APPROACHING THE EXPIRATION DATE
LIBOR, a measure of the borrowing costs between banks for unsecured short-term loans, has formed the foundation of millions of financial contracts worldwide for decades now. But despite the rate’s ubiquity, doubts had surfaced in recent years about its integrity and value.
A 2014 study by the Financial Stability Board (FSB), which reviewed the reliability and robustness of interbank benchmarks, recommended the development of alternative nearly risk-free rates (RFRs) and proposed ways for financial markets to adopt them instead.3
Meanwhile, efforts by the UK’s regulatory body, the Financial Conduct Authority (FCA), to reform LIBOR led to the conclusion that the benchmark was potentially “unsustainable” and “undesirable” in the long run. In 2017, the FCA said it would not compel banks to submit their LIBOR quotes after December 2021, effectively giving it an expiration date.4
Those announcements spurred regulators in several jurisdictions, including the US, Switzerland and Japan, to advance their own domestic RFRs to gradually replace LIBOR. However, the sheer scale of the undertaking at hand, given LIBOR’s pervasiveness in the fabric of global markets, is proving to be daunting and difficult.
As Matthieu Sachot, a director at management consultancy Chappuis Halder & Co., told our Hong Kong audience, the volume of assets in the firing line is significant.
“You have to consider your loans, your debt securities, your equity securities. You have to account for your liabilities and then account for the indirect impact to your P&L, for example,” he said, adding off-balance sheet items such as credit facilities, swaps, futures, options and collateral to the list.
Kush Handa, Head of Balance Sheet Trading North East Asia for ANZ, also outlined the challenges ahead. “It’s an incredible amount of work because we have an incredible amount of exposure across a variety of asset and liability classes. I think the most amount of work, obviously, is looking at contracts,” he said.
Regarding contracts, there are concerns that legacy covenants do not sufficiently deal with the prospect of changes in the underlying benchmark, and that the interim provisions would need to be addressed urgently in a post- LIBOR era.
“The contracts have some kind of fallback regime which, to a greater or lesser degree, does give comfort as to what rates would be applied in the situation where LIBOR is either not available or is not appropriate,” explained Fiona Cumming, a partner at law firm Allen & Overy. “But they are typically temporary measures and they are not designed to be used on a going-forward basis.”
For instance, all floating rate instruments would suddenly turn into fixed rate ones from January 2022 because the rate would remain stuck at last LIBOR quote calculated on 31 December 2021.
According to Cumming, such cases place a real emphasis on trust and fairness as the financial institutions involved would be obliged to clearly communicate the risks to their clients to avoid any disputes.