Andrew Bailey’s speech on Wednesday 11th July 2018 was part of a globally-co-ordinated move involving a statement from the FSB, remarks from Chris Giancarlo and fellow Commissioners’ at the CFTC’s Market Risk Advisory Committee in the US, and the launch of the ISDA consultation (at the time of writing, not yet on its website), which he said “rightly points to the overnight RFRs… as the foundation for a fall back rate”. It is essential reading that cannot be much summarised without losing important detail, but these are some points:
- About 30% of the c. US$170 trillion notional of LIBOR-based interest swaps cleared by LCH mature after end-2021. Inserting robust fall back clauses via ISDA protocols can reduce the risk of contract frustration, but a smoother path to transition will be the gradual variation or replacement of these contracts, perhaps through multilateral compression – which, of course, runs smack into concerns about how this could lead to contraventions of EU27 law after a hard Brexit, and explains why regulators such as the Bank of England have been so vocal about this for many months (the concerns are well known (see previous FinBrief entries and the ISDA Brexit page for more).
- There is “substantial consensus that the largest part of the market currently relying on LIBOR – that is the bulk of interest rate derivatives – does not need term rates. This part of the market is focused on hedging the general level of interest rates rather than term bank credit risk. It is already able to operate from a risk management perspective with the overnight risk-free rates, compounded where appropriate. Because term rates are not needed for the bulk of the derivatives market, and because the overnight RFRs are likely to be the most robust interest rate benchmarks available – since they are firmly grounded in transactions – we expect that liquidity in interest rate derivative markets will in future be OIS-based, i.e., directly linked to the overnight RFRs”.
- It is probable that with future liquidity in swaps and futures centred on these overnight RFRs, there will be powerful incentives for other instruments, including bonds and securitisations, also to reference the overnight RFRs.
- However, there is demand in cash markets for forward-looking term rates, “perhaps especially in respect of smaller and medium-sized issuers, and in syndicated loan markets, where parties may decide that knowing coupon or interest payments in advance is more important to them than a few basis points in spread. Hence our support for the development of forward-looking term rates derived from the RFRs”. It is “quite feasible” that the future will have two centres of gravity in interest rate reference rates – the larger one, used in most interest rate derivatives, around overnight RFRs, and the smaller one, for some syndicated loans and possibly bonds, and any related interest hedging (which is what we as transactional lawyers are more likely to encounter) having term rates, based on the overnight RFR to facilitate hedging.
- The smoothest way to transition to post-LIBOR contracts is to start moving away from LIBOR in new contracts (which for us as transactional lawyers, means doing so as soon as we have an alternative – which means waiting for the outcome of the ISDA consultation).
- What about legacy contracts where it is impractical to convert e.g. bonds with hundreds of holders, where unanimous or majority consent is required to change the terms of bonds? Could these rely on a “synthetic LIBOR”, e.g. by adding appropriate term credit spreads to overnight RFRs? “It is difficult… to see how the term credit premia that LIBOR seeks to measure, but for which the active underlying transactions from which it can be measured are so few, can be obtained from other sources. We have not seen a compelling answer… For this reason, we do not see synthetic solutions as a part of a long-term solution to evolving LIBOR”.
- But would a ‘synthetic LIBOR’ be better than nothing for stranded legacy contracts? It seems that this is what ISDA addresses in its consultation, and the FSB does not rule it out in principle, but the analysis and feedback received so far is that even if it is merely as “a lifebuoy for legacy rather than a long-term future… it does not offer an easy solution”. He agrees with ISDA that “the term credit spread would almost certainly need to be fixed rather than dynamic because of the lack of market to measure” – but, as we noted on Finbrief recently, a bank borrowing inter-bank will have to pay more in a stressful time, and at the same time assets based on a synthetic LIBOR based on a RFR would pay less, so that inherently has basis risk for a bank.
- Supervised firms will need to be able to demonstrate to regulators that they have adequate plans in place to mitigate the risks, and to reduce dependencies on LIBOR.
- Issuers of LIBOR-related listed securities need to disclose the risks in prospectuses – this is already happening
- Investment advisors and portfolio managers may need to be able to show that they have considered whether such investments remain suitable for a particular client or portfolio if there is no clear and appropriate plan on what will happen in the event of discontinuation.
Head of Knowledge Management (Finance and Projects)
Mark Daley joined DLA Piper in 2015 after over thirty years’ experience as a debt finance lawyer in private practice in London and Hong Kong.