Best practice: Libor legacy products

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The FCA’s July 2017 announcement that panel banks would no longer be compelled to submit their rates after the end of 2021 has thrown the industry into a state of profound unease.

At the heart of the debate is the question of how to deal with the incredibly high number of legacy products. These are Libor-tied products whose lives extend beyond the end-2021 Libor discontinuation date. It is here where risk is most concentrated and here where battle-lines are most likely to be drawn.

Broadly speaking, considerations of the risks attached to legacy products may fall into four (interlocking) categories: product complexity, infrastructure, client impact and litigation risk. Practice Insight has already revealed the danger posed by certain US hedge funds, who may be inclined to buy up legacy floating rate notes on the cheap and then act as holdouts.

See also: Hong Kong market demands consensus on Honia

“When you try to rank products in terms of difficulty to transition, you cannot use purely a product lens, you need to apply a customer lens as well,” said EY’s Ibor lead Shankar Mukherjee. “In addition, banks are also thinking about implementation issues. It's not just a matter of changing the products themselves. What is very often harder for banks to do is change the front-to-back infrastructure.”

Mukherjee stressed that the legacy infrastructure, especially the banking book, was inefficient. He also said that less sophisticated clients added an extra level of complication.

“There is a potential conduct and selling risk in making any changes to the contract,” he added. “While the underlying product may be simple, the associated counterparty and legal conduct risk make it harder for the banks to execute.”

Practice Insight, in consultation with EY, has ranked Libor legacy products according to the four categories. Five contains the most risk, and one the least risk.

This is, of course, an approximate guide. Each product contains its own unique set of challenges and there is by no means a one-size-fits-all approach even within the same product class.

There is no easy rank order.

Product complexity: how complex it is to change the terms of products to risk-free rates (RFRs)

Infrastructure challenges: how difficult it is to change systems, models, processes associated with the product

Client impact: how difficult it is not to leave the clients worse off

Litigation risk: the likelihood of facing disputes and legal challenges

See also: Ford leverages position to support transition from Ibors

Securitisations

Product complexity: 2/5

Infrastructure challenges: 2/5 

Client impact: 1/5

Litigation risk: 3/5

TOTAL: 8/20

The fact that securitisation clients are sophisticated investors pushing for transition eases the risks associated with this famously complex product.

Banking sources have also told Practice Insight that securitisations are moving up in prioritisation because the market is moving on.

But that does not mean there are no risks, as ICMA's Katie Kelly explains: "Securitisations have many more complexities than bonds. The plumbing for the consent solicitation is the same, but there are many more parties in a securitisation transaction; there is a subordination structure within the securitisation itself, and there are credit rating agencies ratings to take into account. There may even be a dormant or non-engaged issuer, and consent of holders of all different tranches within the securitisation may be required to effect the amendment."

Securitisations also amortise, meaning the principle amount outstanding pays down over the life of the transaction. The amount outstanding today could be different in two years' time. Itis therefore harder to estimate accurately the amount of legacy securitisation contracts.

"It now appears that securitisation is one of the biggest markets of legacy floating rate notes," said one European banker.

See also: Investors approve first ever amendment to Libor legacy bond

Loans

Product complexity: 5/5

Infrastructure challenges: 4/5      

Client impact: 4/5                              

Litigation risk: 3/5

TOTAL: 16/20

Loans face significant infrastructure and client impact issues. The loan market is also a long way behind other products.

Mukherjee stressed the problems faced by loans: "I was talking to one global bank recently and they said that cash management was the hardest thing to do because the infrastructure is so antiquated and they were operating in 50 countries. They said they needed to change the system, retrain people and change the associated offices. Maybe it's a simple product, but the execution is very difficult."

The millions of outstanding retail mortgages adds an extra ‘unsophisticated’ twist to the legacy loan conundrum. The potential for value transfer when transitioning to the new RFR, together with a whole class of unsophisticated investors who may not understand the changes, could mean massive costs for firms.

"When you're dealing with retail mortgages, if you're changing to Sonia, it may be fair to add extra basis points to account for the difference in the rates, but are you actually going to be able to do that?" one banking source said. "To avoid litigation risk if affected counterparties complain, the bank may wish to cover the extra basis points themselves."

The banking source said this was currently a key talking point in the industry.

Loans also carry a reversionary rate risk. "It's a monster issue trying to figure out how you deal with retail mortgages and reversionary rates," said the source. "The majority of mortgages begin at fixed and then go to floating rate. Banks have huge parties looking at that."

The consensus was that loans are generally harder than bonds.

"The banks invented Libor because they wanted something that included their own credit," a second banking source said. "Sonia doesn’t include bank credit. So for the bank market, if they accept Sonia, they need to figure out a way of pricing in the additional credit spread."

Bonds

Product complexity: 3/5      

Infrastructure challenges: 3/5                              

Client impact: 3/5      

Litigation risk: 5/5

TOTAL: 14/20

Bonds contain high levels of litigation risk. As the market moves closer to the 2021 deadline, liquidity should begin to build in RFRs and subsequently decline in Libor-tied notes.

This could mean that Libor legacy contracts decline in value, creating a situation where investors are looking to offload their positions. If hedge funds are willing to take the risk, they could buy these notes up on the cheap and then act as holdouts further down the line.

Owing to the complex nature of international securities infrastructure, it is often difficult for banks and issuers to know the identity of the end-investor.

Litigation risk is particularly concentrated in the US. New York law is more stringent than English law, which means the contracts will be difficult, perhaps impossible to amend. US culture also has a massive appetite for litigation. Litigation funds have mushroomed in recent years; an increase in appetite for risk accompanies such growth.

Michael Held,  general counsel and executive vice president of the legal group at the Federal Reserve Bank of New York, recently called Libor transitioning a "DEFCON 1 litigation event". Bonds and loans look especially vulnerable.

"The ABP bond amendment was a big tick," said a liability management source. "Yes, we've done one. We can do more. However, the concerns we've come across are mainly infrastructure concerns. There are hundreds of legacy bonds out there, but the process takes time and there is administration cost."

The consensus was that the consent solicitation route should not be the sole route, if only for the fact that the liability management industry is not equipped to deal with the sheer volume of amendments in the coming months.

The hope is that the process may become more ‘streamlined and industrialised’ once momentum builds behind the transitioning process and more issuers follow ABP's lead. On this point, Mukherjee struck an optimistic note. He suggested that there was a clear commercial incentive to support amendments because investors would not want to be left holding illiquid Libor legacy bonds.

One recalls that the Woodford fund is wobbling not because the underlying assets are fundamentally bad, but because they are illiquid.

Derivatives

Product complexity: 2/5

Infrastructure challenges: 3/5

Client impact: 3/5

Litigation risk: 3/5

TOTAL: 11/20

Derivatives are generally perceived as leading the legacy charge, thanks to the International Swaps and Derivatives Association (Isda) protocols. However, like all products, there is still risk attached to the transition.

The Isda protocols may provide a standardised approach, and enable whole batches of derivatives to be moved over to RFRs in one go, but derivatives also have a tail of less sophisticated clients who may not support the changes.

As for infrastructure challenges, while complexity is low-to-medium, volume is high and models are complex; hence the three out of five scoring.

Linear products will be easier than non-linear products to shift onto the RFRs.

"Isda has proposed a clear trigger and fallback on a permanent discontinuation of Libor, and further consultations are underway," said Kelly. "This can all be implemented into derivatives contracts by way of protocol."

If the protocol is adhered to between parties, it applies automatically to all associated derivatives transaction between those parties, so individual amendments by way of something like consent solicitation are not required.

In principle, derivatives are easier to amend, although the details are still under consultation and so not yet finalised.

Bhas Nalabothula, head of European interest rate derivatives at Tradeweb, said: "On the derivatives side, the market still has a lot to do, but there are mechanisms, such as the Isda fallbacks that are being determined and defined, that will be a unified way for the market to transition when Libor ceases to exist."

He added, "Transitioning activity in the derivatives space is intermittent. This is because clients are doing it at their own pace. It's really client by client dependent."

See also: How regulators can mitigate Libor litigation risk

See also: Libor fallbacks still not aligned across products

See also: Funds keep cards close to chest on post-Libor litigation