Twin-track solution for ‘tough legacy’ Libor falls flat

Critics deplore lack of detail in UK taskforce's call for parallel legal fix and synthetic rate

Libor-deadline-is-approaching-fast. montage

A sketchy report on one of the big challenges in Libor transition has disappointed observers who were hoping for more detail.

The report recommends a belt-and-braces approach to rescuing derivatives, bonds and loans that will be left without a viable reference rate when Libor stops being published. Panel banks will be free to walk away from the benchmark from the end of 2021.

“There’s literally nothing in here that hasn’t been talked about and isn’t already on people’s minds,” says a partner at one London-based law firm. “Given the stage we’re at, it’s pretty disappointing. It feels like no one is really looking at this.”

The taskforce’s twin solutions – a legislative fix and a short-lived synthetic version of Libor – are intended to resolve so-called tough legacy positions. These are Libor-referencing instruments that cannot be moved to a new rate prior to the benchmark’s demise and also lack a viable contractual fallback. 

Both solutions have been on the table since the middle of last year, but there is little sign of progress in the taskforce’s eight-page document, other than a statement of the group’s official position: the UK government should consider legislation, it states, with synthetic Libor “pursued in parallel”.

The twin options are wrapped in caveats, and no next steps are proposed. The document was published on May 29 by the tough legacy subcommittee of the Bank of England-convened working group on sterling risk-free reference rates.

In contrast, its US counterpart published a 20-page report in March that included eight pages of proposed legislative text.

Similar legislation for English-law contracts would help international consistency, the UK taskforce notes, but given the time constraints, it would not be possible to wait on the outcome in the US. The market has 18 months until the earliest point at which Libor can die.

There’s literally nothing in here that hasn’t been talked about and isn’t already on people’s minds
Partner at one London-based law firm

“[The UK taskforce] hasn’t really made a choice of which way they want to go and I don’t think they thought very deeply about the legislation,” says a second London-based lawyer. “It all points to them thinking it will be helpful if the UK was similar to the US – and that legislation would be helpful if we can’t get all of this done in time – but these tough legacy measures don’t really seem to be so important to them.”

Others see the report’s lack of detail as a deliberate attempt to ensure market participants do not throw themselves into the tough legacy safety net. In its paper, the taskforce calls for the market to continue trying to escape Libor-linked contracts prior to the benchmark’s death, noting “this is the only way for parties to have certainty over their contracts.”

“A bit fiddly”

Lawyers have reservations about both of the paths suggested by the taskforce.

Critics warn it may be difficult to define the scope of any legislation, including which contracts it applies to and whether the law would override existing fallback language or transition negotiations. It is also unclear whether compounded-in-arrears Sonia – the replacement for sterling Libor – would be the only available substitute, whether a legislative fix could be extended to other Ibors, and whether it could be applied to English-law contracts outside the UK.

“I think legislation is desirable but most people would probably only rely on it for contracts where they can’t get any engagement with other parties. It’s not so much that those contracts are difficult to fix, because the difficult ones don’t really lend themselves to a legislative solution,” says Guy Usher, co-head of financial markets and products at Fieldfisher.

He adds: “You might be able to use legislation as part of your toolkit for components of the most complex contracts. But it’s not necessarily going to solve masses of the tough legacy problem because by definition that’s a bit fiddly.”

If you go for something quite narrow and specific, you can potentially get something through quicker and then take that problem off the table
Guy Usher, Fieldfisher

A common example of tough legacy positions are bonds and securitisations that would use the last available Libor fix in perpetuity once publication of the benchmark ceased, turning a floating-rate bond into a fixed-rate one. This can be averted via consent solicitation – essentially, asking investors to agree to a different reference rate – but for widely held instruments, gaining approval from the bulk of investors is time-consuming and costly.  

Other examples given by the taskforce include derivatives that are hedging an underlying, non-negotiable Libor exposure, Libor-linked mortgages that have no fallback, and loans that require bilateral negotiation to transition. In some cases, the number of negotiations required is what lands these instruments with the tough legacy badge.

“When you look at what is classed as tough legacy, it’s not always structural issues within the deal or the instrument – some of it is just volume,” says Claude Brown, a partner at Reed Smith. 

While legislation could ease transition for vanilla contracts such as floating-rate notes and syndicated loans – where time is the greatest obstacle, given the volume of transactions involved – it is unlikely to be a cure-all for the most complex transactions such as contracts containing multiple Libor exposures or inter-creditor agreements, lawyers say.

More than £7 billion ($8.9 billion) of sterling Libor floating-rate notes have already been flipped to Sonia via consent solicitations. While achievable for narrowly held instruments such as benchmark covered bonds and master trust securitisation programmes, the need to obtain approval from 75% of the noteholders means it will be costly and time-consuming to alter the remaining £50 billion or so of notes set to mature after 2021.

“Bonds and securitisations are tricky because consent solicitation is difficult and expensive, but we’re doing a lot of them. We’re running several Libor transition projects at the moment and have found that the tough legacy and fallback problems fall into a finite number of categories,” says Brown.

Rather than complex, catch-all laws that may struggle to be effective for true tough legacy exposures, addressing specific issues such as consent solicitation in bonds may help speed the legislative process, adds Fieldfisher’s Usher.

“If you go for something quite narrow and specific, you can potentially get something through quicker and then take that problem off the table. But it doesn’t necessarily feel like emergency legislation if you consider everything else that’s going on in the world right now,” he says.

Going beyond sterling

The taskforce requests consideration for legislation to extend to other Ibor rates – a move that adds political complexity to any legislative process. Working groups on Libor transition were set up by central banks in each jurisdiction, recognising the systemic nature of benchmark interest rates. What’s more, successor rates are at varying stages of development – most of them lagging behind Sonia in the UK.

“It’s not difficult to draft the law to apply to other Ibors and currencies but you have to work out how to treat the alternative approach being developed by other working groups and that depends what they are proposing and whether that rate even exists,” says Diego Ballon Ossio, senior associate at Clifford Chance.

He adds there’s no guarantee legislative changes would be enforceable if overseas counterparties suffer losses as a result of the switch. To avoid lengthy litigation, a conflict of laws analysis must typically be carried out to see which laws eclipse others in each jurisdiction.

“If you’re not resident you need to be able to show that the law you’ve chosen under your contract is actually the law that should apply. It depends on the legal system, but ultimately you can see how you can build an argument to say it shouldn’t apply if it puts you in a worse position,” says Ballon Ossio.

In a nod to the extreme uncertainty around the legislative route, the taskforce also proposes creating a synthetic Libor. This would see the defunct rate continuing to be published under some kind of simple formula – likely a fixed spread over compounded Sonia. It’s also far from a bulletproof solution, requiring the approval of Libor’s guardian, Ice Benchmark Administration, or intervention from the rate’s regulator, the UK’s Financial Conduct Authority (FCA).

Under the European Union’s Benchmarks Regulation, a benchmark regulator does not have the authority to force wholesale methodology changes in a critical rate. Even if those powers were granted as part of proposed BMR amendments, lawyers worry the rate would be no more robust than Libor itself.

“It could help if you can construct something that would just slot into contracts, but you’re just replacing one problem with another. If Libor is a bad benchmark, a synthetic version could be as bad or worse depending on how you constructed it. You’d be buying yourself more time but perhaps in an equally unsatisfactory way,” says Usher at Fieldfisher.

It’s also not clear how the FCA would prevent the use of a synthetic Libor in new transactions, or how long it would need to be kept alive to protect legacy contracts. For example, some securitisations requiring a tough legacy fix are 20 years or more from legal maturity, Usher notes – and synthetic Libor is only described by the taskforce as a way to “stabilise” Libor during a “wind-down period”. 

“If you can’t fix it in the next year and a half, how are you then going to fix it in the next three years that synthetic Libor might run for after that?” he asks.

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