ASIC issues information sheet on managing conduct risk during LIBOR transition

ASIC has published INFO 252, a long-awaited information sheet which addresses conduct risk issues for both sell-side and buy-side firms arising out of the discontinuation of LIBOR. As the transition from LIBOR rates to alternative reference rates (ARRs) enters its final stage (with the end of 2021 assumed to be the deadline by which transition must be achieved), Australian institutions will no doubt find ASIC’s articulation of the ways in which they can seek to mitigate the clear risk of conduct issues arising from their engagement with customers useful. However, fundamental concerns will remain and those institutions will need to continue to undertake their own analysis, and monitor the LIBOR transition landscape carefully to reflect what remains a highly dynamic situation, in the way that they prepare for the end of 2021.

Background

The end of LIBOR, and the replacement of those rates by ARRs, raises profound issues for the financial services industry. LIBOR rates appear in huge volumes of contracts (both in number and value) and the fall-backs which have typically been incorporated within those contracts are uncommercial or impractical. Moreover, the switch to any of the available ARRs have economic consequences (i.e. they will change the rate payable under the contract, benefiting one party and causing detriment to the other) which are not possible to predict (and therefore fully mitigate) in advance.

We have often heard financial services regulators, over the last few years, seek to place the onus on the sell-side institutions to engage with their customers and encourage them to agree to amendments to their contracts so that a smooth transition can be achieved. On one level, that is perfectly understandable. Banks are sophisticated counterparties to high volumes of impacted contracts, and are subject to a range of regulatory duties which are of relevance in the transition process. However, there is a clear danger that the pressure which is being placed on banks to transition their customers from LIBOR may cause those customers to believe that the banks are accepting greater responsibility than they in fact are for the decision to agree to proactive amendments to legacy LIBOR contracts, and the outcomes which follow. In particular, a real concern will be that customers are left with the impression that, as a result of the educational role which banks can no doubt play, they are being advised by the banks that a particular ARR is the most suitable one for their individual circumstances.

It is against that background that the ASIC information sheet will be welcomed. However, it is fair to say that significant concerns remain.

Sell-side guidance

The information sheet provides some helpful reminders about the steps that banks can use as they seek to satisfy the requirement to treat clients fairly, and (for entities that are AFS licensees) to do all things necessary to ensure that the financial services they provide are provided efficiently, honestly and fairly. It is broken into four sections: Treating clients fairly; performance of products and services; client communication; and risk management framework.

A critical part of getting this aspect right is for buy-side firms to ensure that their staff, particularly those with customer-facing roles, are appropriately trained to undertake the important task of reducing any asymmetries of information. Unpacking this, it is vital that those staff-members understand both the substance of the issues which LIBOR transition raises, as well as the nature of the duties which the institution owes to its customers in the process. The former is particularly challenging in the context of LIBOR transition – not only are the adjustment methodologies which are used in many of the ARRs complex, but many remain (even at this late stage in the process) under development. For example, forward-looking term rates (in broad terms, the closest equivalent replacement rates for LIBOR terms rates) are still very much in the process of being developed, with no certainty that they will be available for all (or any) LIBOR currencies. Accordingly, whilst banks are expected by ASIC to explain the benefit of transition to ARRs, it will be important also to explain the risks inherent in the process. However, importantly, ASIC have put down a marker that attempts to rely on warnings and disclosures will have limited effectiveness. It will therefore be necessary for banks to carefully articulate, in clear and objective terms, what the potential range of outcomes might be, and what factors may impact on those outcomes, instead of warnings which amount to no more than a generic exposure to risk. This will be a significant undertaking.

An area in which the information sheet does not provide much guidance is in relation to the performance of the products and services which it makes available to customers, and the customer communications which will ensure that the customer understands the way in which it will perform. This is a difficult area in which to generalise because the point is that what an appropriate decision looks like for a given customer will be highly dependent on individual circumstances; there is no one size fits all approach. Slightly unhelpfully, ASIC uses the straightforward example of a long-dated LIBOR contract with an expiry after 2021 without adequate fall-backs being sold to a customer who is led to believe that it will continue to perform in the same way before and after 2021, as its example of misconduct. The overwhelming majority of situations will look very different to this example and will require far more detailed analysis. As such, the ASIC guidance does not in this respect take banks very much further forward; they will have to form their own views on what products to propose to particular customers. Moreover, whilst unsurprising, banks will need to treat the blanket statement that they should adhere to the ISDA Protocol for “all relevant derivative contracts” with appropriate caution. Whilst that may well be the right outcome in respect of many derivative contracts, there will be some for which that may expose clients to basis risk or where the amendments introduced by the Protocol need more careful consideration.

There is clearly an important governance aspect to banks’ approach to LIBOR transition. In order, ultimately, to be able to explain and address questions regarding the process which they have followed, banks will rely on the frameworks which they have in place as well as their record-keeping practices which record those frameworks. In the risk management framework section of the information sheet, ASIC has provided a reminder about the importance of these governance arrangements to address the complexity and the “constantly evolving dependencies and processes” which are involved. Whilst much work has been done across the industry to form consensus on appropriate adjustment methodologies to apply to ARRs and contractual fall-back language to use to bring them in effect, there are many twists and turns which can be expected between now and the end of 2021. Just to take one particularly topical category of such developments, the contractual and extra-territorial scope, as well as the ultimate economic effect, of the legislative proposals for LIBOR currently being considered by various legislatures around the world may well affect outcomes for contractual counterparties in ways that will remain uncertain well into 2021. Planning a transition programme, including oversight of the design of communications to clients to explain the issues involved, is an even more challenging task given the evolving landscape. Given that ASIC’s clear statement that overall responsibility and accountability for that programme rests with the board and senior management, it is obviously critical that they are closely engaged in its direction and the impact on it of developments (including those in other jurisdictions).

Buy-side guidance

The information sheet also helpfully provides some useful pointers for buy-side institutions. As ASIC notes, the impact on buy-side institutions is broad, and focus is needed on the relevance of LIBOR to performance fees, borrowing arrangements, portfolio management, client reporting, market trends and product liquidity. Buy-side institutions will need to be particularly careful in managing their indirect exposures to LIBOR transition through the investments which they have with third parties portfolio managers, by conducting adequate due diligence, risk management and contingency planning for each of those providers.

 

Michael Vrisakis
Michael Vrisakis
Partner
+61 2 9322 4411
Fiona Smedley
Fiona Smedley
Partner
+61 2 9225 5828
Charlotte Henry
Charlotte Henry
Partner
+61 2 9322 4444
Harry Edwards
Harry Edwards
Partner
+61 3 9288 1821

LIBOR transition measures in the new Financial Services Bill: the legal framework, market impact and risks

This article was originally posted on Banking Litigation Notes.

On 21 October 2020, the UK government introduced the Financial Services Bill (FS Bill) to Parliament, which has been described by HM Treasury (HMT) as a new Bill “designed to ensure the UK’s world-leading financial services sector continues to thrive and grasp new opportunities on the global stage”.

The focus of this blog post is on the LIBOR transition measures included in the FS Bill, which are consistent with the Chancellor’s announcement of the legislative fix mechanism on 23 June 2020, as considered in our previous blog post: UK Government announces LIBOR legislative fix: summary of proposals and our initial observations.

This blog post explains the legal framework of the measures included in the FS Bill, and explores the potential market impact and legal risks.

Legal framework

The FS Bill amends the Benchmarks Regulation 2016/1011 (EU BMR), as amended by The Benchmarks (Amendment and Transitional Provision) (EU Exit) Regulations 2019 (UK BMR). It provides an overarching legal framework which gives the FCA new and enhanced powers to manage the wind-down of a critical benchmark, i.e. LIBOR.

The draft legislation seeks to reduce the risk of litigation arising from disputes about the continuity of so-called “tough legacy” LIBOR contracts. In simple terms, it does this by providing new and enhanced powers for the FCA where it has determined that a critical benchmark is at risk of becoming unrepresentative, or has become unrepresentative, and that its representativeness cannot reasonably be maintained or restored. In such circumstances, the FCA will have the power to designate a change to the methodology by which LIBOR is set so that references in “tough legacy” contracts to LIBOR will effectively be treated as a reference to the new methodology (the synthetic LIBOR rate), rather than a rate which no longer exists.

The key points to note on the legal framework are as follows:

  1. The FCA will have the power to give notice to a relevant benchmark administrator (under Article 21(3B)(a) or Article 22B(3)(a)) that the critical benchmark is unrepresentative (of the market or economic reality that the benchmark is intended to measure) or its representativeness is at risk.
  2. Where the FCA has given notice under Article 21 or 22B, it may designate a critical benchmark as an “Article 23A benchmark”.
  3. Use of an Article 23A benchmark by UK supervised entities will be prohibited under Article 23B.
  4. However, in order to ensure an orderly wind-down of the benchmark for “tough legacy” contracts, the FCA will have discretion to determine specific categories of contracts which will be exempt from this prohibition on use. The exception from the prohibition against using an Article 23A benchmark appears at Article 23C, under which the FCA may publish a notice permitting “some or all legacy use of the benchmark by supervised entities”.
  5. While an Article 23A benchmark can continue to be used (where exempt from the prohibition by Article 23C), the FCA will be able to direct a change in the methodology of the benchmark and extend its publication for a limited time period for the benefit of “tough legacy” contracts. Article 23D allows the FCA to impose requirements on the administrator of the Article 23A benchmark, including as to the way in which the benchmark is determined and the input data. Article 23D(6) says that the FCA will not be restricted in its exercise of this power by having to replicate the market or economic reality that was intended to be measured by the benchmark immediately before it became an Article 23A benchmark (although the FCA may have regard to that when exercising the powers).
  6. Before exercising its new powers, the FCA will be required to issue statements of policy to inform the market about how it intends to exercise these powers (Article 23F). The FCA will be able to engage with industry stakeholders and international counterparts as appropriate through this process. In particular, the FCA must prepare and publish a statement of policy with respect to:
    • The designation of benchmarks under Article 23A;
    • The exercise of its powers under Article 23C and Article 23D;
    • The exercise of its power under Article 21A (which relates to the “new use” of a critical benchmark that is to be ceased).

The framework provides for a UK legislative solution to the cessation of LIBOR by way of primary legislation, so that the market has comfort that a cliff-edge scenario will be avoided, but leaves the policy detail to be worked out by the FCA at a later stage. The likely market impact of this approach and effect on the risk profile are considered further below.

Market impact

The policy statement accompanying the FS Bill notes the government’s recognition of the existence of “tough legacy” LIBOR contracts, which face “insurmountable barriers” in transitioning away from LIBOR. There is no doubt that the legislative fix is a helpful and significant step forward, and the market will welcome the introduction of a mechanism to address tough legacy LIBOR (as we noted in response to the Chancellor’s statement in June 2020). However, key questions remain about the approach and scope of the protections offered by the FS Bill (considered further in the section below on litigation risks) and this continued lack of clarity at this late stage in LIBOR transition will be a source of frustration for many.

The policy statement emphasises that firms should continue to prioritise active transition away from LIBOR to alternative benchmarks. It says it is in the interests of financial markets and their customers that the pool of contracts referencing LIBOR is shrunk to an irreducible core ahead of LIBOR’s expected cessation after end-2021. Our expectation is that the market will not take its foot of the pedal of transition efforts as a result of the legislative solution. This is not just because of this warning from HMT, but (in particular) because of the likely narrow scope of the legislative fix and the desire to retain control over the economic effect of any switch.

Risk profile

The key risk areas arising from the drafting of the FS Bill are as follows:

1. Definition of “tough legacy” LIBOR contracts

The FS Bill does not define “tough legacy” LIBOR contracts, i.e. which contracts will fall within the Article 23C exemption. However the policy statement confirms that HMT and the FCA are of the view that this exemption is intended for those contracts that genuinely have no realistic ability to be renegotiated or amended to transition to an alternative benchmark.

This is therefore a legislative fix that is somewhat more narrow in scope than the approaches which have been suggested by the European Commission (see here) and in the US by the Alternative Reference Rates Committee (see here). The suggestion that the solution will apply only to “tough legacy” contracts indicates that there may be some legacy LIBOR contracts, which are not swept up by the proposed legislative solution, even if they have not been actively amended bilaterally or by consent solicitation, or amended via market protocol.

It is possible that the legal framework and supporting communications from HMT and the FCA have been deliberately positioned to avoid giving the market the comfort of a broad and certain legislative solution, to ensure transition efforts are not slowed. However, we will need to wait for the FCA’s policy statements to confirm the scope, and market participants would be wise not to rely on any expansion.

2. Methodology changes to LIBOR

Another aspect of the legislative solution, which has been left to the FCA’s policy statements, is the selection of the methodology for calculating synthetic LIBOR.

The FCA has given some general guidance to the market already. In particular, we note the comments of Edwin Schooling Latter (Director of Markets and Wholesale Policy at the FCA) in a webinar on 18 September 2020 hosted by the UK’s Working Group on Sterling Risk-Free Reference Rates (RFRWG), the FCA and others. Mr Schooling Latter suggested that the FCA would use the same adjustment spread as ISDA, but with the adjusted risk-free rate (RFR) being based on a forward-looking approach. This issue was foreshadowed at the time of the Chancellor’s announcement, in a statement made by ISDA’s CEO, Scott O’Malia:

“For one thing, derivatives markets have opted to use overnight RFRs compounded in arrears, which require amendments to contractual terms in addition to referencing a different rate. Given tough legacy contracts currently reference a forward-looking term IBOR and cannot be amended, it indicates a ‘synthetic LIBOR’ will be a forward-looking term rate based on the RFRs plus a spread adjustment. Indeed, the FCA says that use of overnight RFRs compounded in arrears ‘may not be possible to replicate within the restrictions of the existing LIBOR framework’.”

As a result, there are two critical points on the value of synthetic LIBOR to be aware of:

  • When the legislative solution is triggered, because conversion of LIBOR to synthetic LIBOR will not be present value neutral, there will be an immediate and obvious change in the interest paid under the relevant contract, over which none of the parties to the contract will have control (having been unable to amend the relevant contract before the trigger); and
  • Where one contract is converted to synthetic LIBOR via the legislative solution (e.g. an unamended loan), but its associated hedge is converted via ISDA’s 2020 IBOR Fallbacks Protocol, the hedge will no longer exactly match the cash product (see our banking litigation blog post on the ISDA Protocol).

3. Extraterritorial scope

The FS Bill purports to have extra-territorial effect, as it is not limited to contracts governed by UK law and applies to all UK supervised entities. This is tempered by express requirements for the FCA to have regard to the likely effect outside the UK when exercising its various powers delegated under the draft Bill. In particular, this applies to the FCA exercising its power of prohibition (Article 21A), exemption (Article 23C) and change of methodology (Article 23D).

There is an interesting question about the inter-relationship between the UK, EU and ARRC proposals (see our blog post: Legislating for LIBOR transition: UK/EU jurisdictional battle or complementary regimes?).  All three legislative solutions currently seek to have extraterritorial effect, not limiting themselves to contracts governed by their respective laws. This is of course subject to change; it is worth noting that the EU Council has responded to the draft legislation published by the European Commission with the suggestion that it should only apply to EU law contracts (or certain third country contracts, but only where the third country has not sorted out its own fix). Indeed, in circumstances where it is not clear what legislation will ultimately get passed, it is difficult for market participants at this stage to assess whether extra-territoriality is a good thing or not.

It is possible that the regime applicable to a particular contract will not ultimately change the new rate that is applicable on the cessation of LIBOR, if the successor rates adopted for each currency of LIBOR are consistent (e.g. that the UK, EU and ARRC transition a USD LIBOR contract to SOFR plus a spread adjustment). However, it is entirely possible that the successor rates adopted will not be the same, particularly taking into account differing approaches to the calculation of the successor rate (e.g. whether it is a compounded RFR in arrears rate plus a spread, or a forward looking rate plus a spread). Of course, the calculation of the credit spread adjustment may also be different, although currently this appears less likely.

4. Safe harbour

The debate surrounding the inclusion of “safe harbours” in the legislative solutions for LIBOR cessation provided by the different jurisdictions, is complicated by a lack of clarity as to what is meant by these words. The phrase “safe harbour” is generally used to mean that a party affected by the legislation in question is protected from a particular type of civil claim. In the context of LIBOR cessation, the spectrum of potential claims is broad, as set out in our first article on the risks of LIBOR cessation, dating back to early 2019.

The FS Bill in and of itself seeks to prevent claims as to the continuity of LIBOR-linked contracts, by securing the continued publication of a rate which meets the contractual definition of LIBOR. However, it is noteworthy that ARRC’s legislative solution contains an express and very widely drafted safe harbour provision, which is intended to encourage market participants to adopt the ARRC recommended rate, by offering protection from claims as a result of adopted the legislative fix. The European Commission has confirmed that it intends to include a safe harbour, but has not yet provided detail on the drafting.

As things stand, “forum shopping” between proposed legislative solutions seems a real possibility (in view of the differing approaches taken to the applicability, and potentially the substantive outcome, of the proposed regimes). Material inconsistency between the safe harbours offered by the regimes must surely also increase the risk of disputes arising in relation to the appropriate regime to choose.

5. Risk of challenge by way of judicial review

There is greater risk of challenge (for example by way of irrationality or other public law grounds) to delegated legislation, than primary legislation. It is therefore noteworthy that much of the detail of the UK’s legislative fix has been left to subsequent FCA policy. While this is unsurprising given the time pressures involved, it is potentially significant, because of the greater risk of challenge to the FCA’s policy statements which articulate the detail of the provisions.

There are a number of references to the fact that the FCA may only exercise its powers under the FS Bill where it is desirable in order to advance the FCA consumer protection objective or integrity objective (e.g. the FCA’s power to permit legacy use of the benchmark under Article 23C). This is of course derived from the FCA’s statutory operational objectives. However, the effect of the pre-condition in the UK’s legislative solution is to introduce a further discretionary exercise for the FCA to assess whether action is necessary to protect consumers and/or ensure market integrity. In turn, this could increase the risk for judicial review of the FCA’s exercise of its powers (as it provides an additional layer of decision/determination by the FCA that is subject to challenge).

6. Consistency with proactive transition

It is clearly not the intention of the authorities that the methodology change brought about by the legislative fix contained in the FS Bill should extend to legacy LIBOR contracts that have been actively amended bilaterally or by consent solicitation, or amended via market protocol. However this is not spelt out at present in the FS Bill, which is potentially unhelpful and contrary to the spirit of ongoing transition efforts.

Ensuring that this is ultimately avoided will need careful and precise drafting to define “tough legacy” in the FCA’s exercise of its regulatory powers.

 

Michael Vrisakis
Michael Vrisakis
Partner
+61 2 9322 4411
Fiona Smedley
Fiona Smedley
Partner
+61 2 9225 5828
Charlotte Henry
Charlotte Henry
Partner
+61 2 9322 4444
Harry Edwards
Harry Edwards
Partner
+61 3 9288 1821

Leaving LIBOR – the ISDA Protocol and Supplement

This article was originally posted on Banking Litigation Notes.

With LIBOR due to disappear by end-2021, work has been underway to facilitate the transition from LIBOR and other IBORs to alternative risk free rates (RFRs). The derivatives market has been at the forefront of the transition and is some distance further ahead than other financial markets. In particular, ISDA has recently published the 2020 IBOR Fallbacks Protocol and IBOR Fallbacks Supplement, which introduce hardwired fallbacks from IBORs to relevant RFRs for new products and legacy products.

Publication of these documents is a key milestone in the transition journey from IBORs to RFRs, and amounts to the starting gun being fired on what is expected to be a mass market wide repapering and amendment exercise as the market says goodbye to the old world of IBORs and welcomes the new world of RFRs. We expect clients will wish to enter into the IBOR Fallbacks Protocol to amend existing transactions, and to include the IBOR Fallbacks Supplement in new trades. In agreeing to do so, hardwired fallbacks from LIBOR to RFRs will be included in the transactions, which will clearly have a significant impact on those transactions and beyond. Clients are therefore well advised to give careful thought to the issues raised by these documents.

Our briefing (which can be found here) provides a detailed analysis of the two publications, including the issues they raise and how adherence to these documents will affect clients’ existing and future transactions.

Michael Vrisakis
Michael Vrisakis
Partner
+61 2 9322 4411
Fiona Smedley
Fiona Smedley
Partner
+61 2 9225 5828
Charlotte Henry
Charlotte Henry
Partner
+61 2 9322 4444
Harry Edwards
Harry Edwards
Partner
+61 3 9288 1821

LIBOR Transition Status Update: October 2020

The cessation of the London Inter-bank Offered Rate (LIBOR) at the end of 2021 has long been an issue vexing the global financial services industry given the scale and geographic spread of exposures to the affected benchmarks across the currencies and terms in which it is published.

The LIBOR Transition Status Update: October 2020 provides a comprehensive update on what is happening, including the current status in key markets, the impact of Covid-19, proposed legislative interventions on legacy contracts, litigation and regulatory risks, as well as potential next steps for financial services companies.

 

Charlotte Henry
Charlotte Henry
Partner
+61 2 9322 4444
Harry Edwards
Harry Edwards
Partner
+61 3 9288 1821
Patrick Lowden
Patrick Lowden
Partner
+61 2 9225 5647
Michael Vrisakis
Michael Vrisakis
Partner
+61 2 9322 4411
Fiona Smedley
Fiona Smedley
Partner
+61 2 9225 5828

Webinar – The Road to LIBOR Transition

LIBOR (and other IBORs) will cease to exist in their current form from the end of 2021, creating significant issues for financial institutions with exposure to LIBOR contracts, and the risks associated with the economic consequences of switching to the replacement Risk Free Rates.

In 2019, Michael Held, the New York Fed’s GC, described the discontinuation of LIBOR as “a defcon 1 litigation event if ever I’ve seen one”.

Our global LIBOR transition team at Herbert Smith Freehills today held a webinar to discuss their insights into how banks can mitigate the risk, including:

  • addressing contractual continuity issues, such as frustration or force majeure;
  • regulatory enforcement and class actions arising from the continued sale of LIBOR-linked products and/or the amendments to contracts to transition from LIBOR; and
  • compliance with BEAR and other senior manager regimes across the globe in managing the transition.

The discussion explored the latest developments in the derivatives and cash markets in responding to the challenges and incorporated the experience of our global LIBOR transition team, and their engagement with regulators and clients in the UK, Asia, and Australia:

  • Harry Edwards, co-head of our global LIBOR transition team;
  • Patrick Lowden, head of our debt capital markets and securitisation practice; and
  • Hannah Cassidy, regulatory expert and co-chair of our global banks sector group.

The session was facilitated by Charlotte Henry, partner and banking regulatory expert in our corporate team.

Access the Webinar here.

 

Harry Edwards
Harry Edwards
Partner
+61 3 9288 1821
Patrick Lowden
Patrick Lowden
Partner
+61 2 9225 5647
Hannah Cassidy
Hannah Cassidy
Partner
+852 21014133
Charlotte Henry
Charlotte Henry
Partner
+61 2 9322 4444

FSB Report: Supervisory issues associated with benchmark transition: major LIBOR transition risks

This article was originally posted on Banking Litigation Notes.

The Financial Stability Board (FSB) has published its long-awaited report to the G20 on supervisory issues related to LIBOR transition. It follows a survey of the state of preparedness of regulators around the globe and presents its recommendations. The purpose of this engagement is to facilitate greater coordination on a global level, to mitigate the impact on financial stability generally and both financial institutions and non-financial institutions specifically: FSB Report: Supervisory issues associated with benchmark transition.

 

Results of survey on preparedness of global regulators

The results of the questionnaire on supervisory issues strikingly, but unsurprisingly, reveal a wide range across different jurisdictions’ levels of preparedness for LIBOR transition in advance of the expected transition date of end-2021. While some differences in approach and timeline between jurisdictions are to be expected, the report is critical of the differing timelines and supervisory expectations for transition across jurisdictions:

“Jurisdiction by jurisdiction differences in approach and timeline are unavoidable. However, to avoid the greater risk of being unprepared by the end of 2021, there should be no excuses for a ‘race to the bottom’ to move at the pace of the slowest.”

For example, very few jurisdictions have dedicated roll-off timelines or targets to industry, and, where timelines are in place, monitoring is complicated by the varying timelines for different products. The report recommends that authorities in each impacted jurisdiction establish a formal LIBOR transition strategy, which may include interacting with national working groups with a view to set out milestones and a transition roadmap with clearly specified actions that market participants should take. The report also suggests increased international cooperation as a means of mitigating the inconsistency in transition timing and approaches by sharing information on best practices and challenges.

In light of the survey’s conclusion that a considerable portion of financial institutions across jurisdictions are yet to start or are still in the planning stages of their transition, the FSB has highlighted a need to step up the coordination and monitoring effort at an international level. It has accordingly identified a number of areas for strengthened supervisory actions in order to facilitate efforts by individual institutions to progress their transition programmes.

 

Major LIBOR transition risks identified by the FSB

The FSB has also provided a useful summary of some of the major LIBOR transition risks for financial institutions, which will be very familiar to those who have been following the developments on this topic over the last few years, and which we explained in more detail in our previous article on the risks (LIBOR is being overtaken: Will it be a car crash? (2019) 34 J.I.B.L.R.):

  • Operational/systems risks – Systems and processes must be updated for all products currently referencing LIBOR so that they can instead rely on alternative reference rates and calculate and manage any fallback adjustments in order to prevent any operational disruptions.
  • Legal risks – Contract frustration and counterparty litigation are key areas of concern if institutions do not adequately identify and address affected legacy contracts, especially with regard to cash market products and long-dated contracts. The risks could be compounded by the volume and complexity of potential contract amendments and potential consent required for covenant modifications.
  • Prudential risks – Institutions may find difficulties in managing market risks and calculating embedded gains or losses for margin requirements, and experience a range of capital impact issues in case pricing and valuation inaccuracies arise. Where interest rate models need to be developed and approved, institutions may face capacity constraints or a lack of historical data.
  • Conduct, litigation and reputational risks – The report notes risks around conduct risk identification and management, especially with regard to the fair treatment of clients, potential conflicts of interests, mis-selling and misconduct, which could lead to potential class-action litigation.
  • Hedging risks – Different parts of hedged positions may transition at different times or to different fallback rates, leaving institutions exposed to new basis risks. Market participants may also face increased hedging costs if liquidity remains low in the alternative RFRs.
  • Accounting risks – If work to reform national and international accounting standards is not adequate or completed on time, there may be unintended impacts on accounting (e.g. with respect to hedging or profitability) or taxation.
  • Others – Financial institutions face difficulties in communicating transition-related issues with clients (finding the right informational level, etc.) and in pricing instruments (particularly in the early stages of transition when liquidity in new instruments is low). Further, financial institutions and non-financial institutions face potential resource constraints.

 

Michael Vrisakis
Michael Vrisakis
Partner
+61 2 9322 4411
Fiona Smedley
Fiona Smedley
Partner
+61 2 9225 5828
Charlotte Henry
Charlotte Henry
Partner
+61 2 9322 4444
Harry Edwards
Harry Edwards
Partner
+61 3 9288 1821

UK Government announces LIBOR legislative fix: summary of proposals and our initial observations

This article was originally posted on Banking Litigation Notes.

In a written statement on 23 June 2020 made by Rishi Sunak, The Chancellor of the Exchequer, the UK Government has announced its intention to introduce a legislative solution for the transition of so-called “tough legacy” LIBOR-linked products. It intends to include measures in the forthcoming Financial Services Bill to ensure that, by end-2021, the FCA has the appropriate regulatory powers to automatically transition tough legacy contracts away from LIBOR (as we know it) without the need for bilateral or multilateral contractual amendment. The FCA has issued two supporting statements: FCA statement on planned amendments to the Benchmarks Regulation and Benchmarks Regulation – proposed new powers.

In this blog post, we consider the key elements of the proposals and make a number of initial observations as to the potential market and legal impact.

 

Summary of proposals

Reasons underlying the proposals

The Government recognises that progress towards interim milestones for LIBOR transition has been slowed by the COVID-19 pandemic, citing the various recent statements published by the Working Group on Sterling Risk-Free Rates (RFRWG) and the FCA (see our blog post: LIBOR transition: The risks of interim milestone delay for the cash market due to COVID-19).

Without wishing to dilute the message that active transition away from LIBOR remains the best route for contractual and economic certainty, the Government acknowledges that there will be a narrow pool of “tough legacy” contracts that have no appropriate fallback mechanism and cannot be renegotiated or amended by the end of 2021. For these tough legacy contracts, the Government has concluded that legislative steps are necessary to assist transition, agreeing with the Tough Legacy Taskforce report published by the RFRWG (see our blog post: UK Tough Legacy Taskforce recommends LIBOR legislative fix: key risks and next steps).

Mechanism for legislative fix

The proposed primary legislation will not directly impose legal changes to LIBOR-referencing contracts governed by UK law, but instead will grant the FCA certain “appropriate” regulatory powers, via the following mechanism:

  • The Financial Services Bill will introduce amendments to the Benchmarks Regulation 2016/1011 (as amended by the Benchmarks (Amendment) (EU Exit) Regulations 2018) (UK BMR).
  • The amendments to the UK BMR will extend the circumstances in which the FCA may require an administrator to change the methodology of a critical benchmark (e.g. LIBOR) and clarify the purpose for which the FCA may exercise this power.
  • The new powers will be available where the FCA (as the supervisor of the benchmark administrator) makes an announcement that LIBOR is no longer representative (for example, where some submitting banks no longer make submission for given LIBOR currencies or tenors) and will not be restored to representativeness.
  • The new powers will enable the FCA to direct the administrator of LIBOR to change the methodology used to compile the benchmark if doing so will protect consumers and market integrity.
  • The methodology that will be used instead has not yet been determined and it will be left to the FCA to do so. The FCA intends to seek stakeholder views on possible methodology changes in subsequent consultations. However, all indications are that “legislative LIBOR” will be produced using some iteration of the risk-free rates chosen by each LIBOR currency area (i.e. SONIA for the sterling market) with a fixed spread adjustment added to provide a proxy for the credit risk element of LIBOR.

The Government intends to take these measures forward in the forthcoming Financial Services Bill, but the more important developments and detail will be communicated through a series of statements of policy by the FCA, in which it will confirm its approach to the new powers provided by the legislation.

 

Initial observations

  1. Change of approach from the Government and the regulators

For a number of years, the UK Government and the regulators have carefully and deliberately avoided giving any clear signal that a legislative fix for the transition of LIBOR-linked contracts would be forthcoming. This is likely to have been primarily driven by the concern that to do so may result in portions of the market slowing their LIBOR transition efforts. The latest announcements therefore represent a dramatic change of tack.

According to the statements made by the Government and FCA in the context of this announcement, this change of approach has been triggered, in part at least, by the delay to transition efforts as a result of the COVID-19 pandemic. However it seems clear that, in addition, the authorities have recognised the difficulty/impossibility of transitioning certain tough legacy contracts away from LIBOR, notwithstanding the efforts from many sections of the market to achieve this.

  1. Lack of detail provided as to the proposed legislative solution

These announcements are significant but are very light on detail and a number of key questions remain, for example:

  • Which contracts will be caught by the legislation? The announcement suggests that it will cover only “tough legacy” contracts, but how will this be defined?
  • What will be the new methodology for calculating legislative LIBOR? Presumably sterling LIBOR will transition to SONIA plus a spread, but what version of SONIA will be used (spot, compounded in arrears, forward looking term), how will the spread adjustment be calculated, and will there be any variation in the methodologies applied to different asset classes?
  • Which LIBOR currencies and tenors will continue (in the form of legislative LIBOR) and which will not? The FCA has suggested that methodological change may not be appropriate or feasible in all LIBOR currency tenor pairs and so certain pairs may cease entirely.

It seems that the market will need to wait for the draft Financial Services Bill and, in particular, the policy statements to be published by the FCA, in order to understand fully the scope of the proposed legislative solution and its implications for those sections of the market that are most difficult to transition. Given that the FCA envisages “extensive engagement” with market participants and other stakeholders over the coming months to inform this policy work, there may be a significant delay before the market has real clarity on these issues.

Accordingly, while the market has been offered some comfort that a cliff-edge scenario ultimately will be avoided, there is still enough uncertainty surrounding the proposals to make sure that most market participants will not take their foot off the pedal of LIBOR transition – which is presumably exactly the position that the Government and regulators intended to achieve as they continue to attempt to strike a delicate balance.

  1. What will the UK legislative solution mean in practice?

The UK solution means that LIBOR-linked contracts will continue to reference LIBOR – and as such there will be no direct amendment to those contracts. Rather, the way in which the reference to LIBOR in those contracts will play out, will be entirely different. Instead of the current LIBOR methodology, “legislative LIBOR” will apply. The new methodology will bear no resemblance to the previous process of panel bank submissions based on the (theoretical) rate at which banks lend to one another in the interbank unsecured funding market. It will be LIBOR in name only.

This is in many ways an elegant solution, because it means any legacy fallback mechanisms that would be engaged by the permanent cessation of LIBOR will not be engaged unless and until legislative LIBOR ends (thereby avoiding problematic fallbacks in legacy contracts; for example, those that revert to the last available published LIBOR rate, thereby converting a floating rate contract to a fixed rate).

However, there is a potential downside of this approach. Care will be needed in the mechanism that brings about this result, to ensure that contracts that have already been amended to include more robust fallbacks are not caught out. Those that were designed to take effect on the permanent cessation of LIBOR (i.e. contained no pre-cessation trigger) may not engage those negotiated fallbacks as intended or possibly at all (assuming legislative LIBOR will continue for the duration of the longest tough legacy contract). Such contracts could switch to legislative LIBOR, rather than the fallback the parties chose, if they fall within the scope of the proposed legislation.

  1. Contrast in approach in the UK vs the US

The UK’s proposed legislative solution is fundamentally different to the approach being taken in the US, set out in draft legislation prepared by the Alternative Reference Rates Committee (the US equivalent of the RFRWG) (see our blog post: LIBOR transition: What does the US regulator’s proposed legislative fix mean for UK financial markets?).

The US approach involves direct changes to contracts governed by US law. It is a central pillar of the draft US legislation that – following a public statement from one of a number of specified persons (including the US Federal Reserve or one of the regulators) – certain changes will take place automatically in all US law contracts that reference LIBOR as a benchmark interest rate. For example, contracts without fallback language (or which fall back to a LIBOR-linked rate) will automatically transition from LIBOR to a “recommended benchmark replacement” (likely SOFR) plus a spread adjustment. To deal with contracts containing other problematic fallbacks, such as polling for LIBOR or other interbank funding rates, the draft legislation states that such fallbacks will effectively be ignored.

The proposed legislative solution in the UK arguably offers a neater solution, removing the need for complex drafting of this kind. Although the price of that is a longer period of uncertainty while the FCA considers the methodology which it decides to adopt.

  1. Interaction with pre-cessation triggers

It seems likely that the FCA will make an announcement that LIBOR is no longer representative after end-2021, when panel banks are no longer compelled to submit data and confirm they intend to stop submitting. The FCA has said that it will make an assessment of representativeness each time a panel bank departs (see this speech by Edwin Schooling Latter, Director of Markets and Wholesale Policy at the FCA, 28 January 2019).

This announcement will be the trigger for both the FCA’s powers to change the methodology of LIBOR (i.e. it will trigger the replacement of LIBOR with legislative LIBOR) and will also be the trigger for contracts that have been amended to include pre-cessation fallbacks (e.g. derivative contracts where both parties have adhered to ISDA’s proposed single Protocol).

Any statement of non-representativeness will be within the control of the FCA, and will trigger at the same time, the switch of both unamended legacy LIBOR contracts and amended contracts with a pre-cessation trigger. This is good news, particularly for market participants seeking continuity across a portfolio. However, there is a real risk of divergence in the applicable replacement rate, as discussed further below.

  1. Potential impact on litigation risk

The proposed legislative solution itself may give rise to a number of litigation risks. In particular:

Automatic change in interest rate payable resulting in “winners” and “losers”

  • The most obvious impact of the proposed legislative solution is that it will automatically change the interest rate payable under the contract when the methodology for calculation of LIBOR changes. A party paying an interest rate referenced to LIBOR on the date (t) that a statement of non-representativeness is made, will be paying a different rate on day t+1 when the rate switches to legislative LIBOR. However, the spread adjustment will not make the transition present value neutral on t+1 because it will almost certainly be calculated as the difference between the two benchmarks over a set period of time (e.g. the past 5 years). In this sense, it is a blunt tool and unlikely to represent the bargain which the parties would have struck had they been able to/chosen to.
  • The fact that the interest rate payable under LIBOR contracts will change overnight gives rise to the inevitable possibility of “winners” and “losers”, i.e. with parties receiving less or paying more interest under legislative LIBOR from t+1 than they would have received/paid had LIBOR continued without the methodological change. One of the notable benefits of the proposed legislative solution is that the differential will not be as transparent, i.e. it will not be possible to compare the two rates. Even if there are panel banks willing to submit data when no longer compelled to do so – the administrator of the benchmark will no longer publish LIBOR calculated in that way. The legislative solution thereby likely prevents the continuation of a so-called “zombie” LIBOR.
  • However, the change in interest payable will be immediate and obvious on t+1 and this will provide fertile ground for disputes. In particular, there will be mis-selling risks in relation to both the original product referencing LIBOR (e.g. that the customer was mis-sold a LIBOR-linked product when it should instead have been sold a SONIA-linked product, particularly for products post-dating the FCA’s first announcement in July 2017 that LIBOR would be discontinued); but also for contracts actively amended to switch from LIBOR (e.g. that the customer would have been better off not amending and relying instead on the legislative solution).

Portfolio mismatches

  • There will be a particular risk of creating mismatches between different parts of a portfolio, where some products move to legislative LIBOR, but others are amended via bilateral agreement or (for example, in the case of hedging products) the ISDA Protocol. A stated criterion of the FCA is to find a methodology that reduces the risk of divergence between the values of legislative LIBOR and the fallbacks that would come into effect following a non-representativeness determination. However, it seems likely that there will be some differences, as explained by ISDA’s CEO, Scott O’Malia in a statement made on 26 June 2020:

“For one thing, derivatives markets have opted to use overnight RFRs compounded in arrears, which require amendments to contractual terms in addition to referencing a different rate. Given tough legacy contracts currently reference a forward-looking term IBOR and cannot be amended, it indicates a ‘synthetic LIBOR’ will be a forward-looking term rate based on the RFRs plus a spread adjustment. Indeed, the FCA says that use of overnight RFRs compounded in arrears ‘may not be possible to replicate within the restrictions of the existing LIBOR framework’.”

Potential breach of BMR

  • There is a further risk of public or private law claims on the basis that continued publication of legislative LIBOR breaches the requirements of the BMR. The BMR provides that if a benchmark’s representativeness cannot or will not be restored, then its publication must cease within a “reasonable period of time”. The FCA has confirmed that the representativeness of LIBOR will not be restored by the proposed methodology change. As such, it may be argued that the continued publication of legislative LIBOR is in breach of the BMR.

Slowing transition efforts

  • Finally, there is a risk that (contrary to the directions and intentions of the regulator) there will be a slowing in transition efforts, which will result in a larger pool of unamended LIBOR-linked contracts when LIBOR ends. If such contracts are not caught by the proposed legislative solution (e.g. because “tough legacy” contracts are defined narrowly), then there will be serious questions about what fallbacks apply and even the validity of the contracts. Accordingly, in our view, parties would be well advised to press on with their transition efforts, particularly once the ISDA Protocol and Supplement to its 2006 Definitions are published (expected by the end of July).

 

Michael Vrisakis
Michael Vrisakis
Partner
+61 2 9322 4411
Fiona Smedley
Fiona Smedley
Partner
+61 2 9225 5828
Charlotte Henry
Charlotte Henry
Partner
+61 2 9322 4444
Harry Edwards
Harry Edwards
Partner
+61 3 9288 1821

BoE confirms daily publication of SONIA compounded index from August 2020: impact on new vs legacy cash products

This article was originally published on Banking Litigation Notes.

The latest development in the Bank of England’s (BoE) attempts to support the adoption of SONIA in cash products – and to speed up the transition away from LIBOR-linked products – is the publication of its response to the consultation it conducted into the publication of a SONIA index: Supporting Risk-Free Rate transition through the provision of compounded SONIA: summary and response to market feedback (June 2020).

The report follows a discussion paper that the BoE published earlier this year, seeking views on: (a) the BoE’s intention to publish a daily SONIA compounded index; and (b) the usefulness of the publishing a simple set of compounded SONIA period averages. These proposals were part of the BoE’s attempt to “turbo-charge” sterling LIBOR transition (see our previous blog post: The Bank of England’s attempts to “turbo-charge” LIBOR transition in the cash markets: will these increase or decrease the litigation risks?).

 

Report summary

The report confirms that the BoE will produce a daily SONIA compounded index, following near universal support from the market in response to the discussion paper. The aim of the SONIA compounded index is to simplify the calculation of compounded interest rates for market participants and avoiding the potential for different conventions about the compounding of SONIA calculation. Conceptually, the index is equivalent to a series of daily data representing the returns from a rolling unit of investment earning compound interest each day at the SONIA rate. The change in the SONIA compounded index between any two dates can be used to calculate the interest rate payable over that period. The BoE anticipates publishing the index from August 2020, but the precise date is to be confirmed.

However, the BoE does not intend to publish daily a simple set of SONIA period averages, following a “very mixed” response from the market on the merits, and risks, of publishing these screen rates. Whilst there was some broad support for the thinking behind the concept of period averages, much concern was raised about the practical utility of those averages by market participants (particularly sophisticated ones) given the often bespoke way in which interest periods are set and the risk of confusion given the likely need to publish averages for a variety of periods. However, the BoE has said it is open to considering this question again, should the market view develop to become more unified.

 

Impact on risk profile of LIBOR discontinuation

The outcome of the most recent report will affect the risk profile of LIBOR discontinuation in new vs legacy cash products in different ways.

 

  1. New cash products

It is noteworthy that the publication of a SONIA compounded index is designed to overcome the primarily operational challenge of calculating compounded SONIA rates in a simple and consistent way so that borrowers can easily reconcile the rates reported to them by lenders. Publication of a “golden source” SONIA-linked index from which bespoke rates can more readily be calculated, should make it easier for market participants to transition to SONIA-based cash products. This in turn should help market participants to cease issuing GBP LIBOR-linked cash products by the deadline of end of Q1 2021 (the extended deadline, due to the impact of the COVID-19 pandemic). The simple point to make is that – by making it easier to write new cash products in SONIA – this should reduce the overall volume of LIBOR-linked products in the market when the benchmark ceases.

 

  1. Legacy cash products

The outcome of the BoE’s latest report will not solve the inherent difficulties with transitioning legacy LIBOR cash products. Even with the publication of a SONIA compounded index, parties will need to agree the spread adjustment to mitigate value transfer when switching from LIBOR to SONIA on a product-by-product basis. While the UK’s Tough Legacy Taskforce has recommended a legislative fix for “tough legacy” contracts in all asset classes and possibly all LIBOR currencies, this will require the UK Government to intervene with primary legislation (see our recent blog post: UK Tough Legacy Taskforce recommends LIBOR legislative fix: key risks and next steps). The UK Government and FCA have recently made announcements on the scope and form of proposed legislation, which we will consider in a separate blog post.

 

Michael Vrisakis
Michael Vrisakis
Partner
+61 2 9322 4411
Fiona Smedley
Fiona Smedley
Partner
+61 2 9225 5828
Charlotte Henry
Charlotte Henry
Partner
+61 2 9322 4444
Harry Edwards
Harry Edwards
Partner
+61 3 9288 1821

UK Tough Legacy Taskforce recommends LIBOR legislative fix: key risks and next steps

This article was originally published on Banking Litigation Notes.

The UK’s Tough Legacy Taskforce (Taskforce) has issued a paper on “tough legacy” issues in the transition from LIBOR. In an important intervention, it has recommended a legislative fix for all asset classes and possibly all LIBOR currencies. The scope of the recommendation from the Taskforce is wider than many will have expected, but will be broadly supported by the market.

However, while the Taskforce has indicated its preference for a legislative solution of some kind, it is of course not within the gift of the Taskforce, or indeed the regulators, to provide this fix. Moreover, the Taskforce is at pains to point out that any legislative fix is not a solution that will achieve economic neutrality for the parties. By its nature, it would trigger a blunt amendment to contracts, which may not necessarily accord with the parties’ intentions and may not be appropriate. In this blog post we summarise the key conclusions of the Taskforce, discuss what this might mean in the context of litigation risk for LIBOR transition and consider the probable next steps.

 

What are “tough legacy” contracts?

The Taskforce is keen to emphasise that tough legacy contracts are those that do not have robust fallbacks and “cannot be dealt with in any other way”. The Taskforce has considered whether tough legacy contracts are likely to exist across the different asset classes in the UK affected by LIBOR transition, including: derivatives, bonds, loans (syndicated and bilateral) and mortgages.

 

Context and status of the tough legacy paper

To put the status of the paper in context, the Taskforce was set up by the Working Group on Sterling Risk-Free References Rate (RFRWG), to focus on tough legacy LIBOR issues. The RFRWG’s membership consists of a number of representatives from large financial institutions and buy-side market participants. Personnel from the Bank of England and the FCA are also ex-officio members. Accordingly, while the paper notes that the views and outputs of the Taskforce do not constitute guidance or legal advice from the regulators, this paper provides a very useful indication of the latest thinking on the status of preparations for LIBOR transition from both the regulators’ and the market’s perspective.

Publication of this paper has been eagerly anticipated since the beginning of the year, having been foreshadowed in the RFRWG’s roadmap for 2020 (see our blog post: LIBOR transition: litigation risk observations on suite of documents published by the regulators in January 2020). The paper on tough legacy contracts was one of the deliverables for the RFRWG identified in the roadmap. It was originally due in the second half of Q1 2020, but publication was delayed, primarily due to the COVID-19 pandemic.

 

Summary of conclusions 

Case for action

The Taskforce has concluded that there is a “case for action” to consider how to address tough legacy contracts which extends to all asset classes and possibly all LIBOR currencies.

The Taskforce considered each asset class separately, noting that the strength of the case for action differs between them, depending on the contracts involved and the ability to amend the terms. However, while many contracts within certain asset classes will be able to successfully transition, this may be more difficult where:

  1. Contracts form part of complex transactions or arrangements, so there are linkages across different asset classes.
  2. Distribution of the product is broad (e.g. syndicated loans and bonds with a wide investor base) and there may be additional complications with obtaining the necessary consent.
  3. Retail counterparties are involved (particularly retail holders of mortgages or bonds).

The Taskforce explains that it has focused primarily on sterling LIBOR exposures. However, the group notes that exposures to US dollar LIBOR exceed the exposures to sterling LIBOR for UK market participants, and that English law is used extensively to govern financial contracts denominated in different LIBOR currencies. The paper therefore advocates for action to address English law tough legacy contracts denominated in any LIBOR currency.

The paper notes that the case for action has been strengthened by the market impact of the COVID-19 pandemic. While the deadline for the market to be ready for the cessation of LIBOR by the end of 2021 remains the same, there is less time available in practice to meet it.

 

Legislative fix

Having found that there is a case for action for all asset classes, the paper proceeds to recommend that the UK Government considers legislation to address tough legacy exposures. However, the Taskforce recognises that there is no guarantee that such a solution will materialise, that it will materialise across all relevant legal jurisdictions, or that it would be available for all products and circumstances.

Further, it is important to bear in mind that a legislative fix will automatically determine the amendments that will be made to those contracts that are caught, whatever the economic consequences for the parties. This will have a significant impact on litigation risk (see below).

 

Alternative solution: synthetic LIBOR

The paper briefly, but interestingly, notes that an alternative solution of LIBOR being stabilised via a so-called “synthetic methodology”, at least for a wind down period following the end of 2021 or until primary legislation is enacted. This would require either an administrator willing to modify the methodology for LIBOR and/or potentially official sector intervention to modify it.

 

Impact on litigation risk

While the proposed legislative fix should have the effect of reducing the litigation risk for those contracts that are caught by a definition of “tough legacy” contracts, neither the working groups nor the regulators have the power to automatically transition tough legacy exposures. Primary legislation is required to be enacted by the UK Government. The Taskforce recognises the challenge of the Government legislating in the time available, particularly given the obvious need to cooperate across jurisdictions because of the global use of LIBOR. There also remain risks of significant divergence between the legislative measures introduced in different jurisdictions (notwithstanding attempts to cooperate, given local differences across products).

Further, even if legislation is forthcoming, much will depend on the drafting of the provisions to identify those contracts within particular asset classes that will be transitioned in this way and what the economic consequences will be. Even with a spread adjustment to account for the value transfer that arises from the automatic transition to the new reference rate (which would need to be carefully drafted in any legislation), a legislative fix is a blunt tool and the possibility of “winners” and “losers” is inevitable. This will provide a clear incentive for parties seeking to find loopholes in the legislation and challenge the power of the UK Government to effect such changes to private contracts. It is far from certain, at this stage, how this will play out. However, given the clear potential for any legislative fix to operate in a way that is not economically neutral, the risk of disputes arising as a result will not necessarily diminish with the introduction of primary legislation (even if contractual continuity is assured for some contracts).

The message from the Taskforce therefore remains very clear: LIBOR transition should primarily be achieved by active amendment, as this is the only way for parties to have certainty over their contracts and their economic effects. While this is sensible advice, it grates against the genesis and purpose of the paper – that there are some legacy contracts that do not have robust fallbacks and where it will simply not be possible to amend them ahead of LIBOR discontinuation. This highlights the very difficult line which is being trodden between encouraging proactive transition efforts and a safety net. In the absence of a legislative fix as that safety net, however, there is little doubt that the litigation risks remain very real (see our blog post: LIBOR is being overtaken: Will it be a car crash?).

The suggestion of synthetic LIBOR poses separate risks. First, in order for this solution to be effective, the existing reference rate provisions in legacy contracts would need to be capable of being interpreted to include synthetic LIBOR (without amendment). This will depend upon the contractual interpretation of individual contracts, in particular as to how LIBOR is defined. Second, the continued publication of a synthetic LIBOR (which does not sound dissimilar to the so-called “zombie LIBOR” concept) has the potential to increase litigation risk by making the value transfer occasioned by transitioning a given contract more transparent (i.e. more clearly identifying the winners and losers).

 

Next steps

It will be critical to see if and when the UK Government takes up the recommendations from the Taskforce. This will be challenging given the many competing demands for its attention: in particular the COVID-19 pandemic and Brexit.

To date, no draft legislation has been published. If the UK is to follow the approach of the US, it is possible that a first draft will emanate from the Taskforce itself. In the US, the equivalent body to the RFRWG – the Alternative Reference Rates Committee (ARRC) – published the proposal for New York legislation to assist the transition of financial contracts away from US dollar LIBOR (see our blog post: LIBOR transition: What does the US regulator’s proposed legislative fix mean for UK financial markets?). While this would not be the usual procedure for development of primary legislation in this jurisdiction, against the current backdrop and with time moving on, the UK may choose to adopt a similar approach

 

Michael Vrisakis
Michael Vrisakis
Partner
+61 2 9322 4411
Fiona Smedley
Fiona Smedley
Partner
+61 2 9225 5828
Charlotte Henry
Charlotte Henry
Partner
+61 2 9322 4444
Harry Edwards
Harry Edwards
Partner
+61 3 9288 1821

ISDA releases report explaining final results of LIBOR consultation on pre-cessation fallbacks: the nuance behind the consensus

This article was originally published on Banking Litigation Notes.

We commented last month on the announcement from the International Swaps and Derivatives Association (ISDA), confirming the preliminary results of its re-consultation on the implementation of pre-cessation fallbacks for derivatives referenced to LIBOR: ISDA pre-cessation fallback consensus: will this reduce legacy LIBOR risk in the derivatives market?

ISDA has now published a report summarising the responses received from the industry to the consultation, and it makes for very interesting reading.

The report explains that 91% of respondents were in favour of combining pre-cessation and permanent cessation fallbacks without optionality or flexibility, in the amended 2006 ISDA Definitions for LIBOR and a single protocol. A common reason given by market participants was the need to achieve consistency across asset classes (generally between cash and derivative markets) and between cleared and non-cleared derivative markets.

However, although the scale of consensus may at first appear overwhelming, a more detailed reading of the report reveals how delicate that consensus might be. For example, several market participants who were in favour of the pre-cessation trigger indicated that their response was conditional on achieving actual consistency; and some who were not in favour of including the pre-cessation trigger also cited consistency as their main reason (e.g. being more preferable for there to be consistency within an asset class, i.e. non-cleared derivatives, than between asset classes).

It is unsurprising that the desire for consistency from the market is the driving force behind industry views on pre-cessation triggers. Indeed, we have discussed in our previous blog posts that basis risk creating mismatches between different parts of a party’s portfolio, and the impact of a single fallback with no optionality on protocol adherence, were likely to be key factors for market participants.

The upshot is that many respondents who would agree on the importance of consistency as a high level principle have still answered differently in response to the consultation, in part because of slightly different perspectives on how the ISDA consultation fits in with wider industry efforts (which are ongoing). Despite this fact, ISDA has confirmed that it expects to move forward on the basis of both permanent and pre-cessation triggers in the amended definitions and a single protocol. Attention will no doubt turn to the impact of this result on the efforts in other markets, and whether some measure of consistency with the derivative markets can be achieved.

 

Michael Vrisakis
Michael Vrisakis
Partner
+61 2 9322 4411
Fiona Smedley
Fiona Smedley
Partner
+61 2 9225 5828
Charlotte Henry
Charlotte Henry
Partner
+61 2 9322 4444
Harry Edwards
Harry Edwards
Partner
+61 3 9288 1821