Pretty much everybody knows that, come the end of 2021, the benchmark known as Libor is unlikely to continue to be published.
There are many sensible reasons for this. Changes in market dynamics have led to a situation where some $400 trillion in financial transactions may be priced off as few as six trades on any given day – and on some days, even fewer. Then there’s the fact that rates may be calculated through the use of ‘expert judgement’ – leaving them open to the type of manipulation seen in the years following the Financial Crisis.
Steps have been taken to improve the resilience of the benchmark, but the consensus is that Libor is unsustainable longer term and insufficiently robust as a benchmark for the derivatives market in particular.
So far, so reasonable.
However, the elephant in the room for many corporates arises when looking at the replacement that has been recommended. In all cases – and this transition affects all the major currencies: USD, EUR, GBP, JPY and CHF – the private-sector working groups tasked with identifying a replacement benchmark have recommended an overnight near risk-free rate benchmark to replace the term benchmark that is Libor.
To be fair to the working groups – largely made up of derivatives traders, since this makes up 80% of the market that references Libor – this was a reasonable approach. Unsurprisingly, the solution identified works for this market, but perhaps overlooks the fact that Libor is also extensively used in cash markets, for example bonds and loans.
In many jurisdictions, Libor is also referenced in retail products, such as mortgage, which have rather different requirements from a benchmark.
To be clear, longer term, many corporates, and certainly the larger, more sophisticated ones, will be in a position to transact referencing the replacement risk-free-rate benchmarks.
However, transition is the challenge. Bluntly, the issue centres on what corporates will do with all the legacy transactions that reference Libor and mature post-2021. And this is where the International Swaps and Derivatives Association (ISDA) consultation and all the talk of fallbacks comes into play.
Firstly, a definition: a fallback is an alternate rate to be used in the event of the original benchmark (Libor in this case) no longer being available.
In most cases, the fallback language in financial contracts fails to contemplate the permanent discontinuation of a reference rate. Although Libor might be reformed – as indeed has happened – it had been assumed that it would never disappear altogether.
As a result, triggering existing fallback language may result in the last published rate being applied to the transaction, effectively fixing the interest rate applicable to the instrument – rarely the intended outcome.
The announcement by the Financial Conduct Authority in 2017 made the permanent discontinuation of Libor a very real possibility – and everything that has been seen and heard from the regulators since then reinforces the likelihood of that happening.
The Loan Market Association, the International Capital Market Association and ISDA are all working on developing fallback language for their respective markets.
The particular problem with fallbacks is that the replacement benchmarks (RFRs) are overnight and near risk free, whereas the Interbank Offered Rates (IBORs) have term structure and incorporate bank credit risk premium and other factors in a spread (for example, liquidity).
The application of fallback language in a legacy transaction will need to replicate the structure in the original contract and therefore needs to have an element of both a term and spread adjustment. Furthermore, there is a concern that any such adjustment will result in a transfer of value between the counterparties and is therefore being viewed with great suspicion by all parties.
To canvass opinions in relation to fallbacks, ISDA published a here.
A large section of the market is currently waiting for the results of the ISDA consultation to see how the matter of fallbacks will be resolved, and specifically how the bridge between Libor and the RFR will be calculated.
For corporates, much of this feels rather like putting the cart before the horse, as the derivative is traditionally transacted by corporates as a hedge of the underlying cash product (ie the loan or bond).
Ideally, they should respond to the ISDA consultation. In practice, corporates need to think carefully about the fallback language that will be proposed for different products. For corporates, the derivative needs to hedge the underlying cash product; if the reference rate or calculation of spread methodologies differ by product, the hedge may disappear.
Furthermore, it is worth noting that ISDA can amend language within its Master Agreements and Schedules by amending Definitions (which apply to all future transactions) or by publishing a Protocol (which can be applied retrospectively and therefore impacts legacy transactions). It is up to the counterparties to any contract to agree to adopt the Protocol – corporates may not want to do so…