Libor – Simply too big to kill off entirely

Detaching an estimated $350 trillion of financial contracts from Libor was always going to be an uphill struggle. For a rump of so-called “tough legacy” contracts it’s a near impossible task. Now their future lies in the hands of legislators. 

In a recent benchmark transition survey, six jurisdictions told the Financial Stability Board that legislation will be needed to shunt Libor’s most stubbornly welded contracts over to risk-free rates (RFRs). At least two – the US and, more recently, the UK – have already started work drafting suitable language. Another two warn the necessary fixes cannot be guaranteed. 

Legislative proposals currently being thrashed out in the US would provide a safe harbour from litigation for contracts that are difficult to amend, and could trigger disputes as they are flipped to alternatives such as the secured overnight financing rate. The UK’s approach, announced on June 23, would grant the Financial Conduct Authority (FCA) – Libor’s regulator – new powers to alter the methodology underpinning benchmarks deemed too flimsy. 

Synthetic Libor by statute is a “neat fix” according to some industry lawyers – many of whom were disappointed when a long-awaited tough legacy report from a committee of the sterling RFR working group offered little concrete action on one of the biggest challenges of transition.

Others see it as an admission that Libor is simply too big to kill off entirely. “Essentially, the government is forcing the FCA to take a step back. Before, the FCA was saying this is definitely going to die. Now they’ve had to take a bit of perspective and say ‘yes, it’s still dying but we’re going to keep it alive’,” says one London-based lawyer.

Altering Libor’s methodology is fraught with complexity and territoriality concerns. The FCA has the power to alter all Libor rates under its governance, including sterling, US dollar, euro, Swiss franc and Japanese yen. Whether it has appropriate inputs available – likely a forward-looking term rate built from liquid RFR derivatives markets – is another question. What’s more, limiting use of the rates could prove tricky beyond the UK financial firms directly under the FCA’s surveillance. 

UK legislators face a balancing act in crafting a lifeline for tough legacy contracts without encouraging widespread complacency. And there’s little time to do it in. While Libor is not set to cease until after the end of 2021 at the earliest, the FCA is eyeing the end of 2020 for possible confirmation of the benchmark’s demise. It’s at this point the credit spread would be fixed for derivatives fallbacks. 

Remember when participants were calling for transition delays in response to Covid-19 lockdowns? That all seems like a very long time ago. 

Libor Risk – Quarterly report Q2 2020
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