracts entered into under ISDA “2006 Definitions” already include language governing the failure to source LIBOR. However even the 2006 protocols are feared to be unworkable in the medium term, and ISDA are currently working on new “LIBOR replacement” language. One can expect to see references to the new LIBOR alternatives like SOFR and SONIA within this language. However, these new protocols are not to be grandfathered. Instead they will only apply to new derivative transactions with the freshly revised language. Any decision to change the benchmark rate on old trades will remain “bipartite” and clearly exudes litigation risks.
In corporate and consumer loans markets, many are governed by the Loan Market Association (LMA) or Loan Syndications & Trading Association (LSTA) standard form facility agreements. Typically, they allow for the provision of a replacement rate based upon a “three-tier waterfall” of bank reference borrowing rate(s), the lending bank’s cost of funds, or an alternative rate. As with the ISDA provisions above, it’s unlikely these loan provisions would work on large scale and over the medium term and we’d expect the two trade bodies to propose amended provisions shortly, perhaps again referencing the officially sponsored alternatives like SOFR in the US. It may also take legislation to enforce the replacement of LIBOR with another benchmark, and even then, could result in lawsuits and local court decisions. These loans are easily the most troublesome LIBOR-related contracts to successfully transition.
Finally, capital market documentation often includes provisions for alternative reference rates, but without a standard, and requiring amendments to the bond documentation and approval of the majority of bondholders. While perhaps not as challenging as the loan market, some of these transactions will likely see litigation, especially CLOs. We discussthese challenges, market by market, later in the paper.
Finally, the CME, which governs the ETD Eurodollar derivatives, has its own “final” fallback process – “If these and other fallback provisions were exhausted, such that there was an indefinite impairment of a USD LIBOR value, the exchange would be empowered under CME Rule 812 to “establish a final settlement price that reflects the true market value at the time of final settlement.” This would likely be done using the applicable industry-accepted fallback spreads between LIBOR and SOFR.” This reference to “backing into” LIBOR rates for settlement of derivatives contracts, using “accepted (historic) spreads between LIBOR and SOFR” is likely the basis for the discussion of how to calculate the term and credit spreads required to convert an overnight rate (SOFR) into a term rate (e.g. 3month). While ad hoc and problematic, it’s possible that this CME ruling could provide support for the calculation process.
Summary of the 6 problems so far identified
According to regulators who have begun the outreach to market participants, the issues identified so far are;
- Avoiding an economic transfer when the switch is ultimately made to an alternative fallback rate, including:
- Setting a static spread between the “IBOR” and the fallback rate in a neutral way and with differentiation along the curve
- Addressing the absence of term structures in the replacement rates (at least in the initial fall back contemplated for the replacement rates)
- Knock-on effects in arbitrage trades/existing futures contracts
- Defining contractual terms for the transition in advance of the transition occurring (e.g., establishing a trigger with full clarity on the basis of which the calculation would switch to the fallback rate)
- Ensuring that the underlying cash markets make the same transition as derivatives, and ideally do so at the same time
- Suitability of solutions and transition mechanisms for end users/ability to operationalize the change across market participants
We have discussed many of them above, addressing in turn, the follow six problems;
- Premature disorderly collapse –Will legal and compliance officers, feeling that to continue to submit rates to a market that is dying is an unnecessary business risk, call a halt?
- No clear winner – In all five currency regimes, there is still no formal agreement on a precise replacement for LIBOR
- Term premium– how to turn an overnight rate (like SOFR) into a term rate (like 3mth LIBOR)
- Credit Premium– the common problem with all the proposed replacements – the lack of credit risk, a hallmark of the LIBOR rates which were designed to reflect bank unsecured credit risks.
- The legal costs of replacing LIBORwith something else (e.g. SOFR/BTFR) are likely enormous, and no one will want to do this twice
- Reaching agreement on language for converting to the new benchmark – and ensuring some consistency across products and minimizing legal disruptions.
Could the LIBOR reform trigger a financial crisis?
This is the $64,000 question, and impossible to know. Three things can perhaps be said though. With upwards of $350 Trillion of securities affected, LIBOR, its demise certainly matters to the global financial system. It’s not in the interests of regulators to needlessly clip the talons of such a beast without all due care. One would expect the urgency of reform to increase now the FCA has formalized what was already largely expected and discussed amongst banks. Secondly, the genie can’t be put back in the bottle. Now the FCA has determined that LIBOR will retire, any U-turn would naturally be greeted with skepticism, and could end up fermenting a more severe market response. Thirdly, the unsecured nature of LIBOR has always seemed incongruous as a primary valuation metric amongst an ever-more collateralized financial system. Carefully bringing this to a head should reduce the overall risk of the global financial system, but it comes at a cost.
We now round off the paper with specific examples that touch upon how these challenges from the LIBOR reforms impact specific financial markets.