A taskforce belonging to the Financial Conduct Authority and Bank of England's Working Group on Sterling Risk-Free Reference Rates has shed more light on the problems of 'tough legacy' issues that are bound to hamper the UK's transition away from the scandal-struck London Interbank Offered Rate to other rates.

The old interest rate benchmark - discredited forever by the revelations of 2012 - is expected to cease at the end of 2021. Exchange-facing private banks, brokers and other firms must move to alternative rates before that time. The FCA and its working group are still insisting on financial firms removing "Libor dependencies" from their contracts before the end of 2021, after which Libor may no longer continue. The case for further governmental action of some kind has, in its eyes, been strengthened by the effect on the market of the Coronavirus infection because the deadline remains the same but there is less time available in practice to meet it.

Howard Taylor of Capco told Compliance Matters: "The 2021 date will force people to change the rates on their products. If the relationship manager or investment cousellor recives the product from his product department, he might have a problem on his hands. If somebody has a contract going beyond 2021, the firm will have to change the terms in the middle of the contract and it'll have to explain that to the HNW client. If you are a wealth manager, you ought to do an impact assessment of Libor on your client base and work out how to communicate with them about it. You can't necessarily avoid having a contract that goes beyond 2021. If you do have a contract that does, you are stuck with the job of changing it."

Derivative contracts

The taskforce (which, amusingly, always awards itself a capital T in its pronouncements) considers that derivative contracts may be 'tough legacy' contracts, as it calls them, but whether they are or not depends on the circumstances.  Parties to uncleared derivatives are able to negotiate pro-actively with each other bilaterally or multilaterally (e.g. through compression) to change or replace contracts so that their Libor-based exposures are changed to a risk-free rate (RFR), or something else. The risk-free rate is the theoretical rate of return on an investment with zero risk.

These pro-active approaches are considered a better means of transition than the use of a trigger to activate a 'fallback' rate (on Libor’s cessation or before). This may be particularly true in relation to such derivatives as non-linear products.

Fallback provisions in a contract lay out the process by which the parties can identify and use a replacement rate if a benchmark rate such as Libor is not available, perhaps because of a computer failure that affects the designated screen page or a temporary market disruption.

Parties to uncleared derivatives are also able to embed new fallbacks by using the long-expected IBOR fallback documents from the International Swaps and Derivatives Association or by the simple means of bilateral negotiation, while the clearing houses have announced their intention (subject, in some cases, to consultation) to incorporate fallbacks for derivatives subject to clearing into their rulebooks, comparable to those to be published by ISDA. On 15 April ISDA published the latest preliminary results of a consultative exercise on the subject.

Parties to derivatives can also use basis swaps, compression and other methods to pro-actively convert Libor exposures into RFR exposures. Many derivatives will not, therefore, be ‘tough legacy’ contracts. However, the taskforce recognises that the use of the ISDA protocol can only be voluntary for uncleared derivatives and is therefore no universal panacea. Firms are also likely to hedge exposures that are themselves considered to be 'tough legacy' or form part of more complex structures in which the derivatives are subject to the same or similar constraints as the instruments they are used to hedge, thus making the derivatives 'tough legacy' as well. For non-linear products, fallbacks are quite possible but may require more amendments than those likely to be found in the ISDA protocol. It therefore, ideally, would like HM Government to step in with legislation.

Bonds

The fallback provisions in existing bonds (that were issued with Libor in mind) are problematic because:

• in a small number of cases they do not exist;
• they do not contemplate the permanent discontinuation of Libor and ultimately rely on the application of the last available Libor fix for the remainder of their lives; and
• they involve the exercise of discretion within certain parameters, which may not be straightforward.

The working group wants market participants to move or 'transition' their old bonds away from Libor and towards SONIA (the Sterling Overnight Index Average which the Bank of England administers) actively wherever possible. Its Cash Market Legacy Transition Taskforce is going to produce some materials to support this.

Bonds issued before 2017 usually have 'fallback' to a fixed rate; some post-2017 contracts allow transition to an alternative reate, but involve the exercise of discretion on that rate. Some securitisations have outstanding call options and some are retained transactions. Some more recent securitisations have negative consent language which is intended to make amendment easier. Consent solicitation is possible for some bonds but probably not for all and there are high consent thresholds. Some bonds are widely held and there will not be enough time to 'transition' all affected bonds by consent solicitation. In some cases, the sponsor for a securitisation or repackaging may no longer exist or might have gone insolvent, so no decision maker or party will be willing to pay the costs of amending the contract.

Fresh legislation?

The taskforce is only too painfully aware that it is not within its remit to frame legislation. It knows that there are many other calls on the Government's time and that even if new legislation were to appear to sort these problems out, the laws of other nations might not fit it. On the positive side, in this arena and throughout financial regulation in general, the UK is a rule-maker and not a rule-taker.