By: Serge Gwynne, Jennifer Tsim, Adam Schneider, Paul Cantwell and Peter Reynolds
This article first appeared in Financier Worldwide Magazine on January 2020.
FW: What scenarios do you see for the discontinuation of the London Inter-bank Offered Rate (LIBOR)? Can the industry take different scenarios into account in its response?
Gwynne: Like it or not, we live in a world in which uncertainty around the cessation of the London Inter-bank Offered Rate (LIBOR) exists and will continue to exist. Given the position of UK regulators who authorise LIBOR, the base case scenario has to be LIBOR discontinuation for all currencies after 31 December 2021. This assumes a substantial level of transition from LIBOR to alternative reference rates (ARRs) before the end of 2021. If there is still a large stock of LIBOR transactions at that point, there will be huge operational and value transfer risks if LIBOR were to be discontinued. In that scenario, there may be pressure for an extension for some period, probably coupled with a prohibition on new LIBOR-based product issuance. But an extension has been explicitly rejected by several regulators and it would be hugely risky to plan on that basis.
Schneider: There is also a possibility of divergence between currencies. US dollar transition is lagging sterling, so there is a potential scenario in which GBP LIBOR is discontinued but US dollar continues for legacy transactions. To make it more complex, if the number of bank contributors decreases there is a risk of a ‘zombie LIBOR’, which does not meet the standard necessary to be ‘effective’ but which, because it still published, does not trigger the contractual fallback clauses in many deals.
Cantwell: Any firm needs to take these different scenarios into account. Base case plans should assume that LIBOR will cease to be available by the end of 2021. What is certain is that working back from the end of 2021 there is, for many firms, barely enough time to complete all of the required tasks. The client, economic and operational consequences will require a heavy lift to manage. We have seen that the nuances of the different permutations of the scenario can cause inaction, which will delay implementation, so firms need to create thoughtful, approved, firm-wide scenarios – which, by the way, have never included a LIBOR extension.
Reynolds: It would certainly be much simpler for everyone if key deadlines were more concrete. For example, if the regulators could say for definite when LIBOR will stop or could not be used for new issuance from a certain date, that would reduce uncertainty and also remove some perceived first-mover disadvantage for banks to switch to selling RFR-based products.
Like it or not, we live in a world where uncertainty around the cessation of the London Inter-bank Offered Rate (LIBOR) exists and will continue to existSerge Gwynne
FW: How is the transition away from LIBOR for new transactions progressing across currencies and products? Where has there been good progress, and where has it fallen short?
Tsim: Sterling transition is progressing well in both the derivative and bond markets, but lending has not really started. Only a handful of Sterling Overnight Index Average (SONIA) loans have been issued, driven by a combination of lack of borrower demand and bank readiness. This needs to change very quickly if we are to hit the Sterling RFR Working Group target of Q3 2020 to stop new GBP LIBOR products.
Gwynne: One concern that we have heard in the UK is that banks do not want to offer LIBOR and SONIA loans at the same time – they know that counterparties will compare the rates and remain silent if they have the upside but complain bitterly if they have the downside. For this reason, the banks would prefer a fairly hard cutover near the transition date.
Cantwell: The US is lagging a long way behind, with limited activity in all markets. We expect the shift to central counterparty (CCP) Secured Overnight Financing Rate (SOFR) discounting to trigger increased activity in swaps, but this is planned for Q3 next year, which leaves less than 18 months for a full shift away from LIBOR. That feels very tight at this stage.
Schneider: One countervailing argument in the US is that if a firm date is specified, it will be very hard for banks to offer, or for their customers to accept, LIBOR products in the last year. The conduct risks of selling a product that will reset to LIBOR at a time when it probably will not exist seem hard to ignore, even if you can persuade someone to buy it and even if you have the world’s most clear fallback language.
Reynolds: Across Asia Pacific, the situation is very fragmented. Australia has a long history of market-implied rates, and Japan has made material progress, although the regulatory requirements for customer interaction are onerous. Hong Kong and Singapore have reference rate proposals, but much uncertainty remains. Smaller markets are in wait-and-see mode. This makes the whole thing extremely complex for global banks.
If the US market has not transitioned by the end of 2021 there is little chance that Asian markets will have transitionedPeter Reynolds
FW: What do you think has been holding up development of Secured Overnight Financing Rate (SOFR)- and Sterling Overnight Index Average (SONIA)-based loans, and how could this be resolved? What should firms consider in pricing these new products?
Gwynne: Awareness among corporates of the need to transition remains very mixed. Even where they are aware, many would prefer to delay the change either in the hope that a term rate is developed or to push back costs associated with changes to systems to deal with overnight rates. Corporates have many other priorities and preparing for a change at the end of 2021 is not currently near the top of the list.
Tsim: From a bank perspective, several have the ability to offer SONIA loans on a small scale, but few have product innovation and robust systems in place to offer them widely – partly driven by lack of availability of system upgrades from loan system providers. But there are also conduct risk concerns with offering SONIA-based loans – for example if the convention chosen does not become standard or a client would have paid less if it had taken a LIBOR loan for the same period.
Schneider: Exactly the same applies in the US, with even more pressure for a term rate. Banks are also pushing hard for a credit-sensitive rate that will behave more like LIBOR than SOFR and avoid a series of negative impacts on lending economics. The challenge is identifying such a rate, which is based on real-life transactions rather than expert judgement – which proved so flawed in the LIBOR manipulation scandals. Plus, the immature SOFR swap market makes hedging more expensive or risky.
Cantwell: Pricing of the new products is also a challenge. Given that ARRs behave differently from LIBOR, pricing levels and approach also need to change. Product pricing needs modelling of different future interest rate scenarios, particularly where products have embedded optionality such as floors or prepayment options. LIBOR is an enormous percentage of bank balance sheets and so they cannot afford margin erosion through the switch to new products. The assumption that firms will automatically switch from LIBOR to a new rate plus a spread is naive. We are already seeing firms questioning what the right pricing model should be for any given product and market.
Reynolds: Asian markets are heavy users of US dollar products, but both borrowers and banks expect to be followers of the domestic US market. Local currency reference rates, with only limited exceptions, remain a work-in-progress in most large Asian markets.
FW: What are the operational challenges for banks and end users adopting SOFR and SONIA-based products?
Schneider: Systems, operations and risk models need to be changed to reflect the different interest rates. In particular, when a ‘compounded in arrears’ approach is used it means that the interest rate is not known until the end of a period, rather than at the start with LIBOR. Detailed conventions on how daily rates are averaged also need to be defined before changes to systems and processes can be made by both banks and end users. For traded products, risk modelling is a challenge, particularly for SOFR because of the limited historical time series of data. This could lead to capital increases, particularly under the Fundamental Review of the Trading Book standard.
Cantwell: Relying on the fallback language in existing contracts could create operational mayhem. We are advising our clients to avoid this if at all possible. In the US, millions of financial contracts will ‘fall back’ from LIBOR if and when it is no longer published. There is little standardisation in what the fallbacks are, which means banks and their clients will be dealing with a wide range of economic effects. The operations and systems required to perform this at scale are in their infancy. The fact is that no system that we are aware of has ever been capable of handling the cessation of LIBOR. It is like asking if the system could handle the cessation of Tuesdays. Some systems may cope with a brief interruption, but not a cessation.
Relying on the fallback language in existing contracts could create operational mayhem. We are advising our clients to avoid this if at all possiblePaul Cantwell
FW: There has been lots of work on improving fallback language in contracts. What role do you think fallbacks will play in the transition?
Tsim: The regulators are clear that fallbacks should be viewed only as seat belts in case of emergency. Wherever possible, contracts should be changed to alternative rates in advance of LIBOR discontinuation, in which case the fallbacks would not be used. This is for two reasons. First, no fallbacks are fully equivalent to LIBOR – not for lack of effort, but simply because you cannot replicate the behaviour of LIBOR through other metrics. This means that there could be significant value transfer if fallbacks are triggered. For example, many US loans have prime rate as a fallback, which is about 3 percentage points higher than LIBOR, and so would mean many individuals and corporates in theory paying much higher interest. Second, all fallbacks would be triggered at the same time if LIBOR were discontinued. Switching interest payments, valuations and margin requirements to fallbacks would be a major operational challenge.
Cantwell: It is inevitable that some contracts will not be transitioned before the end of 2021, and so fallbacks would be triggered. For example, it is likely that some or maybe many US bonds will be unable to get the 100 percent consensus required to change terms, and there will be other end users who do not want to transition for a variety of reasons. But the reality is that no bank in the world can currently implement fallbacks anyway – they simply do not have the data and systems set up to be able to process them. So even if they will be used only in a minority of cases, banks still need to develop capabilities to execute fallbacks. And these fallback arrangements need to be properly tested well ahead of the end of 2021 to ensure that the switch is smooth and error-free.
FW: What is the process for amending LIBOR contracts? Whose responsibility is it, and what happens if both sides fail to agree?
Gwynne: There is a range of ways contracts could be amended, such as incorporating new fallback language or directly changing from LIBOR to an alternative rate in existing contracts or closing out current contracts and establishing new contracts using an alternative rate. Both sides of the contract will need to agree under any approach – changes cannot be imposed by one side, even if existing fallbacks are ineffective. We expect banks to take the lead on starting the dialogue with end users, proposing changes and ensuring the end users understand and accept the implications of any changes. But end users should not be passive – they should reach out to their banks and request changes before LIBOR is discontinued so that required changes can be made in an orderly way. If both sides do not agree, then current fallbacks will kick in, which could result in significantly higher interest payments or floating rate products become fixed rate, where the last LIBOR rate is used. Customer and transaction-level economic modelling will be critical to inform the transition approach and negotiations with clients. Particularly where clients have multiple products – from simple loan and swap combinations to complex portfolios – understanding the economic impact of fallbacks triggering or a switch to alternative rates is complex.
Schneider: For syndicated loans and bonds, where you have multiple lenders or investors, it will be a challenge to get agreement on new terms. This will be made much easier if the industry can agree on standard adjustments, but this requires convergence both across regions and currencies – for example for multicurrency loan facilities – and ideally across products, for example where loans are hedged by swaps. There are also many products with specific features such as embedded options, caps and floors, where standard adjustments are unlikely to work and so any changes need to be transaction-specific. This requires economic impact analysis to understand the future cashflows and present the value of transactions under LIBOR and alternative rates, under a range of market scenarios.
Cantwell: Many banks will have tens of thousands, or even hundreds of thousands, of LIBOR contracts to amend, which is a massive legal and operational challenge. This requires careful planning, clear guidance to the individuals who will be leading the contract renegotiation, workflow tools to support the process through from initial client discussions to agreement of new terms to issuance and booking of new contracts and reporting tools to track progress. The conduct and litigation risk inherent in this process means that it will need to be handled with extreme care.
The litigious culture combined with the large number of retail and SME customers with LIBOR products and the inevitability of value transfer could create a field day for lawyersAdam Schneider
FW: Do you think the industry will have fully transitioned by the end of 2021?
Tsim: At this stage it is looking increasingly unlikely that full transition will be achieved in time without dramatic acceleration. Sterling derivatives should be possible, but the loan market has to go from a standing start to 100 percent of the market within a short time frame. But there is a potential catalyst in the form of the UK authorities pushing hard for an end to any new sterling LIBOR issuance after Q3 2020. This will be hard to hit but would force both borrowers and banks to make the transition and remove perceived first-mover disadvantages. This would then give 15 months for the transition of the back book, which should theoretically be possible.
Schneider: We do not yet have the same level of regulatory pressure in the US and there is no equivalent to the Q3 2020 end date in mind. With CCPs only transitioning discounting in Q4 next year, it is hard to see the new loans shifting to SOFR, let alone time for the back book to be moved across. The added complication in the US is that LIBOR is used for vast numbers of retail mortgages and other consumer loans, which will be difficult, sensitive and time consuming to transition, as most borrowers have no understanding of LIBOR let alone SOFR.
Reynolds: If the US market has not transitioned by the end of 2021 there is little chance that Asian markets will have transitioned, the possible exception being Australia where most local-currency exposures are already tied to market-based rates. While several of the authorities are putting pressure on banks to understand their exposure and plan transition, they will inevitably be dependent on the speed of development of SOFR product in the US.
LIBOR transactions that extend beyond the end of 2021 continue to be sold today, many with inadequate fallback termsJenny Tsim
FW: How material do you think conduct and litigation risk will be as part of this transition?
Gwynne: In the UK, the conduct risk is huge. It is particularly acute when it comes to transitioning existing LIBOR transactions, where in most cases banks proposed LIBOR-based products, as well as the fallback terms, which have turned out to be inadequate. If customers are not treated fairly in the transition, then it could lead to a further negative impact on the reputation of banks and multibillion-pound fines for individual banks, as we have seen recently with swaps mis-selling and payment protection insurance. The challenge for banks is to define approaches that are fair to their customers, ensure they are executed properly – even where transitions are being executed by a large number of bankers dispersed across the country – and also ensure that fairness can be demonstrated in case there is a retrospective investigation in the future. Conduct risk is particularly relevant for retail customers and smaller businesses, which are generally less sophisticated buyers of financial products and so are more reliant on advice from banks.
Tsim: Even before we get to back book transition, there are other forms of conduct risk. LIBOR transactions that extend beyond the end of 2021 continue to be sold today, many with inadequate fallback terms. This includes 30-year LIBOR swaps and 30-year adjustable rate mortgages with seven years of fixed interest reverting to 1Y LIBOR + 225 bps in 2026. Banks are well aware that the likelihood of LIBOR being available for the duration of these products is low to nil, which creates situations ripe with conduct risk. Second, and counterintuitively, there may be conduct risks associated with selling SONIA-based products. Many banks believe it is still unclear whether it is acceptable from a conduct perspective to sell products to retail or small and medium-sized enterprise (SME) customers where the interest rate is not known in advance. The US does not allow this for consumers, for example. And if customers are pressured to switch to SONIA-based products but can see that they would have been better off with a LIBOR product, they could also claim unfair treatment. Again, the answer for banks is to ensure they can show that conduct risk was fully considered in decisions to sell LIBOR or SONIA-based products, and that all appropriate risk mitigants were put in place.
Schneider: In the US, litigation risk is the primary concern. The litigious culture combined with the large number of retail and SME customers with LIBOR products and the inevitability of value transfer could create a field day for lawyers. To prepare for this, some banks are already involving litigators in the way they are designing their transition programmes. For example, this includes input into the identification of acceptable treatments for different types of customer, decision trees to fairly and objectively determine the optimal range of treatments for individual customers and determination of what data need to be captured at the point of customer transition to show it was done fairly. Customer level economic modelling is also essential. Preparing adequately now will likely save enormous costs defending against litigations in the years to come.
Cantwell: To monstrously misquote Winston Churchill, LIBOR is “a riddle wrapped in an enigma”. LIBOR rates were demonstrably manipulated, and they have few real-life transactions on which they can be based, yet they are not viewed as problematic by most of its users, who do not know what problem is being solved by a forced transition. LIBOR has permeated our system but is extremely fragile and would cause great harm in a crisis if it became unavailable. It touches individual consumers and enterprises great and small, but is understood by few. The challenge of transition should not be underestimated. There are few precedents – perhaps the shift to the Euro or T+2 – but these are actually relatively simple compared with transitioning away from LIBOR in multiple geographies and for multiple products by the end of 2021.