Libor: Rigged, Regulated, Replaced (Part 3)

Fallback Language and Alternative Rates

           In November 2014, in preparation for this transition, the United States Federal Reserve convened the Alternative Reference Rates Committee (ARRC) to “identify a set of alternative USD reference rates that are more firmly based on transactions from a robust underlying market” and to “identify an adoption plan to facilitate the voluntary acceptance and use of these alternative reference rates.”[1] While beginning this monumental shift away from LIBOR, two problems have become extremely apparent. The first issue is dealing with the “legacy contracts” referencing LIBOR, i.e., those referencing LIBOR that mature beyond 2021.[2] The second issue has to do with what happens when LIBOR ceases to exist. Namely, will an adequate substitute rate exist which will allow market participants to lend and borrow in a liquid credit market?

Illustrated in the Bank of International Settlement’s quarterly review, the most pressing legal issue is arguably the migration of legacy contracts to a new benchmark if LIBOR publications become unusable or cease altogether after 2021.[3] According to an analysis performed by the ARRC, trillions of dollars of legacy contracts will still be outstanding, and without an adequate fallback benchmark, the value of these contracts and stability of the underlying market could be severely compromised.[4] Compounding this problem is that the use of LIBOR in new instruments is still rising. For example, the Bank of England’s latest Financial Stability Report noted the notional value of long-dated derivatives contracts referencing sterling LIBOR that mature after 2021 was double in 2018 than it was at the same time in 2017.[5]

The legal solution that, if not already underway by many participants, should be immediately implemented, is the renegotiation of these instruments to include credible fallback language. Similarly, new LIBOR-linked instruments being issued should preemptively include fallback language anticipating the cessation of LIBOR. When publication of LIBOR rates stops, the resulting uncertainty will likely cause instruments and contracts to plummet in value if they lack adequate fallback provisions. Stated bluntly by Tom Wipf chair of the ARRC, “[i]t’s no longer a question of if—but when—LIBOR will become unusable, yet most contracts referencing it don't adequately account for this eventuality.

With LIBOR’s possible 2021 expiration date looming, that obviously poses a massive risk to financial stability and market participants.”[6] As much as large, leveraged intermediaries are exposed, the resulting losses could severely impair their capital, and although unprobeable, possibly weaken the entire system. If anything was learned from the woes of the recent financial crisis, uncertainty about the health and stability of large systemic intermediaries, when coupled with the concern about the adequate capitalization of institutions, can cause a shockingly rapid halt in funding markets, resulting in a diminished supply of credit to all healthy borrowers.

 Additionally, from a legal perspective, fallback language that is inadequate or completely absent creates uncertainty about the value of the underlying assets and will undoubtedly prompt a flood of lawsuits when the losing (and winning) parties of these contracts are ultimately discovered. To put a finer point on it, Michael Held, General Counsel of the Federal Reserve Bank of New York, exclaimed, “[y]ou can imagine the litigation risk when the reference rate for a 20-year contract disappears and there’s no clear path to replace it. Now imagine 190 trillion dollars’ worth of those contracts. This is a DEFCON 1 litigation event if I’ve ever seen one.”[7]

Numerous regulatory and governing bodies such as the ARRC, ISDA, and the Bank of England[8] have developed and published potential fallback language for LIBOR-linked cash products and derivative instruments. Both ISDA and the ARRC identified two distinct triggers where fallback language and replacement rates would be necessary, known as “permanent cessation” triggers and “pre-cessation” triggers. Permanent cessation triggers include an index cessation event where an IBOR becomes unavailable or permanently discontinued. While a pre-cessation trigger includes a scenario where a regulator announces that a specific IBOR is no longer representative of the underlying market.[9]

On April 25, 2019, the ARRC recommended contractual fallback language for both floating rate notes and syndicated loans.[10] The ARRC’s proposed fallback language for floating rate notes outlines numerous trigger events which will start the transition away from LIBOR. The ARRC has also provided a detailed “waterfall” approach to determine which SOFR-based successor rate and the required spread adjustment that would apply.[11] Similarly, the ARRC proposed two sets of fallback language for new originations of LIBOR-linked syndicated loans. The two approaches are aptly named the “hardwired approach” and the “amendment approach.”[12] Under a hardwired approach, the fallback language is included in the original contract, and on the occurrence of a triggering event, the waterfall mentioned above kicks in. Alternatively, the amendment approach provides a foundation for the parties to negotiate and mutually agree on which benchmark replacement should be used as well as the adjustments that should apply.

One thing distinctly absent from the ARRC’s announcement was any proposed fallbacks for derivatives, despite the original purpose of the ARRC, which was to develop the necessary benchmark transition for derivatives. Notably, the Financial Stability Board (FSB) has tasked ISDA with addressing fallbacks for derivatives on all IBORS. As a result, ISDA has simultaneously been conducting a consultation, which began in May 2019, and sought comment on how derivatives contracts should address both pre-cessation and cessation transitions and fallbacks, including, as mentioned above, a regulatory announcement that LIBOR is no longer representative of an underlying market.[13]

The fallback language and alternative rates that ISDA is developing, if implemented for, would transition derivatives contracts to designated alternative risk-free rates (RFRs) for all corresponding currency. For example, “sterling LIBOR contracts would fall back to SONIA, US dollar LIBOR to SOFR, yen LIBOR to TONA and Swiss franc LIBOR to SARON.”[14] On October 21, 2019, ISDA published a summary of their findings, which concluded that no consensus between market participants can be established. As a result, “ISDA will continue to work towards finding a solution for how to address a non-representative covered IBOR in derivatives documentation and how to implement a pre-cessation trigger for fallbacks in this scenario.”[15] However, market participants should not wait until an actual cessation occurs to begin addressing the issue. Proactively implementing adequate fallback language and alternative rates into both new issuances as well as outstanding instruments will undoubtedly mitigate their legal and financial exposure.[16]

In perhaps the most succinct legal analogy regarding the implementation of fallbacks in derivatives and financial products, Andrew Bailey, Chief Executive for the Financial Conduct Authority (FCA) equated fallbacks to wearing a seatbelt. “Fallback language to support contract continuity or enable conversion of contracts if LIBOR ceases is an essential safety net – a ‘seat belt’ in case of a crash when LIBOR reaches the end of the road. But fallbacks are not designed, and should not be relied upon, as the primary mechanism for transition. The wise driver steers a course to avoid a crash rather than relying on a seatbelt.”[17]

What is SOFR?

To take a step back, in June 2017, the ARRC formally recommended a new rate, which was proposed by the New York Fed working alongside the Treasury Department’s Office of Financial Research.[18] This new rate, called the Secured Overnight Financing Rate (SOFR), measures the cost of overnight borrowings through repo transactions collateralized with U.S. Treasury securities.[19] Therefore, SOFR addresses two of the pivotal shortcomings of LIBOR; it utilizes a market that is one of the deepest and liquid markets in the United States, and it is based on actual transactions that occur in the Treasury repo markets.[20]

Jerome Powell and Christopher Giancarlo made this exact point, noting that the choice of SOFR “resolves the central problem with LIBOR, because it will reflect actual market transactions currently reflecting roughly $800 billion in daily activity. That will make it far more robust than LIBOR.”[21] The CME further outlined the benefits of SOFR, namely that it reflects “a broad universe of overnight U.S. Treasury repo transaction activity, making it a benchmark for all seasons, regardless of future shifts in market preferences for bilateral versus tri-party repo.”[22]

Despite this encouraging progress, various issues still emain in finalizing the precise mechanism for integrating SOFR as a replacement for LIBOR. There are fundamental differences that will require tweaking in order to smooth the transition. One key issue is that the majority of linked contracts and derivatives reference either three or six-month LIBOR, with some products referencing longer tenors.[23] SOFR, by its very definition, is an “overnight rate” and therefore, there is no three-month or six-month SOFR.[24] However, as Michael Held pointed out, “Most users of SOFR don’t use a single day’s rate to determine their payments; they use average rates.”[25] So for now, SOFR's transition into filling the void that will be left by LIBOR appears to be steadily moving forward.

Final Thoughts  

           What will likely be seen decades from now as simply a legal and financial growing pain of the ever-complex global economy, the death of the London Interbank Offered Rate represents one of the most monumental legal challenges for today’s derivates and financial markets. From Vince Kasuga and the manipulation of the onion markets[26], to the manipulation of LIBOR rates, financial products and derivatives will forever provide ample incentive and opportunity for manipulation. The rigging scandal that rocked the banking markets only several years ago has provided a plethora of legal precedents, increased regulatory scrutiny, and decreased trust by many consumers. In this manner, the legal and regulatory landscape is merely a derivative itself of the financial markets and its participants. One that I am excited, humbled, and eager to be a small part of as I enter my legal career.

Appendix

The Current Panel Banks Breakdown is as follows:[27]

Global OTC Derivatives Market (billions)[28]

Credit Products that Reference Interest Rate Benchmarks[29]

(See Part 1) (See Part 2)

__________________________________________________________________________

*This paper was originally published on November 26, 2019, and subsequent events, regulatory developments, or enforcement actions may have taken place since it was written.

[1] See ARRC REPORT, supra part 1 note 1, at 4.

[2] For instance, over 40% of LIBOR-based residential mortgage loans currently outstanding extend past 2021. See Michael Held, supra part 1 note 36.

[3] See BANK OF INT’L SETTLEMENTS, supra part 1 note 19.

[4] According to the ARRC, some $38 trillion of existing contracts (as of end-2016) extend beyond 2021 (including $15 trillion that extend beyond 2025). See ARRC REPORT, supra part 1 note 1 at 2, Table 1.

[5] Philip Stafford, Libor Use on the Rise Despite Push for Benchmark Reform, FINANCIAL TIMES (Nov. 30, 2018), https://www.ft.com/content/b6fffeb2-f3eb-11e8-9623-d7f9881e729f.

[6] Michael Held, supra part 1 note 36.

[7] Id.

[8] The Bank of England, similar to the Federal Reserved, has established a working group known as The Working Group on Sterling Risk-Free Reference Rates, to develop and implement transition plans. See SIFMA, SIFMA INSIGHTS: SECURED OVERNIGHT FINANCING RATE (SOFR) PRIMER; THE TRANSITION AWAY FROM LIBOR, (2019) https://www.sifma.org/wp-content/uploads/2019/07/SIFMA-Insights-SOFR-Primer.pdf.

[9] See Press Release, Int’l Swaps and Derivatives Ass’n, ISDA Publishes Two Consultations on Benchmark Fallbacks (May 16, 2019), https://www.isda.org/2019/05/16/isda-publishes-two-consultations-on-benchmark-fallbacks/.

[10] See Press Release, The Alt. Reference Rates Comm., ARRC Recommendations Regarding More Robust Fallback Language for New Issuances of LIBOR Floating Rate Notes (Apr. 25, 2019), https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2019/FRN_Fallback_Language.pdf; Press Release, The Alt. Reference Rates Comm., ARRC Recommendations Regarding More Robust Fallback Language for New Originations of LIBOR Syndicated Loans (Apr. 25, 2019), https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2019/Syndicated_Loan_Fallback_Language.pdf.

[11] See id.

[12] Id.  

[13] INT’L SWAPS AND DERIVATIVE ASS’N, ISDA LIBOR FALLBACKS (2018), https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2018/ISDA-Fallback-Slides-ARRC-Roundtable.pdf.

[14] Int’l Swaps and Derivatives Ass’n., Bearing East, 5 IQ ISDA Q., 1, 47 (2019).

[15] See Press Release, Int’l Swaps and Derivatives Ass’n., ISDA Publishes Report Summarizing Results of Benchmark Fallbacks Consultation on Pre-cessation Issues (Oct. 21, 2019), https://www.isda.org/2019/10/21/isda-publishes-report-summarizing-results-of-benchmark-fallbacks-consultation-on-pre-cessation-issues/.

[16] Despite making the transition sound easy, changing an IBOR-linked contract to reference a new RFR is not as straightforward as just changing the language or rate. IBORs come in multiple tenors such as one, three, six and twelve months, while RFRs, on the other hand, are only available on an overnight basis. IBORs are also calculated to take into account credit risk and other factors, while RFRs do not. See Int’l Swaps and Derivatives Ass’n., Bearing East, 5 IQ ISDA Q., 1, 47 (2019).

[17] Id. at 46-7.

[18] See Press Release, The Alt. Reference Rates Comm., The ARRC Selects a Broad Repo Rate as its Preferred Alternative Reference Rate (Jun. 22, 2017), https://www.newyorkfed.org/medialibrary/microsites/arrc/files/2017/ARRC-press-release-Jun-22-2017.pdf.

[19] The SOFR is published for each U.S. government securities market business day, usually before 8:00 a.m. (ET). The SOFR is published by the Federal Reserve Bank of New York in cooperation with the U.S. Treasury Office of Financial Research. CME GROUP, INTRODUCTION TO SOFR, https://www.cmegroup.com/education/courses/introduction-to-sofr/what-is-sofr.html (last visited Oct. 28, 2019).

[20] See The Alt. Reference Rates Comm., supra note 10.

[21] Jerome Powell and J. Christopher Giancarlo, How to Fix Libor Pains, WALL STREET JOURNAL, (Aug. 3, 2017) https://www.wsj.com/articles/how-to-fix-libor-pains-1501801028. 

[22] See CME GROUP, supra note 19.

[23] Mortgages regularly reference one-year LIBOR.

[24] Michael Held, supra part 1 note 36.

[25] Id.

[26] See Kosuga v. Kelly, 257 F.2d 48, 51 (7th Cir. 1958).

[27] SIFMA, SIFMA INSIGHTS: SECURED OVERNIGHT FINANCING RATE (SOFR) PRIMER; THE TRANSITION AWAY FROM LIBOR, (2019) https://www.sifma.org/wp-content/uploads/2019/07/SIFMA-Insights-SOFR-Primer.pdf.

[28] See Int’l Swaps and Derivatives Ass’n, Key Trends in the Size and Composition of OTC Derivatives Markets (May 20, 2019), https://www.isda.org/2019/05/20/key-trends-in-the-size-and-composition-of-otc-derivatives-markets-2/.

[29] See 2014 FSB REPORT, supra part 1 note 9.