The effort to extinguish Libor is driven mainly by regulators who favour benchmarks based on real trades rather than benchmarks based on banks’ estimates, since the latter may be subject to bias and fraud; in fact recent scandals of benchmark rigging have lead to the imposition of hefty fines (approximately £1.5 billion in the UK in 2014) and even prison sentences in some instances.
The headache faced by the market in connection with the phasing out of Libor is, ironically, a product of Libor’s success over its 30 year lifespan, since more than $370 trillion of deals around the global financial markets are tied to it and it is used as a benchmark for a plethora of products, from simple home mortgages to complex derivatives.
While Brexit seems to be “sucking much of the regulatory oxygen” in the UK and on the continent at large, and little has been done by European regulators to propose a concrete plan for life after Libor, market participants are still eager to find solutions to the problem of a life without Libor since, some participants worry that the transition costs may be bigger than those incurred because of Brexit. To this end, large magic circle law firms such as Linklaters have invested in AI robots in an attempt to find and fix Libor terms in clients’ outstanding contracts; and the International Accounting Standards Board recently published an Exposure Draft Interest Rate Benchmark Reform which proposes exceptions to specific hedge accounting techniques in IFRS9 and IAS 39. In addition, on 16 May 2019, the International Swaps and Derivatives Association launched two consultations which aim to ease the problems that may be faced the period leading up to the extinction of Libor and beyond: the first sets out options for adjustments that will apply to the relevant risk-free rates (RFRs) if fallbacks are triggered for derivatives referencing, inter alia, USD Libor; the second relates to pre-cessation issues, and seeks comment on how derivatives contracts should address a regulatory announcement that Libor or certain other IBORs categorized as critical benchmarks under the EU Benchmarks Regulation are no longer representative of an underlying market.
In the US, the drive to find a solution to the eventual extinction of Libor is being driven by Alternative Reference Rates Committee (ARRC), being an initiative spearheaded by the Board of Governors of the Federal Reserve System and the Federal Reserve Bank of New York, (but with members including regulators (e.g. the S.E.C.), trade associations (e.g. ISDA), and other important market participants (e.g. Goldman Sachs)) which has the aim of developing alternative interest rate benchmarks, creating an implementation plan to support voluntary adoption of the alternative rate, and identifying best practices for contract robustness in the interest rate market. The ARRC has selected the Secured Overnight Financing Rate (SOFR) as an alternative rate to Libor. The ARRC claims that SOFR is more resilient rate than Libor because of the way it is produced and the depth and liquidity of the markets that underlie it. In addition, given that SOFR is an overnight secured rate published each business day at approximately 8:00 a.m. Eastern Time (14:00 GMT+2), the ARRC claims that it better reflects the way financial institutions fund themselves today. Furthermore, in view of the fact that the transactions underlying SOFR regularly exceed $800 billion in daily volumes SOFR is claimed to be a transparent rate that is representative of the market across a broad range of market participants and protects it from attempts at manipulation.
In its effort to ensure a smooth transition from Libor to SOFR, the ARRC has set out a Paced Transition Plan with respect to the adoption of SOFR in the derivatives market. In so doing, the ARRC has developed, or is in the process of developing, contractual fallback language for a range of products such as bilateral business loans, floating rate notes, securitisations, and syndicated loans. This draft language may be used in new contracts that reference USD Libor to ensure these contracts will continue to be effective in the event that Libor is no longer usable.
The examples highlighted above are a clear indication of the market’s concerted efforts to find workable solution to the problem of the extinction of Libor, which desire is propelled by a fear of disruption and litigation, which bring about unnecessary costs, and unwarranted stress.
A recent article in the Financial Times (1 May 2019) quoted Lech Walesa speaking about the risks of “unpicking decades of communism” to underscore the risks and difficulties of moving on from Libor – “it is easy to make fish soup from the aquarium with living goldfish, but just imagine what a challenge it is to try to make the aquarium with living goldfish out of the fish soup”. To my mind, the metaphor is apt, but market participants cannot shy away from the task, there is too much at stake – a solution must be found, and the sooner the better.
This article was first published in the Times of Malta, 5 June 2019.