Fears EU’s ‘tough legacy’ fix could tie risk managers’ hands

Proposal bans use of replacement rate in new products, which some fear could hamper hedging and novations


The European Union’s proposed approach to tackling Libor-linked products classed as “tough legacy” have caused concern among market participants, with some worrying it could limit banks’ ability to risk-manage the products in the future. Others are worried about a potential clash of rules on cross-border products.

The tough legacy moniker relates to products where it is impossible to insert fallback language that would switch them to an alternative rate when the Libor benchmarks end. EU proposals would see the products move onto a statutory replacement rate (SRR) selected by regulators when Libor ceases, but this will only be available for these tough legacy instruments.

If tough legacy trades switch to the SRR, dealers want the ability to reference that benchmark in new derivatives trades in certain circumstances – so they can dynamically risk-manage the products, for example, or novate them to other dealers. Without this, risk management could prove challenging.

“I think it’s important that people who have exposure to any benchmark are able to continue to manage that risk dynamically,” says Rick Sandilands, senior counsel for Europe at the International Swaps and Derivatives Association.

Proposals to update the EU’s Benchmark Regulation, as proposed by the European Commission, will see tough legacy products revert to the SRR upon a trigger event, one of which is an announcement by the UK’s Financial Conduct Authority that a benchmark will cease. The FCA is expected to make these announcements early next year ahead of the cessation of all Libor currencies, bar some of the popular US dollar fixings, at the end of 2021.

The commission is proposing that the SRR can only be used by contracts without fallbacks that are pending at the time the replacement rate is selected. “No contracts concluded after entry into force of the implementing act designating the replacement rate will be allowed to reference the statutory replacement rate,” the proposal says.

No proposed amendments have been made to the text by the European Parliament or Council of the EU.

While this wording therefore indefinitely restricts the use of the SRR to tough legacy products only, workarounds could be available. For instance, if the SRR for sterling Libor is a Sonia-based forward-looking term rate plus a spread, counterparties may be able to trade swaps linked to that benchmark, instead of the SRR specifically.

Sandilands though points to recent statements from the Federal Reserve that could support further use of outgoing benchmarks for risk management purposes.

“It was encouraging to see the Fed recognise in its November 30 statement on Libor transition that there may be circumstances in which it would be appropriate for a bank to enter into new US dollar Libor contracts after December 31, 2021, including for hedging or reducing client exposure. We will have to see whether and how that is reflected in the details of the final proposals,” he says.

Some dealers are also worried that, given many cash products such as loans are not in scope of the BMR, it is unclear what would happen if the swaps fall back to the SRR and the product they’re hedging do not.

“As far as I’ve understood the BMR proposals, they would only apply to contracts that are in scope of the BMR regulation, so they would exclude things like loans but would include the interest rate swaps that are used to hedge loans. You could have a situation where you’re hedged to a loan and your swap undergoes a mandatory benchmark replacement whereas your loan doesn’t, and therefore you’re no longer hedged with the loan. That’s going to create another layer of issues for the market,” says a compliance head at one large dealer.

Contrasting approaches

Others are also concerned about a lack of alignment in how the EU and the UK intend to tackle the tough legacy issue.

The UK’s Financial Services Bill gives the FCA the power to force Ice Benchmark Administration to change the methodology of Libor to create a synthetic version of the benchmark based on the relevant risk-free rates. As the screen name ‘Libor’ still survives, these tough legacy products can continue without disruption and do not need changes to documentation.

If those two rates are different, for banks this creates the possibility that the same tough legacy products traded out of an EU entity will end up on a different benchmark to those traded out of the UK.

“For a bank like ours, which operates very much on a cross-border basis, the logistical complexities of that are non-trivial. Our bank entities in the EU might have to replace legacy contracts within this SRR method whereas UK entities would be following the Financial Conduct Authority’s approach instead – which creates logistical difficulties that I can’t even envision right now,” says the compliance head at the large dealer.

For cross-border products, for example a securitisation where the issuer is in the UK and the investor is in the EU, some are also worried it could lead to legal confusion.

When the FCA announces that Libor will end, EU law applicable to European entities will see the rate as in cessation and therefore replaceable by the SRR, but UK law will not. In a letter sent to the EC on October 6, Joanna Perkins, chief executive of the Financial Markets Law Committee, said that in this situation the governing law of the contract often will dictate what will happen, which in most cases will be English law.

But governing law might be up for debate, as it has been in some swaps disputes involving Italian regional governments, potentially leading to problems if the rates are different.

“Contracts involving EU entities with overseas elements could, in theory, be subject to competing interpretations as to which floating price can be strongly supported (the screen price established under the Financial Services Bill or the SRR), leading to confusion and possible litigation,” wrote Perkins.

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