Killing Libor Proves Harder Than Global Regulators Imagined

Purging Libor from the financial system is proving no easy task.

For more than three years, regulators have steadfastly maintained that the beleaguered London interbank offered rate would be phased out at the end of 2021. On Monday, they abruptly gave ground and pushed back the date of dollar Libor’s anticipated demise by 18 months.

A decision to shift course may have been expected by some, but few anticipated such a long extension. And while officials are adamant that it’s only a temporary lifeline, many see the move as a stunning acknowledgment that the task has been more daunting than envisaged.

At the heart of the delay is the threat to financial stability posed by trillions of dollars of existing contracts and instruments that lack a clear replacement rate. Policy makers have struggled to find a solution to the issue, which stretches across numerous markets.

“Libor dependencies are still entrenched in the DNA of the financial system, which could point to systemic risks if the transition is rushed,” said Subadra Rajappa, head of U.S. rates strategy at Societe Generale SA.

‘Huge Backlog’

While waiting until 2023 to end key Libor tenors doesn’t solve the problem of so-called legacy contracts, a senior Federal Reserve official said it should at least allow for many to expire naturally, especially as policy makers discourage new Libor-linked deals beyond the end of next year.

“This process is just massive because of all the legacy contracts that are hanging out there,” said Tom di Galoma, managing director of government trading and strategy at Seaport Global Holdings. “There’s a huge backlog of them that weren’t going to unwind in a very easy fashion.”

Monday’s decision fueled a rally in eurodollar futures, which are linked to Libor, with traders repositioning for a lower spread adjustment in fallback calculations during the transition.

Killing Libor Proves Harder Than Global Regulators Imagined

Breathing Space

The delay undoubtedly comes as a welcome reprieve to many of the world’s largest banks, which have struggled to transition certain markets to the Secured Overnight Financing Rate, the Fed-backed Alternative Reference Rates Committee’s preferred Libor replacement.

Near the center of the problem is a pile of outstanding debt that can’t be easily amended to include contractual fallback language -- which will therefore struggle to transition. That’s got officials and market watchers warning to a potential wave of litigation if a solution can’t be found.

“The key takeaway is that the extension will give regulators more time to facilitate an orderly transition away from Libor in cash instruments such as securities and loans,” said Scott Buchta, head of fixed-income strategy at Brean Capital. “The big issue here is the lack of uniform fallback language.”

Regulators had been vocal in recent months that the transition was still on track, highlighting recent milestones including the shift by derivative exchanges to SOFR for calculating the value swaps.

More recently, the International Swaps and Derivatives Association unveiled a much anticipated legal protocol to help convert Libor-linked contracts to SOFR once the benchmark expires.

Yet despite the progress, measures to shift existing cash instruments -- such as floating-rate bonds -- away from Libor have proven difficult. Efforts to get lawmakers to support legislation that would impose a fallback benchmark on financial products that lack a viable replacement rate have so far fallen flat.

And as the coronavirus spread the transition began to lose momentum.

Both the U.S. and U.K. governments allowed Libor to be referenced as part of emergency loan programs to help keep businesses afloat during the pandemic. The Bank of England delayed plans to encourage banks to ditch the rate and the U.K. pushed back a deadline for lenders to cease issuing Libor-linked contracts.

Unsafe, Unsound

A senior Fed official made clear Monday that writing new Libor contracts would be seen as unsafe and unsound banking practice if continued beyond the end of 2021, and that the central bank would supervise such firms accordingly. Lawyers say banks should be on guard for tougher regulation.

The Fed “used language designed to engender fear in the banks,” said Michele Navazio, a partner at law firm Seward & Kissel LLP. “That is regulatory speak for we want you to transition.”

The Fed, in a joint statement Monday with the the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency, encouraged banks to cease entering into Libor-referenced securities as soon as practicable.

“It’s not like it has been a disaster and nobody has started switching over,” said Scott Skyrm, executive vice president of Curvature Securities. “It’s just there’s still a lot of work to do. The market is going in the right direction with activity in SOFR picking up, it just needs more time.”

What Analysts Are Saying:

Linklaters LLP: Firms may refocus transition plans

  • “I can’t imagine that it will get people to stop or materially slow down transition plans. There will still be a desire to move,” said capital markets partner Deepak Sitlani. “If you’re prioritizing whether to transition sterling Libor or dollar Libor, notwithstanding the public sector messaging, you may see change in the way people focus.”

SOFR Academy: Efforts to build forward-looking term structure for SOFR could be delayed

  • The move “could delay the build up of liquidity that’s needed,” said Marcus Burnett, director of SOFR Academy, an education technology firm whose clients include banks and asset managers. “The more contracts that move from Libor to the risk-free rate, the higher the likelihood that a robust SOFR term rate can be developed.”
  • “The transition for legacy products probably wasn’t moving as quickly as it could have, and cessation at end of next year would have brought litigation and conduct risks. This extension will help to ensure that Libor transition is fair.”

Seward & Kissel: Loan market will be key beneficiary

  • “I don’t think the announcement was primarily targeted at the derivatives market, rather it was largely aimed at the commercial loan and debt markets that were anxious over the lack of a forward looking term SOFR,” said partner Navazio. “Banks are going to be celebrating, responsibly (I hope), that they’ve got a reprieve.”

Sullivan and Worcester LLP: Relief to firms with legacy contracts incapable of transitioning

  • Firms involved in legacy contracts that are struggling to transition away from Libor “aren’t going to get involved in litigation or have to come up with some work around that may or not work,” said partner Duncan T. O’Brien. “Anyone with one of those obligations just received a windfall.”

©2020 Bloomberg L.P.

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